Dangling the carrot: deferred compensation can help keep your top executives in-house, and performing as promised.

It's always a challenge to attract top talent into senior positions. And, once hired, every effort must be made to keep that talent from being lured away. But did you know that deferred compensation is a tool used more and more frequently these days? You may have shied away from it because the techniques and regulations regarding deferred compensation keep changing. But never fear: Here's a quick update on this important tool, starting with the basics.

WHAT IS DEFERRED COMPENSATION?

Deferred compensation is compensation that, while earned now, is paid to you or made available at a later date. It is taxable at that time, not when earned. Current law allows deferred compensation to be offered to key executives exclusively within Section 457 of the Internal Revenue Code. Two other types of deferred compensation are no longer attractive:

"Stock Options." Some IHEs have been offering their senior executives plans that look like the "stock options" provided to corporate execs. Under these plans, the higher ed executive receives options to purchase mutual funds, for instance, at a fixed price, often below market price. He would not receive taxable income until the option is exercised. If the market value goes down, he simply does not exercise the option. The IRS has ruled that such plans for not-for-profit organizations violate federal tax law.

Split Dollar Life Insurance. Split dollar life insurance enjoyed popularity for 40 years. In such a plan, an employer purchases life insurance on a key employee, retaining a share of ownership in the death benefits or cash value of the policy. The employer pays the premiums while the cash value grows, then gets those premium payments back from a portion of the accumulated cash value. The benefits and the remainder of the cash value belong to the employee. The IRS has now eliminated any tax advantages to such plans. As of 2004, the cash value will be taxed when the employer reclaims the premium payments, thus making such a scheme unattractive. Now for the currently viable plans:

Qualified vs. Non-Qualified Plans. You'll be hearing more about these two kinds of plans. A "qualified plan" is one that applies the same practices and policies to all employees. A "non-qualified plan" allows the employer to provide a benefit selectively to certain employees without having to include other employee classes. Section 457 comprises the IRS provisions that allow for "non-qualified" plans--and that's the topic of this article. Still, we must also take into account:

Eligible and Not Eligible Plans. To complicate matters further, there are two kinds of non-qualified 457 plans:

* [section] 457(b): "Eligible for tax deferral without substantial risk of forfeiture." In these plans, the individual has the right to the funds in the future, when she leaves the organization or retires, no matter what happens. There is "no risk of forfeiture."

* [section] 457(f): "Not eligible for tax deferral without substantial risk of forfeiture." These are plans that are linked to the individual's future performance of substantial services, and she will receive the compensation only if the performance occurs--that's the "risk of forfeiture." (See "Link It to Performance!" on next page.)

FEATURES OF A 457 PLAN

There are several positive features of a 457 plan:

* Contributions to these plans are not subject to income tax until withdrawn or no longer subject to risk of forfeiture.

* The plan can be made available only to certain "highly compensated" or select management employees.

* The assets can be invested in any investment instrument.

Two big changes for 457(b) plans. If you're considering the 457(b) plan, be aware of these changes:

EGTRRA. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) dramatically changed the retirement planning landscape for 457(b) plans. This section has applied to nonprofit organizations since 1986 but was not used much, prior to EGTRRA. The lukewarm utilization was principally due to the plan's low deferral limit ($7,500) and the fact that the ability to defer compensation under it was reduced by any deferral made under either Code [section] 403(b) or [section] 401(k). As these sections allowed higher limits, organizations generally adopted them, rather than 457(b) plans. Now, under EGTRRA, an organization can provide more than double the pre-tax deferred benefits than could be provided prior to its passage. With the advent of EGTRRA, the game has changed. Under EGTRRA:

* You can establish a plan that allows deferral of $12,000 for 2003.

* That's in addition to the deferrals made under a 401(k) or 403(b).

* Combining these changes doubles the deferrable amounts!

What's more, the amount that can be deferred will increase by an additional $1,000 in each of the next three years, reaching a maximum of $15,000. This is possible because the 457(b) contributions no longer have to be reduced by deferrals under any other plan. And--if an individual is within three years of retirement, he can contribute up to double the maximum, if the institution's plan allows it.

PLR 200321002. In February 2003, the IRS released PLR 200321002. The ruling was actually requested by a [section] 501(c)(3) organization. It had adopted a 457(b) plan for one participant, who was a key employee. The deferral would last until the participant reached age 70, died, became disabled, separated from service, or had an unforeseeable emergency. The plan allowed the maximum deferral, and allowed the participant to change distribution options once during the Life of the plan. The assets were placed in a trust, but the terms of the trust kept them within the reach of the organization's creditors in the event of insolvency. A third party was trustee of the trust. The participant was allowed to direct the investment of the funds among a range of choices established by the employer.

The IRS ruled that the plan was an eligible plan under [section] 457(b), on the assumption that the trust was enforceable by creditors if the employer became insolvent. Income taxation was deferred until distributions were made to the participant. The trust was considered a grantor trust, which meant that any income was taxable to the organization. Assuming the income consists of dividends, interest, and capital gains, this shouldn't result in any tax under the unrelated business income tax rules.

While the above result is not surprising, the ruling lays out some required terms of a 457(b) plan, and reinforces expected results.

REPORT DEFERRED COMP ON YOUR 990

With a 457 plan, deferrals should be included as compensation on Form 990 for an officer, director, key employee, or one of the five highest-paid employees. If the employee is still in the position when she receives distributions, he should also be included on Form 990 for the year of payment. What can't deferred comp be used for?

* Vacations, sick leave, compensatory time, severance pay, and other non-salary items. New regulations do allow deferral up to the limits if the person is leaving, and makes the election before the month in which the compensation would have been payable for certain payments that would be made upon termination.

* As a reward for volunteer service.

* If your institution is a church or a church-controlled organization. (Religious colleges or seminaries: check your eligibility!)

LINK IT TO PERFORMANCE!

Deferred compensation--especially the 457(f) version--is an especially good carrot to dangle to reward achievement of sped tic performance objectives. One caution: Avoid having it seen as an "entitlement," as salary often is. Instead, be clear about the link between a specific accomplishment and a specific deferred comp award.

For the Dean of Admissions, for instance, a quantifiable goal might be to improve the selectivity of the college from 60 percent to 45 percent over a three-year period while preserving diversity and without reducing the academic quality of the entering class. The carrot could be a specific dollar amount placed in a deferred comp plan when the objective is achieved. Of course, you need to design the reward carefully. In this case, if the payment is put into a 457(b), then it continues to be tax-deferred. But if the dean already puts the maximum into her 457(b), then the additional payment would fall under 457(f) and the amount is then taxable since she has achieved the objective and there is no Longer a "risk of forfeiture." The deferral comes in at the beginning of the arrangement in this case.

DOES DEFERRED COMP MAKE A DIFFERENCE?

In my work with IHEs, I now see deferred compensation used much more often, particularly for the majority of colleges and universities where enrollment and financial stability can only be achieved through strategic thinking, innovation, and attention to every detail of operations. It is becoming a very common practice for boards to include in presidential contracts the carrot of deferred compensation, linked to specific performance objectives. These boards want presidents to be highly motivated to make the significant strategic changes demanded in today's highly competitive environment. It's not surprising, then, that gradually, presidents are beginning to consider such carrots for other staff positions, at least where performance can be measured. Could that be your CFO, dean of enrollment management, and development officer? Yes, it could.

Larry Ladd leads the higher education practice for Grant Thornton LLP (www.gt.com/highered), from the firm's Boston office.