This article is reprinted with permission from the
August 31, 2001
edition of
New York Law Journal.
2001 NLP IP Company.


Deferred Compensation: Reasons For Its Growing Use

By Joseph E. Bachelder

THE USE OF deferred compensation as a vehicle of executive compensation is on the increase. For purposes of the following discussion, deferred compensation means arrangements whereby part or all of an executive's current cash compensation is deferred to a later year for payout. This may include salary and/or bonuses (including annual and long-term bonuses) and also guaranteed payments that otherwise would be paid currently such as make-whole payments to new executives. It also means, for purposes of this discussion, supplemental executive retirement programs (SERPs). Equity awards in the form of employer stock options and restricted stock, while deferred compensation in the sense that the economic benefits are realized at a later date, are not included in the meaning of that term as used here.

The following discussion focuses on some of the reasons for the current interest in deferred compensation.

One reason is the opportunity for (a) accumulation of investment returns on deferred amounts on a pre-tax basis and (b) future payouts (at the end of the deferral period) at a lower marginal income tax rate (result of step-downs over a five-year period under the new tax law). Historically, a reason for deferring executive compensation, rather than paying it out in the taxable year earned, has been the opportunity for the executive to build up credits for interest or other deemed investment returns on a pre-tax basis. This benefit, of course, exists even though tax rates remain the same.

With the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001, Pub.L.No. 107-16, 115 Stat. 38 (the Tax Relief Act of 2001), a second reason exists for deferring compensation to a later taxable period. With a descending federal income tax rate structure over the next several years, not only is deferred compensation accumulating on a tax-free basis but payouts can be made in a taxable year with a tax rate lower than the current year.

Prior to the enactment of the Tax Relief Act of 2001, the highest marginal federal income tax rate was 39.6 percent. Following is the tax rate reduction schedule under the Tax Relief Act of 2001:

Year* Highest Marginal Tax Rate
2001 3.9.1 percent
2002 38.6 percent
2003 38.6 percent
2004 37.6 percent
2005 37.6 percent
2006 35.0 percent

* The adjusted tax rate applies to taxable years beginning during the calendar year indicated.

Under the new tax law, starting in 2006 the highest marginal rate remains at 35 percent through taxable years beginning in 2010. Thereafter, it reverts to 39.6 percent. 1

Figure 1 provides an illustration of the future after-tax amounts attributable to a $100,000 bonus earned at the end of 2000 and paid out under three alternatives: (a) the bonus is paid out at the beginning of January 2001 with the after-tax amount invested in municipal bonds bearing interest at a rate of 4.5 percent, (b) the bonus is deferred for approximately five years (paid out at the end of 2005) and credited with earnings of 8 percent a year (pre-tax) and (c) the bonus is deferred for approximately 10 years (paid out at the end of 2010) and credited with earnings of 8 percent a year (pre-tax). 2

 

FIGURE 1

 

After-tax Comparison between an Executive's
(i) Receiving $100,000 Bonus at the beginning of January 2001
and (ii) Deferring Bonus for (a) 5 years (payout at the end of 2005)
and (b) 10 years (payout at the end of 2010)*

A. Assumptions

2001

2005

2010

Federal income tax rate

39.10%

37.60%

35.00%

State income tax rate (NY)

6.85%

6.85%

6.85%

  Effective income tax rate

43.27%

 

41.87%

 

39.45%

  Rate of return on investment of after-tax proceeds of $100,000 (estimated tax-free municipal bond rate)

4.50%

  
  Guaranteed rate of return on deferred compensation

8.00%

        

B. $100,000 paid in 2001

   

2001

 

2005

 

2010

   

($000)

 

($000)

 

($000)

BONUS RECEIVED

$100.0

   Taxes

- 43.3

       
  Net after taxes (invested in municipal bonds)

$56.7

 

$56.7

 

$56.7

  Cumulative interest on municipal bonds    

14.0

 

31.4

  Total (after taxes on bonus) at end of 2005 and 2010    

$70.7

 

$88.1

           

C. $100,000 deferred from 2001 to (i) 2005 or (ii) 2010

   

2001

 

2005

 

2010

   

($000)

 

($000)

 

($000)

  BONUS DEFERRED

$100.0

 

$100.0

$100.0

  Cumulative guaranteed rate of return (8%)**    

46.9

 

115.9

  Taxable amount    

146.9

 

215.9

  Taxes in year paid out    

- 61.5

 

- 85.2

  Total (after taxes) at end of 2005 and 2010    

$85.4

 

$130.7

* It is assumed that the deferral was non-discretionary with the executive, or, if elective, that the election was made by the executive in a timely manner so as to avoid constructive receipt of income in 2001.

** While the guaranteed rate of return of 8% is a generous one, it is within customary levels for deferred compensation programs. In the author’s experience, guaranteed return rates as high as 14% have been applied to deferred compensation. Frequently, higher rates of return are conditioned upon continued employment, with an adjustment to a lower interest rate if the executive voluntarily terminates (or is terminated for cause) prior to a fixed date.

 

Caution is needed in deferring compensation that constitutes compensation eligible for coverage under pension plans.

An executive could "lose back" what he "gains" in deferring compensation if the deferred amounts do not qualify for purposes of compensation covered under tax qualified or non-tax qualified retirement programs, thus reducing the compensation base for determining retirement benefits. These may include both defined benefit and defined contribution plans. Thus, care must be taken if salary and bonus, the typical items of compensation covered by retirement programs, are deferred.

Special arrangements should be made allowing the deferred amounts to be treated as current compensation for purposes of determining compensation covered under applicable retirement programs. This may include special supplemental coverage under a non-tax qualified plan to make up for amounts lost, pursuant to applicable tax rules, under a tax qualified plan. The problem just noted may apply to other plans as well where benefits are driven by salary and/or bonus. These may include welfare benefits such as life insurance and disability protection.

Additional Retirement Benefit

Note the aggregate end-value of setting aside $100,000 per year for 10 years. Assume that, instead of just deferring $100,000 of compensation once (the example given in paragraph 1) an executive sets aside $100,000 each year for 10 years. What will $100,000 a year deferred for each of 10 years produce at the end of 10 years? As in paragraph 1, assume that guaranteed earnings are credited to the account at a cumulative compound rate of 8 percent. For a 50- year-old executive, this stream of 10 deferred payments (assume the $100,000 is credited at the beginning of each year) will produce approximately $1.6 million at age 60. At this point, none of the $1.6 million of accumulated deferred amounts has been taxed.

On the basis of this, the employer might provide the executive a supplemental lifetime pension starting at age 60 of approximately $133,000 per year using common actuarial assumptions. The conversion of the $1.6 million into an annual pension amount can be accomplished without tax until the annual payments are made, at which time the executive will be taxed on each payment as received. An executive thus can create a significant additional retirement benefit to add to his regular pension if he defers $100,000 per year of salary and/or bonus.

As noted at the end of paragraph 1 above, care must be taken that the executive not lose coverages under other plans driven by current compensation, including retirement plans, insurance coverages, etc., as a result of shifting salary and/or bonus from current compensation to deferred compensation. Special supplemental coverage arrangements will probably be necessary to accomplish this.

Prospects for Annuity

A third aspect of deferred compensation arises when comparing a $500,000-a- year pension commencing at age 60 versus a stock option award producing the equivalent age 60 value which is then converted into an annuity. Assume a 50- year-old executive today will be eligible for a pension of $500,000 commencing at age 60. At age 60, a single life annuity of $500,000 has a value of approximately $6 million using common actuarial assumptions.

As an alternative, assume that the executive, age 50, today is awarded a stock option that, hopefully, will provide him $6 million of gain (i.e., spread) at age 60. Assume also the following:
    Current stock price: $30
    Annual growth rate of stock price: 10 percent
    Price (rounded to nearest dollar) after 10 years: $78
    Gain (spread): $48

Based on a spread of $48, to have an aggregate gain of $6 million the executive would need an option grant of 125,000 shares. At today's market price, 125,000 shares will have an underlying market value of $3,750,000. If the executive is earning currently $500,000 in salary and bonus, it means an option grant covering shares equal in value to approximately 7.5 times his current cash compensation. This may not be a size of grant that the employer wishes to make. (The counter to this, as noted below, is that the option is not a charge against earnings whereas the pension is.) From the standpoint of the executive, while it has an upside (that is, the executive might realize more than $6 million), the option runs the risk that it ultimately may provide a spread of less than $6 million.

In order to make a true financial comparison of (a) the $500,000-per-year pension starting when the executive is age 60 and (b) the stock option with a spread of $6 million at the same age, the after-tax value of the $500,000 per year pension and the after-tax value of the annuity that can be purchased with the after-tax proceeds of the $6 million option gain must be made. The chart at Figure 2 gives that comparison.

 

FIGURE 2

 

$500,000 Annual Pension vs. Annuity Purchased with Amount Remaining
After Tax on $6 Million Stock Option Gain ($000)

A. $500,000 Annual Pension
(actuarial present value at age 60: approximately $6 million)

           

($000)

  Effective income tax rate  

40.0%

     
  Pension        

 

  Annual payment before taxes        

$500

  Taxes        

200

  Annual payment after taxes        

$300

              

B. Annuity Purchased at Age 60 with $6 Million Option Gain
($3.6 million net after taxes)

       

($000)

 

($000)

  Option gain    

$6,000

   
  Taxes on option gain    

- 2,400

   
  Net after taxes    

$3,600

(a)

 
  Single life annuity produced with $3.6 million        

$300

             
  Taxation of annuity under Section 72 of the Internal Revenue Code
  Assumed life expectancy at age 60 (years)    

24

   
  Total payment over life expectancy ($300,000 x 24)    

$7,200

(b)

 
  Tax exclusion component of annual payment=(a)/(b)  

50.0%

$150

   
  Taxable component of annual payment  

50.0%

$150

   
  Taxes        

$60

  Annual annuity payment after taxes        

$240

 

The executive with stock option gains of $6 million could purchase an annuity out of the after-tax proceeds of $6 million (approximately $3.6 million). Assuming an annuity factor of 12, that would provide him an annuity with an after-tax value of approximately $240,000 per year ($3.6 million divided by 12 equals $300,000; $300,000 less $60,000 in taxes equals $240,000). This compares with the $500,000 pension described in Part A of the chart that provides an after-tax value of $300,000 per year.

The foregoing explains why a "shift" of economic emphasis from equity to guaranteed pension may, in some cases, be preferable from the standpoint of the executive. On the other hand, the employer may prefer the option to the pension from an accounting standpoint. The option is not a charge against earnings whereas the cost of the pension is a charge, generally spread over the period ending at the projected retirement date (actual retirement date if sooner).

Deferred Stock Units

A fourth issue in this area involves deferrals and "swaps" of stock option gains for deferred stock units. When an option is exercised, the pre-tax gain (spread) is taxed and the opportunity for future growth on that gain is limited to an amount that is a little over one-half of the pre-tax amount (assumes ordinary income tax on the spread at current federal and state (New York) tax rates).

In recent years, corporate employers with stock option plans have developed a practice that allows exercise of stock options without tax to the option holder at the time of exercise. The first step is for the option holder to turn in employer stock he already owns in exercise of his stock option. In return, the executive, without tax, receives back a number of shares equal to the shares used to exercise the option. More than 20 years ago, in Revenue Ruling 80- 224, 1980-2 C.B. 235, the Internal Revenue Service (IRS) confirmed that the turning in of shares of the employer already owned by an executive in payment of the exercise price of the option did not result in tax to the executive on any increase in value of such previously owned employer shares over its tax basis.

In the second step, based on a prior election, the executive defers the remaining shares that he would have received as a result of his exercise of the option. Generally, these deferred shares are called "share units" or "deferred stock units." Under applicable tax rulings and cases on the subject of deferring compensation, practitioners generally have been comfortable with the idea that an irrevocable election to defer made by the option holder prior to the exercise of the option is effective in deferring tax on the remaining shares (that is, the option spread) until payout of the deferred stock units at a later date. 3

In EITF Issue No. 97-5, the staff of the Financial Accounting Standards Board (FASB) indicated that the option-exercise-gain-deferral arrangement as just described would not result in loss to the employer of the no-charge position applicable to stock options for accounting purposes. In the same ruling, however, the staff indicated that if the executive converted the deferred stock units into a deferred diversified portfolio, such conversion would make the arrangement subject to variable plan accounting.

Another example of converting option gain into deferred compensation without tax to the executive at the time of deferral is the subject of a more recent IRS ruling, PLR 199901006 (Jan. 8, 1999). PLR 199901006 held that the swapping of unvested stock options for credits under a deferred compensation arrangement did not result in taxable income to the option holders making the exchange.

The accounting consequence to the employer of a stock option swap like that covered by PLR 199901006 has not been settled by a FASB staff ruling. It is possible that FASB might view a stock option swap differently from a stock option exercise as described in Revenue Ruling 80-244 and conclude that it would result in variable plan accounting. An employer contemplating a stock option swap arrangement should discuss it with its auditors.

A fifth use of deferred compensation has been to provide "guarantees" to new executives. Whenever a new executive is employed there may be a "sign-on" bonus to guarantee reimbursement for what was forfeited by the executive upon leaving his former employer. Instead of a taxable up-front payment, the executive may prefer that the guaranteed "make-whole" amount from his new employer be in the form of deferred compensation. This allows a continuing build-up of the guaranteed amount on a pre-tax basis. From the standpoint of the new employer, a deferred arrangement that vests over a period of time provides a "golden handcuff" on the new executive. He cannot leave during the vesting period without forfeiting at least some of the guaranteed amounts. 4

One can protect tax deductions under 162(m) of the Internal Revenue Code. Code Section 162(m) limits deductibility of certain compensation to $1 million a year for a "covered employee" of a public corporation, generally the chief executive officer and the four other most highly compensated officers for the taxable year in question. If compensation is deferred and paid out to an executive when he is no longer a "covered employee," the $1 million deduction limitation will not apply.



FOOTNOTES:

1Pub.L.No. 107-16, 901, 115 Stat. 38, 150 (2001). There are two bills pending in the U.S. House of Representatives to repeal the Tax Relief Act of 2001's sunset provision and to provide, among other things, that the reduction in the marginal tax rates be permanent. See H.R. 2316, 107th Cong. (2001); H.R. 2327, 107th Cong. (2001).

2The tax analysis does not reflect certain changes under the Tax Relief Act of 2001 such as those affecting personal exemptions and itemized deductions.

3Stock-for-stock exercise of an option followed by deferral of the option gain was the subject of a column by the author, "Deferral of Stock Option Gains," NYLJ, May 30, 1997.

4Frequently, up-front "make-whole" payments to new executives have been handled through forgivable loans to the executive allowing him to receive current cash with tax deferred to a later date. However, in Technical Advice Memorandum 200040004 (Oct. 6, 2000), the IRS raised questions regarding whether a loan to an executive pursuant to a forgivable note was currently taxable or not. See discussion of this ruling in a column by the author, "Tax Treatment of Loans to Executives," NYLJ, Mar. 21, 2001.