Taxation Of Pension And Profit Sahring Plans
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The term “the non-qualified deferred compensation” (NQDC) refers to those methods of compensation under which the participant receives payment for services long after they are rendered. This study centres attention on the use, terms, and effects of NQDC plans as they influence executives. First, taxation is particularly important to executives because their earnings have been subjected to especially high rates under our progressive individual tax system. In addition, executives’ efforts are extremely important in guiding the production of goods and services. The concentration of attention on NQDC plans used in large corporations is justified because of the importance of such companies in the nation’s economy. This paper is primarily a study of the pros and cons of NQDC, the effects of federal taxation on the use and conditions of NQDC plans for executives in large corporations, and of the economic effects arising from them. NQDC plans have changed greatly in the last 20 years, partly as a result of increased taxation. A very important aspect of this change is the increased use of deferred-type plans. Although this study is primarily concerned with NQDC plans, it considers briefly at several places other types of compensation plans.
NQDC plans which include executives may be classified on several grounds. The principal classification used in this study is as follows:
Deferred distribution bonus plans
Deferred distribution profit-sharing plans
Formal retirement plans
Available evidence indicates that four kinds of NQDC plans increased in recent years among large corporations (Bradshaw 2). NQDC plans increased in use among large financial concerns. Large corporations are not the only companies which have increased the use of such plans in recent years. Available evidence indicates that most of the recent plans have been adopted by corporations, as distinct from proprietorships and partnerships; that the number of plans has increased rapidly in recent years compared to the total number of active corporations; and that many of the plans have been adopted by small corporations (Caruth 56). As reported by executives, the following five broad factors contributed to the growth among large corporations of NQDC plans which include executives: (a) increased personal and corporate taxation; (b) increased competitive pressures in competing for employees, including executives, and in maintaining efficient organizations; (c) increased profits which accompanied an increased national income; (d) reduced old age security of employees, mainly the lower paid employees; (e) wage and salary stabilization. Increased competitive pressures and increased taxation, particularly personal taxation, were the most important factors contributing to the growth of NQDC plans (Earles 4).
There is a list of qualification requirements which must be satisfied by retirement, deferred distribution profit-sharing, and deferred distribution bonus plans before certain tax advantages may be enjoyed by employee participants, the companies maintaining the plans, and the plans themselves (Bradshaw 3). Plans meeting these qualification requirements are usually designated as qualified plans, while plans not meeting these requirements are called nonqualified or unqualified plans. Therefore, NQDC plans can be extremely flexible.
The status of a compensation plan as to its qualification was not too important until recently. Before deferred-type compensation plans were greatly altered to penalize nonqualified plans and to increase qualification requirements, the tax disadvantages of nonqualified compensation plans were not too serious, even when tax rates were high. Some nonqualified plans led to federal tax advantages which were quite favorable compared with those of qualified plans. Moreover, before the era of high federal tax rates, any difference in tax treatment accorded qualified and nonqualified plans was far less significant than it was after federal tax rates rose.
Advantages of NQDC Plans
Tax advantages to employers and highly compensated employees, including executives, are of great importance as factors contributing to the recent growth of NQDC plans. Classified according to the method used in financing the liabilities to participants, NQDC plans are either funded or unfunded. Under a funded plan, all contributions, whether made by the employer or by the participants, are paid to an independent agent who manages the contributions collected and the earnings on all funds invested. The agent may be a life insurance company, in which case the plan is designated as an insured plan, or a trust, in which case the plan is designated as a trusteed plan. Contributions made under a funded plan are for the purpose of financing the liabilities so as to insure the eventual payment of benefits.
Under an unfunded plan, liabilities are not financed, in the sense that no payments are made under the plan by any party until benefits are paid to participants. Payments are made by the employer to create a fund from which future payments may be made. The fund is managed for the employer, however, not the participants, and any payments made from it are paid to the employer. Participants do not contribute under unfunded plans, and all the liabilities represent obligations, not necessarily enforceable, of the employer to participants. The employer may recognize these obligations by creating a balance sheet reserve.
The funded or unfunded nature of a plan is an important determinant of the tax advantages enjoyed by the employer. Under a well-established principle of income tax law, certain expenses may be deducted from taxable income only if they are actually paid by the company claiming the deduction. It is not possible to claim a deduction under an unfunded plan until the participants start to receive benefit payments, while it is possible to claim a deduction for contributions made to a funded plan, provided that the deduction is allowed for the type of plan concerned, before benefits are paid to participants (Weinberger 2). Since the timing of deductions is often of great advantage to a company, the distinction between funded and unfunded plans, which forms the essential grounds for permitting deductions under tax law, is of fundamental importance in comparing the tax advantages of NQDC plans.
Significance to employer and to participant, and combined tax advantages as factors in the growth of plans
As indicated above, the tax advantages influencing the growth of deferred-type plans vary in accordance with the type adopted and its basic purposes. Although some companies adopting NQDC plans with general coverage include executives only incidentally, other companies adopting such plans are significantly influenced by the heavier personal taxation of executives. For companies in the former group, the tax advantages to the company are more important than those to participants. For companies in the latter group, the tax advantages to both executives and the company are important. For the many companies adopting profit-sharing and retirement plans with restricted coverage, the tax advantages to executives are of special importance. Although companies adopting NQDC plans are mainly concerned with the tax advantages to executives, those applicable to the employer are not disregarded.
Measurement of the tax advantages accruing to the employer or participant from the use of a NQDC plan involves a comparison of the tax liabilities accruing from its use as compared with those arising from the use of an alternative plan. Such tax advantages are based upon assumed behavior of the employer or the participant. Each of the plans within a ranked category yields equivalent tax advantages to the employer. Although different types of qualified plans do not yield exactly equivalent tax advantages, the differences are not important for purposes of this paper.
Differences in tax savings arise under the plans because the ability to deduct compensation paid or accrued through these plans and the time when deductions may be taken vary considerably. These differences in tax savings depend upon the existence and level of expected future profits and tax rates relative to those in the present. The amount of taxes saved by the employer under the plans depends on the form of business organization.
Employer contributions currently paid to NQDC plans may be deducted currently by the company to the same extent as compensation paid in salary if the rights of participants to such contributions are nonforfeitable when the contributions are made, and the tax savings accruing to the company are the same as those for any other rank one plan. Nonqualified unfunded plans yield smaller tax advantages because the corporation is only allowed to deduct contributions paid from future taxable income. The present rights of participants to future benefits may be either forfeitable or nonforfeitable, but this distinction is of no relevance in determining the time when deductions may be taken. Despite the appearance that the company gains interest earnings on taxes saved by current deduction, it yields more tax advantages than future deduction only because future profits are uncertain. If the amount of future profits were known for certain, nonqualified unfunded plans would yield the same tax advantages as funded plans (Toshihiro 5).
Tax advantages to executive participant
The relative tax advantages of NQDC plans to the executive participant under conditions prevailing in recent years are more difficult to evaluate than those to the employer. There is some question as to whether increases of compensation granted through nonqualified unfunded plans would be taxable during the payment period, as is assumed. This question is especially appropriate as applied to deferred compensation plans and nonqualified bonus plans created for one participant. If accruals under such plans were taxable as earned during the contribution period, these plans would produce the highest tax liability to the participant (Weinberger 7).
There is a disadvantage connected with the tax treatment of nonqualified plans in addition to those previously discussed. When the employer grants increased compensation under these plans, it pays a contribution which is included in the taxable income of the participant for that year. The extra tax liability of the participant must be paid in cash from other income. This cash drain implies that nonqualified plans may be less advantageous to the participant than salary annuity plans, under which he receives cash with which to pay the extra taxes.
Nonqualified unfunded plans are not always financed by balance sheet reserves. Among many small companies, funds committed to fulfill liabilities under deferred compensation or perhaps nonqualified unfunded bonus plans are paid to an insurance company as premiums under a policy taken out by the company on the life of the participant. The policy is payable to the company when the participant reaches a certain age, when he dies, or when the endowment date is attained, in a form as determined by the employer when it exercises its payment option.
The tax advantages of such a plan are slightly greater than those of plans used in large companies. Although interest earned by the insurance company is practically tax free, it is taxable as income to the employer when received, unless received as proceeds at the death of the participant. Assuming that the company receives the interest other than as a result of the death of the employee, the interest in principle is taxable to the company as received. When the deferred payments are paid to the participant, the company takes a deduction for the payments, as under any unfunded plan. Compared with the accrual of reserves, the use of insurance is more advantageous because the accumulating power of the interest earnings, which are practically tax free until received by the company, is greater than that of interest earned by the employer, which is taxable as earned (Laffie 2).
Combined tax advantages to company and participant of different plans
Under the conditions applicable to companies and to executives, only qualified plans invariably yield the greatest combined tax advantages to both the company and the executive. The relative status of other deferred-type plans depends upon further conditions. For executives who are not very highly compensated, salary annuity plans provide the next highest tax advantages, while for those who are highly compensated, nonqualified unfunded plans come next after qualified plans. Qualified plans provide the highest combined tax advantages; nonqualified unfunded plans, the next highest; and salary annuity plans, the third highest (Caruth 90).
When corporate tax rates are the same in both the payment and contribution periods, nonqualified unfunded plans are more advantageous than salary annuity plans. There was a marked increase in the use of nonqualified deferred compensation plans and nonqualified unfunded bonus plans.
In all three cases, the superiority of the tax advantages available under qualified plans is evident. Although NQDC plans produce approximately the same tax advantages as salary annuity plans in the three cases, they are very disadvantageous in that they force the participant to pay additional taxes on the increased compensation from other income. Nonqualified trusted and insured plans are least advantageous of all plans in most of the situations arising under the tax assumptions. Under tax assumptions, these plans are more advantageous than salary annuity plans and others of approximately equal advantages where the tax rates applicable during the contribution period are much higher than those during the payment period. Even under these conditions these plans are less advantageous than nonqualified unfunded plans, which can be utilized to defer payments to highly compensated individuals.
Summary of conclusions
Differences in the tax advantages to the employer company arise because of differences in the ability to deduct compensation paid or accrued and in the time when allowable deductions may be taken. Differences in the tax advantages to the executive arise because of variances in the time when contributions or accruals are taxed to the participant and in the tax treatment of interest earnings. Under conditions prevailing in recent years, the combined tax advantages of various deferred-type compensation plans are dependent upon the relative position of corporate and personal income tax rates in the contribution period (active employment period) as compared with the payment period (deferred payment period).
Under the conditions of constant profits and tax rates nonqualified unfunded plans yield smaller tax advantages than qualified plans only because the uncertainty of future profits reduces the possible tax savings from the future deduction allowed nonqualified unfunded plans as compared with those available from the current deduction allowed under qualified plans. Nonqualified unfunded plans are especially disadvantageous when a company is allowed to claim a deduction only in the year when the contribution is paid.
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Caruth, Donald L. (2001). Managing Compensation (And Understanding It Too): A Handbook for the Perplexed. Quorum Books: Westport, CT.
Earles, Melanie James. (2002). ‘Employment Benefits and Divorce: Who Pays the Tax? Journal of Accountancy. Vol.: 193 (2).
Laffie, Lesli S. (2004). ‘Audit Initiative Targets Executive Compensation: The IRS Will Examine Public Companies and Their Key Employees.’ Journal of Accountancy. Vol.: 197 (3).
Toshihiro, Ihori. (2002). Social Security Reform in Advanced Countries: Evaluating Pension Finance. Routledge: New York.
Weinberger, Mark (2002). ‘Use Best Practices in Executive Compensation Plans.’ Journal of Accountancy. Vol.: 193 (6).