The Fiduciary and Financial Risks of Deferred Compensation for Executives Hans J. Schreiber, CFP, CTFA, Senior Vice President Phillip Long, J.D., Vice President Overview What is Executive Compensation? What do Employees Want from the Plans? What Are the Risk to Employers? 2 1
What is Executive Compensation? What do Executive Compensation Plans Offer? Allows a Promise of Compensation Without Current Taxation Allows Employers to Contribute Above Benefits Usual Contribution Limits Generally Less Testing than Traditional Retirement Plans Do Not Have to Require Immediate Funding Not Subject to Most of ERISA When Properly Designed 4 2
Qualified Plan/403(b)/457(b) Are Not Executive Compensation Annual Deferral Limit Annual Contribution Limit Testing Limits 5 Potential Executive Compensation Plan Design Defined Contribution Plans Employee Deferral Plans Phantom Stock/Shadow Equity Plans Defined Benefit Plan Stock Plans 6 3
Employer Form Dictates Design Regulations Private, For Profit Governmental Churches Nonprofits 409A Limited to select group of HCEs/mgmt Securities Laws 457(f) Can be open to all employees State Laws 409A. Cannot have 457 plans. Can be open to all employees State Laws? Must be 457(b) or 457(f) plus 409A Limited to a select group of HCEs/mgmt 7 Executive Compensation Versus Usual Retirement Plans Contribute to Plan: Employer or Employee OR Independent Contractor in some cases decide on whether to contribute. Specific timing rules apply in deciding when to contribute. Contribute to Plan: Employer or Employee decide on whether to contribute. Timing rules are relatively liberal. When Benefit Paid: Plan document dictates the benefit terms (when paid, how paid, etc.) Limited opportunity to choose or alter when benefit paid. When Benefit Paid: Plan document dictates the benefit terms (when may paid, how paid, etc.) Employee can have much discretion on when the benefit is paid (and is taxed). Payment Security: Cash benefits paid to the employee generally from Employer s general assets. Employee has limited security. Cash payment is treated as wages for employees or as ordinary payments to independent contractors. Stock plans may have different taxation. Payment Security: Benefit is paid from a trust or custodial account. Employee s benefit is protected from creditors. Payment is taxed as a retirement payment (e.g., no FICA, FUTA). 8 4
General Taxation Rules of Executive Compensation Non 457 Plans No taxation when deferred if 409A complied with FICA taxes due under special timing rule Income tax due at payment (unless 409A violated) 457 Plans Generally 457(f) No taxation when deferred if 409A complied with FICA and income tax due at lapse of substantial risk of forfeiture 9 FICA Special Timing FICA taxes, the special timing rule treats as wages amounts deferred under a nonqualified plan as of the later of (i) the date on which the services are performed; or (ii) the date on which the employee s right to the deferred compensation is no longer subject to a substantial risk of forfeiture (vests). 10 5
What do Employees Want? Participants Generally Want to Avoid Risk of Nonpayment Corporate bankruptcy funds not secured from creditors Importance of timing and distribution election lump sum or over a period of years? Deferral election how much to defer, impact on cash flow, taxes etc Non Qualified Plans are often misunderstood not enough communication/education provided by the company Limited access to money unlike 401K plans, you cannot take loans Investment options? Do they mirror 401k? Self directed opportunities? 12 6
Benefits Sought by Participants Forced savings strategy Tax deferred compounding Can provide income stream until RMDs kick in from qualified plans Higher deferral limits than 401Ks 13 What are the Risks to Employers? 7
Ideal Lifespan of Executive Compensation Design a Plan free from most regulation Prepare to pay the benefit when it comes due. Offer employee/contrac tor as must flexibility as possible. Pay the benefit when due. Minimize taxes and maximize deduction to employer. 15 Risks Plan Operation Funding Plan Design Litigation Risks Taxation and Deductions 16 8
Plan Design Risks Governmental Plans 457(f) Church Plans 409A 457 for certain related orgs ERISA exemption? Private, For Profits 409A Exempt from most of ERISA? Securities laws Not for Profits 409A 457(b) and 457(f) Exempt from most of ERISA? 17 ERISA Exemption: For and Not for Profits Arrangement is unfunded Limited to a select group of highly compensated employees or management 18 9
ERISA Exemption: For and Not for Profits It is the view of the Department that in providing relief for top hat plans from the broad remedial provisions of ERISA, Congress recognized that certain individuals by virtue of their position or compensation level have the ability to affect or substantially influence, through negotiations or otherwise, the design and operation of their deferred compensation plan taking into consideration any risks attendant thereto, and therefore, would not need the substantive rights and protections of Title I. Must make a tophat filing Subject to ERISA s administrativereview provisions 19 Litigation Belka v. Rowe Furniture Corp. (571 F. Supp. 1249, D. Md. 1983): plan was exempt because (1) between 1.6% and 4.6% of the workforce was covered; and (2) the average participant salaries that were three to four times the company average and concluded that it indicated a highly compensated group. Darden v. Nationwide Mutual Insurance Co. (717 F. Supp. 388 (E.D.N.C. 1989): 18.7% coverage was too large to be considered select. Demery v. Extebank Deferred Compensation Plan (B) (216 F. 3d 283, 2d Cir., 2000): [A] select group could be wider (than just senior management) and targeted at middle management rather than at the very top executives. 15.34% was probably at or near the upper limit of the acceptable size for a select group. Bond v. Marriott (2016): the DOL takes a very limited view of the exemption 20 10
ERISA Exemption: Churches Churches are exempt from ERISA unless they opt into ERISA Includes a church and an association of churches Includes a plan maintained by an organization that satisfies two conditions: Its principal purpose or function is the administration or funding of a retirement or welfare plan for church employees. It is controlled by or associated with a church Subtype: A qualified churchcontrolled organization (QCCO), which is a church controlled taxexempt organization under Code Section 501(c)(3) other than an organization which: Offers goods, services, or facilities for sale, other than on an incidental basis, to the general public. Normally receives more than 25% of its support from either these sales or governmental sources, or both. 21 Why Does this Matter? Church Exemption from ERISA Does not have to limit participation to a select group Would still be unfunded Non QCCOs or Traditional Church Subject to 457(b) or (f) Organizations improperly classified as a church may have to carefully review their coverage. 22 11
IRS 409A Corrections IRS Notices 2010 6 and 2010 80 correcting errors regarding document or form failures, such as impermissible provisions in deferred compensation agreements. IRS Notice 2008 113 correcting errors regarding operational failures (i.e., not doing what the plan documents say to do in certain circumstances). Chief Counsel Advice Memorandum 201518013 If an amount is subject to a substantial risk of forfeiture at all times during the year, no amount is includible in income as a result of the Section 409A failure during such year. 23 Penalties for Violating 409A Deferred compensation for the taxable year and prior taxable years becomes includible in gross income for the taxable year; Accrued interest is assessed on the taxable amount; and A federal penalty of 20% of the deferred compensation to be included in gross income is assessed. In addition, a 409A violation may trigger state level penalties by assessing additional California taxes and a further 20% penalty. 24 12
Funding Risks Normal Retirement Plans Executive Compensation Retirement Plans Plan Design Decides on benefit levels Funding Trust holds assets for exclusive benefit of participants Benefit Payments Made to participants in accordance with the plan. Much flexibility. Plan Design Decides on benefit levels Funding None Required Benefit Payments Made to participants in accordance with the plan. Could remain unpaid. 25 Funding Options Employer s General Assets Taxable Trust Insurance Policies Payments in Stock 26 13
Taxation Risks Taxation: Generally employees do not want to pay income taxes before the amounts paid 457 timing rule 409A risks Section 83(b) Employees want to minimize FICA, etc. taxes Use of special timing rule 27 Litigation on Special Timing Rule Davidson v. Henkel Corp. The court concluded that the employer was liable to participants in a nonqualified deferred compensation plan for failing to withhold FICA tax in a manner that would have decreased their overall tax liability. The additional FICA tax reduced the participants benefits under the plan, and the court concluded that this result was inconsistent with the plan s design and purpose. 28 14
Deduction of Executive Compensation No deduction until the amount is taxable to the employee For profits No deduction unless the compensation is reasonable Publically held entities: salary over $1 million non deductible for certain officers, including CFO, no exclusion of performance based pay Non taxed Entities Unreasonable compensation violates private inurement Compensation over $1 million subject to excise tax for certain officers Seeks to treat not for profits like for profits: excise tax on the company 29 Disclosures This presentation is not tax or legal advice. Consult your individual tax or legal professional concerning your personal situation. This presentation is not investment advice or advice in a fiduciary capacity. 30 15