Does Tax Reform Threaten The Viability of Nonqualified Deferred Compensation?

Nonqualified deferred compensation has been an essential tool in assuring an appropriate retirement income for executives. The rules under ERISA and the Internal Revenue Code (Code) governing qualified plans make it impossible for the highly paid executive to receive an income in retirement replacing most of his or her working income. There are caps on how much of an executive’s compensation can be considered in determining the amount contributed to an individual account plan or benefit to be paid under a defined benefit plan.



In effect, compensation over the covered compensation limit does not generate any additional retirement income benefit. Additionally, the Code caps at $18,000 ($24,000 if at least age 50) how much of a taxpayer’s salary may be reduced. To the extent compensation cannot be deferred the executive is left trying to accumulate future capital on an after-tax basis.

The economics of deferral always favor the deferring party, as a tax paid later is cheaper than a tax paid now at either constant or declining marginal rates. In fact, taxes deferred to a year of higher marginal rates can still be advantageous. As long as the difference between the current lower and future higher marginal rates is not too great and as long as there is a sufficient return earned on the deferral, it should be possible to “break even” at an amount of time that is realistic for the taxpayer to achieve.

The Trump administration is energizing a long overdue reform of the federal tax system. Some of the highlights of Trump’s tax reforms, as well as the “Built for Growth” plan of House Ways and Means Committee Chairman Kevin Brady (R-Texas) impacting deferred compensation planning include:

Reducing the marginal rate on the business income of public companies from a high of 35 percent to a rate of 15 percent (Trump plan) or 20 percent (Brady plan). This change would make deferring compensation more expensive to the employer by reducing the tax savings from the compensation expense deduction. However, deferral of compensation would remain advantageous for executives as their marginal rate of income taxation could be lower in retirement. The Trump and Brady plans cap at 33 percent the highest marginal rate on earned income. Under the Trump plan, capital gains would be preferentially taxed at a rate no higher than 20 percent. The Brady plan excludes half of capital gains with the effect of reducing the top rate on capital gains to 16.5 percent. 

Reducing the marginal rate on business income of privately-held companies that are flow-through entities from a high of 39.6 percent to a rate of 15 percent (Trump plan) or 25 percent (Brady plan). This change also would make the cost of deferring more expensive to the employer. However, it would provide substantial tax savings for executives.

Replacing the current  federal estate and generation-skipping transfer tax system with a Canadian style deemed capital gains tax at the death of the stockholder. Capital gains held until death and exceeding $10 million would be taxed with an exemption for small businesses and family farms. This style of repealing and replacing the estate tax means nonqualified deferred compensation will not generate a transfer tax or deemed capital gains tax.  The paid deferred compensation will, of course, remain subject to federal income taxation.

What Happens Next?

As the 2017 year develops, here are a few “forks in the road” to follow as a quick barometer on the legislative seriousness in reducing marginal tax rates and the likely direction of any tax reforms voted out by the House Ways and Means Committee and the Senate Finance Committee.

1. Will the House Ways and Means Committee eliminate the deduction for state and local income and property taxes?
   The elimination of one of the most expensive tax expenditures under the Code maximizes the possibility of the lowest marginal rates on income. The real estate industry will argue that repeal unfairly affects the value of real estate purchased under the prior system. Many financially distressed states and municipalities will argue that their constituents will be “double-taxed” to the extent taxes paid to them are still income for federal income tax purposes. Their ability to raise future revenues might be constrained.
   
   
2. Will the Senate Finance Committee follow the likely lead from the House Ways and Means Committee by passing a destination-based cash flow tax (DBCFT) with border adjustment or DBCFT?
   Such a regime for the taxing of corporate income at the lowest rates possible represents the leap into the economic unknown. No country has ever made such a change. The anticipated benefits of increased exports may be offset in part or in full by a more valuable dollar. These doubts may spur the Senate to a less radical reform of corporate income taxes especially in light of comments from President Trump expressing concern about the House plan as too complicated. A difference between the House and Senate versions of corporate income tax reform will need to be resolved by the bill’s joint conference committee.
   

The Road Ahead: Under Construction (And When Completed Bumpy and Ultimately Blown Up?)

Whatever iteration the reforms of the Code take, I believe there will be both non-tax and tax reasons to defer. I do not envision the covered compensation limits or the deferral limits ever being removed any time soon. Those are the two drivers of the need for the executive to defer. Both the Trump administration and the “Built for Growth” proposal presently do not address reforms to the world of qualified plans and IRAs.

The nature of the enacted reforms will impact and likely increase the cost to the employer of deferral by the reduction of the marginal rate on corporate and flow-through income. While nonqualified deferred compensation looks likely to survive tax reform, stay vigilant! I encourage advisors to read the Tax Reform Act of 2014 proposed by former House Ways and Means Committee Chairman David Camp. There are many revenue raising proposals Congress can turn to, including the elimination of deferral through a risk of forfeiture based upon achieving a performance standard.

And if all of these considerations were not exciting enough, much of the proposed legislation, if enacted through “reconciliation,” will be expiring in 10 years.

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the position of The American College of Financial Services.