Deferred compensation is a sacred cow. Postponing taxable income until the low tax nirvana in the future remains unchallenged as a sound economic plan.

I disagree in many cases. Non-qualified deferred compensation plans have downsides and risks. I have recently seen several deferred compensation arrangements that created unexpected and significant problems. Sometimes, sacred cows end up as hamburger.

I have written ad nauseum about non-qualified plans. These plans are popular with my clients, and I continue to recommend them when the circumstances are right. In this memo, however, I will point out some of the problems that these plans can create.

Background The "deferred compensation plans" I am speaking about here are the so-called "non-qualified plans." Let’s review.

Deferred compensation plans come in two flavors.

First, there are "qualified" deferred compensation plans. These are 401(k) plans, profit sharing plans, SEPs, defined benefits plans, and the like. These plans are "qualified" under specific and highly complex sections of the tax laws. If a plan "qualifies," there is a tax bonanza. The hallmark of a qualified plan is the asymmetry of the deduction and the taxable income: the employer gets an immediate tax deduction for plan contributions while the corresponding taxable income is deferred. Employees do not report taxable income until years later, when the benefits are paid out. Further, assets funding the benefits are set aside in a separate trust, where earnings and gains are tax exempt.

Second, there are "non-qualified" deferred compensation plans. This group includes every other arrangement that employers, employees, and their advisors can dream up to postpone the payment and taxation of compensation. Non-qualified plans are an eclectic, amorphous, and shifting grab-bag of compensatory arrangements. The hallmark of non-qualified plans is the symmetry of deductions and income: the employer’s deduction occurs simultaneously with the taxation of the employee. The assets, if any, funding the arrangement remain in the control of the employer, and are subject to the claims of its creditors.

Problems Caused By Non-Qualified Plans This is not a manifesto of why non-qualified plans should be avoided. Rather, I want to point out where non-qualified plans can spawn unexpected problems for both the employer and the employee.

1. The biggest problem with non-qualified plans is the risk that the compensation deferred will never be paid. To avoid constructive receipt of income, the employer’s promise to pay something in the future must be unfunded and unsecured. The employee is merely an unsecured general creditor of the employer. If the employer goes out of business, you’re sunk.

The assumption that big employers will always be there to make good on their promises to pay in the future is false. Enron and World Com proved that even the largest employers can collapse. I have many clients, retired from big name companies, holding their breaths before the next deferred comp check arrives. I also have clients who lost all their deferred comp.

2. The underlying premise for deferred compensation plans is, remarkably, unchallenged. That premise, a gem of conventional wisdom, is that tax brackets will be lower when the employee is retired.

Who made that law? Assuming (i.e., guessing) what Congress will do with tax rates far out in the future is dangerous. And, even if rates remain unchanged, many will continue to be in high tax brackets in retirement.

3. Did you know that deferred compensation is subject to payroll taxes (FICA) when deferred, not when paid? It is. Lots of people don’t know that. This adds complexity and confusion, as many employers do not pay the taxes properly.

4. Non-qualified plans are subject to ERISA, which surprises many. ERISA, the federal pension law, applies to any employer plan which defers compensation, even though the plan is not "qualified" under the tax laws.

ERISA requires all deferred compensation plans, both qualified and non-qualified, to be fully funded, to hold assets in a segregated trust, to cover most employees, etc. The trick with non-qualified plans is to fall under the ERISA "top hat" exception to avoid all these requirements.

A plan satisfies the "top hat" exception if it is (i) for a select group of management or highly compensated employees, and (ii) unfunded. Moreover, the plan must register with the U.S. Department of Labor (DOL) by filing a "top hat" exemption notice.

Two problems flow from this. First, if a "top hat" plan does not register with the DOL, significant penalties apply. Second, a non-qualified plan may not meet the "top hat" exception because it covers too many employees. If more than a "select group" of management or highly compensated employees are in the non-qualified plan, there’s trouble. What is a "select group?" There is no flat answer, but the rule of thumb seems to be not more than five percent of the employer’s workforce.

I have seen this problem: A company was being sold and the buyer’s due diligence examination found a non-qualified plan covering about 40% of the staff. That was clearly larger than a "select group." The result was a significant reduction of the purchase price to cover this new "liability."

5. CPAs tell me that non-qualified deferred compensation plans are reported as long term liabilities on the employer’s balance sheet. That can have all sorts of unintended consequences.

6. If the employee dies before all payments are made, extra taxes may be triggered.

I recently settled an estate where the decedent had been an executive at a large, publicly traded corporation. The balance of the unpaid deferred compensation at the time of his death was more than two million dollars. The employer was certainly able and willing to pay out the remaining benefits. But, two problems arose.

First, the plan called for benefits to be paid to the decedent’s estate, rather than to the surviving spouse. Second, and more troublesome, the plan required a single lump sum payment. The result was a huge amount of income tax being paid all in one year.

The ironic twist was that the employer, during the employee’s lifetime, would have been pleased to restructure the death benefit payee and the timing of the payments to almost anything the employee would have requested. But, after his death it was too late. The plan had been set up years earlier and had not been looked at by anyone for at least ten years. Its provisions surprised both the company and the estate after the employee died.

This illustrates that even the best, and most generous, non-qualified deferred compensation plan provided by a financially powerful employer needs to be reviewed carefully by the advisors for the employee.

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