In a highly competitive marketplace, it’s critical to offer the most tax-advantageous compensation plan to attract top executives. The tax code allows employers to develop such plans, and excess benefit plans and restricted stock are two of the top strategies.
Employers can attract top executives by offering excess benefit plans. They can provide additional benefits for certain highly compensated employees above what can be provided due to limits in most qualified plans. For 2023, total annual additions to a defined contribution plan by both the employer and employee are limited to $66,000. Under a defined benefit plan, the annual benefits payment limit is $265,000 for 2023. With an excess benefit plan, however, an employer can pay benefits in excess of these limits with the excess amounts being credited to a nonqualified deferred compensation account to be paid to the employee at a later date.
There are two ways employers can set up this type of plan. Funded plans segregate the contributions in a reserved account, which is only for these contributions. Employers can back up these assets by purchasing annuities or setting up a secular trust, which functions as an irrevocable trust that an employer sets up with a third party to maintain assets for an exclusive purpose.
An unfunded excess benefit plan is risky for the employee. It is backed only by its general assets. There’s no segregation of assets and no annuity—the executives rely on the employer’s word. This is risky because the company could become insolvent or have a change in management.
One way the employee can help mitigate this risk is to have the employer set up these assets in a rabbi trust, a legal document that ensures the executive receives their deferred income. The main pitfall of a rabbi trust is that it doesn’t protect the assets if the company goes bankrupt.
Tax consequences are a little different between funded and unfunded plans. The employer receives a tax deduction the year the employee includes the contribution in their gross income. The main difference in a funded versus an unfunded plan is that the employer can’t use earnings on top of the contribution as a deduction.
Another difference for an unfunded plan is that taxation is deferred for the employee until the benefits are fully vested and/or the employee receives the deferred income. Also, regarding taxation to the employee, a funded plan is taxed on the vesting date, while an unfunded plan is taxed on receipt.
Lastly, nonprofit entities and government plans are taxed the same regardless of whether a plan is unfunded or funded. They are governed by Section 457 of the tax code.
Restricted stock is becoming popular among employers. One advantage for a corporation to offer restricted stock is that it is less dilutive compared to stock options. This type of stock typically vests after a few years of service—five, seven, etc.
The tax treatment of restricted stock is the same for both the employer and employee. It becomes taxable income after the restrictions lapse. For example, if ABC Tech offers its new CFO 2,000 shares of restricted stock, the employee must stay in their role for a set period. Once that time ends, it becomes taxable income. The employee will be taxed only on the future gain at the long-term capital gains rate if he or she holds the vested shares for more than one year. It’s advantageous that the employee be taxed in this manner because these rates are traditionally much lower than ordinary income rates.
Executive compensation is an intricate topic that must be approached with precision. Excess benefit plans and restricted stock can yield tremendous tax savings for both employers and employees. If handled correctly, implementing the appropriate employee benefit can increase both executive morale and value for shareholders.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Mark Brumbelow is managing principal of tax at PYA and has nearly two decades of experience assisting middle-market, private equity-backed, and public companies located across North America. He has supported clients on federal and multi-state engagements, domestic tax reporting, and has provided consultation and review of income tax provision calculations under ASC 740.
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