Deferred Compensation Planning Opportunities for Executives of Tax-Exempt Entities

Executives of nonprofit, tax-exempt entities are often frustrated by their inability to duplicate the opportunities available in the for-profit sector to defer their receipt of significant amounts of otherwise current (and currently taxable) compensation to the period following their retirement. This frustration has been exacerbated by the significant tax increases included in the American Taxpayer Relief Act of 2012.

In the for-profit sector, in addition to deferrals available under tax-qualified plans, an executive may defer unlimited amounts of current compensation, with the deferred amounts, plus earnings, typically payable to the executive following the executive's termination of employment. So long as such deferred amounts are not funded in a vehicle that is beyond the reach of the general creditors of the employer, the deferred compensation and related earnings are not subject to federal income tax until it is paid to the executive, notwithstanding that the executive is typically fully vested in the deferred compensation.

In the tax-exempt sector, however, Section 457 of the Internal Revenue Code imposes different rules with regard to the amount of compensation which an executive may annually defer. Under Section 457, deferred compensation in excess of specified annual amounts is taxable to the executive in the year in which such deferred compensation is no longer subject to the executive's ongoing employment (i.e., when the executive is "vested" in the deferred compensation), without regard to whether the employer funded its obligation to pay the deferred compensation at the designated distribution date.

These rules are often construed by tax-exempt employers as limiting the deferred compensation opportunity that can be provided to key executives outside of tax-qualified plans to the amount ($17,500 in 2013) that can be provided through an "eligible" (for purposes of Code Section 457) deferred compensation plan.

Two important planning techniques, however, can significantly increase the amount of compensation that a key employee of a tax-exempt entity may annually defer.

First, changes in the Code, which became effective in 2002, eliminated the offset of amounts deferred under an eligible Code Section 457 plan against deferrals that the executive may make under a tax-sheltered annuity or a 401(k) plan, thereby permitting an executive to "double up" his or her pre-tax deferrals. In 2013, for example, an executive can elect to defer $17,500 under a tax-sheltered annuity or 401(k) plan and also defer $17,500 of otherwise currently taxable income under an eligible Code Section 457 plan. (An additional $5,500 deferral may be made if the executive is at least 50 years old by the end of 2013.)

Second, by carefully tying additional deferrals to the executive's targeted retirement date and inserting appropriate provisions in the executive's employment agreement, the executive can effectively defer significant additional compensation, subject only to a risk of forfeiture in the event that the executive elects to voluntarily terminate employment prior to the targeted retirement date. The executive can be protected against an involuntary termination of employment (other than for "cause"), death, disability, etc. and can even be protected against a risk of forfeiture in the event the employer becomes insolvent before the additional deferrals are paid to the executive.

For example, assume that a senior executive of a tax-exempt college who is 55 years old and earning $200,000 annually wants to significantly increase his or her deferrals during the next five years, in anticipation of retiring upon reaching age 60. The college currently maintains a defined benefit plan under which the executive accrues a pension benefit under the rules applicable to all college employees. The executive, in addition, participates in a 403(b) tax-sheltered annuity program made available by the college, making the maximum deferrals ($17,500 plus the $5,500 "catch up" contribution) permitted for 2013.

By (i) persuading the college (at no cost to the college) to implement an eligible Section 457 plan for the executive and (ii) taking advantage of the legislative change repealing the coordination of the Section 457 and Section 403(b) limitations, the executive can defer an additional $17,500 in compensation in 2013. Under the applicable rules, the executive can be fully vested in this additional deferral, but the deferred amount (plus earnings on the deferred amounts) must remain unfunded or, alternatively, can be funded by the college in a "rabbi trust," the assets of which remain subject to claims of the college's general creditors.

In addition, the executive may defer an unlimited amount of additional compensation pursuant to an "ineligible" Section 457 plan. If the executive elected to defer, for example, an additional $50,000 in 2013, such amount would be deducted from the executive's 2013 salary and invested in a mutual fund, certificate of deposit, etc. as the college and the executive determine. These funds (and their earnings) could be funded in a rabbi trust or even in a trust the assets of which would be beyond the reach of the college's general creditors. So long as the $50,000 deferral (plus earnings on the deferral) would be subject to forfeiture if the executive voluntarily elects to terminate his or her employment with the college prior to reaching age 60 (the targeted retirement date previously selected by the executive), the deferred amount and its earnings would not be subject to federal income tax until it is actually paid to the executive following the executive's retirement, in accordance with whatever payment arrangements the executive had previously elected. (The college, at a future date, could agree to "vest" the executive in the deferred compensation even if the executive elected to prematurely retire without thereby causing the tax deferral arrangement to fail retroactively, so long as the executive could not, as a legal matter, force the college to vest the executive in the deferred compensation upon the executive's early retirement.) By carefully addressing these issues in the employment agreement and the Section 457 plan document, the executive can be fully protected against the risk of forfeiture if the executive terminates employment with the college prior to reaching age 60 due to the executive's death, disability or involuntary termination by the college other than for cause. (Significant severance protection can be built into the executive's employment agreement to protect the executive against being terminated by the college without cause prior to reaching the executive's target retirement age of 60.)

Section 409A of the Code should also be noted. This provision of the Code adds restrictions regarding the ability of an employer and an executive to change the timing and the form of payments (e.g., lump sum, installments) to be made under an "ineligible" Section 457 plan after those terms have been initially established. Significantly, Section 409A does permit an ineligible Section 457 plan to provide for an accelerated distribution from the plan to the executive at the time the executive becomes vested in his or her account balance, thereby assuring the executive that in the event the executive vests in his or her ineligible Section 457 plan account earlier than originally anticipated, the plan will be permitted to distribute sufficient cash to the executive to cover the income taxes owed by the executive upon becoming vested in his or her account, notwithstanding that the distribution date and form of distribution previously specified by the executive might not otherwise permit such a distribution.

As is apparent, these planning techniques afford executives of tax-exempt entities the ability to defer substantial amounts of compensation to the period following their anticipated retirement, creating the potential for significant capital accumulation and tax savings while minimizing, through careful drafting of the relevant employment contracts and plan documents, the "credit risk" relating to the employer's solvency, the "employment risk" relating to the executive's premature termination of employment and the impact of the limitations imposed pursuant to Code Section 409A.