This PYA Insight appeared in Bloomberg’s Daily Tax Report.
In a highly competitive marketplace, it is critical to offer the most tax-advantageous compensation plan to attract top executives. The Tax Code provides options to allow employers to develop such plans. Some of the top strategies include Excess Benefit Plans and restricted stock.
Excess Benefit Plans
One way employers can attract top executives is by offering an Excess Benefit Plan. These plans can provide additional benefits for certain highly compensated employees in excess of what can generally be provided due to limits applicable to most qualified plans. Traditionally, employees can only contribute up to $56,000, including employer contributions, to a defined contribution plan in a year. However, the Excess Benefit Plan enables executives to save up to $225,000 extra per year in a separate contribution plan.
There are two ways employers can set up this type of plan. It can either be funded or unfunded. Funded plans segregate the contributions in a reserved account, which is only for these contributions. Employers can back up these assets by purchasing annuities or setting up a secular trust. A secular trust functions as an irrevocable trust that an employer sets up with a third party to maintain assets for an exclusive purpose.
An unfunded Excess Benefit Plan is extremely risky for the employee. The plan is only backed by its general assets. There is no segregation of assets and no annuity. The executives rely on the employer’s word. This is risky because the company could become insolvent or have a change in management. One way the employee can help mitigate this risk is to have the employer set up these assets in a rabbi trust. A rabbi trust is a legal document that ensures the executive receives his or her deferred income. The main pitfall of a rabbi trust is it does not protect the assets if the company goes bankrupt.
From a tax planning standpoint, the tax consequences are a little different between funded and unfunded plans. The employer receives a tax deduction the year the employee includes the contribution in his or her gross income. The main difference in a funded vs. unfunded plan is that earnings on top of the contribution cannot be used as a deduction by the employer. Another large difference for an unfunded plan is that taxation is deferred for the employee until the benefits are fully vested and or the employee receives the deferred income. Also, regarding taxation to the employee, a funded plan is taxed on the vesting date, and an unfunded plan is taxed on receipt.
Lastly, non-profit entities and government plans are taxed the same regardless of whether a plan is unfunded or funded. They are governed by IRC Section 457.
Restricted stock is becoming extremely popular among employers. One advantage for a corporation to offer restricted stock is that it is less dilutive compared to stock options. This type of stock typically vests after a few years of service—five, seven, etc.
The tax treatment of restricted stock is the same for both the employer and employee. It becomes taxable income after the restrictions lapse. For example, if ABC Tech offers its new CFO 2,000 shares of restricted stock, the employee must stay in his or her role for a set period. Once that time ends, it becomes taxable income. The employee will be taxed only on the future gain at the long-term capital gains rate if he or she holds the vested shares for more than one year. It’s advantageous that the employee be taxed in this manner because these rates are traditionally much lower than ordinary income rates.
Executive compensation is an intricate topic that must be approached with precision. Excess Benefit Plans and restricted stock can yield tremendous tax savings for both employers and employees. If handled correctly, implementing the appropriate employee benefit can increase both executive morale and value for shareholders.
If you would like more information about executive compensation and its impact, or if you need guidance related to any business advisory, tax planning and/or strategy matter, one of our executive contacts would be happy to assist. You may email them below, or call (800) 270-9629.