Category Archives: Deferred Compensation

Deferred Compensation

Phantom Stock Plans

Phantom Stock Plans

Phantom stock plans are written contractual arrangements between the company and the key employee which are designed to mimic actual stock ownership.  These plans generally involve the granting of a stated number of stock units which are credited to the key employee’s account.  Each unit has the equivalent value of an outstanding share of the employer’s common stock. The benefit provided to the key employee under the simplest form of phantom stock plan equals the appreciation in the value of the “phantom” stock between the date the employee is credited with the phantom shares and the date the benefit is paid.

Instead of merely paying a benefit equal to the appreciation in value of the “phantom” stock between the date the “phantom” shares are granted and the payment date, it is possible to structure the benefit so that it equals the entire value of the “phantom” shares as of the payment date.  In addition, if the intent is to closely mimic actual stock ownership, the key employee’s “phantom” stock account could be credited with all cash, stock dividends, and stock splits which are attributable to the “phantom” shares.

Payment of the benefit generally occurs upon termination of employment as a result of retirement, death or disability, or at a specified future date, depending upon the company’s preference.  The benefit can be paid out in installments (either in cash or common stock of the company) over a period of years.  Generally, the benefits are paid in cash because the company does not want the key employee to actually have direct stock ownership.

Consequences of Phantom Stock Plan

A. Key Employee – No tax is payable by the key employee at the time the “phantom” stock is credited to the employee’s account.  The employee is taxed when the benefit is actually paid and there is no further substantial risk of forfeiture.

If the plan is designed to make annual payments to the phantom plan participants to replicate the cash and stock distributions made to the company’s actual stockholders, the payments are taxable to the phantom plan participant as ordinary income and deductible to the company when paid.

B. Company – There is no deduction available to the company upon the initial crediting of the “phantom” stock to the employee’s account under the phantom stock plan.  When the employee is paid the benefit, the company is entitled to a compensation deduction for the same amount as the employee includes in income.

C. Compliance with Employee Retirement Income Security Act of 1974 (ERISA) – Phantom stock plans are generally designed as “top hat” plans which are unfunded and maintained by the company for a select group of management or highly compensated employees.  This exempts the plan from most of ERISA’s provisions.  In order to comply with the ERISA reporting requirements for “top hat” plans, there is a one-time filing with the United States Department of Labor.

D. Informal Funding – While the payment of the plan benefits cannot be “secured”, it is possible to informally fund the benefit payments by having the company accumulate cash, or other asset, or purchase a life insurance policy on key employees’ lives.  However, the policy cash value, as well as the death benefit, must be subject to the general creditor claims of the company in order to avoid the arrangement being treated as a “funded” arrangement.

E. Accounting – The company must charge its earnings with compensation expense over the period during which the phantom stock is outstanding in an amount equal to the fair market value of the value accrued to the employee under the plan.

F. Compliance with Section 409A – Section 409A of the Internal Revenue Code was enacted as part of the American Jobs Creation Act of 2004 and sets forth various requirements relating to deferred compensation plans. A phantom stock plan is a form of deferred compensation and will need to be carefully structured to avoid any adverse tax consequences to the key employee under Section 409A.  If the plan fails to satisfy the requirements of that section, the key employee would be taxed on the unpaid amount deferred under the plan and would be subject to penalties.  Correctly structured the plan should qualify under Section 409A so that there will not be a problem of the key employee having income before the benefit is actually paid.

Issues to Consider

For companies that want to offer their key employees the opportunity to share in the company’s success without giving up an actual equity stake in the company, phantom stock plans provide a great deal of flexibility.  Because these plans are written contractual relationships, the company is not subject to the legal requirements which would normally apply if the key employee received actual stock.  The plan may be creatively structured with measuring criteria and vesting schedules that act as “golden handcuffs” to retain valued employees and to align the key employees’ interests with those of the company.

In determining whether to implement a phantom stock plan, some of the considerations are as follows:

1. Which key employees will participate?  In order to obtain exemption from most of ERISA provisions, the plan must be designed to benefit a select group of management or highly compensated employees.

2. When will the “phantom” shares be granted and when will they vest?

3. What will be the cutoff or triggering events requiring payment (i.e., death, disability, retirement, termination of employment or a specific date)?

4. How is the payment of the benefit to be made?  Generally it will be made in cash as opposed to the company stock.  Will the company have sufficient cash to pay the benefit?

5. Should the obligation of the company be informally funded through the acquisition of life insurance policies on the lives of those individuals covered by the phantom stock plan or with other investments?

6. Will the compensation liabilities shown on the company’s books as a result of the phantom stock plan have any adverse effects on the company’s ability to obtain financing?

7. Will the payment of the benefit be in one lump sum or spread over a period of time?

8. How many “phantom” shares will be initially granted?  Will there be any crediting for the equivalent of any cash dividends, stock dividends, or stock splits which would be attributable to the phantom shares?  Keep in mind that the “phantom” shares while not direct equity interests in the company, dilute the existing equity of the company’s shareholders by reducing assets by the value of the new obligations.

9. How will the valuation of the company be conducted in order to determine the value of the shares?  The associated costs of the valuation need to be incorporated into the decision to implement a phantom stock plan.

Examples of plan designs:

  • Employer will create a performance metric equal to a fixed dollar amount or percentage of profits, each year the value of the funds put aside will grow based upon the growth of the business or fixed rate of return
  • Employer may assign a number of shares to the key person based upon a percentage of salary, which may or may not tie into the performance of the company.
  • Employer might create a straight non-qualified “profit share” equal to a percentage of earnings and each year those funds could increase in value but not vest until retirement, change of control or death of the primary shareholder – thus creating a true golden handcuff. – Use of NQDC Plans At AllTime High – Use of NQDC Plans At AllTime High*.

Check out the latest trends in Executive Benefits and the percentage of companies that are implementing them.


*By selecting the above link you will be taken to a website which is outside of this website. Products or services from other entities are not endorsed , nor is this site responsible for information contained in their Internet sites. Latest Updates – April 2012


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Click on the following link to access this month’s update* from one of our trusted information sources (


For a complete dictionary of non-qualified plan terms, designs, and other standard plan question, go directly to their home page at* for more info.



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Deferred Compensation Ins and Outs – Video

Deferred Compensation Ins and Outs, and Interview with Matthew Schiff

This is the Third Clip in a series of three. Check out our articles for additional videos.

Deferred Compensation in Not For Profits – Video

What are the issues that the employer and employee must be aware of when they implement a deferred compensation plan for any not for profit entity?

This is the Second Clip in a series of three. Check out our articles for additional videos.

Recruit, Retain, and Defer? – The Wealth Channel Interview with Matthew – Video

The First of Three Interviews on the American College’s Wealth Channel about how to create benefit  programs that Attract, Retain and Reward your key employees.  Here we will go into a discussion about the types of programs available for these plans that are subject to IRC 409A.

Death, Taxes, and Relationships

There are three things that never seem to change here in America: no one lives forever, relationships rule and taxes aren’t going away. Death, taxes and relationships are here to stay, and they all play a role in the past, present and future of life insurance.

Yesterday, I called one of my widow clients. Her husband of 45 years passed away in a freak car accident, and now she’s trying to make it one day at a time. When our clients die, we walk in with cash to help when they need it the most. The loss of a loved one leaves a huge hole in our clients’ hearts. Life insurance can help them carry on when depression is knocking at the door.

Taxes are here to stay. The first federal income tax was enacted by President Abraham Lincoln in 1861 to assist in the Civil War effort and was meant to go away five years later. However, federal income taxes never went away. Today, with the national debt registering nearly $17 trillion of debt and $115 trillion of debt plus unfunded liabilities, we are beyond the point of no return.

In his best-selling book “Aftershock,” Bob Wiedemer writes, “Well, as everyone knows, there is no repayment plan.” He says there are still two bubbles that will burst in our economy in the next several years. First, the U.S. dollar will collapse, and second, U.S. government bonds will default. This means we will have to raise taxes to cover our obligations, period.

So what can you do about these severe economic problems? Relationships will open doors to help you serve your clients with additional security in uncertain times. You have the solution of bringing in tax-preferred cash into desperate situations when everyone else is asking clients to pay their bills. For pennies on the dollar, you can bring guarantees into your clients’ unstable financial worlds.

We are here on a mission to bring security and assistance to those who need it most. Life insurance is not bought; it is sold. Those sales happen through relationships between you and your best clients. You need to help clients buy life insurance so that you will walk in with tax-free cash when their loved one walks out.

Matthew Schiff, CEO of Schiff Benefits Group in Horsham, PA (contact Matthew), is one of the friendliest guys I’ve ever met. He’s a sanguine extravert who is, at his core, a quick-start entrepreneur. Matthew reminisced about his earliest recollection of working with his father in the life insurance business: “I remember when I was 13 years old, I was doing data entry on qualified plans. I would go in to work in the morning with my father, then take the train to the yacht club and sail through the afternoon, and my mother would pick me up.

“My father had a qualified-plan business because he had grown up in the qualified plans division of a major life insurance company. Dad’s first major non-qualified plan was written in 1973 with a Fortune 500 company.”

The world is changing all around us. Qualified plans have changed. Our clients’ income has changed. “What works for us today are our marketing campaigns to our centers of influence,” Schiff says. “We’re showing clients how to create executive benefit plans for their key employees. We set it up on a tax-efficient basis, and if they want to, they can fully recover their costs.

“If I look at what ties the past, present and future together, here’s what I see. In the 1970s, it was all about defined benefit income. Pre-1974 ERISA, it was all about creating plans to benefit the owners and key employees of companies. We had a long time-horizon. We looked out 10 years with a 7% interest rate. We got into the ’80s and ’90s, it was fast money.

Today, we are getting back to the defined benefit income; that’s what’s working today for us. Everybody wants the same thing today as they did in the 1970s — benefits for key employees. Today, we use non-qualified plans to fulfill what the owner and the key employees want to accomplish.”

Share your competence with those who can use it most. Help others solve their problems with tax-efficient, investment-grade life insurance.

by Brent Welch

Published in Life Insurance Selling Magazine, September, 2011

AALU Washington Report Bulletin 11-46 – PLR 201117001

Amendments to Tax Exempt Organization’s Deferred Compensation Plan Will Not Cause Grandfathered Deferrals to Be Subject to Code § 457

Under § 457(b), state and local governments and tax-exempt entities may establish and maintain “eligible deferred compensation plans” for the benefit of their employees. These 457(b) plans may be maintained in addition to 401(a), 403(a) and 403(b) plans. They must, however, satisfy certain conditions, including an annual limit on the amount that may be deferred by each participant. If the conditions are satisfied, amounts deferred under the plans are not includible in income until they are paid to the participant. Generally, if a deferred compensation plan maintained by a governmental or tax-exempt entity is not a 401(a), 403(a) or 403(b) plan and does not satisfy the conditions of § 457(b), it is considered a 457(f) plan under which deferred amounts will be includible in income in the first year in which no substantial risk of forfeiture exists, regardless of when such amounts are actually distributed to the participant. For these purposes, a substantial risk of forfeiture exists so long as rights to compensation are conditioned upon the future performance of substantial services by any individual.

Prior to 1986, deferred compensation plans and arrangements maintained by tax-exempt entities were not subject to the requirements of § 457. Rather, such plans and arrangements were treated similarly to deferred compensation plans and arrangements maintained by for-profit entities, under which no annual limitation on deferred amounts exists. So long as a promise to pay deferred compensation in the future is unsecured, the deferred amounts are not includible in the employee’s income. The Tax Reform Act of 1986 (“TRA ’86”), however, extended the rules of §457 to deferred compensation plans maintained by tax-exempt organizations for tax years beginning after 1986. “Grandfathered” plans of tax-exempt employers, though, are not subject to the requirements of § 457.

A deferred compensation plan maintained by a tax-exempt organization is considered “grandfathered” to the extent that deferrals under that plan were fixed pursuant to a written document on August 16, 1986. For this purpose, a deferral was considered fixed on that date if the deferral was then determinable under the written terms of the plan as a (i) fixed dollar amount, (ii) a fixed percentage of a fixed base amount (e.g., amount of regular salary, commissions, bonus or total compensation), or (iii) an amount to be determined under a fixed formula. Additionally, even if the plan, by its terms, did not contain a fixed deferral amount on August 16, 1986, the deferrals continue to be treated as though they were fixed if the deferral formula was not changed after August 16, 1986. Provided the deferred compensation plan remained grandfathered, all deferrals made pursuant to the formula in existence on August 16,
1986, even if made in subsequent tax years, remain exempt from § 457.

A plan, however, will lose its grandfathered status and will be subject to § 457(b) (or 457(f) if the conditions of 457(b) are not satisfied) as of the effective date of any modification to the plan that directly or indirectly alters the (i) fixed dollar amount, (ii) the fixed percentage or (iii) the fixed base amount to which the percentage is applied or the fixed formula.

Because these grandfathered plans do not fall within any exceptions under § 409A, they (unlike 457(b) plans) are subject to the requirements of that section. It appears that in this instance the employer is amending the plan to ensure that its terms are in compliance with § 409A, particularly with regard to the timing of payments and the participant’s right to change the time or form of payment. Without expressing any opinion regarding § 409A, the Service ruled that the proposed amendments would not affect the grandfathered status of the plans in question.

This ruling is the first in this area in over twelve years and was probably triggered by the Treasury regulations and guidance existing under § 409A. For an example of a ruling issued in 1992 on this subject, see our Bulletin No. 92-61. Although PLRs cannot be used or cited as precedent, PLR 201117001 provides employers of grandfathered deferred compensations plans with some comfort that amendments to such a plan to comply with the § 409A time and form of payment requirements will likely not cause the plan to be subject to the current requirements of § 457.

Any AALU member who wishes to obtain a copy of PLR 201117001 may do so through the following means: (1) use hyperlink above next to “Major References,” (2) log onto the AALU website at and enter the Member Portal with your last name and birth date and select Current Washington Report for linkage to source material or (3) email Anthony Raglani at and include a reference to this Washington Report.

PDF Copy of this Summary – AALU PLR 201117001 Summary (Bulletin 11-46)


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Overcoming Retirement Plan Contribution Limitations in Mid Sized Corporations (A Sample Case)

Key Goals
• Overcoming 401(k) limitations
• Key employee retention
• Integration of nonqualified deferred compensation plan with the 401(k) contributions
• Tax free growth
• Cost recovery of the employee benefits


(This information provided is only an outline.  Current contribution limits and laws may have changed to impact the benefits highlighted below)

ABC Corporation, a multinational, private C Corporation based in New York had over 2000 employees who were mostly hourly wage earners. They also had about 90 management and highly compensated employees who were key to growing this company in their specific marketplace.

The benefits broker, a mid-sized property casualty firm with a benefits practice was having problems getting 401(k) participation up. Specifically, over the three prior year’s rank and file participation was so low that the highly compensated individuals received thousands of dollars per year in refunds from their 401(k) plan because of the “top hat” testing. The net amount contributed to the 401(k) per year per highly compensated employee after the mandatory refunds ended up being only $955.

To rectify this problem the employer had to try and increase 401(k) participation. The employer was willing to making matching contributions to the 401)k) plan, but it only wanted to make those contributions to those employees that were putting money away. They had spent the last 8 to 10 months consulting with outside “benefit” firms that had recommended some solutions but those firms either could not convey the proper solution or the employer perceived it as and added expense. The ultimate goal was to build up the business and then sell it off in five to ten years. Keeping key management was important but not so much that it would reduce the future value of the company.

Problem #1 401(k) Limitations

The 401(k) plan was a cross tested plan and severely limited highly compensated employee contributions. The initial recommendation was to convert the plan to a Safe Harbor plan where the key employees would be able to “max out” their contributions up to the annual contribution limit ($14,000 at the time). This would alleviate refunds from the retirement plan for the highly compensated employees and give them another reason to remain with the company.

Solution #1 Increase Participation Through Company Match

While changing the 401(k) plan to a Safe Harbor structure was an easy fix, it was going to cost ABC Corporation almost $350,000 annually. When looking at the distribution of those funds, most of the money went to the rank and file employees who were not contributing voluntarily. The owner was willing to make contributions to the retirement plan, but only to those who already contributed on their own behalf.

Instead of taking the Safe Harbor approach an alternative, and less costly solution was to increase the 401(k) matching contribution to a dollar for dollar match of the first three percent of compensation with a graded vesting of 6 years on the employer match. Combining that with additional enrollment meetings by the 401k company they could increase the amount that highly compensated employees would be able to contribute without giving away “free money”.

Problem #2 Further Bonus Deferral Opportunity

The employer was losing trusted “key employees” each year because of the limitations in the 401(k) as well as the inability to defer large bonuses that were paid quarterly. While the bonuses were handsome, this money was not needed to live on and could not be deferred to a future date. A number of the consulting firms had suggested nonqualified deferred compensation for these bonuses, but the recommended solution was usually a mutual fund offering that would generate taxation on growth as dividends and capital gains were distributed by the funds to the corporation.

Separately, until the Financial Standards Board came out with FAS statement 159 in August of 2007, which allows for booking the “unrealized gain” of a marketable security, the mutual fund choice was less than desirable for the employer because the mutual fund was accounted for under FAS 115 (the purchase price of the asset). This accounting imbalance made the company’s financials less attractive to a potential acquirer, which was important to the current owner who hoped to sell the company in the coming years. In the rare instances that Corporate Life Insurance was discussed, it had always been presented as a benefit cost item, not an asset that could provide a useful funding vehicle.

Solution #2 COLI Fund Nonqualified Deferral Plan

By showing the employer a nonqualified deferred compensation plan informally funded with Corporate Owned Life Insurance (better known as “COLI” where the employer is the premium payor, owner, and beneficiary) funded at the “net after tax” cash flow of elective employee deferrals, the employer accomplished a savings program that accomplished all of the following:

• Could discriminate in favor of only management employees.
• Had no material impact on cash flow (net after tax funded)
• Created an asset on the balance sheet equal to the employee benefit liability (Accounting of COLI under FASB TB 85-4)
• Created a tax deferred vehicle for the growth of the mutual funds inclusive of the dividends and capital gains on a year by year basis
• Created a cost recovery mechanism that made the employer “whole” for their costs upon the death of the key executive
• Allowed the insurance policies to be issued on a guaranteed to issue basis

Problem #3 Coordination with 401(k) Plan Deferrals

After implementing the quarterly deferral program and revising the 401(k) plan, the employer recognized that there still may be a need to integrate any potential distributions from the 401(k) back into the deferred compensation plan (something that have been clarified somewhat in the final 409A regulations). To prevent the 401(k) refunds from coming back in a taxable manner when the intent was to defer them until retirement, changes had to be made to the 401(k) plan to allow for automatic deferral of those distributions to the deferred compensation plan.

Solution #3 Pour Over Election

To really bring everything together it was determined that ABC Corporation should establish a “pour over” election from the 401(k) into the deferred compensation plan. These elections had to be done in the December of the year prior to making any contributions to the 401(k) plan (i.e. December of 2006 for 401(k) distributions in March of 2008). If the plan failed its annual test then any distributions would roll into the existing deferred compensation plan. This was not mandatory but allowed employees to max out their 401(k) contribution automatically and let the 401(k) TPA determine how much money would roll into the deferred compensation plan in the following year. It also allowed employees to make a deferral election that might be above the IRS limits in any year and have those funds automatically be placed in the nonqualified deferred compensation plan seamlessly.

When all the changes were made, the employer had created a deferred compensation plan with almost fifty COLI policies, $275,000 of after tax annual contributions (or about $415,000 pre-tax), implemented key man insurance, had a matched asset against future liabilities and had created an asset that would recover most, if not all, of the out of pocket expenses for both the 401(k) plan as well as the nonqualified deferred compensation program.

Added Opportunity

On top of working with the employer on implementing the changes on their 401(k), we were able to create a program where we had the opportunity to work with over ninety highly compensated employees on many facets of their financial planning. In this case, it was the advisor who introduced us to the corporation who met individually with the participants.

On top of the initial sales, each and every quarter we have the opportunity to meet with senior management to work with them on cost recovery of their disability, long term care and health insurance premium costs. Every time a new key employee joins the firm we automatically enroll this employee into the deferred compensation program and the employer once a year adds to the COLI pool if and when the deferrals would cause a modified endowment on the existing insurance.

Lessons Learned
As part of the implementation of the integrated programs we had some logistical issues of enrolling key employees from around the world. By using WebEx and conference calls we were able to do two enrollment meetings for all ninety employees (even those half way around the world) when it was convenient for all. And by properly conveying the program with charts and sample pages we were able to get almost 70% plan participation in the deferral program.

Key Questions
Advisors should be asking their clients in similar situations . . .

• Has your 401(k) failed a “top hat” test in the last three years?
• Would any of your employees like to exceed the IRS’ 401(k) contribution limit
• Would you like to give a bonus to select employees but have it vest over a period of time?
• Do you want to recover the costs of providing benefits to all your employees by selectively insuring your key employees?
• Have you thought about giving ownership to your key employees but are afraid that would give up control?


*  This article is based upon a set of specific consequences based upon the laws and regulations in force at the time of implementation.  Changes in facts, circumstances and today’s law are not contemplated within.