Is it Time to Establish a Deferred Compensation Plan?

Due to profitability, many ethanol industry executives are considering tax impacts to their annual bonuses, writes Joe Leo. Although there are many factors to consider, one option is a deferred compensation plan.
By Joe Leo | October 14, 2014

The ethanol industry is arguably experiencing its most profitable year despite the uncertainty exists with the 2014 renewable volume obligation, distillers grains exports to China and rail transportation logistics difficulties. As a result of this profitability, many executives in the ethanol industry are considering the impact that taxes will have on their annual bonuses, which are frequently tied to the economic performance of their plants. A number of clients have recently inquired about developing deferred compensation plans in order to reduce their taxable income. While it is too late this year for many executives to defer current year income, it is possible to establish a nonqualified deferred compensation plan that will allow deferrals in future years. This tax planning tool can pay dividends, especially if the ethanol industry continues to experience its current profitability. Further, this tool can be very effective for executives as they near retirement age, when they presumably will have less taxable income than they currently have.

Deferring the payment of taxes is nothing new in the ethanol industry. Many corn suppliers are well-versed in deferring payments for corn until their next tax year. The concept of a nonqualified deferred compensation plan operates in much the same way. Electing to defer compensation to a future year, presumably when your taxable income will be lower, can significantly reduce the amount of taxes you pay. There are risks associated with income deferrals that you should be aware of before implementing a nonqualified deferred compensation plan, however.

Participants in nonqualified deferred compensation plans can defer income until a certain date in the future or on the occurrence of some event in the future, such as retirement or termination of employment. Participants in a nonqualified deferred compensation plan should work with their financial advisers to implement a strategy for deferring income that makes sense for their particular circumstances. IRS regulations allow participants in a nonqualified deferred compensation plan to be taxed on the deferred income in the year that it is received, instead of the year the income is earned, provided certain requirements are met. Failure to meet these requirements can result in a 20 percent penalty and interest, which are intended to negate the benefit received from the income deferral. 

The general rule for nonqualified deferred compensation plans is that an employee must elect to defer income in the taxable year, before the year in which the compensation is earned. For example, an employee who wishes to defer a portion of their annual salary for 2015 must elect the deferral on or before Dec. 31. There are exceptions to this general rule for newly hired employees, employees who are newly eligible to participate in the nonqualified deferred compensation plan or when an employer implements a new plan. 

The deadline for making a deferral is different for performance-based compensation, such as a net income bonus or production related bonus. For performance-based bonuses, the deferral election must be made at least six months before the end of the period for which the performance-based bonus relates. Further, the deferral election cannot be made after the amount of the performance-based pay for that year becomes readily ascertainable. 

Keep in mind that once the deferral election has been made, it may not be revoked except in limited circumstances. Those circumstances include the disability of the employee who has made the deferral election and an unforeseeable emergency experienced by the employee.

There are risks associated with nonqualified deferred compensation plans. These plans are not the same as more traditional retirement vehicles such as 401(k) plans which are held in separate accounts that cannot be reached by an employer’s creditors. Those who have deferred income in a nonqualified plan are subject to losing the entire amount of their deferred income in the event the employer files for bankruptcy or the employer does not have the assets to make the deferred compensation payment when it is due. An executive who participates in a nonqualified deferred compensation plan is a general unsecured creditor of the employer and is subject to the same risks as any other nonsecured creditor. In addition, participants in a nonqualified deferred compensation plan are subject to the risk that tax rates will increase in the future since the participant will pay taxes on the income when it is paid, as opposed to when it is earned. 

Even though nonqualified deferred compensation plans are not without risk, they can be important tax planning tools for executives who are eligible to participate. 

Author: Joe Leo
Attorney, BrownWinick Law Firm
[email protected]