| In addition
to providing qualified plans to employees, many business owners
implement nonqualified alternatives in order to supplement
retirement benefits. These selective benefit plans are
generally offered to key employees and owners. One popular
nonqualified benefit is deferred compensation.
Basically, nonqualified deferred
compensation refers to an arrangement between an employer and an
employee in which compensation for current services is postponed
until some future date or the occurrence of a future
event. The effect is to postpone taxation for the
employee until compensation is received - usually at retirement or
disability.
Type of Deferred Compensation
Deferred compensation plans can be
categorized several different ways. Plans can be either funded
or unfunded, forfeitable or nonforfeitable, defined benefit
or money purchase. They can also provide one or a
combination of death benefits, disability benefits and retirement
benefits.
Funded plans generally
involve a trust fund or escrow account where the employer
transfers money for its "promise to pay" deferred
compensation at a later date. These are not very popular as
the participant may be deemed to have "constructive
receipt" of such funds and therefore inherit a current tax
liability when funded.
IRS Revenue Ruling 60-31, 1960-2 CB
174, states that an employee's right to receive deferred
compensation, backed during the deferral period solely by an
employer's "naked promise" to pay, produces no currently
taxable income for the employee. A deferred compensation
plan is not regarded as funded merely because the
corporation purchased and owns a life insurance policy or annuity contract
to make certain that funds will be available when needed.
Rabbi Trusts
One of the problems with a typical unfunded
deferred compensation plan is that the employee has no guarantee
that future payments will be made. If the employer defaults
in making promised payments, becomes insolvent or files bankruptcy
the employee simply becomes a general creditor.
The rabbi trust protects an
executive from an employer's future unwillingness or inability to pay promised
benefits while retaining the benefits of deferred income taxation.
The IRS has stated in a series of private letter rulings that an
irrevocable trust or an escrow account can be established to fund
a deferred compensation agreement as long as the assets placed
into the rabbi trust remain subject to the claims of general
creditors. If this condition is met the employee will not be
deemed to have "constructive receipt" of the assets,
and, therefore, will not have received a current economic benefit.
Hence, the employee will not be required to pay taxes until the
payments are made at a future date.
The rabbi trust gives the employee
security in knowing that the employer is, in fact, setting aside
money to fulfill its obligation under a deferred compensation
agreement.
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