Chapter 2 Review

Although the adequacy of capitalization and the desirability of products or services are important factors in the success of any business, it is the drive and imagination of the firm's management that account for the bulk of its profits.  In short, it is the business' ability to attract and retain key executives that is often essential to its success.  Nonqualified plans -- particularly deferred compensation plans -- may be instrumental in enabling a business to attract and retain those high-impact executives.

While nonqualified deferred compensation plans are often discussed as though they were all of a single type, "deferred compensation plan" is a more generic term that includes true deferred compensation plans as well as salary continuation plans; the principal difference in these plan types derives from whose money -- the employer's or the employee's -- funds the benefits.  These plans generally provide an array of highly selective executive benefits including retirement benefits, pre-retirement survivor benefits and disability benefits.

Nonqualified deferred compensation plans may be designed according to a defined benefit or a defined contribution model, somewhat similar in that respect to qualified plans.  Salary continuation plans are generally defined benefit in design, while true deferral plans tend to be of the defined contribution type.

Plan benefits are normally provided in nonqualified deferred compensation plans to a small group of highly compensated key employees; as such, these plans are discriminatory in nature.  They may be funded or unfunded, depending upon whether or not specific assets are allocated to provided the promised benefits.  Funded plan benefits are shielded from the claims of the employer's creditors and provide no tax-deferral benefits for the executive participant.  Plans that are considered unfunded plans, however, may be supported by the purchase of a particular asset, i.e. they may be informally funded and still provide tax-deferral as long as the assets supporting the benefits may be attached by the employer's creditors.

Life insurance is often seen as the most desirable informal funding vehicle for nonqualified deferred compensation plans.  Its use provides tax benefits to the employer and the opportunity to recover plan costs.  Although any type of permanent life insurance may usually be used to informally fund the plan benefits, universal life insurance is often desired because of its premium flexibility and easy access to the policy's cash value.   

Nonqualified deferred compensation plan benefits may be secured against a successor management's decision to withhold them through the use of a rabbi trust.  This trust provides a level of protection for plan benefits, but, since the trust assets are attachable by creditors, the approach still gives the executive participant the benefit of tax deferral.  A secular trust, in contrast, offers more significant protection for plan benefits by shielding them from both a decision by management to withhold them and the employer's general creditors in the case of insolvency or bankruptcy.  This protection, however, comes at a price: that price is the loss of tax deferral by the executive.   

Chapter 2 Review Questions

All of the following benefits are frequently included in a deferred compensation plan EXCEPT:

A.     retirement benefits
B.     medical reimbursement benefits
C.     disability benefits
D.     pre-retirement survivor benefits

What is the normal tax treatment of survivor benefits received under a deferred compensation plan?

A.     Survivor benefits are always tax-free
B.     Survivor benefits are subject to capital gain taxation
C.     Survivor benefits are income taxable up to the policy’s cash value
D.     Survivor benefits are fully taxable as income

Which of the following organizations may NOT establish a deferred compensation plan for an executive?

A.     A regular corporation
B.     An S corporation
C.     A sole proprietorship
D.     Regular corporations, S corporations and sole proprietorships may all establish deferred compensation plans for executives

All of the following would be reasons for an executive in a close corporation to prefer a deferred compensation plan rather than an ownership stake EXCEPT:

A.     Lack of a ready market in which to sell shares
B.     Deferred compensation plans normally give participants vested interests
C.     Restrictions on the right to sell shares
D.     A desire on the part of the owners to limit ownership

Which of the following trusts exempts certain deferred compensation assets from being attached by an employer’s creditors?

A.     Rabbi trust
B.     Secular trust
C.     Grantor retained income trust
D.     Secular trust