Client Letter: Compensating Key Employees

05 Jan

Dear Client:

Clearly, one of the most important factors in attracting and holding key employees is your company’s program for compensating executives. Naturally, the basic salary is of great importance, but equally important may be special plans of incentive compensation; plans for allowing executives to participate in the ownership of the company through stock options, stock bonuses and other stock-acquiring arrangements; and special plans for deferring compensation. For this reason, many special devices have been developed to compensate the executive.

There are three basic types of benefits currently in use for compensating the executive. These are direct compensation; perks or non-cash fringe benefits; and deferred compensation plans. There are basic differences among these three major types of executive compensation, including their respective tax implications for you, as the employer, and the employee.

Direct compensation. As its name implies, direct compensation is comprised of immediate pay to executives in the form of salary, cash bonuses and qualified stock bonus plans. Direct compensation differs from fringe benefits in that it typically involves cash payments or other evidences of indebtedness to the executive that can be readily negotiated or sold for cash. Direct compensation also differs from deferred compensation in that its impact is immediate (or within a year’s time) rather than delayed until some future date. Generally, executives must recognize income in the year they receive direct compensation, and employers can deduct corresponding amounts in the year they pay direct compensation.

“Perks” or non-cash fringe benefits. Perks are those benefits that most employees think of as being fringe benefits. Thus, the perks that an employer may provide its employees consist of such non-cash benefits as company cars, exercise facilities and employee cafeterias. In the context of executive compensation, however, directors, officers, and managers have come to expect perks “above-and-beyond” those available to the average employee. Therefore, many companies have developed executive perks that consist of such “extra” benefits as chauffeured limousine services, use of corporate stadium skyboxes, and expenses-paid attendance at trade or professional conventions.

Perks tend to differ from direct compensation in that they typically involve the use of employer-provided facilities or reimbursement of employer-induced expenses rather than the payment of cash or its equivalent. Like direct compensation and unlike deferred compensation, perks provide an immediate economic and financial benefit to participating employees. Generally, the Internal Revenue Code provides that all perks are taxable as wages to participating employees unless the perk is specifically exempted from taxation.

Deferred compensation. Deferred compensation refers to what would otherwise be direct compensation or a perk (i.e., fringe benefit); except that it is so structured as to postpone receipt of a portion of an executive’s taxable compensation until sometime after it has been earned by the executive. Conceptually, deferred compensation plans are a type of benefit located midway between the immediate benefits of direct compensation and perks, and the long-range benefits bestowed under a retirement plan.

A common aim of a deferred compensation plan is to shift otherwise taxable compensation into a future year and, thus, defer, if not reduce, the income tax that would otherwise be paid to the IRS. For example, the deferral of income may be for a fixed period of time or until the executive has satisfied obligations to the company. Deferral of taxable income depends, however, on whether a specific provision in the tax code permits such deferral relative to a given form of deferred compensation and upon what conditions. Types of deferred compensation include deferred bonuses, stock options, and the so-called golden parachute payments.

Because qualified deferred compensation plans lose favorable tax treatment if they do not met nondiscrimination rules, few, if any, such plans are designed to provide executives with special treatment or benefits. However, a key means by which companies can attract and retain top executive employees is a nonqualified deferred compensation plan. By providing executive compensation through a nonqualified plan, employers can effectively furnish benefits to key employees beyond the benefits typically available to non-management personnel.

Nonqualified plans offer flexibility and ease in administration. However, benefits under a nonqualified plan are also not guaranteed and, therefore give employees less security than benefits provided by a qualified plan. In addition, nonqualified plans are subject to election, distribution and funding rules.

Individuals who defer compensation under plans that fail to comply with these rules are subject to current taxation on all deferrals and to enhanced penalties. Specifically, compensation deferred under nonqualified plans that do not satisfy the requirements, is subject to tax (and interest and penalties) in the year of the deferral, to the extent not subject to a substantial risk of forfeiture and not previously included in income. Therefore, these plans must be designed carefully to avoid the loss of any possible tax deferral.

Considering the importance of a quality compensation plan to retaining key employees, it is essential that a plan be well thought out. We can assist you in developing a plan that will meet your needs and reduce your tax burden. Please call our office at your convenience to arrange an appointment.

Sincerely yours,

Sal Censoprano, ATA CRTP

Reproduced with permission from CCH’s Client Letter, published and copyrighted by CCH Incorporated, 2700 Lake Cook Road, Riverwoods, IL 60015.

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