Employers choose to offer nonqualified plans—among them, split-dollar, executive bonus, stock incentive, and deferred compensation—for a variety of reasons. They are great tools for recruiting and retaining top talent. They can be structured to benefit a select group of executives. And when properly drafted, they are exempt from Employee Retirement Income Security Act (ERISA) qualified plan rules, such as limits on contributions, making them attractive to highly compensated employees.
What Is a Deferred Compensation Plan?
In its simplest form, a deferred compensation plan allows select executives to defer receipt of current income—and thus payment of taxes—until a later date, usually retirement. Keep in mind that a nonqualified deferred compensation (NQDC) plan is not a type of product but a written agreement outlining a future unsecured promise between the employer and select management to provide
supplemental retirement benefits. Various financial products may be used to assist in financing this promised payout obligation, including corporate-owned life insurance and mutual funds.
Who Is an Ideal Candidate for an NQDC Plan?
Several questions guide us in determining whether an NQDC plan is appropriate for a business.
- How is the business structured for income tax purposes (e.g., C corporation, S corporation, LLC, partnership)? Further, who does the plan seek to benefit: the owner(s) or other key executives and management staff? If the owner wants to be included in an NQDC plan, then the business must be a C corporation, which essentially creates two separate tax entities from the owner’s perspective.
The other entities are generally considered pass-through tax structures, meaning that the profits flow from the business to the owner and are taxed at his or her personal income tax rate. In these situations, there are no opportunities for deferral of income at the owner level. If the NQDC plan includes only nonowner key executives, however, then any of the tax entity structures listed above could be appropriate, depending on the other circumstances involved.
- Is the employer looking for an up-front income tax deduction? If so, then perhaps a bonus plan should be considered, as there is no up-front tax deduction for the employer with an NQDC arrangement. Instead, the employer must wait until benefits are paid out to employees to claim a tax deduction; at that time, the employees will pay taxes on the income they receive.
- What is the employer’s primary goal? Has the employer recently lost a key executive? Is a strategy for retaining top talent—perhaps a “golden handcuffs” plan design—in order? Knowledge of the employer’s objectives, including how many employees he or she needs to incentivize, helps us decide on the most appropriate plan choice.
- How much control does the employer want to retain? With a traditional qualified plan, obviously, nothing about it prevents a key executive from leaving the firm. With an NQDC plan, however, participants risk forfeiting benefits if they choose to leave the firm before an agreed-upon date or event.
- How concerned is the employer about plan administration? NQDC plans must be tracked and reported as liabilities on the business balance sheet. In addition, when payments are made in the future, appropriate tax reporting is required. Depending on the size of the business and the number of participants, a company’s tax advisor may be able to handle the administration. For larger firms, however, hiring a third-party administrator may be a more prudent solution, though it comes with a cost.
How Should Plans Be Structured to Ensure Income Tax Deferral?
There are a variety of possible deferred compensation plan designs. These can range from salary continuation plans, where the employer funds all or a portion of the benefits, to true salary deferral plans, where the executive defers receipt of his or her own income.
In order for the plan to be exempt from ERISA Title I restrictions on contribution limits, however, it must be unfunded. This doesn’t prevent the business from using financial vehicles such as life insurance to plan for future liabilities. It simply means that these funding mechanisms must be assets of the business, subject to the creditors of business, and the employee can’t have any current interest in them.
In addition, the plan must generally meet two specific exemption tests:
- Excess benefit plan. The plan should be designed to provide benefits for the participants above any qualified plan limits.
- “Top hat” plan. The plan should cover a select group of management or highly compensated executives, often referred to as a top hat group. There are various definitions for a top hat employee; the simplest is an employee who, by virtue of his or her position, could exercise control over his or her own deferred compensation plan.
From the participant’s perspective, in order for the plan to continue providing income tax deferral, it must meet a few requirements. The agreement must be an unsecured promise of benefits, the benefits must not be vested or accessible to the participant, and the benefits must be subject to “substantial risk of forfeiture” (access cannot be made until a triggering event, such as separation of service, has occurred). Once the benefits are paid to the participant (usually at retirement), they become subject to income tax.
What About Section 409A?
Deferred compensation plans are required to comply with Internal Revenue Code (IRC) Section 409A, which, among other things, guides when a plan can pay benefits to executive participants. Violation of these rules can result in the loss of tax advantages as well as penalties.
Key provisions of Section 409A include the following:
- Before compensation is earned, the employee must elect to receive future deferred compensation as a lump sum or as installments over time.
- An employee can elect to switch from a lump-sum payment to installment payments, but the change must be elected at least a year before and the first installment must be made no earlier than five years after it otherwise would have been distributed.
- A distribution to a key employee of a publicly traded corporation must be delayed at least six months following separation of service.
You may be able to access your deferred compensation early if any of these five circumstances apply:
- Extreme hardship due to a condition beyond your control
- A domestic relations order due to divorce
- A cash-out for less than the IRC Section 402(g) limit
- To pay FICA taxes or other taxes due to a vesting event
- Termination of the plan by the employer (If termination is discretionary and not due to the employer’s bankruptcy or change in control of the business, distributions must be delayed 12 months.)
Although you can elect to schedule a distribution that coincides with your child’s entry into college, if allowed by the plan, the distribution must be scheduled before you need the money to pay tuition.
Written plan requirement. All NQDC plans must be in writing. An attorney drafts the agreement between the employer and the executive, outlining the terms of the benefit formula that determines the amount paid to the participant, as well as the schedule of triggering events (e.g., separation from service, disability, change in ownership or control of the sponsoring employer) that will result in a benefit payment. In addition, a brief informational filing (ERISA Reporting and Disclosure Statement), listing the company name, tax ID, and participants, must be sent to the Department of Labor within 120 days of a new plan’s inception.
If corporate-owned life insurance is used to assist in informally funding any future liabilities, the employer must fulfill a notice and consent with the employee and annually file Form 8925 with the IRS.
Election restrictions. To comply with Section 409A regulations, the election to defer compensation must generally be made at the close of the tax year prior to the earnings year. For many businesses, this is December 31. There are some timing exceptions for new participants to existing plans, as well as for certain performance-based compensation.
When they make their initial deferral election, participants must also designate the time and form of distributions. For example, they can elect to receive their deferred income at retirement in a lump sum. This election can be changed, provided that it is made at least one year before the originally scheduled payment date and the change delays the originally scheduled payment for at least five years.
Although NQDC plans are relatively straightforward to establish, businesses must follow specific requirements and rules to be in compliance. We can work with you to identify the most appropriate approach for your business so that you can benefit from these recruitment and tax-advantaged compensation agreements.
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This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.
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