By: Randall A. Denha, J.D., LL.M.
The nonqualified deferred compensation plan (“NQDC”) is an often used technique to help attract, retain, and reward executives or other highly compensated individuals. In fact, this technique can be used to provide additional long-term savings or retirement benefits to key employees, to provide additional incentives to achieve business milestones, or both. It is known by many names such as: salary deferral plan, elective deferral plan, excess 401(k) plan, ERISA excess plan, top hat plan or deferred bonus plan to name a few.
In defining an NQDC plan, let’s consider each word.
Nonqualified. A “nonqualified” plan is not required to meet all of the technical requirements imposed on “qualified” plans (like 401(k), pension, and profit sharing plans) under the Internal Revenue Code (IRC) or the Employee Retirement Income Security Act (ERISA). However, rhea e required to meet the requirements of IRC Section 409A, covered in detail in Part 3 of this article series.
Deferred. Your receipt of compensation is delayed until a future time (such as the date when you reach normal retirement age).
Compensation. You can defer regular salary, bonuses, or any other type of compensation. Frequently, the compensation deferred is additional (or supplemental) compensation provided by your company to fund the arrangement.
Plan. An NQDC plan can be established for one individual (e.g. an agreement foe one executive), or it can be established for a large number of individuals selected at the complete discretion of the company (e.g. all the highly paid executives of the company). An NQDC arrangement also can be established for an independent contractor, including directors.
As the name implies, NQDC plans are not ERISA-qualified plans. Because of that, they are not subject to most of the strict ERISA requirements for qualified plans. NQDC plans can be custom tailored to help the employee beneficiary achieve a wide variety of financial objectives with different timing. Unlike ERISA plans, which require the plan sponsor to transfer ownership of assets to a trustee, an NQDC plan creates a contractual obligation between the employer and the employee. There is no “pot of money” to pay the benefit. Instead, paying the promised benefit is a contractual obligation of the employer. If the employer fails, the NQDC plan participants are among its unsecured creditors.
NQDC has long been used to provide cash incentives for achieving corporate goals, and this is true in businesses of all types and sizes. There is a use for such arrangements in family businesses that can help to maintain control within the family while retaining the services of non-family management. In many family-owned businesses, there are executives and other valuable employees whose help is vital to the success of the business. It’s not unusual for these people to want some stake in the business beyond the paycheck, specifically an ownership interest in the business. Some family business owners will consider allowing non family ownership if no one in the family wants to lead the business. In fact, an eventual transfer to loyal employees may be a useful and a profitable exit strategy for the family. But what if that hasn’t been determined yet? Or suppose there are capable family members working alongside the non-family executives? How can those executives be rewarded and provided with incentives similar to ownership of the family business, when the desire and expectation of the family is that ownership remain within the family group? This is where NQDC may be a substitute. There are several forms that such deferred compensation may take.
The NQDC usually rewards a select group of employees. A nonqualified deferred compensation arrangement may provide for the deferral of base compensation (i.e., salary), incentive compensation (e.g., commissions or bonuses), or supplemental compensation. The arrangement may permit the employee to elect, such as on an annual basis, whether to defer compensation or to receive it currently, similar to a salary reduction or cash-or-deferred arrangement under a qualified employer plan. Alternatively, the arrangement may provide for compensation that is payable only on the occurrence of future events, not currently.
Because such a plan is not subject to the complex rules under ERISA that are applicable to tax-qualified retirement plans (regarding eligibility, nondiscrimination, funding, trust requirements, etc.) the employer can be flexible in designing nonqualified deferred compensation plans to meet specific objectives. As such, there is considerable design flexibility. Such arrangements are structured in whatever form achieves the goals of the parties; as a result, they vary greatly in design. Considerations that may affect the structure of the arrangement are the current and future income needs of the employee, the desired tax treatment of deferred amounts, and the desire for assurance that deferred amounts will in fact be paid. But the employer’s promise to pay must be unsecured. Thus, the employee remains an unsecured creditor of the employer.
An NQDC plan cannot be formally funded without causing the employee to have reportable income immediately – even though the actual benefits are not paid until a future date. Put another way, for income tax purposes, participants do not recognize the income when it is deferred under an NQDC plan. Income is recognized only when the employee makes withdrawals from the NQDC. To offset concern by employees on funding being there at a future time and to provide the employee with some certainty that the plan will pay out as promised, many employers may choose to informally fund their NQDC plans.
The most prevalent types of unfunded nonqualified deferred compensation plans are any or all of the following three:
• Elective deferral arrangement. Under an elective deferral arrangement, a participant defers a portion of compensation that is otherwise to be received immediately. The election to defer is contained in a written agreement that specifies the amount of salary, bonus, commissions, or other income to the deferred as well as the time and manner of payment (i.e., upon separation from service, specified date) that the account balance is distributed and the form of distribution (e.g., lump sum, installments).
• Restoration plan. A restoration plan is designed to “restore” benefits or contributions that are cut back or limited under a tax-qualified retirement plan due to Internal Revenue Code limits. Restoration plans are common and generally do not result in negative attention from shareholders. A restoration plan may be in the form of a defined contribution plan or defined benefit plan, each discussed below.
• Defined contribution restoration plan. A 401(k) restoration plan is the most common type of defined contribution restoration plan. Under a tax-qualified 401(k) plan, a participant’s elective deferrals are limited to $17,500 per year (indexed to inflation). Any employer matching contribution
• Supplemental executive retirement plan (SERP). Typically, a SERP is in the form of a defined benefit plan under which benefits are based on a pension formula. Unlike restoration plans, SERPs are not designed merely to replace lost benefits but to provide more generous benefits to covered executives. These benefits are generally paid or commence at retirement. Due in large part to the negative views of SERPs held by many institutional shareholders and their advisors, the prevalence of SERPs has declined significantly over the last ten years.
There are three ways for an employer to handle the liability under an NQDC plan: 1) do nothing; 2) purchase taxable investments (e.g., stocks, bonds and mutual funds); or 3) purchase permanent life insurance on the employee’s life. Remember that the assets or life insurance policy are the property of the employer and, therefore, subject to the claims of the employer’s creditors. Insofar as whether taxable investments are used or the purchase of life insurance, the latter has several advantages over taxable investments as a funding vehicle for NQDC plans.
First, the inside build up of cash value occurs tax free (unless the employer is subject to the alternative minimum tax discussed below). Second, the owner of a life insurance policy can make tax-free withdrawals from the policy up to the amount of the owner’s basis and, thereafter, can take a tax-free policy loan (subject to contract limitations and charges). Third, life insurance death benefits are income tax free to the employer (subject to the AMT). However, regular C corporations (with annual gross receipts of $7.5 million) may be subject to an effective AMT rate of 15 percent on the inside build-up in a policy and on the death benefit when received.
At the employee’s retirement, disability or death, the employer can use the death benefit (or cash values) to: 1) pay retirement or disability benefits through distributions of policy cash values; 2) pay pre-retirement survivor income benefits to a deceased employee’s beneficiaries; 3) pay the employee’s beneficiaries the remainder of the retirement or disability benefits should death occur during the retirement or disability income period specified in the plan; and 4) help reimburse the employer for funds paid out for policy premiums and retirement or disability benefits. Permanent life insurance is a popular choice for informally funding an NQDC plan for many reasons. The three major tax advantages of life insurance (discussed above) are important factors: the tax-free build-up of cash values, tax-free access to cash values and the tax-free receipt of the death benefit (subject to the AMT). In addition, life insurance provides safety of principal and flexibility in the amount and frequency of premium payments.
Non-qualified deferred compensation creates significant planning opportunities for company owners and key employees, including increased retention of key employees. By working together during the design, implementation and administration of NQDC plans, the planning team can ensure that the selected NQDC plans meet the planning goals of both the employer and its key employees, which often include its owners.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.