Page 106 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

92 The Complete Guide to Executive Compensation

dent of the participant, the participant’s spouse, or a dependent [as defined in section
152(a)] of the participant, loss of participant’s property due to casualty, or other similar
extraordinary and unforseeable circumstances arising as a result of events beyond the
control of the participant.” The withdrawal is not to “exceed the amounts necessary to
satisfy such emergency plus amounts to pay taxes.”
10. A large portion of the deferred income can be passed on to the beneficiaries through
properly designed trusts and supplemental insurance coverage provided by the employer
and thereby avoid estate taxes but not income taxes.
11. Short-term deferrals significantly reduce year-to-year fluctuations to incentive pay-
ments and smooth out the taxable earnings of the executive. This is important when
high marginal tax rates are in effect, thereby enabling the executive to tailor income to
meet personal needs.
12. Nonfunded, deferred compensation plans enable the company to preserve capital by
with-holding a portion of compensation to a future date and thereby increase current
cash flow. This may be especially important to a threshold or emerging company.
However, the Accounting Principles Board (APB) Opinion No. 12, “Deferred
Compensation Contracts,” should be examined carefully to ensure the expending of
future benefits is properly reflected.
13. The company benefits to the extent it recaptures forfeited payments since these would
have been lost if paid when earned. In addition, it will benefit to the extent it
credits the deferral with a value less than the cost of borrowed capital.
14. It is advantageous to the company for an executive to defer until retirement that por-
tion of pay that otherwise would be nondeductible under Section 162(m) of the IRC,
which places limits on deductible compensation in excess of $1 million.
15. Nondiscounted, nondeferred stock options and stock appreciation rights whether paid
in cash or stock, are excluded from Section 409A. Restricted stock is also excluded.

DEFERRAL DISADVANTAGES

Conversely, there are a number of disadvantages to deferring compensation. These include
the following:

1. Unless the amount deferred is protected against inflation, it will have significantly less
value when received than when earned, even under the most favorable tax circum-
stances. Or even if it is vested and has less value when received than the executive
believes could have been obtained, the executive will not be very happy. The $40,000
deferred over four future years in the earlier discussion would amount to a total of
$52,432 if credited at 7 percent interest. Assuming a 50 percent tax is in effect, this
amount is reduced to $26,216. Contrast this with the $40,000 paid immediately and
half of it paid out for taxes. If the remaining $20,000 were invested in 5.5 percent, tax-
free bonds, it would net $24,776 after four years—$1,440, or 5.5 percent less than the
deferred net payment. Thus, while the deferral is better, it may not be considered siz-
able enough to be worthwhile. This is especially true if the recipient believes the
$20,000, if invested in stocks, real estate, art, or the like, would have a much greater net
appreciation (after deducting capital gains taxes at the time of sale).
Application of a rate of interest to preserve purchasing power is, therefore, very log-
ical, especially during periods of inflation. Approaches include a specific percentage