What Is Deferred Salary? Key Principles & Tax Rules
Understand deferred salary: its foundational concepts, how it's structured, and the essential tax rules for future compensation.
Deferred salary represents a portion of an employee’s compensation that is not paid immediately but is instead set aside for disbursement at a future date. This arrangement is a contractual agreement between an employer and an employee. The primary purpose of deferred salary is to postpone the receipt of income, often until events such as retirement, termination of employment, or a specific future milestone.
Core Principles of Deferred Salary
Deferred salary arrangements are typically established through a formal contractual agreement between the employer and the employee. This agreement details the specific amount of compensation to be deferred, the duration of the deferral period, and the precise conditions under which the payout will occur.
Most deferred salary plans are classified as “non-qualified” plans, meaning they operate outside the stringent regulations of the Employee Retirement Income Security Act (ERISA) that govern qualified retirement plans. This non-qualified status grants greater flexibility in plan design and participation, often allowing employers to offer them to a select group of management or highly compensated employees.
In non-qualified deferred compensation plans, the deferred funds are generally not held in a separate trust or account for the employee. Instead, these funds typically remain part of the employer’s general assets, making the employee an unsecured creditor of the company, and the deferred amounts are subject to the claims of the employer’s general creditors in the event of bankruptcy or insolvency.
A fundamental principle of deferred salary is that the employee does not have immediate constructive receipt or control over the deferred funds. Access to these funds is restricted until the specified payout event or date occurs. This lack of current access is a critical element in achieving the intended tax deferral.
Taxation of Deferred Salary
The taxation of deferred salary primarily revolves around the “constructive receipt” doctrine, which states that income is taxed when it is made available to a taxpayer without substantial limitations or restrictions, even if not physically received. Properly structured deferred salary plans are designed to avoid constructive receipt, meaning the employee is not taxed on the deferred income until it is actually paid out or made available.
For employees, deferred salary is generally taxed as ordinary income in the year it is received. For example, if $20,000 of salary is deferred annually for 10 years, the employee is taxed on the $200,000 in the year it is paid out, rather than in the years it was earned. This timing can be advantageous if an employee expects to be in a lower income tax bracket during retirement.
Employers typically cannot deduct the deferred compensation expense until it is actually paid to the employee and included in the employee’s gross income. The employer’s tax deduction must align with the employee’s income recognition. This contrasts with qualified plans where employers can often deduct contributions when made.
A key distinction in deferred salary taxation involves Federal Insurance Contributions Act (FICA) taxes. Unlike income tax, FICA taxes on deferred compensation are often due in the year the services are performed and the right to the deferred income vests, even if the income itself is not yet paid out.
Common Deferred Salary Arrangements
Non-Qualified Deferred Compensation (NQDC) plans are arrangements where an employer and employee agree to defer compensation. These plans are highly flexible, allowing for deferrals of salary, bonuses, and long-term incentive payments. NQDC plans are often used to supplement qualified plans, particularly for highly compensated employees who may face contribution limits in traditional retirement accounts.
Supplemental Executive Retirement Plans (SERPs) are a specific type of NQDC plan designed to provide additional retirement benefits, typically for key executives and highly compensated employees. These plans aim to supplement or replace income beyond what qualified plans can offer. SERPs can be structured as defined benefit plans, promising a specific retirement income, or as defined contribution plans, where the employer contributes amounts to an individual account.
Phantom stock plans provide employees with benefits that mirror stock ownership without granting them company shares. Employees receive “units” that track the value of the company’s actual stock. Payouts from phantom stock plans are based on the increase in the company’s stock value or the full value of the phantom shares.
Stock Appreciation Rights (SARs) give an employee the right to receive a cash payment equal to the appreciation in the value of a specified number of company shares over a set period. Similar to phantom stock, SARs allow employees to profit from stock price increases without owning the underlying stock. SARs are typically granted with a specified grant price and vesting schedule, and the payout is the difference between the stock’s value at exercise and the grant price.
Long-Term Incentive Plans (LTIPs) often incorporate deferral features, where performance-based payouts are delayed until certain future conditions are met. These plans align employee incentives with company performance over an extended period. The design of LTIPs can be based on various employee or company metrics, with payouts contingent on achieving those targets and meeting specific vesting periods.