Evaluating a deferred compensation plan.Facts: Tom Henderson Thomas Edward "Tom" Henderson (born January 26, 1952 in Newberry, South Carolina) is an American former professional basketball player. A tough-minded 6'4" guard from the University of Hawaii, Henderson was selected by the Atlanta Hawks in the first round of the 1974 , an executive, wants to retire in approximately five years. Tom is currently in the 39.6% marginal tax bracket Tax Bracket The rate at which an individual is taxed due to a particular income level. Notes: Each income class is taxed at a different level. Generally, the more you make the more you are taxed. , but anticipates being in the 28% bracket In programming, brackets (the [ and ] characters) are used to enclose numbers and subscripts. For example, in the C statement int menustart [4] = ; the [4] indicates the number of elements in the array, and the contents are enclosed in curly braces. during retirement years. Tom is evaluating a deferred compensation plan that his employer, Community National Bank (CNB CNB Czech National Bank CNB Centro Nacional de Biotecnologia CNB City National Bank CNB Citizens National Bank CNB Croatian National Bank CNB Chloronitrobenzene CNB Corresponsales No Bancarios (Spanish, Colombia) ), designed to provide him with additional funds at retirement. Under the proposed arrangement, the parties would implement a five-year deferred compensation plan, commencing Jan. 1, 2001 and ending Dec. 31, 2005. At the end of each calendar year, CNB would accrue To increase; to augment; to come to by way of increase; to be added as an increase, profit, or damage. Acquired; falling due; made or executed; matured; occurred; received; vested; was created; was incurred. an amount equal to 10% of Tom's TOM'S Co., Ltd (株式会社トムス Kabushiki-gaisha Tomusu annual base salary. The deferred compensation would be credited on CNB'S books to a deferral deferral - Waiting for quiet on the Ethernet. account in his name. The entries to Tom's account are only memorandum entries; no actual funding occurs, because this is an unsecured Unsecured A loan or equity interest that is given without any guarantee of payment, performance, satisfaction or opportunity for return from the recipient. No property, interest or security is used as collateral in either a guarantee or a pledge. promise plan payable from the company's general assets. Each December December: see month. 31, CNB would accrue as credited earnings an amount equal to 7% of the previous year's December 31 balance in the deferral account. (Seven percent was chosen, because this is the rate Tom can earn on outside investments). The deferred compensation due to Tom would be paid in installments on Jan. 1, 2007-2009. Each installment would equal one-third of the deferred benefit as of Dec. 31, 2005, plus the appreciation (i.e., interest) for the year. If employment is terminated by reason of death, disability or discharge, the account balance would be paid in three annual installments commencing 30 days after termination. If Tom dies before receiving payment of his entire deferral account, the unpaid balance in the account would be payable to his designated beneficiary beneficiary Person or entity (e.g., a charity or estate) that receives a benefit from something (e.g., a trust, life-insurance policy, or contract). A primary beneficiary receives proceeds from a trust or insurance policy before any other. (or to his estate, if no beneficiary has been designated). The payment schedule to the beneficiary or estate would be the same as it would have been to Tom had he lived. Issue: Would this deferred compensation plan be advantageous to Tom? Analysis Whether the plan is beneficial depends on a mix of economic, tax and financial considerations. However, Tom's adviser can use the following five-step approach to evaluate the proposed arrangement. Step 1: Evaluate the risk of deferral. The deferred compensation arrangement is unfunded (i.e., paid from the employer's general assets rather than from assets restricted and secured for compensation), Ownership Of the deferred amounts remains with CNB; its creditors can attach the funds. While Tom believes the company, under current ownership, can and will pay the deferred amounts when they become due, he is uncertain whether new ownership (as a result of a merger or acquisition) would be willing to honor As a verb, to accept a bill of exchange, or to pay a note, check, or accepted bill, at maturity. To pay or to accept and pay, or, where a credit so engages, to purchase or discount a draft complying with the terms of the draft. the deferred compensation contract. Therefore, he may request a funded arrangement, such as a rabbi trust Rabbi Trust A trust created for the purpose of supporting the non-qualified benefit obligations of employers to their employees. Notes: Called a Rabbi trust due to the first initial ruling made by the IRS on behalf of a synagogue, these forms of trusts create security for , to partially protect his deferred compensation. Step 2: Figure the present value of the projected cashflow stream. Exhibit 1 illustrates a cashflow plan for the company's accumulation of deferred amounts (compensation and earnings) and the receipt of the deferred amounts by Tom. (Deferred payouts calculated in the schedule for years ending 2006-2008 are paid on January January: see month. i of the following year.) The table includes a net present value (NPV NPV See: Net present value ) calculation.
Exhibit 1: Cashflow Schedule of Compensation Deferrals and Payouts
(1) (2) (3) (4)
End of Deferred Earnings(2) Deferred
year Salary comp.(1) 7% payout(3)
2001 $262,500 $26,250 $ -- --
2002 272,250 27,225 1,838 --
2003 282,590 28,259 3,872 --
2004 293,540 29,354 6,121 --
2005 305,150 30,515 8,604 --
2006 -- -- 11,343 (65,356)
2007 -- -- 7,562 (61,575)
2008 -- -- 3,781 (57,793)
Total $1,416,030 $141,603 $43,121 $(184,724)
(5) (6) (7)
Balance Executive
End of end of tax(5) NPV(6)
year year(4) (28%) (1/1/01)
2001 $26,250 $ -- $ --
2002 55,313 -- --
2003 87,444 -- --
2004 122,919 -- --
2005 162,038 -- --
2006 108,025 18,300 33,173
2007 54,012 17,241 29,485
2008 -- 16,182 26,107
Total $511,723 $88,765
Notes: (1.) Deferred compensation [Column (2)] = Column (1) x 10% (2.) Earnings [Column (3)] = Previous year's Column (5) x 7% (3.) Deferred payout pay·out n. 1. The act or an instance of paying out. 2. A percentage of corporate earnings that is paid as dividends to shareholders. [Column (4)] = [Column (5) at (12/31/2005)/3] + Column (3) for current year (4.) Balance at end of year [Column (5)] = Previous year's Column (5) + [Columns (2) + (3)] - Column (4) (5.) Tom's tax [Column (6)] = Column (4) x 28% (6.) NPV [Column (7)] = [Column (4) - (6)] x 6% discount factor from NPV table, based on a Jan. 1, 2001 agreement starting date. The accumulated ac·cu·mu·late v. ac·cu·mu·lat·ed, ac·cu·mu·lat·ing, ac·cu·mu·lates v.tr. To gather or pile up; amass. See Synonyms at gather. v.intr. To mount up; increase. unpaid compensation at Dec. 31, 2005 (the end of the fifth year) is $162,038; this amount includes the 7% interest factor. This cashflow schedule indicates that this amount would be paid in three equal installments of $54,013, plus each year's interest earnings. Exhibit 1 shows the projected after-tax value of deferred compensation for Tom and the effect of Federal tax in tax years 2007-2009, assuming the income is taxed at 28%. The total after-tax benefit for the three year payout period Payout period The time period during which withdrawals from a retirement account or annuity are paid. is $133,001 ($184,724 - $51,723). Using a 6% discount rate, the NPV of these benefits as of Jan. 1, 2001 (the agreement's start date) is $88,765. Step 3: Compare inside versus outside earnings growth. Tom effectively earns 7% pretax pre·tax adj. Existing before tax deductions: pretax income. pretax adj [profit] → vor (Abzug der) Steuern interest in the deferred compensation plan. He also earns 7% pretax on his personal investments. To compare the inside growth to the outside growth, it is necessary to compute To perform mathematical operations or general computer processing. For an explanation of "The 3 C's," or how the computer processes data, see computer. the cashflow that will be realized if no deferral occurs and the after-tax compensation is placed in outside investments. Exhibit 2 assumes no deferral and investment of after-tax income with pretax earnings of 7%, or a 4.2% [7% x (1 - .396)] after-tax return (with earnings being compounded annually on the accumulated investment total). The NPV of this future cashflow stream for the five-year period is calculated using a 6% discount rate.
Exhibit 2: Cashflow Schedule of Outside Earnings Growth
(1) (2) (3)
End of Federal Tax After-tax
year Salary (39.6%) income(1)
2001 $26,250 $(10,395) $15,855
2002 27,225 (10,781) 16,444
2003 28,259 (11,191) 17,068
2004 29,354 (11,624) 17,730
2005 30,515 (12,084) 18,431
2006 -- -- --
2007 -- -- --
2008 -- -- --
Total $141,603 $(56,075) $85,528
(4) (5) (6)
Earnings Annual NPV on
End of (4.2%) addition to 1/1/00
year after-tax(2) investment(3) (6% inflation)
2001 $ -- $15,855 $14,958
2002 666 17,110 15,228
2003 1,385 18,453 15,493
2004 2,160 19,890 15,755
2005 2,995 21,426 16,011
2006 3,895 3,895 2,746
2007 4,058 4,058 2,699
2008 4,229 4,229 2,653
Total $19,388 $104,916 $85,543
Notes: (1.) After-tax income [Column (3)] = Column (1) - Column (2) (2.) Earnings [Column (4)] = Sum of previous years' Columns (5) x 4.2% after-tax interest factor (3.) Annual addition to investment [Column (5)] = Column (3) + Column (4) The total annual addition to the investment for the eight-year period is $104,915. The NPV of these investment benefits as of Jan. 1, 2001 (the agreement's beginning date) is approximately $85,543. Step 4: Consider the executive's cashflow needs and retirement goals. Tom already has a great deal of personal wealth. Therefore, the deferral will not restrict his current standard of living. The deferral plan will also provide Tom with more cash at retirement, which is what he wants. Step 5: Summarize sum·ma·rize intr. & tr.v. sum·ma·rized, sum·ma·riz·ing, sum·ma·riz·es To make a summary or make a summary of. sum the results. The projected cashflow's NPV under the deferred compensation arrangement is $88,765. In present value terms, this is $3,222 ($88,765 - $85,543) more than Tom could earn by paying tax up front and investing the after-tax income in other investments. Conclusion The cashflow in this arrangement seems to work in Tom's favor. Because he is somewhat concerned with the unfunded nature of the plan, he may want to use a rabbi trust, which provides partial security for his deferred compensation without a loss of tax benefits. A review of Tom's personal cashflow needs shows that he can defer de·fer 1 v. de·ferred, de·fer·ring, de·fers v.tr. 1. To put off; postpone. 2. To postpone the induction of (one eligible for the military draft). v.intr. the cash without affecting his current standard of living. Further, the deferred arrangement will work quite well as a forced savings plan to supplement his retirement income. Despite these advantages, the $3,222 net benefit under the deferred compensation plan is probably not significant enough for Tom to enter into this arrangement unless the company creates a rabbi trust to provide some payment security. Editor's note Editor's Note (foaled in 1993 in Kentucky) is an American thoroughbred Stallion racehorse. He was sired by 1992 U.S. Champion 2 YO Colt Forty Niner, who in turn was a son of Champion sire Mr. Prospector and out of the mare, Beware Of The Cat. Trained by D. : This case study has been adapted from "Guide To Tax Planning Tax planning Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. for Individuals," 4th Edition, by Anthony J. DeChellis, Douglas L. Weinbrenner, Catherine A. Roeder and James F. Reeves, published by Practitioners Publishing Company, Fort Worth, TX 1999. Albert Ellentuck, Esq. Of Counsel King and Nordlinger, L.L.P. Arlinton, VA |
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