A tax professional is often asked when providing tax preparation or tax planning services as to the tax consequences when an employer compensates an employee. There are three basic types of benefits currently in use for compensating the key employee. These are direct compensation; perks or non-cash fringe benefits; and deferred compensation plans. There are basic differences among these three major types of compensation, including their respective tax implications for you, as the employer, and the employee.
Direct compensation: Direct compensation is comprised of immediate pay to employees in the form of salary, cash bonuses and qualified stock bonus plans. Direct compensation differs from fringe benefits in that it typically involves cash payments or other evidences of indebtedness to the executive that can be readily negotiated or sold for cash. Direct compensation also differs from deferred compensation in that its impact is immediate (or within a year’s time) rather than delayed until some future date. Generally, employees must recognize income in the year they receive direct compensation, and employers can deduct corresponding amounts in the year they pay direct compensation.
“Perks” or non-cash fringe benefits: Perks are those benefits that most employees think of as being fringe benefits. Thus, the perks that an employer may provide its employees consist of such non-cash benefits as company cars, exercise facilities and employee cafeterias.
Perks tend to differ from direct compensation in that they typically involve the use of employer-provided facilities or reimbursement of employer-induced expenses rather than the payment of cash or its equivalent. Like direct compensation and unlike deferred compensation, perks provide an immediate economic and financial benefit to participating employees. Generally, the Internal Revenue Code provides that all perks are taxable as wages to participating employees unless the perk is specifically exempted from taxation.
Deferred compensation: Deferred compensation refers to what would otherwise be direct compensation or a perk (i.e., fringe benefit), except that it is so structured as to postpone receipt of a portion of an employee’s taxable compensation until sometime after it has been earned by the employee. Conceptually, deferred compensation plans are a type of benefit located midway between the immediate benefits of direct compensation and perks, and the long-range benefits bestowed under a retirement plan. Some employers use deferred plans as “golden handcuffs”. Since the benefit the employee will receive is delayed until some future date and the employee may run the risk of forfeiture of receiving the benefit if not employed by that certain future date, the employee has a compelling reason to stay with the employer.
A common aim of a deferred compensation plan is to shift otherwise taxable compensation into a future year and, thus, defer, if not reduce, the income tax that would otherwise be paid currently to the IRS. For example, the deferral of income may be for a fixed period of time or until the executive has satisfied obligations to the company. Deferral of taxable income depends, however, on whether a specific provision in the tax code permits such deferral relative to a given form of deferred compensation and upon what conditions. Types of deferred compensation include deferred bonuses, stock options, and the so-called golden parachute payments.
Because qualified deferred compensation plans lose favorable tax treatment if they do not meet nondiscrimination rules, few, if any, such plans are designed to provide employees with special treatment or benefits. However, a key means by which companies can attract and retain top employees is a nonqualified deferred compensation plan. By providing executive compensation through a nonqualified plan, employers can effectively furnish benefits to key employees beyond the benefits typically available to non-management personnel.
Nonqualified plans offer flexibility and ease in administration. However, benefits under a nonqualified plan are also not guaranteed and, therefore give employees less security than benefits provided by a qualified plan. In addition, nonqualified plans are subject to election, distribution and funding rules.
Individuals who defer compensation under plans that fail to comply with these rules are subject to current taxation on all deferrals and to penalties. Specifically, compensation deferred under nonqualified plans that do not satisfy the requirements is subject to tax (and interest and penalties) in the year of the deferral, to the extent not subject to a substantial risk of forfeiture and not previously included in income. Therefore, these plans must be designed carefully to avoid the loss of any possible tax deferral.
Note: Because each individual and business’s tax situation is different, if you want to learn more about the taxability of compensation paid to employees from either the employee or employer perspective, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation.
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We wish to thank CCH for its contributions to this post using CCH’s Client Letter library published and copyrighted by CCH Incorporated, 2700 Lake Cook Road, Riverwoods, IL 60015.
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