Compensation Planning: Current vs. Deferred Salary

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1 Current vs. Deferred Salary S\W Framework as Applied to Compensation Planning Consider all parties Identify alternatives that leave either party indifferent (mutually preferred contract) Compare after tax profitability or cost across alternatives Select the best alternative

2 Current vs. Deferred Salary Assume: Salary or Bonus = $10,000 = BTCF Employer s Tax Rate =.3 = t co = t cn Employee s Tax Rate =.4 = t po =t pn Employer s r c =.1 Employee s r p =.05 Current Salary Employee s after tax benefit = 10,000(1-.4) = $6000 Employer s after-tax cost = 10,000(1-.3) = $7000

3 Current vs. Deferred Salary Deferred Salary Employer s Perspective: Suppose salary is deferred for 10 years. What is the future value of the unpaid salary to the company after 10 years? = BTCF(1 - t co ) (1 + r cn ) n = 10,000(1 -.3)(1.1) 10 = 18,156 Let D n = Deferred Salary; then D n (1-t cn ) = After-tax cost of deferred salary paid at time n

4 Current vs. Deferred Salary Employer s Perspective Continued: Set the after-tax cost of Salary equal to the after-tax cost of Deferred Compensation (both stated in terms of future dollars): Future cost of Salary Future Cost of Deferred Compensation BTCF(1 - t co ) (1 + r c ) n = D n (1 - t cn ) 18,156 = D n (1-.3) = $25,937 Employer is indifferent between paying $10,000 now or $25,937 ten years from now.

5 Current vs. Deferred Salary Employer s Perspective Continued: To solve for Dn : D n = BTCF (1 + r c ) n [(1 - t co ) / (1 - t cn )] Employee s Perspective: For the employee, what is the future value of receiving salary currently? BTCF (1 - t po ) (1 + r p ) n 10,000(1 -.4) (1.05) 10 = 9,773

6 Current vs. Deferred Salary Employee s Perspective Continued: What is the future value of deferred salary for the employee assuming t pn is constant? Dn(1-t pn ) 25,937(1-.4) = $15, 562 Wow! It s obvious what the employee should do, but why? r c > r p and t 0 =t n for both parties Note: This problem assumes tax rates are constant over time. Let s see how to relax that assumption.

7 Current vs. Deferred Salary General Observations: Employer is indifferent between current salary and D n = BTCF (1 + r c ) n [(1 - t co ) / (1 - t cn ) ] (1) What happens as t cn increases relative to t co? Employee: FV of Salary BTCF (1 - t po ) (1 + r p ) n (2) Deferred Salary D n (1-t pn ) (3) Current Salary is preferred when: (2) > (3) Substituting the equation (1) above for D n in equation (3) and rearranging gives:

8 Current vs. Deferred Salary General Observations Continued: Current Salary is preferred when: [(1 - t po ) / (1 - t pn )] X [(1 + r p ) n / (1 + r c ) n ] > [(1 - t co ) / (1 - t cn )] Change in employee s relative tax rates? Change in employer s tax rates? Relationship between r c and r p?

9 Salary vs. Pension Assume same facts as before. Decide between current salary or pension. Employer s Perspective: Employer is indifferent across either alternative. After tax cost is $7,000. Why? Employee s Perspective: After-tax future value of pension = BTCF (1 - t pn ) (1 + R c ) n where R c = % = $22,807 Remember the after-tax future value of salary was $9,773

10 Salary vs. Pension In general, the employee s after tax accumulation from either $1 of salary or pension plan contribution will be: Pension: (1 - t pn ) (1 + R c ) n Salary: (1 - t po ) (1 + r p ) n Pensions preferred to salary when: (1 - t pn ) (1 + R c ) n > (1 - t po ) (1 + r p ) n or when: (1 + R c ) n > (1 - t po ) (1 + r p ) n (1 - t pn ) How does preference for pensions vs current salary change as tax rates for the employee rise or fall? As r p increase relative to R c? Could that ever happen?

11 Deferred Comp vs. Pension In general, for each dollar of current salary sacrificed, deferred compensation will be worth the following after-tax amount: (1 - t co ) (1 + r c ) n (1 - t pn ) (1) (1 - t cn ) Each dollar contributed to a pension plan would yield: (1 - t pn ) (1 + R c ) n (2) Deferred Compensation is preferred to Pension when (1) > (2) or: or when: (1 - t co ) > (1 + R c ) n (1 - t cn ) (1 + r c ) n Implications if tax rates expected to increase?

12 Compensation Planning In another textbook, the following statement is made: "Few tax advisers would disagree with the following preference rankings for compensation arrangements." Preference Ranking Tax Effect to Employer Current deduction Current deduction Current deduction Deferred deduction No deduction Tax Effect to Employee No income recognition Deferred income Current income Deferred income Income recognition Do you agree with these rankings? What assumptions are implied by these rankings?

13 Compensation Planning Corporation Summary Employee $10,000 Salary $9,773 $25,937 Deferred $15,562 $10,000 Pension $22,807 Why is the pension superior in this instance? Contribution is pre-tax, earnings compound at R instead of r, and tax rate was stable. So why would a company and/or employee opt for the deferral option?

14 Other Issues Pension assets are not liquid. Withdrawal penalty applies until age Non-discrimination rules of pension plans require broad coverage. Can t target selected individuals. Administrative cost for pensions are high. Amount of pension plan contributions are constrained by law. In deferred compensation programs, the employee becomes an unsecured creditor of the firm. For startup firms with cash flow constraints, deferred comp may be useful especially since their tax rates will almost certainly rise.

15 Questions How does the use of insurance policies to fund deferred compensation affect the analysis? How do deduction limits on executive salary affect employers incentives to defer compensation? In general, when does deferred compensation make sense? Is deferred compensation really at risk? Other non-tax costs associated with deferred comp? Any non-tax benefits? Is deferred comp really as bad as the articles suggest? Was John Welch s deferred comp contract with GE mutually beneficial?

16 Compensation Comparisons ISO s vs. NQO s vs. SAR s Tax Cost to Employee and Tax Benefit to Employer Grant Exercise Sell Stock Price $10/share $20/share $30/share ISO s Employee $0 $0 -$20g Employer $0 $0 $0 NQO s Employee $0 -$10t e -$10g Employer $0 $10t c $0 SAR s Employee $0 -$10t e -$10t e Employer $0 $10t c $10t c Where t e is the employee s tax rate, t c is the employer s tax rate, and g is the employee s capital gains rate. Thought Questions: 1. If we assume t c is greater than or equal to t e, then which of the three alternative forms of compensation dominates from a pure tax perspective (remember to consider all parties)? How do the financial reporting rules seem to affect the decision? 2. Before the Tax Reform Act of 86 t e =.50 and g =.20. After the Tax Reform Act of 86 t e =.28 and g =.28. How did this Act affect the relative attractiveness of ISO s and NQO s?

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