Deferred Compensation Plan Eligibility
The type of organizations that can, and do, install deferred compensation plans is broad. In fact, it is difficult to review the balance sheet of any substantial corporation and fail to find a note referencing an existing deferred compensation plan. Although the reasons for establishing these plans may be the same regardless of the type of organization, certain types of organizations have very special reasons.
A public corporation is a corporation whose shares of stock are readily available to the general public and are bought and sold in the open market. Although the names of certain giants come to mind when we think of public corporations -- names such as IBM, AT&T and General Motors, for example -- this category includes firms that are far less visible and that may also be less responsive to stockholders.
In order to put some restraints on the large compensation packages that certain public corporations were awarding their senior executives, Congress amended the Internal Revenue Code in 1993 to add §162(m) that generally limits the tax-deductibility of certain executive compensation to no more than $1 million.
Non-deductibility of Excessive Employee Compensation
Sec. 162. Trade or business expenses TITLE 26, Subtitle A, CHAPTER 1, Subchapter B, PART VI, Sec. 162 STATUTE (m)
Certain excessive employee remuneration
(1) In general In the case of any publicly held corporation, no deduction shall be allowed under this chapter for applicable employee remuneration with respect to any covered employee to the extent that the amount of such remuneration for the taxable year with respect to such employee exceeds $1,000,000.
This IRC change generally makes the compensation that exceeds $1 million for these individuals more expensive. Not surprisingly, some of these organizations have looked to deferred compensation plans as a means of appropriately rewarding their senior executives.
Public corporations also employ deferred compensation plans as a way to attract and retain key executives -- motivations that are very common in other organizations.
Closely Held Corporations
Closely held corporations generally avoid some of the restraints that normally apply to public corporations, such as the non-deductibility of certain executive compensation under IRC §162(m). These organizations, however, have their own reasons for using deferred compensation in their executive pay packages. Chief among the reasons for establishing a deferred compensation plan is the desire to attract key executives and, once hired, to provide incentive for them to remain with the organization.
Although a closely held corporation may have resources that rival those of a giant public corporation, that is not usually the case. It is more likely that such organizations are unable and unwilling to provide the level of compensation and employee benefits normally associated with large public corporations. They may be able to afford significant benefits packages, however, as long as those benefits are selective. In simpler terms, they may be willing and able to offer one individual a generous salary and benefits arrangement but not be able or willing to provide it to all employees. It is in this kind of setting that nonqualified plans -- particularly deferred compensation plans -- have an important niche.
It isn't only the organization's needs, however, that may provide the motivation for installing a deferred compensation plan. Senior executives also have an important voice in the matter. As a result, it is not unusual for a senior executive to try to design his or her compensation arrangement to offer both:
Current income tax relief, and
Supplemental retirement income
An executive in the top tax bracket could easily be taxed at a combined state and federal marginal income tax rate of 40 percent on the next dollar earned. By delaying receipt of income to a time when his or her marginal tax rate is lower, the executive may be able to avoid a considerable amount of income tax. Deferred compensation plans allow the executive to accomplish that. In addition, that deferred income may substantially increase the executive's income during retirement.
It isn't only corporations, whether public or closely held, that may install and benefit from a deferred compensation plan. Sole proprietorships, partnerships and limited liability companies may also receive benefits from such a plan. Although owners of these organizations won't enjoy the tax benefits of deferred compensation, the organizations can use these plans to attract and retain non-owner executives.