Deferred Compensation: Details You Want to Know NACUBO Tax Forum Joseph D. Olivieri, PwC October 21, 2013 St. Louis, Missouri
Agenda PwC Slide 2 Goals of a Deferred Compensation Program Types of Deferred Compensation Scenarios
PwC Slide 3 Goals of a Deferred Comp Program Recruit or retain executives Permit tax-deferred wealth accumulation for retirement or otherwise Provide incentive compensation Provide protection for the executive on involuntary termination without cause
Types of Deferred Compensation PwC Slide 4 Qualified Plans / 403(b) 457(b) 457(f) Split dollar life insurance
Qualified Plans / 403(b)s PwC Slide 5 Defined Contribution 401(k) / 403(b) Account established for each participant Pre-tax deferrals permitted subject to limit ($17,500 for 2013, plus catch-up) Total contribution limit of $51,000 for 2013 Defined Benefit Benefit expressed as an annual accrual or hypothetical account Complex issues around funding, etc.
Qualified Plans / 403(b)s PwC Slide 6 Advantages Tax-deferred accumulation until distribution (or later if rolled into IRA) Benefits are secure from creditors Disadvantages Contributions / benefits subject to limits and nondiscrimination testing (government plans generally exempt from non-discrimination testing) Compliance requirements may be complex
Section 457(b) Plans PwC Slide 7 Available to exempt organizations and state / local governments Permits contribution of up to $17,500 annually also may be catch up opportunity Contribution may be made by employee or employer Contributions to government plans must be funded Not subject to section 409A
Section 457(b) Plans PwC Slide 8 Advantages Amounts may be fully vested without tax Permits additional wealth accumulation on taxdeferred basis Disadvantages Relatively low contribution limits Can t be rolled over (unless governmental plan) Not secure from creditors (unless governmental plan)
Section 457(f) PwC Slide 9 Tax-exempt and governmental employers are subject to these rules Deferred amounts are subject to tax at vesting Exceptions for severance pay, vacation pay, and other benefits 10 or 12-month pay for teachers? May be defined contribution or defined benefit
Section 457(f) PwC Slide 10 Advantages Unlimited deferral opportunity Limited compliance requirements Disadvantages Must be at risk of loss to avoid premature taxation Not exempt from section 409A
Section 409A PwC Slide 11 Imposes requirements on deferred compensation plans Time of payment must be set up front Limited payment events may satisfy section 409A Limited ability to accelerate or defer payment 20% additional income tax applies to affected participant if a violation occurs Section 457(f) plans may be subject to section 409A
Section 409A PwC Slide 12 Exception short-term deferrals If deferred amount is taxable at vesting, and not further deferred, plan is exempt from section 409A Section 457(f) plans generally meet this exception and are exempt, assuming amounts paid at vesting However, if amounts are distributed later (e.g., during retirement), section 409A may apply because pre-tax amounts will be paid after they are earned
Scenario 1: Recruitment PwC Slide 13 Exempt organization wants to bring on a new executive from a for-profit organization Executive has significant restricted stock award that will be forfeited when he resigns his position with his former employer Organization wants to make him whole to incent him to join, but does not want him to walk and take the money
Scenario 1: Recruitment PwC Slide 14 Assume amount at issue beyond limits of 457(b) and qualified plan However, a 457(f) plan may provide a solution Organization could agree to pay executive a make up amount if he completes a service period If executive quits before end of the period, he forfeits the award No tax consequence to executive prior to vesting
Scenario 1: Recruitment PwC Slide 15 What if executive is terminated? Is he required to forfeit under these circumstances this would put him / her at additional risk However, IRS has ruled that involuntary termination without cause is a risk of forfeiture Similar results on termination for death / disability Good reason termination also may qualify May not receive if termination for cause
Scenario 1: Recruitment PwC Slide 16 What if organization wants to reward executive by accelerating vesting and payment? IRS may challenge whether risk of forfeiture was substantial at inception May look at whether organization has enforced the service requirement
Scenario 1: Recruitment PwC Slide 17 What if the executive completes the service period, and the parties want to defer taxation further? There is a limited ability to extend a deferral period This is because the extension of deferral period would bring the plan within section 409A plan would no longer be exempt from section 409A
Scenario 1: Recruitment PwC Slide 18 Section 409A generally does not recognize extensions of a vesting period Pending IRS guidance would impose this requirement on section 457(f) plans, and this would prevent deferral of vesting Subject to rule change, plan could defer vesting under section 409A rules election made at least one year in advance, and deferral of at least 5 years
Scenario 2: Retirement PwC Slide 19 What if organization wants to enhance retirement benefits for senior executives? Executives may be mid-career joiners unable to benefit from lengthy period of tax deferred accumulation under a defined contribution plan Or market volatility may have limited their ability to accumulate significant retirement benefits
Scenario 2: Retirement PwC Slide 20 Qualified plan / 403(b) Usually method of choice may allow for extended income tax deferral and there is no FICA tax (except for employee deferrals) If have a 403(b) or 401(k) plan, employees may contribute pre-tax up to the annual limit $17,500 plus catch-up, if applicable No ADP testing for 403(b) plan
Scenario 2: Retirement PwC Slide 21 Qualified plan / 403(b) However, exempt organization plans are subject to non-discrimination testing This means that contributions for highly compensated employees must bear a reasonable relationship to those for non-highly compensated employees as a percentage of salary
Scenario 2: Retirement PwC Slide 22 Qualified plan / 403(b) Notwithstanding this, IRS testing rules are flexible Making a minimum level of contribution for nonhighly compensated employees may allow significant contributions for highly compensated employees If these rules can be met, may be able to increase annual contributions on behalf of executives from $17,500 (annual deferral limit) to $51,000 (total annual contribution limit)
Scenario 2: Retirement PwC Slide 23 Defined Benefit Plan If this level of saving is not sufficient, consider a qualified defined benefit plan Equivalent annual deferrals may be substantially greater than those available under defined contribution plans (e.g., approximately $120,000 for someone age 50) New plan designs are available to limit volatility, etc. risks
Scenario 2: Retirement PwC Slide 24 457(b) Plan May allow pre-tax contributions to a 457(b) plan Allows increase in annual accumulation by $17,500 (possibly more if close to retirement and certain requirements met) Amounts may be fully vested at all times With qualified plan contribution, $35,000 of employee deferral (not counting catch up) and possibly $33,500 of employer contribution
Scenario 2: Retirement PwC Slide 25 Section 457(f) Plan If a greater amount is nevertheless required, consider a 457(f) plan Could establish necessary amount and provide for payment at anticipated retirement age, subject to service until that age Encourages retention as well as accumulating retirement benefit for executive Salary deferrals?
Scenario 2: Retirement PwC Slide 26 457(f) Plan What if organization decides to change direction and remove executive? Executive may be protected program may provide that amount vests upon involuntary termination without cause What if executive wants to leave early and take benefit? IRS may challenge substance behind plan s risk of forfeiture
Scenario 2: Retirement PwC Slide 27 457(f) Plan What if executive decides to work beyond established retirement age? Same analysis as above would need to be able to extend deferral period in compliance with section 409A
Scenario 2: Retirement PwC Slide 28 What about executive who s close to / at retirement? Assume too close to payment date for qualified plan / 457(f) plan to work Special 403(b) plan rule for post-retirement contributions
Scenario 2: Retirement PwC Slide 29 Use consulting agreement require continued services to receive annual payments? IRS is suspicious of these programs questions whether substantial services are intended to be provided Non-compete agreement? Does not work under section 409A Pending IRS guidance would remove this in 457(f) context
Scenario 2: Retirement PwC Slide 30 How are amounts taxed during retirement? Section 457(f) states that amounts taxed under section 457(f) at vesting are taxed under section 72 when distributed Tax at vesting creates a basis in the benefit Pro rata portion of each distribution is subject to income tax FICA tax at vesting only
Scenario 3: Severance PwC Slide 31 How may executive be protected from not-forcause dismissal? Provide a severance benefit Normally a multiple of annual pay Payable upon involuntary termination without cause or good reason
Scenario 3: Severance PwC Slide 32 How does severance fit under section 457(f)? Section 457(e)(11) indicates severance plans are not subject to section 457(f) However, plan may not be considered severance unless payment only available upon involuntary termination If amount can be received on voluntary termination, will not be severance would be taxed at vesting
Scenario 3: Severance PwC Slide 33 Severance under section 457(f) has not been clearly defined IRS pending guidance indicates that section 409A standard will be applied Thus, severance would be limited to lesser of (i) two times annual pay or (ii) $255,000 (IRC 401(a)(17) limit) Would have to be paid by end of second taxable year following termination
Scenario 3: Severance PwC Slide 34 Severance plans are subject to section 409A Exemption for plans meeting dollar and timing limits If subject to section 409A, would need to be paid in accordance with plan Could not accelerate or defer payments Severance would be subject to FICA as paid
Scenario 3: Severance PwC Slide 35 Alternatives Lump sum payment Exempt from section 409A Limited ability to enforce non-compete, or to cut payments off if executive obtains new employment Cash flow issues Payable as normal payroll Subject to section 409A (unless meet severance limits), and so ability to change payment date would be limited
Other Issues PwC Slide 36 Reasonableness of compensation (section 4958 for 501(c)(3) organizations) Form 990 reporting Application of ERISA State law issues
Contact Information PwC Slide 37 Joseph D. Olivieri Managing Director, PwC (646) 471-8264 joseph.d.olivieri@us.pwc.com
PwC Slide 38 This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. federal, state or local tax penalties. This includes penalties that may apply if the transaction that is the subject of this document is found to lack economic substance or fails to satisfy any other similar rule of law. 2013 PwC. All rights reserved. In this document, "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. This document is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.