Deferred Compensation Plans – Common Types

Deferred compensation plans are used by businesses to compensate and incentivize their employees without offering the employees equity ownership in the business. A deferred compensation plan for an executive allows the business to retain talent by compensating the executive over a longer period of time such as during their retirement.

The following are some common types of deferred compensation plans:

Phantom Share Plan

  • Imitates equity ownership by issuing ‘shares’ that have a value connected to the fair market value of the outstanding stock of the company
  • Phantom ‘shares’ can be issued pro-rata to employees or can be tied to productivity; vesting is usually by meeting performance standards or over a certain length of time
  • The value of the phantom shares increase or decrease together with the fair market value of the business
  • Payments tied to the phantom shares are forfeited if the employee leaves prior to the occurrence of a payment trigger
  • Typical payment triggers are the sale of the business, retirement, death or disability and payment on a certain future date
  • The amount of the payment received is equal to the per-share value of the company on the trigger date
  • Employer receives no income tax deduction until a payment is made to employee; employee defers income tax until payment is received or the date the payment is not subject to forfeiture by employee

Long Term Incentive Plan

  • Rewards employee performance; not connected to the financial success of the company or the fair market value of the company stock
  • Typically paid over a period of 3-5 years; can be very structured with complicated payment schedules
  • No vesting; employees must be employed on December 31 of the year in which performance is measured to receive plan payments; payment forfeited if not employed on December 31
  • Payment equal to a percentage of employee’s regular salary
  • Employer receives income tax deduction when payment is made to employee; employee incurs income tax upon receipt of payment

Nonqualified Deferred Compensation Plan

  • Non-qualified plans avoid limitations placed on other types of qualified retirement accounts such as 401k
  • Non-qualified plans may limit participation to certain executives, make larger contributions and require longer vesting periods than qualified plans
  • Employee may defer income tax over a longer period of time as payments to employee are deferred
  • Appealing option for employees who have maxed out their contributions to qualified plans
  • Business segregates funds to pay awards; funds remain subject to creditors of the business and therefore subject to a substantial risk of forfeiture; resulting in no income tax due to employee on the award of deferred compensation
  • Vesting periods can be a substantial length of time (15 years)
  • Payments can be accelerated if there is a change of control event
  • Typical payment triggers are the later of two events: a fixed date, retirement, death, disability, change in control, termination of services
  • Payment amount is equal to a set formula which the business uses to make annual contributions of cash to the plan
  • Payment is generally in the form of an annuity or a lump sum; employee has the option to choose the form of payment
  • Employers can not deduct amounts contributed to the plan and payments are not subject to income tax by employee until they are distributed; however the employee is required to pay FICA taxes up and until payment is received

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