Many companies want to reward employees, contractors, and others with incentives to reward their contributions without dipping into the cash needed to continue investing in the business. As a result, companies may turn to “deferred compensation” structures, giving these contributors stock options, future bonuses or other future compensation arrangements.
These types of arrangements can be excellent ways to encourage employee and contributor loyalty. Unfortunately, there are financial consequences if done incorrectly. Generally, income is taxed when it is actually received, not just when it is earned, but “nonqualified” deferred compensation actually results in current tax consequences.
What types of compensation are “deferred”?
Nearly any type of compensation can be deferred in some way, from salary and hourly wages, to different types of sick, vacation, or paternity leave, to the various types of stock grants. Simply put, if a service provider receives something of economic value at a time set out in the future, the compensation is deferred.
Here are some common types of deferred compensation:
- Deferred bonuses or salary arrangements,
- Stock options or other stock grants,
- Pension plans,
- Termination or Severance Payments
Why defer compensation?
Deferring compensation allows a company to reward contributors where it does not currently, but expects to later have, cash (or appreciation in capital value) to do so. In addition to that, deferring compensation can result in tax savings where tax rates decrease, or the recipient enters a lower tax bracket. Finally, deferred compensation plans can create “golden handcuffs” where contributors are encouraged to continue their working relationship in order to obtain loyalty bonuses.
How do you obtain tax deferral?
In order to minimize or defer taxes on deferred compensation plans that are issued in the current year, there are two basic conditions that need to be met:
- The compensation cannot be distributed until a fixed date or event.
This can be a fixed date (for example, “you receive a million dollars on June 30th, 2025”) or a fixed event. A few common “fixed events” are separation from the company or a change in the ownership of the company. These fixed events can’t be negotiated; if the recipient has the option to defer it further even after the fixed event occurs, the plan will not qualify for deferred tax treatment.
Additionally, this fixed date needs to occur more than 2 ½ months after the close of the year. Under the tax rules, deferred compensation occurring 2 ½ months or less after the close of the current year should be included in compensation paid in the current year.
- The compensation cannot be “accelerable.”
In other words, there cannot be any conditions or options under which the recipients get the compensation before the fixed event occurs.
Bonus rule for stock options
For stock options to receive deferred compensation treatment, they need to be issued at Fair Market Value (“FMV”).
For public companies, FMV can be any “reasonable” method based on publicly traded stock. But, for private companies, this gets trickier. Most companies get something called a “409A Valuation”, an independent appraisal of the company’s value. Less commonly, the regulations allow for an individual with five years of experience, knowledge, education, or training to perform a valuation (subject to some additional conditions), or the company to develop a “binding formula” used to value the company for purposes of compensation issuance, regulatory filings, and loan covenants. Any of these methods will create a presumption that the valuation is valid.
My company’s deferred compensation doesn’t satisfy the rules, what now?
Consequences to “nonqualified” deferred compensation plans depend on timing. Nonqualified plans are common as well, they’re just includible as compensation in the year issued. If an executive or founder knows that a plan fails the qualification test, then they should also know that related compensation is included in the current year or they need to amend the plan to satisfy the test.
If a plan fails the test in a later year, the consequences are more problematic. Section 409A provides that future nonqualified assessments result in penalties equal to 20% additional tax incurred on top of the the applicable income tax, as well as 1% annual interest accrued on the payment owed.View all posts by this author