Elections Made a Year in Advance

What the arrangement does

A non-qualified deferred compensation plan allows an executive to defer receipt of salary or bonus beyond the year in which it is earned. The amount is not taxed until received, and it grows in the meantime on a pre-tax basis.

Unlike a qualified plan there is no contribution limit, which is what makes it attractive at this income level. The price is that the deferred amount remains an unsecured obligation of the employer, subject to the claims of the employer's general creditors. In an insolvency the executive is a creditor, not a beneficiary.

The timing rule that governs everything

The election to defer must generally be made before the start of the year in which the services giving rise to the compensation are performed.

The election is therefore made on projections rather than facts, a full year in advance, before the executive knows what the bonus will be, what their other income will look like, or what their circumstances will be when it is paid. A narrower rule permits a later election for certain performance-based compensation, and it has its own conditions.

Distributions cannot be moved

The time and form of payment must be fixed at the time of deferral, and payment may generally be triggered only on a limited set of permitted events: a fixed date or schedule, separation from service, death, disability, a change in control, or an unforeseeable emergency as narrowly defined.

An executive cannot simply ask for the money. Accelerating payment is generally prohibited outright. Deferring further is permitted only under a rule requiring the change to be made at least twelve months in advance, not to take effect for twelve months, and to push the payment out by at least five additional years.

A further rule applies to specified employees of publicly traded companies, requiring a six-month delay on payments triggered by separation from service.

Why the penalty sits with the executive

Where a plan fails, whether in its documents or in its operation, the consequence is severe and it is imposed on the participant.

1. 01All vested deferred amounts under the arrangement become immediately includible in income, including amounts deferred in earlier years and not yet received.
2. 02An additional tax is imposed on that amount, on top of ordinary income tax.
3. 03A premium interest charge applies, computed from the year the amount first vested.

The questions worth asking before deferring

• What is the employer's credit like, over the full period of the deferral rather than today, and how much of the executive's total net worth is already exposed to it through salary, equity, and now this.
• What rate is expected on receipt. Deferral into a year of similar or higher rates achieves only the compounding, and a deferral into retirement in a high-tax state can be worse than taking the income now.
• What happens on separation, on a change in control, and on death, since these are the events most likely to occur before the scheduled payment date.
• Whether the plan interacts sensibly with the executive's equity vesting, since deferring salary into a year that already carries a large vest concentrates rather than smooths income.