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Compensating Key Employees

November 12, 2021 

Key employees are essential assets of a business because they are vital to the success of a company. Companies design different compensation plans, including basic salaries and incentive compensation, to attract and maintain key employees. There are three major types of benefits for compensating the executives: direct compensation, perks or non-cash fringe benefits, and deferred compensation plans. The tax implications of the compensations would be different for both the employees and employers.

Direct compensation. Direct compensations are immediate payments to executives, which are usually in the form of cash payments or other evidence of indebtedness to executives that are negotiable or sold for cash. Direct compensations include salary, cash bonuses, and qualified stock bonus plans. The impact of direct compensation is immediate, which is generally within one year.

For the tax treatment, employees need to recognize income in the year that they receive the direct compensation payments, and employers need to deduct the direct compensation amount in the year that they make the payments. However, there’s a limitation on publicly held corporations, and they may not deduct more than $1 million of compensation paid to top executives.

"Perks" or non-cash fringe benefits. Perks are mostly non-cash benefits such as company cars, exercise facilities, and employee cafeterias. Yet, perks for the top executive could be extra benefits above the ones provided to average employees. Executive perks could include chauffeured limousine services, use of corporate stadium skyboxes, and expenses-paid attendance at trade or professional conventions. Unlike deferred compensation, the impact of perks is immediate. Furthermore, perks are usually in the non-cash forms such as employer-provided facilities. Perks are taxable to the receiving employees unless there are tax exemptions.

Deferred compensation. Deferred compensations are taxable incomes that are postponed until they are earned by the executives. Therefore, the taxable income would be deferred to a future date and the income tax would be reduced in the current period, if the deferred compensation satisfies the tax code conditions. Deferred compensations include deferred bonuses, stock options, and golden parachute payments.

An attractive deferred compensation plan to top executives is a nonqualified plan, which gives flexibility yet less security to participants. However, if an individual fails to comply with the requirements or rules, he or she needs to pay tax (and interest and penalties) on the related deferred compensation amounts. Accordingly, an employer should develop a qualified and nonqualified compensation plan thoroughly.


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