In the real world, these key employees have mortgages, college expenses and retirement planning concerns just like all other employees. They have sought after talents and want to be motivated to maximize those talents and be paid for their efforts. So, what key employee benefits will work for them in this challenging economic environment? Stock rights, whether in the form of stock grants, restricted stock, or stock options, don't have the bang for the buck they used to.

In the last few years, the losses incurred with underwater stock options have been painful for many key employees. In addition, in closely held businesses, stock valuation can be an internal source of controversy. Cash bonuses continue to be a form of incentive, but they have little value as a golden handcuff. They are paid and forgotten, with little reason for the employee to stay if something better is offered by a competing firm. 

Deferred compensation remains one of the shining stars in the key employee benefits arena. When an employer creates a bonus structure that aligns with the performance desired of the key employee, and that bonus is scheduled to be paid at a future date, there are many positive effects:

• It ties the employee to the firm.
• It offers the employee tax deferral.
• If the employee has a say in how the bonus is invested, it adds a layer of perceived control for the employee.

Deferred compensation has experienced a resurgence in popularity in a struggling, but recovering, economy. IRC Section 409A has helped define the rules for deferred compensation and provide employees with enough flexibility to make the benefit attractive. 

A current concern, however, is whether the threat of increased marginal tax rates causes income deferral to be less attractive. If income will be taxed in the future at a higher rate, is the key employee better off receiving the money now and paying tax at a lower rate? Especially since the employee can then enjoy capital gain treatment on some of the money's growth, is there a reason to defer?  A recent white paper by the Principal Financial Group, Plan Decisions and Changing Tax Conditions analyzes this question. 

While this paper offers a number of interesting observations and insights, two of its conclusions particularly address this question: 

• Although distributions from nonqualified deferred compensation plans are taxed at ordinary income tax rates upon distribution, this disadvantage versus capital gains taxation on after-tax investing often is outweighed by the long-term tax-deferred earnings on pre-tax gross contributions.
• In all but the most significant tax-rate increase situations, and except for very short-term deferral and distribution scenarios, deferred compensation outperforms after-tax investing.

A similar study was performed by CAPTRUST Financial Advisors (Dissecting the Deferral Benefit, see www.captrustadvisors.com).  Their analysis yields similar results, and they offer four factors that lower the risk of negating the benefits of deferring income: 

1. Higher marginal income taxes during the accumulation phase
2. Longer time period for tax-deferred accumulation
3. Higher investment earnings
4. Longer payout period during the distribution phase

Both the analysis and the conclusions associated with this tax and investment question are complex. But the bottom line is that deferral of income offers a key employee numerous benefits while the risk of eventual tax increases is so uncertain as to be nearly moot. For employers interested in incentivizing key employees to do good work and stay with the company, deferred compensation plans continues to offer a powerful benefit.