Accumulated Earnings and Deferred Compensation

SUMMARY

Accumulated earnings and deferred compensation are two ways in which organizations attempt to avoid taxes, but if not effectively managed, they can lead to additional taxes and penalties.

Accumulated Earnings

Accumulated earnings occur when a company holds on to earnings instead of distributing them to stockholders. This is done mainly by closely held corporations in order to avoid the double taxation of dividends.

The federal government tries to prevent the over-accumulation of these earnings by imposing two taxes.

• Accumulated Earnings Tax: Called the AET, this tax is imposed on retained earnings in excess of the bona fide needs of the corporation. The company’s intent is the crucial factor in triggering the application of this tax. Operating cycle must be taken into account when determining reasonable need, since some companies require working capital for inventory purposes or to expand operations. The Bardahl formula is useful for determining operating cycles.
• Personal Holding Company Tax: Called the PHC tax, it is designed to keep companies owned by high-income individuals from sheltering passive income that would otherwise be taxed as regular income to these individuals. It applies to personal holding companies in which more than 50% of the stock value is owned by 5 or fewer individuals and 60% or more of corporate income is from passive sources (like dividends and interest).

Deferred Compensation

Companies may also postpone payment of compensation to executives to reduce the tax burden to these employees. For example, an organization may put supplemental compensation into a retirement plan so that the employee will not have to pay taxes on this compensation until it is received in retirement. It is assumed that the employee will be in a lower tax bracket then, and so will lose less of the income to taxes.

Qualified plans

Organizations have the choice of offering qualified or nonqualified plans. Qualified plans meet the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). The employer may deduct contributions to these plans as a business expense, and employees don’t have to pay taxes on the benefits until they receive the money (usually upon retirement).

Nonqualified plans

Most nonqualified plans are designed to provide supplemental income to executives, are unfunded, and subject to creditor claims in the event of bankruptcy. If the organization goes bankrupt, the employee may never see the money. Also, the employer may only take a tax deduction for plan contributions when the employee receives the benefit (often many years in the future). On the plus side, there are no restrictions on the size of benefits that may be offered by these plans AND there are no reporting requirements.

For employees to avoid current taxation of nonqualified plans, these 3 issues must be considered:

1. Constructive receipt: An amount may become currently taxable to an employee even before it’s actually received.
2. Economic benefit: Any benefit with financial value must be included in compensation for income tax purposes in the year the benefit is granted.
3. Risk of forfeiture: A substantial risk of forfeiture must be incorporated into the design of the plan. The plan must be unfunded or the assets in the plan must be subject to the general creditors of the organization in the event of bankruptcy.

There are many types of nonqualified deferred compensation plans available. This course describes the following:

• Excess Benefit Plans
• Rabbi Trusts
• Secular Trusts
• SERPs
• Vested Trusts
• Stock Options
• Stock Appreciation Plans (SARs)
• Restricted Stock
• Golden (and other) Parachutes

For further information, please see Course 21:Compensation for Business Leaders, Course 74: Trends in Retirement Plans and Course 20: The Basics of Equity Compensation