Which Plan Meets a Client's Needs?

There are many types of deferred compensation plans. Each is designed to meet specific needs of an employer and its key employees. The role of the financial services professional is to help the employer assess its needs and match them to the appropriate plan.  

The primary deferred compensation plan types are:

Top Hat or deferred bonus plans;
Supplemental Executive Retirement Plans (SERPs); and
Excess Benefit Plans.

 Top Hat Plans (Deferred Bonus Plans)

A top hat plan is maintained by an employer primarily to provide deferred compensation for a select group of management or highly compensated employees.  The term "top hat" refers to the formal hats worn by business executives in the late 19th and early 20th centuries and by inference, to the primary prospects for these plans, namely, key business executives.  

Under a top hat plan, executives forgo receipt of currently-earned compensation, such as a portion of salary, commissions, or bonuses, and direct these funds to be paid out at retirement. These plans are typically set up as defined contribution plans. That is, the amount of income that is deferred and its investment gain are credited to an account set up for the executive. The executive's benefit is an aggregate amount of all contributions and earnings.

The employer may initiate these plans as a perk or at the request of the executive during employment contract negotiations.

 Supplemental Executive Retirement Plan

A supplemental executive retirement plan (SERP) is the most popular type of nonqualified deferred compensation plan. A SERP satisfies the employer's objective of enhancing executive retirement benefits and is often provided as a supplement to an existing qualified plan.

Like the top hat plan, the employer maintains a SERP primarily for the purpose of providing deferred compensation (in this case not a deferred salary but rather a deferred benefit) for a select group of management or highly compensated employees. However, unlike a top hat plan the plan participant is not required to forgo any current compensation.

At bottom, the difference between "top hats" and SERPs is whose money is funding the plan benefits. In a top hat" plan, the employee defers current compensation (a bonus or salary) into the plan to fund future benefits, in a SERP, the employer promises to fund eventual benefit payments.

 Excess Benefit Plan

An excess benefit plan is used for executives who are already maxed out under their employer's qualified retirement plan. This may not occur until the employee receives payment. An excess benefit plan satisfies the employer objective of exceeding the maximum contribution and benefit limits for qualified plans-the so-called Code Section 415 limits.

The Section 415 limits for qualified plans differ depending on whether the qualified plan is a defined benefit plan, a defined contribution plan or a combination plan. The maximum benefit for a defined benefit plan in year 2007 is 100% of income up to $180,000 (this dollar amount is indexed annually for inflation).

The contribution limit for a defined contribution plan in 2007 is the lesser of 100% percent of salary, or $45,000 (this dollar amount is indexed annually for inflation). The limit for a combination plan is slightly greater than the limit available under either plan. The combined plan limit is reduced if a plan is deemed a top heavy plan (as are most small employer plans).  

Regardless of how a deferred compensation plan is structured is intended to accomplish two important functions:

To provide a benefit to the participant at some time in the future, and
To avoid income taxation on that future benefit until it is actually received

Overview of Taxation

For the participating key executive to avoid current income tax liability arising out of the deferred compensation arrangement, the promised benefits must not be secured in any way.

Understandably, this lack of security may be a cause of concern to a deferred compensation plan participant.  To overcome this concern regarding the insecurity of promised deferred compensation benefits, two important trusts have been developed: rabbi trusts and secular trusts.  These trusts and their impact on the taxability of benefits are discussed in detail later in the course.

Two income tax concepts are particularly pertinent to understanding how deferred compensation plans operate:

the constructive receipt doctrine; and
the economic benefit doctrine.

Constructive Receipt Doctrine

The constructive receipt doctrine states that income that is not actually received may be taxed as if it had been received, if the individual constructively received the income. Constructive receipt occurs when income is

set aside for the individual;
credited to the individual's account; or
made available to the individual without any substantial restrictions on the individual's control over the income.

Economic Benefit Doctrine

The economic benefit doctrine requires that an individual recognize income if property has been handled in a way that provides a cash-equivalent economic benefit to the individual.

Fortunately for deferred compensation purposes, a mere unsecured promise to pay income in the future does not constitute constructive receipt, provided the employee does not have access to the compensation that has been deferred.   As a result, when properly set up, a deferred compensation plan usually will not result in current taxable income to the employee.   ..... for a more detailed discussion of Taxation