By Mark P. Altieri and Linda J. Zucca

As the effective rate of income taxation for individuals has risen during the 1990's, the level of interest in the design of executive compensation packages that decrease the impact of taxation has also increased. This increase in effective rate was caused both by an increase in the nominal maximum marginal tax rates and a reduction in allowable itemized deductions and exemptions. In a span of just a few years,
the Revenue Reconciliation Act of 1990 and the Revenue Reconciliation Act of 1993 increased the nominal maximum marginal rates from 28% to 39.6% for individuals. Also, the 1990 Act initiated the phase-out of personal and dependency exemptions and the reduction of itemized deductions for high income taxpayers that added three to five percent in additional indirect marginal taxation. These latter "hidden" tax rate increases were made permanent by the 1993 legislation.

Advisers have responded
to these increases in individual tax rates by developing more deferred compensation arrangements (DCAs) for top executives of both small and large employers. DCAs are one of the few remaining legitimate devices for deferring income taxation of the employee. DCAs are usually provided in addition to the more common tax qualified pension or profit-sharing plans.

What is a DCA?

Broadly defined, a nonqualified deferred compensation agreement (DCA) is a contractual agreement pursuant to which an employee (or independent contractor) agrees to be paid in a future year for services currently rendered to an employer. Deferred compensation payments generally commence upon termination of employment (e.g., retirement) or pre-retirement death or disability. The DCA is generally geared toward payout at retirement to provide cash payments to the retiree and to defer taxation on the deferred compensation to a tax year when the recipient is in a lower tax bracket. Although the DCA is typically unfunded (for reasons discussed below), the obligation still constitutes a contractual promise that must be performed by the employer absent the employee being in material breach of his or her contractual promises under the DCA. However, because these arrangements are not qualified plans, the cost of the plan is not deductible to the employer until the benefits are taxable to the employee.

DCA plans may be categorized on the basis of two characteristics: 1) the structure of the plan (elective and nonelective), and 2) the funding status of the plan (unfunded, informally funded, and formally funded).

Plan Structure

An Elective DCA is one under which the employee opts to receive less salary and bonus compensation than he or she would otherwise currently receive and to defer receipt of the reduced amount to a future tax year. The initiative behind the deferral comes from the employee. This plan structure is essentially a defined contribution plan based on the amount deferred together with an interest factor. It is important that the election to defer income be made prior to the time the income is earned. For example, an agreement would be entered into on or before December 31, 1997, to defer 10% of compensation that would otherwise be earned and payable in the 1998 calendar year. The IRS will not issue an advanced ruling on a fact situation in which the agreement to defer compensation is entered into after the underlying services that earned such deferred compensation have been rendered. Because the employee is initiating the deferral of compensation that would otherwise be shortly earned and received, it would be inappropriate to impose a substantial risk of forfeiture on the DCA benefits. Therefore, an elective deferral should be fully vested and payable in the event of termination of employment for virtually any reason. Revenue Ruling 60-31 specifically allows income tax deferral irrespective of
the existence of a substantial risk of forfeiture.

A Nonelective DCA provides a deferred compensation benefit, in the form of a salary continuation agreement, as a pure fringe benefit to key employees. In this situation, the DCA benefit is a defined benefit (usually pegged to an average of active compensation for a number of years) without a stated interest factor. A nonelective DCA benefit is given as an add-on component of the compensation package to the participating employee. It does not result in a reduction in salary or bonus compensation otherwise currently payable, but usually incorporates a substantial risk of forfeiture requiring a number of years of service before the benefits fully vest.

Funding Status

Any form of DCA is likely to constitute a "pension plan" as defined under ERISA. An employee pension plan is defined in ERISA section 3(2) to include "any plan, fund or program established or maintained by an employer...to the extent...such plan, fund, or program (A) provides retirement income to employees or (B) results in a deferral of income by employees for periods extending to the termination of covered employment or beyond." ERISA pension plans must generally contend with the Title I reporting and disclosure, participation and vesting, funding and fiduciary responsibility requirements of the law. Compliance with these Title I requirements is extremely burdensome, time consuming and costly. Therefore, absent an exemption from ERISA compliance, most employers shy away from the maintenance of a DCA. The intensity of the employer's desire to obtain an exemption from the requirements of Title I of ERISA also has a direct impact on the funding decision for a DCA plan. The most common way to find an ERISA exemption is to structure the DCA plan as a "top-hat" plan. If the DCA is "unfunded and is maintained by an employer primarily...for a select group of management or highly compensated employees," it is exempted from most Title I requirements. The concept of such a "top-hat" plan being unfunded for ERISA purposes generally conforms to the concept of the plan being unfunded for tax purposes, discussed below. Which employees constitute a "select group of management or highly compensated employees" is much more vague. Although the concept is clearly meant to distinguish "top-hat" key employees from rank-and-file employees, the Department of Labor (DOL) has formulated no definitive standard. The DOL has indicated the requisite top-hat group be limited to individuals who, by virtue of their position or compensation level, have the ability to affect or substantially influence the design and operation of the DCA.

An unfunded or informally funded (described below) DCA should meet the objectives of both obtaining an exemption from most Title I ERISA requirements and deferring the taxability of the benefits to the employee until receipt of cash payments under the actual and constructive receipt doctrines of federal income taxation. The easiest way to avoid an actual or constructive receipt tax problem is for
the employee to receive only the employer's unsecured contractual promise to pay DCA benefits in the future at inception of the DCA, to refrain from any formal funding of the plan, and to require that payments are payable only out of the employer's general assets.

Economic Benefit Doctrine. Distinct from the actual and constructive receipt doctrines, and providing an additional means by which the government can currently tax a DCA, is the economic benefit doctrine. The economic benefit doctrine would currently tax the value of property transferred by an employer to fund a DCA to the extent the property transferred was legally set aside from the claims of creditors of the employer (e.g., under a trust arrangement) for the benefit of the employee under the DCA. This is true even though the benefitted employee has no current actual or constructive access to money or property funding the trust. The fact the benefitted employee is actually receiving a currently vested and secured economic benefit from the overall arrangement invokes current taxation.

Despite the above general rule, a number of "informal funding" techniques have developed that do not invoke the economic benefit doctrine, three of which will be briefly described here.

Life Insurance or Annuity Contracts. First, the employer's obligation may be financed through life insurance or annuity contracts. The policy must be the sole property of the employer and constitute a general asset subject to employer creditor claims.

Rabbi Trust. A second type of informal funding device is the creation by the employer of a "Rabbi Trust." The Rabbi Trust is established to provide the employee with some additional security that the employee will receive benefits in the event of a hostile change in management without accelerating employee taxation. The employer makes contributions to an irrevocable trust to provide for deferred compensation payments. Although the employer's contributions to the trust are generally irrevocable, the assets placed in the trust must remain subject to the claims of the employer's general creditors if the employer becomes insolvent or enters bankruptcy proceedings. If the employee has no ownership rights in the trust assets, the same favorable tax treatment for the employee generally available with a DCA results. Additionally, the DOL will not consider this type of plan to be funded for ERISA purposes if contributions to the trust by the employer are not currently taxable to the employee for income tax purposes.

FASB's emerging Issues Task Force recently placed an issue involving Rabbi Trusts on its agenda. It involves DCA's where the stock of the employer is placed in the trust as the funding for the DCA. At this writing, the action of the EITF on the issue is not known.

Set Aside Accounts. Similar to the above general line of informal funding and segregation of funds authority, an employer may establish a memorandum account to track the accumulation of benefits and to earmark assets to informally fund its obligations. Such set-aside accounts must, again, remain subject to the claims of the employer's general creditors. Additionally, an employee may designate a non-binding preference regarding the investment of employer assets used to finance DCAs. The employee remains a mere unsecured creditor of the employer.

Formally Funded DCA. A formally funded DCA is one in which an employer sets aside funds (in a nonqualified trust or escrow arrangement) to be used in meeting its obligations to pay deferred compensation in the future. The funds are either beyond the reach of the employer's general creditors or the employee has an interest in the funds that is senior to that of the employer's general creditors.

This arrangement intentionally invokes the economic benefit doctrine. The employee recognizes compensation income (in an amount equal to the value of the contribution to the trust or other funding vehicle) in the first taxable year in which his or her interest in the fund becomes substantially vested. As in the case of an unfunded or informally funded DCA, the employer's deduction may be taken in the year in which the employee recognizes income from the deferred compensation. Since the employee's taxable event is accelerated, so is the timing of the employer's deduction.

A funded deferred compensation arrangement is often referred to as a "secular" trust arrangement. In many cases the employee is willing to incur current taxation to obtain the enhanced security the secular trust arrangement provides. Additionally, an employer may be more willing to set up this type of funded deferred compensation arrangement since its deduction for contributions to the plan are accelerated. However, severe ERISA problems may result. A DCA (other than an excess benefit plan) that is formally funded by a trust or other funding vehicle has to comply with minimum vesting and other burdensome Title I ERISA requirements.

Financial Accounting for DCAs

Crucial to the determination of the appropriate accounting treatment for the DCA is the structure of the agreements themselves. The process of identifying the applicable accounting literature is outlined in the accompanying Exhibit and the following section.

Generally, accounting for DCAs is governed by paragraph 6 of APB No. 12, as amended by paragraph 13 of SFAS No. 106. As described earlier, to avoid ERISA compliance problems most DCAs will be structured as "top-hat" plans for the benefit of some or all of the employer's highly compensated or management employees. If the DCAs, taken together, are equivalent to a "postretirement income plan," the DCA should be accounted for under the general accounting rules of SFAS No. 87. DCAs that qualify under this criteria would include the earlier analyzed nonelective (defined benefit) or elective (defined contribution) "top-hat" plans if the top-hat arrangement used a standard formula and applied to most or all of the top-hat group. If the deferred compensation contracts, taken together are equivalent to a "postretirement health or welfare plan," the accounting and disclosure rules of SFAS No. 106 are appropriate. By definition, most DCAs would not qualify for SFAS 106 reporting since they primarily defer income rather than provide health or welfare benefits. Finally, any DCAs that do not fall into one of the above categories should be accounted for as individual contracts in accordance with APB No. 12. These DCAs would be a reciprocal of those arrangements covered by SFAS No. 87 noted earlier in this paragraph, that is, they would include "top-hat" arrangements (either elective or nonelective) where either one or a relatively few in number of the top-hatters were participating in the arrangement or if the benefit formula varied substantially for a top-hat plan covering most or all of the top-hat group.

DCAs Accounted for Under
SFAS No. 87

DCA plans are treated as though they are unfunded for accounting purposes if they are either unfunded (payable directly from the general assets of the employer) or informally funded (Rabbi Trust), as opposed to being formally funded (Secular Trust). Thus, the vast majority of DCAs will, as discussed earlier, be considered to be unfunded in the calculations of both periodic expense and minimum liability.

Under the provisions of SFAS No. 87, the periodic cost of an "unfunded" DCA will be composed of the--

* actuarially determined service cost
that represents the benefits earned by the covered employees during the current period,

* interest cost on the beginning
balance of the projected benefit
obligation associated with the DCA, and

* amortization of any prior service costs or unrecognized gains or losses, if any.

These calculations and cost components are the same as those required for any unfunded defined benefit plan under SFAS No. 87.

At the end of the reporting period, the minimum liability to be reported on the balance sheet will be the pension liability (actuarially determined present value of future benefits) since there are no offsetting plan assets formally set aside to fund the plan. Any informal funding arrangements, such as a "Rabbi Trust," must be classified as general assets of the employer, and income from those assets should be included in other income rather than as a reduction of periodic expense. However, the restrictive nature of the trust assets should be disclosed in the notes to the financial statements.

DCAs Accounted for Under
APB No. 12

If the DCA agreements, taken together, are not equivalent to a postretirement income (and thus not subject to the provisions of SFAS No. 87), the agreements must be accounted for individually under the provisions of paragraph 6 of APB No. 12, as amended by paragraph 13 of SFAS No. 106. Basically, the future benefits granted to the employee should be recognized as expense during the period(s) in which the benefits are earned (service period). At the end of the service period, the amount accrued should be equal to the "...then present value of the benefits expected to be provided to the employee, any beneficiaries, and covered dependents in exchange for the employee's service to that date."

During the service period, the employer will record compensation expense as well as interest expense on the accumulated obligation. In periods subsequent to the service period, interest expense will be recorded until benefits have been paid in cash.

Example. The following example of a DCA plan accounted for as an individual contract under APB No. 12, as amended by SFAS No. 106, illustrates these
calculations.

Chris Smith is hired by Acme, Inc. on January 1, 1995. As a part of her employment package, she is covered by a DCA contract. The contract provides she will receive payments of $10,000 per year for 10 years commencing one year after her expected retirement date of January 1, 2005 (a nonelective, defined benefit DCA). To receive the benefit, she must be employed by the company for the next five years. In this case, the service period (and the vesting period) is five years. A discount factor of 10% is considered reasonable.

The present value of the benefits at January 1, 2005, the retirement date, is $61,442. The Table provides a summary of the expenses and cash flows for the contract. Since the service period ends on January 1, 2000, five years after hire, the five years from January 1, 2000 to January 1, 2005 do not require a service cost component. However, interest cost accumulates on the DCA liability at 10% per year. On January 1, 2000, the present value of the liability is $38,151. APB No. 12, as amended by SFAS No. 106, does not specify a method for compensation expense recognition other than it must be accrued "...in a systematic and rational manner." The use of an ordinary annuity factor approach provides a simple method of allocation, yielding an annual compensation expense of $6,249 for each of the five years in the service period.

As with DCAs accounted for under the provisions of SFAS No. 87, any informal funding arrangements must be classified as general assets of the employer, with appropriate footnote disclosures. Likewise, any income from these informal funding arrangements must be included in the income of the employer rather than offset against the expense of the individual DCA agreements.

Additional Accounting Issues

There are three areas of potential accounting concern relating to DCAs, whether they are accounted for under the provisions of SFAS Nos. 87, 106, or APB No. 12 as amended by SFAS No. 106: 1) The use of segregated assets and Rabbi Trusts as informal funding vehicles, 2) the use of company owned life insurance policies (COLI) as an informal funding vehicle, and 3) deferred tax considerations.

General Assets and Rabbi Trusts as Informal Funding Vehicles. Because these informal funding vehicles do not entail actual contributions to an ERISA plan, they remain the assets of the employer. On the employer's balance sheet, they should be included with other cash and investments, and income from these assets should be included on the employer's income statement as "other income" rather than as a reduction of current DCA expense. The existence of an informal funding plan should be disclosed in the notes to the financial statements.

COLI as an Informal Funding Vehicle. Company owned life insurance policies with the employer as beneficiary (COLI) are a popular informal funding vehicle for DCA plans. The accounting for COLI purchased for informally funding a DCA plan is the same as that acquired for other corporate purposes. The cash surrender value of the policy should be included as an investment on the balance sheet. Any premiums paid in excess of increases in cash surrender value of the policy are recorded as an expense, but not as part of DCA periodic expense.

Deferred Tax Considerations. Because the DCA expense recorded during the service period does not render a tax deduction until paid, the DCA gives rise to a deferred tax asset, usually long term in nature. Under the provisions of SFAS 109, if it is more likely than not the deferred tax asset will not be realized, the deferred tax asset should be reduced by a valuation allowance. Income from general assets or a Rabbi Trust used as informal funding vehicles is recognized in accounting income and is taxable in the period earned and thus does not give rise to a deferred tax asset or liability. Although the premiums paid on a COLI in excess of increases in cash surrender value are expensed on the income statement, they are not deductible for tax purposes and are a permanent difference. *

Mark P. Altieri, JD, LLM, CMA, CPA, is an assistant professor and Linda J. Zucca, PhD, CPA, an associate professor in the department of accounting at Kent State University.

In Brief

Deferring Income for Top Executives

A nonqualified deferred compensation agreement is one whereby an employee or independent contractor agrees to be paid in a future year for services currently rendered and generally commence on termination of employment. Such plans may be elective or nonelective and either funded, nonfunded, or informally funded. Informal arrangements include the use of life insurance or annuity contracts, a "Rabbi Trust," or set aside accounts. Most plans are not funded in order to avoid ERISA requirements. Such arrangements are generally not deductible to the employer and taxable to the employee until receipt of cash payments under the actual or constructive receipt doctrines of Federal income taxation. If the arrangements, considered together, constitute a postretirement income plan for a broad group of management or highly compensated employees, they are accounted for under the provisions of SFAS No. 87. If they are not, they are accounted for under APB No. 12 or SFAS No. 106. Because most such plans are not health or welfare plans, they are accounted for under APB No. 12.