Question

Hello, this is a TAX question regarding deferred compensation.

1. What is a highly compensated person under ERISA (the qualified deferred compensation rules)? Why is that definition significant and how is it applied?

Answer 1

Deferred compensation is a portion of an employee's compensation that is set aside to be paid at a later date. In most cases, taxes on this income are deferred until it is paid out. Forms of deferred compensation include retirement plans, pension plans and stock-option plans. An employee may opt for deferred compensation because it offers potential tax benefits. In most cases, income tax is deferred until the compensation is paid out, usually when the employee retires. If the employee expects to be in a lower tax bracket after retiring than when they initially earned the compensation, they have a chance to reduce their tax burden.

There are two broad categories of deferred compensation, qualified and non-qualified. These differ greatly in their legal treatment and, from an employer's perspective, the purpose they serve. Deferred compensation is often used to refer to non-qualified plans, but the term technically covers both.

Qualifying

Qualified deferred compensation plans are pension plans governed by the Employee Retirement Income Security Act (ERISA), including 401(k) plans, 403(b) plans and 457 plans. A company that has such a plan in place must offer it to all employees, though not to independent contractors. Qualifying deferred compensation is set off for the sole benefit of its recipients, meaning that creditors cannot access the funds if the company fails to pay its debts. Contributions to these plans are capped by law.

Non-Qualifying

Non-qualified deferred compensation (NQDC) plans, also known as 409(a) plans and "golden handcuffs," provide employers with a way to attract and retain especially valuable employees, since they do not have to be offered to all employees and have no caps on contributions. In addition, independent contractors are eligible for NQDC plans. For some companies, they offer a way to hire expensive talent without having to pay their full compensation immediately, meaning they can postpone funding these obligations. That approach, however, can be a gamble.

From the employee's perspective, NQDC plans offer the possibility of a reduced tax burden and a way to save for retirement. Due to contribution limits, highly compensated executives may only be able to invest tiny portions of their income in qualified plans; NQDC plans do not have this disadvantage. On the other hand, there is a risk that if the company goes bankrupt, creditors will seize funds for NQDC plans, since these do not have the same protections qualified plans do. This makes NQDCs a risky option for employees whose distributions begin years down the line, or whose companies are in a weak financial position.

What is a Select Group of Management or Highly Compensated Employees?

The problem of identifying those employees entitled to participate in an exempt plan is frequently difficult. Neither ERISA nor its legislative history provides a firm indication of when an employee is a "management" employee, when an employee is "highly compensated," or when a plan covers a select group.

A number of observations are appropriate in this regard. While management employees are not necessarily highly compensated, and vice versa, there are no obvious policy reasons which should prevent an exempt plan from covering both management and highly compensated employees. The "or" in the phrase "a select group of management or highly compensated employees" should not be interpreted as disjunctive. It also would seem that a plan could cover all management and highly compensated employees and still qualify for exemption. Thus, the participation of all of the targeted group would appear to be consistent with the exemption despite the use of the term "select group."

The most difficult determination is identifying employees to be considered as management or highly compensated. With respect to management, the Conference Report to ERISA provides, in discussing the exemption, that "if a 'phantom stock' or 'shadow stock' plan were to be established solely for the officers of a corporation, it would not be covered by the labor fiduciary rules." In many large publicly held corporations, however, lower level officers do not perform management functions. Therefore, it is possible that the Labor Department would choose to ignore the legislative history and limit management employees only to those who perform management functions.

' Similar problems exist with respect to "highly compensated" employees. The Internal Revenue Code uses the term "highly compensated" in the context of providing that qualified plans may not discriminate in favor of certain categories of employees, including officers and the highly compensated. Many tax provisions use the term "highly compensated." For example, a recent provision in the Revenue Act of 1978 provides a definition of "highly compensated individuals" in setting forth antidiscrimination rules under which reimbursements from medical reimbursement plans will not be taxable to the recipient. This section defines a highly compensated individual as one who is one of the five highest paid officers, a shareholder

who owns more than 10% of the stock of the employer, or a person who is among the highest paid 25% of all employees. The Department of Labor has apparently also wrestled with the question of the meaning of the term "highly compensated." In his October 1976 speech, William J. Chadwick discussed the difficulties of setting standards to determine who is "highly compensated" for these purposes, particularly standards that are capable of being applied across the board. Perhaps the most direct indication of the Department of Labor's position thus far is contained in four opinion letters issued by the Department on the exemption.Each of these opinion letters was issued prior to 1977 and there was no analysis of the exemption in any of them. They give important insight, however, since the Department focused closely on the size of the targeted group and its salary, each in relation to the remainder of employees.