Legal Definitions - deferred compensation

Deferred compensation refers to a portion of an employee's earnings that is set aside by an employer and paid out at a later date, rather than being received immediately when earned.

This arrangement is often used for various reasons, including:

• Tax planning: Employees might defer income to a future year when they expect to be in a lower tax bracket, potentially reducing their overall tax liability.
• Retirement savings: It can serve as a supplementary retirement savings vehicle, especially for highly compensated employees who have maximized contributions to traditional retirement plans.
• Employee retention: Companies use it to incentivize employees to stay with the organization, as the deferred funds are often contingent on continued employment for a specified period.

Here are a few examples to illustrate how deferred compensation works:

• Executive Retention Bonus: A technology company offers its Chief Technology Officer (CTO) a $100,000 bonus for successfully launching a new product. However, to ensure the CTO remains with the company for the next few years, the company structures the bonus as deferred compensation. The CTO will receive $25,000 annually over the next four years, provided they are still employed by the company at the time of each payment.

  This illustrates deferred compensation because the CTO earned the full $100,000 bonus in the current year for the product launch, but the actual payment of that compensation is spread out and delayed until future years, contingent on continued employment.

• Restricted Stock Units (RSUs) with a Vesting Schedule: A growing startup grants a new software engineer 5,000 Restricted Stock Units (RSUs) as part of their compensation package. These RSUs represent a promise of company stock, but they don't fully belong to the engineer immediately. Instead, they "vest" over a four-year period, with 25% of the RSUs becoming fully owned by the engineer each year. The engineer can only sell or fully control the stock once it has vested.

  Here, the grant of RSUs is a form of compensation earned upon joining the company, but the actual benefit and control over that compensation (the stock itself) is deferred and delivered incrementally over the vesting period.

• Non-Qualified Deferred Compensation (NQDC) Plan: A senior partner at a law firm earns a substantial annual salary and bonus. To save more for retirement beyond the limits of their 401(k), they elect to participate in a non-qualified deferred compensation plan offered by the firm. Each year, they choose to defer 15% of their bonus into this plan, which will then be paid out to them in installments starting five years after their retirement from the firm.

  This example shows deferred compensation because a portion of the partner's current earnings (their bonus) is intentionally set aside and its payment is delayed until a specific future event (retirement plus five years), allowing for potential tax advantages and additional savings.