Deferral Dilemma

With taxes ready to rise, should executives take their deferred comp now or later?

With taxes on both ordinary income and capital gains slated to increase in 2011 and again in 2013, some companies may have difficult decisions to make about the timing of certain aspects of executive compensation.

On one hand, 2010 may be the best time for executives to take as much compensation as possible, since the current 35% top rate on ordinary income will rise to 39.6%, assuming the Bush tax cuts expire on schedule. On top of that, the new health-care reform measures plan to hike both employer and employee contributions to Medicare by 0.9% starting in 2013, up from 1.45% each currently.

From that perspective, companies with deferred-compensation plans that were established before 2005 may want to consider closing the plans and paying out benefits accrued before 2005 before year-end, says William Dunn, a partner in PricewaterhouseCoopers’s national office who specializes in executive-compensation consulting. (The window is closed for plans established after 2005, since they are subject to Section 409(a) of the tax code and require at least 12 months between shutdown and payout.) Companies may also want to consider accelerating some 2011 bonus payouts by a month or two into December of 2010.

On the other hand, executives who receive a pile of cash now could have trouble deciding where to put it. “You’re going to have to position that money somewhere,” be it in stocks, bonds, or other types of investments, notes Dunn, and tax rates on investment income are going up simultaneously with ordinary income rates. Capital-gains taxes are slated to rise from 15% to 20% next year, and in 2013, health-care-related legislation will impose an additional 3.8% on all investment income, including capital gains, interest payments, and dividends.

“Individuals need to avoid the knee-jerk reaction of ‘I just need to get my money now’ and think about the fact that deployment costs will be higher,” says Dunn.

At any rate, deciding whether to close a deferred-comp plan in 2010 will also depend on a variety of legal considerations. Deferred-comp-plan language is varied and complex, and will ultimately determine the viability of a shutdown, says Dunn. So far, he says, he has seen only a few companies shut down a plan, but he is fielding questions from a number that are thinking about doing it.

Accelerating bonuses, meanwhile, will work best for private companies or employees who are not named in a public company’s proxy, since bonuses for top officers at a public company often hinge strictly on performance and face additional tax burdens if performance goals are not met, under Section 162(m) of the tax code. Also, companies should not ask employees if they want accelerated bonuses or not, because even those who refuse may be subject to tax, thanks to a principle known as “constructive receipt”: the idea that people are taxed when the money becomes available to them, not when they take it.

The good news? There’s still plenty of time to make the decisions. Dunn says he’s advising clients to wait as long as the fall elections, in hopes that their results will give some indication of where future tax rates might head.

 

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