Deferred Compensation Plan

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Extract: “Challenges of life insurance marketing – business applications” by Rizwan Ahmed Farid, 2010


Remunerations are paid in a variety of ways. Employees are paid salary, commissions, housing, company maintained limousines, stock options, quarterly or annual bonuses, profit sharing, medical cover for self and family, group insurance, provident fund, gratuity, pension, and fringe benefits, etc. Professionals are paid retaining, consultancy and arbitration fees and incidental expenses etc. Tax rules, however, frequently work to discriminate against highly paid executives and professional advisors who are most often responsible for an organization’s profits.

Fortunately, a properly designed executive benefit plan can meet the needs of this high income group employee as well as his employer through the use of a Deferred Compensation Plan. This is a contractual agreement between an employer and an employee, in which a portion of the earnings, or compensation for current services and work performed, is held back or deferred for payment at a future date. It is also used by sportsmen, artists, etc whose income earning years are numbered. This enables them to defer a portion of their high incomes to later years when work opportunities may be limited.

Deferred Compensation plans are use as a means to avail substantial concessions in income tax.[1] The plan is designed so that the premium paid under the policy is not considered a part of the employee’s earned income. Legally the income deferred is not yet part of the employee’s earned income and therefore, is not counted as taxable income. With a deferred compensation plan the employee receives some tax relief on his present income and can save money for retirement or other needs. The important key element in designing a non-qualified deferred compensation plan is to make sure that the employee, consultant, advisor, sportsman, artist, independent contractor, etc will not be required to pay income tax on those deferred amounts until the amounts are actually out paid to such persons at future dates.

In term of such plans, the income of an executive or professional services provider could be spread over a number of years instead of being received in one lump sum amount. In other words, the deferred compensation plan results in a change in the manner in which the person is compensated for services rendered; from a lump sum payment to payment in the form of a deferred annuity or life cover. The insurer may act as a Third Party Administrator for the plan.

Many employees these days are taking a proactive stance on retirement planning, seeking innovative ways to ensure that they will have sufficient income to maintain their standard of living after retirement. However, highly compensated employees investing in their future may encounter the following obstacles:

  1. Approved retirement plans have several specific rules concerning highly paid employees, making it difficult for them to accumulate sufficient savings to maintain their standard of living.
  2. Employers are restricted on how much they can deduct from employees salaries and/or contribute to defined contribution plans.

Nonqualified deferred compensation plans can help in this instance by providing “extra” (deferred) benefits to key executives and employees who are interested in supplementing their retirement income on a tax-deferred basis.

The motivation to enter into a deferred compensation agreement may be floated by either the employer or the employee:

  1. For recruitment or as an inducement to stay with the business, the employer may offer captivating Executive Benefit Plans to a few selected key-persons.
  2. Highly paid executives or consultants may want to enter such as agreement if they would like to defer a portion of their present earnings and thereby drop to a lower tax bracket.[2]

Advantages for Employers

  • Recruit, reward and retain skilled executives
  • Limit the plan to a select group of executives or highly compensated employees.
  • Flexibility in the design of the plan
  • Install the plan on a confidential basis without any hassle

Advantages for Employees

  • Defer more income towards retirement so that retirement income is sufficient to maintain current standard of living
  • May be placed in a lower tax bracket because deferred income is not considered as part of taxable income
  • Helps ensure that employees’ heirs will be provided for

[1] Commissioner Of  Income Tax v  Manzoor Qadir. APLD, Volume XXIII

[2]  Commissioner of I. Tax v Manzor Qadir, APLD. Volume XXIII