In 1901, Andrew Carnegie sold Carnegie Steel to J.P. Morgan for a staggering $480 million, one of the largest deals in history at the time. But perhaps his greatest innovation wasn’t the sale itself, but how he rewarded key personnel who helped him build that empire. Carnegie famously structured large bonuses and incentives, like the million-dollar bonuses he gave to executive Charles Schwab, effectively pioneering modern key-person compensation. [1] Today, executive compensation plans might be more nuanced and structured than Carnegie’s hefty checks, but the underlying purpose remains the same: attract, reward, and retain top talent strategically.
In this article, we’ll explore two popular and powerful compensation structures—Deferred Compensation Plans and Supplemental Executive Retirement Plans (SERPs), exploring how they can help you retain key talent, optimize tax outcomes, and strategically manage cash flow.
Deferred Compensation Plans
Deferred compensation is exactly what it sounds like: part of an employee’s pay that you defer (delay) paying until a future date. Instead of receiving, say, a $100,000 bonus this year, a key employee might elect (or agree) to receive that money in five years or at retirement. Why do that? The idea is to reward your MVPs for sticking around and to potentially give them a better after-tax result. By postponing income, an executive might receive those dollars in a year when they’re in a lower tax bracket (for example, post-retirement), meaning the IRS receives a smaller chunk of taxes.
Meanwhile, your company benefits by holding onto cash longer and effectively using that deferred payout as a “golden handcuffs” tool for retention. Since nonqualified deferred comp plans don’t have to follow strict IRS contribution limits or cover all employees, you can tailor a plan to just your key people. For instance, highly compensated executives who’ve maxed out their 401(k) can defer additional income beyond IRS limits, a flexibility not available in qualified plans.
- Tax deferral on compensation until distribution
- Potential for lower tax bracket at distribution
- Supplemental retirement income
- No IRS contribution limits unlike 401(k)s
- Investment growth can accumulate tax-deferred
- Powerful tool for executive retention
- Improved cash flow management
- Selective participation (not all employees)
- Tax deduction available when paid out
- Minimal ongoing administrative costs
However, most deferred compensation plans for key employees are “unfunded” promises. In other words, the deferred money isn’t held in a dedicated trust for the employee (at least not one they can access freely); it remains part of the company’s general assets. This allows for tax deferral and flexibility but means the employee is trusting the company’s financial health down the road. Thankfully, setting up a basic deferred comp plan is not as daunting as it sounds. Government filings are typically less complex and there is less administrative overhead to worry about. [2]
Tax Considerations for Deferred Compensation
From a tax perspective, deferred compensation plans have some clear benefits—and a few caveats—for both the executive and the company:
Employee Income Taxes
An executive does not pay income tax on the deferred portion in the year it’s earned. The funds (and any growth/interest credited to them) are taxed as ordinary income only when actually received in the future. Ideally, this occurs when the executive is retired or otherwise in a lower tax bracket, reducing the overall tax hit.
Employer Tax Deduction
Your company doesn’t get to deduct the compensation in the year it’s deferred. Instead, the business can only take a tax deduction when it eventually pays out the money to the employee. In essence, the timing of the company’s deduction matches the employee’s income recognition.
Payroll Taxes (FICA)
Deferred amounts are generally still subject to Social Security and Medicare taxes at the time of deferral (to the extent they haven’t exceeded wage bases), assuming the benefit is vested. However, if the deferred comp is conditioned on future services (for example, “you only get this if you stay with us five more years”), then FICA taxes can be postponed until those conditions are met. In short, you might still owe payroll tax on deferred amounts upfront, even though income tax is deferred.
IRS Rules (Section 409A)
To preserve tax deferral, nonqualified plans must follow certain IRS rules on when and how distributions occur. The election to defer compensation generally must be made before the year in which the comp is earned, and the payout timing (e.g. at retirement, or a five-year delay) has to be set in advance. We’ll discuss this in more detail later, but be aware: mishandling a deferred comp plan (like paying out early when it’s not allowed) can trigger tax penalties.
| Category | Key Considerations |
|---|---|
| Employee Income Taxes |
• No income tax in year compensation is earned • Growth/interest on deferred amount also tax-deferred • Taxed as ordinary income when received • Potential for lower tax bracket at distribution |
| Employer Tax Deduction |
• No deduction when compensation is deferred • Deduction only available when paid to employee • Timing of deduction matches employee's income recognition |
| Payroll Taxes (FICA) |
• Social Security and Medicare taxes typically due at deferral • Applied to extent not exceeding wage bases • May be postponed if compensation conditioned on future service • Payroll taxes may apply even when income tax is deferred |
| IRS Rules (Section 409A) |
• Deferral election must typically be made before earning year • Payout timing must be established in advance • Limited distribution events and timing options • Non-compliance can trigger severe tax penalties • Early distributions generally not permitted |
Supplemental Executive Retirement Plans (SERPs)
You can think of a Supplemental Executive Retirement Plan (SERP) as a promise of a lucrative retirement bonus for your top people. A SERP is a nonqualified deferred comp arrangement designed specifically to provide supplemental retirement income to select executives. In practice, it often works like a company-paid pension substitute: the business might agree to pay a key executive a certain amount per year for 10 years after retirement, or a lump sum, if predefined conditions are met. Those conditions could be reaching a certain age, a set number of years with the company, or other performance/tenure milestones.
Because a SERP is not subject to ERISA’s qualification rules, you don’t need to offer it to everyone and you won’t be constrained by contribution limits. This flexibility means you can customize the benefit level to what makes sense for each executive and your company’s goals. It’s a powerful carrot to dangle for someone whose talent you can’t afford to lose.
From the company’s perspective, SERPs are attractive because they’re a commitment for the future rather than an immediate cash outlay. You can choose to “informally fund” the future obligation (more on funding options shortly) or simply pay benefits out of cash flow when the time comes. And since there’s no IRS approval required, you avoid the red tape of setting up a traditional pension. Just remember that a SERP is a promise, and like any promise it’s only as good as the promisor’s ability to keep it.
- Supplemental retirement income beyond qualified plans
- No IRS contribution limits
- Tax-deferred growth during working years
- Customized benefits based on performance and tenure
- No immediate taxation during accrual phase
- Powerful executive retention tool
- Future commitment rather than immediate cash outlay
- Flexible design without ERISA restrictions
- Selective offering to key talent only
- Tax deduction when benefits are paid
Tax Considerations for SERPs
SERPs follow the general tax pattern of other nonqualified deferred comp plans, with a few additional points worth noting:
Tax Deferral for the Executive
While an executive is accruing benefits in a SERP (e.g. earning the right to a future $X per year in retirement), they are not paying taxes on those future benefits yet. There’s no immediate income tax during the earning years, because nothing is “constructively received” by the executive. When retirement hits and the SERP begins to pay out, those payouts are taxed as ordinary income to the executive, just like a paycheck or a 401(k) distribution would be. No special capital gains or dividend rates here—it’s compensation for services, plain and simple.
No Immediate Tax Deduction for the Company
Just as with other deferred comp, a company can only deduct the SERP payments when they’re actually made to the executive.[3] If you’re funding the obligation over time (for example, by buying an insurance policy each year), those funding steps generally aren’t deductible at the time. The upside is that when your retired exec is collecting their SERP benefit down the road, your company finally gets to write off those payments as a business expense. In essence, the tax benefit to the business is delayed to match the employee’s income recognition.
Funding and Tax Treatment
Many companies fund SERP promises informally via cash-value life insurance or other investments. Be aware that if you use a company-owned life insurance policy, the premium payments typically are not tax-deductible as an expense (they’re considered a capital investment). However, the cash value grows tax-deferred inside the policy, and you can use policy loans or withdrawals later to help pay the SERP benefits. Additionally, if structured properly, the life insurance death benefit can come in tax-free to the company, which might then be used to reimburse the company for benefits paid or to directly fund promised benefits to the executive’s beneficiaries. This can provide a sort of built-in recovery of costs. (One note: if instead you bonus the premium to the executive and have them own the policy, that’s a different arrangement with its own tax implications—typically called a bonus plan, not a SERP.)
Risk and Security
A SERP, like any nonqualified plan, is unsecured. The executive is trusting that the company will be around and willing to pay the benefit in the future. If the company experiences financial trouble, SERP benefits could be at risk. Unlike a funded 401(k) or pension plan, which is held in trust and generally protected from company creditors, SERP assets (even if linked to a life insurance policy) are part of the company’s assets. That means if the company goes bankrupt, those assets are reachable by creditors and the executive might not see the promised payments.[3] It’s a risk-reward tradeoff: the company gets flexibility and the exec gets a nice promise, but both sides need to be confident in the company’s long-term health.
| Category | Key Considerations |
|---|---|
| Executive Taxation |
• No immediate income tax during accrual phase • No tax until benefits are actually received • Payouts taxed as ordinary income upon distribution • No preferential capital gains treatment |
| Company Tax Deduction |
• No immediate tax deduction when SERP is established • Deduction only available when payments are made to executive • Funding vehicles (insurance, investments) not deductible • Tax benefit timing matches executive's income recognition |
| Funding Vehicle Taxation |
• Insurance premiums are not tax-deductible • Cash value growth is tax-deferred within policy • Policy loans/withdrawals can be tax-free if structured properly • Death benefits generally received tax-free by company |
| Security Considerations |
• SERP is an unsecured promise to the executive • Assets remain subject to company creditors • No ERISA protection like qualified plans • Company bankruptcy could jeopardize benefits • Risk-reward tradeoff requires confidence in company's future |
Funding Mechanisms: Rabbi Trusts and Corporate-Owned Life Insurance
A promise is great, but savvy executives will ask how you plan to ensure the money is there when it’s time to pay up. Enter funding mechanisms like the Rabbi Trust and corporate-owned life insurance (COLI). These tools don’t change the fundamental nonqualified nature of the plan (the funds are still not directly in the employee’s control), but they can provide a measure of reassurance and financial backing to your compensation arrangements.
Rabbi Trusts
Despite the name, this isn’t about clergy—it’s a type of irrevocable trust approved by the IRS (in a private letter ruling involving a rabbi, hence the moniker) to hold funds for nonqualified plans. How it works: your company sets up a trust, contributes assets to it (cash, investments, etc.) over time, and those assets are earmarked to pay the deferred compensation or SERP benefits for executives. The trust is irrevocable, meaning you can’t pull the money back out on a whim to fund the company yacht; it’s legally set aside for the plan participants. This gives the employee some peace of mind that the funds are being saved for them. However—and this is crucial—the assets in a rabbi trust are still subject to claims of the company’s creditors if the company goes under.[4] In other words, a rabbi trust might protect against a change of heart by the employer but not against bankruptcy or insolvency risk.
From a tax standpoint, contributions to a rabbi trust don’t trigger immediate tax to the employee (since the money is not truly secure beyond the reach of creditors, the IRS says the employee hasn’t “constructively received” it). The earnings in the trust are typically taxed to the company as they accrue (since it’s the company’s trust), but that also means when it eventually pays out to the employee, the company won’t be taxed on those earnings at that time (the employee will, as income).
Corporate-Owned Life Insurance (COLI)
Another common funding strategy is for the company to purchase life insurance on the life of the key executive. The company owns the policy, pays the premiums, and is the beneficiary. Why do this? Two big reasons: tax-deferred growth and death benefit leverage. The cash value in a permanent life insurance policy grows tax-deferred. So if you have a long-term liability (like paying an executive in the future or providing their spouse a benefit if the executive dies), a life insurance policy’s cash buildup can be an efficient way to accumulate the needed funds without annual taxes dragging it down. When it’s time to pay the deferred comp or SERP benefit, the company can access the policy’s cash value via loans or withdrawals (typically tax-free if done within policy guidelines, though the death benefit will be reduced) and use that to cover the payments.
Alternatively, if the executive passes away before or during the payout period, the policy’s death benefit provides a tax-free lump sum to the company. That money can reimburse the company for what it will pay the executive’s beneficiaries or cover any remaining benefit obligation. Using COLI can also help offset the cost of the plan over time; some arrangements are designed so the policy’s death benefit and cash value growth effectively recoup what the company has paid out. It’s worth noting, however, that life insurance comes with fees and mortality costs, and it’s only as good as the health and longevity of the insured executive and the financial strength of the insurer. Also, the company generally cannot deduct the premium expense (since it’s the owner and beneficiary). COLI is best viewed as a long-term funding play: a way to invest in a tax-advantaged vehicle to meet a future liability.
- Protection against company change of heart
- Provides executives with greater security
- Flexibility in investment options
- No executive taxation until distribution
- Demonstrates company commitment
- Assets still subject to company creditors
- No protection in bankruptcy
- Trust earnings taxed as they accrue
- Additional administrative complexity
- Setup and maintenance costs
- Tax-deferred growth of cash value
- Potential tax-free access to funds
- Death benefit can offset plan costs
- No additional tax reporting for growth
- Flexible premium payment schedule
- Insurance costs and fees
- Limited by executive insurability
- Premiums not tax-deductible
- Performance depends on insurer stability
- Sensitive to interest rate changes
Conclusion and Call to Action
Designing key person compensation packages is both an art and a science. As we’ve seen, deferred compensation plans, SERPs, and other NQDC arrangements can offer powerful ways to reward and retain the people who matter most in your business, all while optimizing taxes and costs. The right plan can strengthen loyalty and give your key talent (or yourself as an owner) added peace of mind about the future. But these plans don’t exist in a vacuum. It’s critical to ensure they fit into the bigger picture of retirement planning, business succession, and even estate considerations for you and your key employees.
Ready to take the next step? Consider sitting down with a qualified, fee-only advisor to evaluate which executive comp plan and funding mechanisms could work in concert with your overall financial, retirement, and estate plans. We’re here to help you reveal possibilities, shine a spotlight on any gaps, help ensure tax efficiency, and adjust for any changes in your circumstances or the regulatory landscape. All you have to do is click the button below, and here’s to keeping your best people rewarded, your plans robust, and your financial future on solid ground!
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