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DEFERRED COMPENSATION
The objective of this course is to examine areas that are often overlooked in the valuation of a company. While the first part of the course dealt with accumulated earnings; this section deals with deferred compensation issues that create a liability or potential gain for the company. The probability of a liability is strong anytime compensation is deferred. This happens most often in the administration of benefits. There are two situations that will almost automatically create a liability:
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When an employee is vested in a benefit.
Vesting The process by which an employee obtains the right to a benefit with no risk of forfeiture. -
When an employee has a right to something, but the company has not set aside the necessary funds. This creates an unfunded liability for the future.
Let’s take a look…
Company J’s sick-leave policy allows employees to build up hours without a cap. Greg has hundreds of hours built up. He recently fell ill.
Company J must pay his full salary for an extended period of time. This payment is at Greg’s current salary level. For all similar employees, Company J has a large unfunded potential liability that is unaccounted for.
A note about unfunded liability situations...
| Sick leave | Vacation |
|---|---|
| Most sick-leave plans don’t pay for accumulated sick leave at the time of separation, but they may pay for some portion or percentage as outlined in the policy. Most policies restrict the amount of accumulation. | Vacation time is usually more controlled than sick leave. The build up of hours is usually restricted to a maximum number. Vacation hours are payable upon separation. |
The most common deferred compensation plans are retirement plans – qualified and nonqualified.
Qualified Plans
Qualified plans fall under the jurisdiction of the Employee Retirement Income Security Act of 1974 (ERISA).
ERISA has 4 basic requirements for qualified plans:
- Minimum age and service requirements for participation. Employees are eligible for participation when minimum requirements are met. In most cases, a broad range of employees must participate if the plan is to be qualified.
- Vesting. The plan must have a vesting schedule by which all participants acquire a right to the benefits.
- Funding. There are minimum funding and trust requirements.
- Fiduciary. A fiduciary must oversee the plan to make sure it follows transaction rules.
Q: What is the basic advantage of qualified plans?
A: Taxes.
Let’s take a look at the tax advantages of a qualified plan from the viewpoints of employees and employers:
| Employees | Employer |
|---|---|
| Plan assets are tax deferred until the employee receives the benefit. The benefit, when paid out to the participant, is not subject to FICA or other payroll-based taxes. Since the plan is funded, the assets are secure. | Contributions made by the employer to the plan are tax-deductible to the employer. |
Qualified plans include 401(k) plans and 403(b) plans (for public school employees and other tax-exempt organizations).
Memory Jogger
Accrued sick time is a deferred compensation plan that may be: