By David Hauptman

Deferred compensation plans can serve as more than just an attractive benefit to help executives fill the retirement income gap left by 401(k) plans. They’re also a great way to counter the risk and cost of lost deductions that their employers may face under the 2017 Tax Cuts and Jobs Act.

Several specific changes to the tax code as a result of the act are worth noting. For starters, performance based compensation and commissions no longer are excluded from the previous deduction limit of $1 million, so employers that are publicly held lose tax deductions on a larger portion of compensation. In another change, the principal executive officer and principal financial officer, plus the three other highest paid officers of the company, are now permanently “covered” employees – after retirement and perhaps after death.

The upshot? The magnitude of lost deductions has the potential to be huge. How can deferred compensation help? Having your covered employees shift compensation from pre- to post-retirement can reduce, if not eliminate lost deductions altogether.

Consider two scenarios illustrating the impact of a non-qualified deferred compensation plan (NQDC) against this backdrop: Public companies must disclose deferred compensation for named executive officers (NEOs). Balances in NQDC plans are at risk of company financial solvency since plans are not formally funded for ERISA purposes and plan participants must be general creditors. What message is sent to employees, shareholders and other officers if the NEO is not deferring?

Scenario No. 1: CEO does not participate in deferred compensation plan:

Year Gross Comp (salary + bonus) Pretax deferred comp elected into NQDC plan Net comp paid by Company Lost deduction
2019 $1,300,000 $0 $1,300,000 $300,000
2020 $1,350,000 $0 $1,350,000 $350,000
2021 $1,450,000 $0 $1,450,000 $450,000
2022 $1,500,000 $0 $1,500,000 $500,000
Total   $0   $1,600,0000

As the table shows, a company with a combined 25 percent federal plus state effective tax rate would lose $400,000 to the bottom line – or $1.6 million in total lost deductions with a 25 percent tax refund. And the CEO loses, too, by paying tax at the highest rate in the highest bracket without advancing retirement savings.

Scenario No. 2: CEO does participate in deferred compensation plan:

Year Gross Comp (salary + bonus) Pretax deferred comp elected into NQDC plan Net comp paid by Company Lost deduction
2019 $1,300,000 $300,000 $1,000,000 $0
2020 $1,350,000 $350,000 $1,000,000 $0
2021 $1,450,000 $450,000 $1,000,000 $0
2022 $1,500,000 $500,000 $1,000,000 $0

Here, not only has the company lost nothing, but the CEO has enjoyed a potentially reduced tax bill and a compounded rate of pretax retirement savings. The CEO also could elect to receive distributions of the $1.6 million over ten years. Providing there was no other income during that time, the annual $200,000 payments would be taxed at a lower rate and bracket than if received pre-retirement.

It’s also important to note that the deferred amounts are still subject to the deduction limit under the revised tax code when they are paid. If the entire deferred balance of $1,450,000 was paid out at once, a deduction of $450,000 would be lost.

It’s worth looking into, if your named officers are willing. But do nothing without first consulting experienced compensation counsel. And keep in mind that there are complex tax rules for deferring compensation and how it can be paid. Penalties for not following them can be stiff.

HUB International’s specialists in retirement and benefits strategies are available to consult with your organization on ways to enhance executive benefits.