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Pay me later: how deferred compensation works for top association executives.

When a tax-exempt association asks its executives what additional compensation they would like to receive, the answer is often deferred compensation. These executives are no different from their counterparts in the for-profit world in seeking to minimize the immediate tax burden on their compensation. Unfortunately, tax-exempt associations confront greater limitations in the deferred compensation options they may offer their executives.

A three-layered approach

In providing deferred compensation to its executives, most employers inevitably adopt a three-layered approach based on hierarchy. Each executive's total deferred compensation package is a combination of any deferred compensation made available to all employees, plus any special provisions for that executive. In this regard, associations are no different from other employers.

1. Qualified plans. A number of deferred compensation plans are qualified under Section 401 of the tax code. With the exception of Section 401(k) plans (which are still limited to for-profit employers and tax-exempt employers that adopted the plans by July 1, 1986), qualified plans may be established by both taxable and tax-exempt employers. The great advantage of qualified plans is that they permit participants to defer the inclusion of plan benefits in their taxable income until the time of distribution, even though those benefits become fully vested, and even though they are held in trust for participants' exclusive benefit.

2. Tax-deferred annuities. Another broad-based layer of deferred compensation--available only to public schools and Section 501 (c) (3) organizations--may be provided through tax-deferred annuities. Described in Section 403(b) of the tax code, tax-deferred annuities permit employees of these organizations to make pretax contributions toward the purchase of retirement annuities. They thus serve much the same function as a for-profit employer's Section 401(k) plan. Though tax-deferred annuities are subject to a number of tax code limitations, highly paid executives may defer up to $9,500 per year under this option.

3. Top-hat plans. Any additional layers of deferred compensation must be provided solely to "a select group of management or other highly compensated employees." Such a group, often referred to as a top-hat group, should not be confused with the highly compensated employees in whose favor qualified plans may not discriminate. Anyone who earns more than $60,000 a year falls into the highly compensated category. A top-hat group is an even more exclusive club.

Two types available

Tax-exempt organizations may establish two different types of top-hat plans. Both receive at least somewhat favorable tax treatment under Section 457 of the tax code. The price for this favorable tax treatment, though, is a requirement that the executives' deferrals remain subject to the claims of the association's general creditors in the event the association becomes insolvent.

This is because any top-hat plan must be "unfunded"; payment of an executive's benefit may not be guaranteed through the purchase of an annuity contract or the holding of money in a trust fund. The executive's only assurance of receiving his or her benefit must be the association's contractual promise to pay.

Should the association become insolvent, the executive must be treated no better than an unsecured creditor of the association. This is in stark contrast to qualified plans and tax-deferred annuities, which must always shield participants' benefits from the reach of the employer and its creditors.

Section 457(b) plans. Of the two types of top-hat plans available to tax-exempt associations, those described in Section 457(b) of the tax code provide the more favorable tax treatment. Such a "457(b) plan" permits each executive to defer taxation on amounts up to $7,500 per year. This tax deferral continues even after an amount becomes vested. The executive is taxed on these deferrals (and any subsequent earnings) only when they are distributed.

Significantly, though, all amounts contributed to a tax-deferred annuity count against the $7,500 maximum deferral under a 457(b) plan. Any executive who takes full advantage of the opportunity to defer $9,500 through a tax-deferred annuity will be unable to defer any additional compensation under a 457(b) plan. Moreover, because a tax-deferred annuity is always fully funded (i.e., removed from the reach of the association and its creditors), most executives who are eligible for both types of plans choose the tax-deferred annuity over the 457(b) plan.

Section 457(f) plans. Associations whose executives merit significant deferred compensation may find it necessary to adopt the only other type of plan available to them. Because the tax consequences of such a plan are described in Section 457(f) of the tax code, these plans are often referred to as 457(f) plans.

Participants in a 457(f) plan are not subject to the $7,500 annual deferral limitation of a 457(b) plan. They may thus defer an unlimited amount of their compensation. In most other respects, however, a 457(f) plan's tax consequences are significantly less favorable than those associated with a 457(b) plan.

Amounts deferred through a 457(f) plan are taxed as soon as they become vested. An executive may thus pay a high price for any tax deferral: If his or her employment is terminated (even involuntarily) prior to the specified vesting date, all nonvested deferrals must be forfeited. At the time a 457(f) deferral becomes vested, the executive is taxed not only on the amount of that deferral but also on any earnings that have accrued prior to the vesting date. Postvesting earnings do enjoy a tax deferral, however. Such earnings are not taxed until distributed to the executive.

For example, assume a participant in a 457(f) plan elects to defer $10,000 of her 1993 compensation. Pursuant to an agreement between the participant and her employer, she will become fully vested in this deferral at the end of 1995, by which point $3,000 in earnings will have accrued on the $10,000 deferral. Additional earnings of $5,000 accrue by 1999, when the participant retires and elects to receive an immediate distribution of her entire account balance.

This participant will owe no tax on the $10,000 deferral during 1993. She will be taxed in 1995 on the full amount of that deferral and earnings ($13,000). Taxation on the additional $5,000 in earnings will be deferred, however, until 1999.

Interim tax distributions

Because participants in 457(f) plans incur tax liability at the time deferred amounts become vested, many such plans permit participants to elect annual distributions in amounts necessary to satisfy this tax liability. Such "interim tax distributions," though they pose no threat to the association or other plan participants, may substantially undermine any tax deferral for participants who elect them.

This is because interim tax distributions are treated as drawn first from any previously untaxed amounts that remain in the participant's account. Those amounts are postvesting earnings on prior deferrals and will be taxed at the time of the interim tax distribution. Only after all such postvesting earnings are distributed--and therefore taxed--is the remainder of any interim tax distribution treated as drawn from previously taxed amounts (on which no additional tax is imposed). This ordering rule largely destroys a 457(f) plan's primary tax advantage--the deferral of tax on postvesting earnings.

An executive who participates in a 457(f) plan may preserve this tax deferral on postvesting earnings by paying from his or her own assets the taxes that arise on the vesting of a deferred amount. An association could mandate this result by providing that no interim tax distributions will be made. As a practical matter, though, many executives balk at participating in any deferred compensation plan that could expose them to substantial tax liability without also providing a means for either satisfying or avoiding that liability. For this reason, it is wise to consider other alternatives to a flat prohibition on interim tax distributions.

* Free availability. One option, of course, is to make interim tax distributions freely available. Before allowing an executive to elect such a distribution, however, remind him or her of the adverse tax consequences of doing so.

* Delayed vesting. Another approach is to delay the date on which deferrals are vested. Because vesting requirements under the Employee Retirement Income Security Act (ERISA) do not apply to 457(f) plans, such a plan could provide, for example, that vesting not occur unless and until an executive remains continuously employed by the association through the earliest of his or her death, disability, or attainment of a specified retirement age. Under such a provision, an executive avoids all tax liability until the earliest of these vesting events.

* Executive elections. Many executives prefer to suffer immediate taxation rather than risk forfeiting their deferrals. This is particularly true of executives who fear an involuntary termination of employment. Where this is the case, the rate at which deferrals vest could be left to the election of each executive. Risk-averse executives could elect rapid (or even immediate) vesting, while executives more concerned about tax deferral could elect to remain nonvested until retirement age.

The trust fund option

As noted above, even the limited tax deferral available under a 457(f) plan depends on the plan remaining unfunded. In the event of the association's insolvency, executives participating in such a plan could lose their deferred compensation to the association's general creditors.

For this reason, executives might ask that their deferrals be held in a trust fund to which the association's creditors have no access. When fully informed of the adverse tax consequences resulting from this course of action, however, executives often drop this request.

For example, executives participating in a funded plan would lose the benefit of Section 457(f)'s tax deferral on postvesting earnings. Instead, the executives would be taxed each year on the increase in their vested accrued benefits--regardless of whether they received any distribution.

To make matters worse, the trust fund itself would be taxable. To the extent the trust fund's annual earnings exceeded its distributions, the fund would owe tax. This additional level of tax would, of course, reduce the assets available to pay benefits to executives participating in the deferred compensation plan.

One way to avoid this double taxation would be to annually distribute all of the trust fund's earnings to participating executives. These distributions could be claimed as a deduction, fully offsetting the amount of the trust fund's taxable income. Unfortunately, such distributions would be fully taxable to the executives. Moreover, an executive younger than 59 1/2 at the time of the distribution would be subject to a 10 percent penalty tax on premature distributions. Combined with federal, state, and local income taxes, this penalty tax could push the marginal rate to nearly 50 percent.

In addition to these adverse tax consequences, the establishment of a funded deferred compensation plan would defeat the plan's reliance on ERISA's top-hat exemption. The plan would be subject to all of ERISA's funding, trust, vesting, reporting, and disclosure requirements. Given these tax and ERISA consequences, an employer would surely be better off making additional cash compensation available to its executives. Each executive could then decide whether to take advantage of tax-sheltered investments.

This is not to say that association executives must entirely forego a trust fund for holding of their deferred compensation. The agreement establishing any such trust should make clear, though, that the deferred amounts will remain subject to the claims of the association's general creditors in the event of the association's insolvency. Such a trust, commonly referred to as a "rabbi trust" (because the first such trust for which the Internal Revenue Service issued a private letter ruling involved the payment of deferred compensation to a rabbi), is treated as a mere extension of the sponsoring employer.

For tax purposes, any income, deductions, or credits otherwise attributable to the trust are instead attributed to the employer. In the case of a tax-exempt association, this effectively shields the trust's income from tax.

Unfortunately, the advantages of a rabbi trust are limited. It can protect executives from a change of heart on the part of the association's board or top management. Rather than being forced to litigate his or her entitlement to plan benefits, the executive (or former executive) simply submits a claim to an independent trustee. Assuming the participant meets the plan's requirements (and the association is not then insolvent), the trustee should pay those benefits.

Other considerations

Before embarking on a deferred compensation program for top executives, it is important to consider a number of factors besides the tax and ERISA consequences covered in this article.

Is the goal to recruit and retain talented executives, or does the association wish to reward long-term executives for loyal service? Will executives be expected to defer a portion of their current income, or will the association use additional assets to fund the deferrals? And will executives have any right to direct the investment of any amounts set aside to provide future benefits? Discuss these and other questions with the executives involved and with a professional who is qualified to draft a deferred compensation program.

Because tax-exempt associations must contend with tax code restrictions that do not apply to taxable employers, any tax deferral comes at a price. The executive must run the risk of forfeiting deferred compensation if his or her employment is terminated before an agreed vesting date. Once vesting occurs, the executive may be taxed before he or she is entitled to receive any deferred amounts. Structuring the deferred compensation program to assist with this tax liability may undermine the entire program's purpose.

Associations that recognize these problems in advance can overcome most of the obstacles standing in their way of providing significant deferred compensation to their executives. At a minimum, the association's deferred compensation program can be structured in a way that lets each participating executive select the risks he or she is willing to face--and the tax advantages to be gained.

Who Wears a Top Hat?

If your association is subject to the Employment Retirement Income Security Act (ERISA)--and all but governmental and church-controlled associations are--you'll want to identify your top-hat employees before you establish any deferred compensation plan. Technically, this term refers to "a select group of management or highly compensated employees."

Your association will have much greater flexibility in creating a deferred compensation plan if it covers only top-hat employees. If any other employees are covered, the plan must comply with all of ERISA's requirements--which effectively forecloses all deferred compensation options other than qualified plans and tax-deferred annuities.

Unfortunately, the Labor Department has never formally defined the types of employees who may be covered under a top-hat plan. Its most authoritative statement on this question limits participation in such plans to individuals who, "by virtue of their position or compensation level, have the ability to affect or substantially influence, through negotiation or otherwise, the design and operation of their deferred compensation plan, taking into consideration any risks attended thereto, and |who~, therefore, would not need the substantive rights and protections of |ERISA~." DOL Advisory Opinion 90-014A. Taken literally, this description would probably apply to no more than a handful of top executives who help set policy for the association.

Many employers have adopted top-hat plans covering employees who seem not to meet this definition, but these employers run the risk of a Labor Department determination that their plans are fully subject to ERISA. Serious consequences could result from such a determination--including liability for breach of fiduciary duty. The safer course is to limit participation in any top-hat plan to those executives who truly engage in policy-making.

Kenneth A. Mason is a partner with the Kansas City, Missouri, law firm of Spencer Fane Britt & Browne.
COPYRIGHT 1993 American Society of Association Executives
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Title Annotation:Annual Meeting Issue
Author:Mason, Kenneth A.
Publication:Association Management
Date:Aug 1, 1993
Previous Article:Lessons from Sydney.
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