It is late 2013 and you are a successful oil executive currently working in Alaska for a major oil company. Tomorrow morning you will have the opportunity to negotiate with your employer to receive some amount of deferred salary in 5 years in exchange for $75,000 of your year-2013 compensation. If this compensation is not deferred, it will be paid to you on December 31, 2013, as a year-end bonus. Both you and your employer can earn a before-tax rate of return of 12%. Your employer’s combined federal and state income tax rate is 40% and is expected to remain constant throughout the 5-year period. Because Alaska does not have an individual income tax, you will pay only a federal tax of 39.6% on income earned in 2013. However, you are being transferred to New York at the beginning of next year, where you will be groomed for a top-level position in the firm. You expect your combined federal, state, and city income tax rate to be 50% in the year 2014 and to remain at this level throughout the 5-year period.
a. What is the highest deferred compensation payment that your employer would be willing to pay?
b. What is the lowest deferred compensation payment that you would settle for?
c. Can you and your employer get together and write a mutually beneficial deferred compensation contract? Now suppose you are married to a psychic. As you are making your computations in preparation for tomorrow’s meeting, your spouse informs you that she is getting a clear image of you drinking beer at a bar on the Gulf Coast of Florida while reading a copy of Deep Sea Fishing Weekly dated 5 years from today and demanding that the bartender give you the AARP discount for retirees (which you will not get because you are not old enough).
d. Your spouse interprets this image as indicating that you will snap mentally from the stress 5 years from now (2018), quit your job, and move to Florida, where you will become the captain of a small charter boat and pay federal income taxes at a 31% rate when your deferred compensation is received in the year 2018. Note: Your spouse has never been wrong before. Under these conditions, what is the lowest deferred compensation payment that you would settle for?
e. Under these new conditions, can you and your employer get together and write a mutually beneficial deferred compensation contract?