Non-qualified
Deferred Compensation Plans
What is it?
A nonqualified deferred compensation
(NQDC) plan is an arrangement between an employer and an employee to defer the
receipt of currently earned compensation. NQDC plans do not have the
tax-favored benefits of qualified retirement plans. On the other hand, most
NQDC plans do not have to comply with the participation, vesting, funding,
distribution, and reporting requirements imposed on qualified plans by Internal
Revenue Code (IRC) Section 401(a) and the Employee Retirement Income Security
Act (ERISA).
Since
a NQDC plan doesn't generally have to comply with these IRC and ERISA
requirements, it's a flexible form of employee compensation that allows you to
tailor the benefit amounts, payment terms, and conditions of the plan to both you
and your employee's needs. As a result, a NQDC plan can cover any group of
employees without regard to nondiscrimination requirements, provide unlimited
benefits to any employee, and can provide different benefit amounts for
different employees under different terms and conditions. In addition to its
flexibility, a NQDC plan can also provide your employee with significant tax
benefits. Unlike cash compensation, which the IRS taxes currently, your
employees can defer taxation of their NQDC plan benefits.
Caution: In order to achieve tax deferral for employees, a NQDC plan
must either be "unfunded," or if "funded" the benefits must
be nontransferable and subject to a substantial risk of forfeiture.
Example(s): Hal and his employee Mark agree that Hal will pay Mark a
salary of $100,000 a year. In addition, Hal agrees to pay Mark another $10,000
for each year that Mark works for Hal, payable upon Mark's retirement. Hal and
Mark have established a form of nonqualified deferred compensation. At the most
basic level, this is how such a plan works.
Tip: The extent to which ERISA applies to a NQDC plan depends on
the type of NQDC plan and the funding status of the plan. NQDC plans are almost
always designed to avoid virtually all ERISA requirements. To avoid application
of most ERISA requirements, the NQDC plan must be unfunded and provide deferred
compensation benefits primarily to a "select group of management or highly
compensated employees," as discussed below. This is often referred to as a
"top-hat" plan.
Tip: One type of NQDC plan, an "excess benefit plan,"
can be funded, and yet avoid most of ERISA's requirements. See the discussion
later in this article.
Caution: The SEC has sometimes taken the position that NQDC plans may
be subject to registration under the Securities Act of 1933. Even if this
position is correct, many exceptions to registration apply. Public companies
may also need to report NQDC plans to the SEC or shareholders. Consult a
securities expert for more information about these requirements.
NQDC plans vs. qualified plans
A
qualified plan like a profit-sharing plan or a 401(k) plan can be a valuable
employee benefit, generally covering all or most employees. A qualified plan
provides an immediate tax deduction to the employer for the amount of money
contributed to the plan for a particular year. As for the employee, he or she
isn't required to pay income tax on amounts contributed to the plan until those
amounts are actually distributed from the plan. However, in order to receive
this beneficial tax treatment, a qualified
plan must comply with strict and highly complex ERISA and IRS rules. In
addition, qualified plans are subject to a number of limitations on
contributions and benefits. These limitations have a particularly harsh effect
on highly paid executives.
In
contrast, an employer will generally make NQDC plans available only to select
executives and other key employees in order to avoid ERISA's requirements, and
adverse tax consequences. And there are no dollar limits that apply to NQDC
plan benefits (although compensation must generally be reasonable in order to
be deductible). With this type of plan, an employer typically won't be allowed
to take a tax deduction for amounts contributed to the plan until such time as
funds are actually distributed from the plan and received as taxable income by
participating employees. In effect, an employer often isn't entitled to a tax
deduction until years after contributions are made to the plan. As with a
qualified plan, employees generally don't recognize the deferred compensation
income currently (when it is earned) for income tax purposes. Rather, they
recognize the income when payment is received from the NQDC plan.
Caution: Although most NQDC plans result in the tax structure
described, actual tax consequences depend on the specific design and funding
provisions of the NQDC plan.
Caution: Unlike qualified plan benefits, unfunded NQDC plan benefits
may be lost in the event of an employer's bankruptcy or insolvency. This is one
of the primary drawbacks to unfunded NQDC plans.
Funded vs. unfunded plans
In general
Nonqualified
deferred compensation (NQDC) plans fall into two broad categories, funded plans
and unfunded plans. It is important to understand the technical meaning of
these terms in order to understand the tax and ERISA consequences that flow
from establishing a NQDC plan. Unfunded plans are far more common than funded
plans because they can provide the benefit of tax deferral while avoiding
almost all of ERISA's burdensome requirements. Funded plans, on the other hand,
must generally comply with ERISA, and provide only limited deferral
opportunities.
The
following chart shows the general features of unfunded and funded plans.*
|
Plan Type
|
Coverage
|
Taxation of Benefits
|
ERISA
|
Creditor Protection
|
|
Unfunded(and informally funded)
|
Limited to select group of management or highly
compensated employees
|
Benefits generally taxed when paid
|
Very limited application
|
Benefits subject to claims of employer's creditors
|
|
Funded
|
Any employee may be covered
|
Benefits generally taxed when vested**
|
ERISA applies***
|
Benefits protected from employer's creditors***
|
*Special
rules apply to excess benefit plans, church plans, and plans maintained by
governmental and tax-exempt employers.
**See
our separate topic discussion, Secular Trusts and Annuities, for more detailed
information.
***
Employee secular trusts may not be covered by ERISA. If not, then whether
benefits under these plans are protected from the claims of the employer's
creditors may depend on state law.
When is a plan considered "funded?"
There
is no specific definition of "funding" in either ERISA or the Internal Revenue
Code. But the concept has been defined by court cases and guidance from the
Department of Labor and the Internal Revenue Service. In general, a plan is
considered funded if assets have been irrevocably and unconditionally set aside
with a third party for the payment of NQDC plan benefits (for example, in a
trust or escrow account) and those assets are beyond the reach of both you and
your general creditors. In other words, if participants are guaranteed to
receive their benefits under the NQDC plan, the plan is considered funded. This
is also sometimes referred to as "formal funding." One of the most
common methods of formally funding a NQDC plan is the secular trust.
Conversely,
unfunded plans are those where either assets have not been set aside (that is,
a "pay as you go" plan), or assets have been set aside but those
assets remain subject to the claims of your general creditors (often referred
to as an "informally funded" plan--see discussion below). In general,
in an unfunded plan, your employees rely solely on your unsecured promise to
pay benefits at a later date. In order to avoid ERISA, you must limit participation
in unfunded NQDC plans to a select group of management or highly compensated
employees. These plans are often referred to as "top-hat plans".
Caution: Funding may also be deemed to occur if your employees have
any legal rights to specific assets you set aside to meet your NQDC plan
benefit obligations that are superior to those of your general creditors, or if
employee communications lead employees to believe that their benefits are
secured by specific assets. Careful drafting of all plan documents and consultation
with pension professionals is important to avoid this potential problem.
Tip: While there may be some fine distinctions between funding
for tax purposes and funding for ERISA purposes, in almost all cases if a plan
is considered funded for one purpose, it will be considered funded for the
other.
What is an informally funded plan?
While
most employers want to avoid formally funding their NQDC plans in order to
avoid ERISA and provide the benefit of tax deferral, they often want to
accumulate assets in order to ensure they can meet their benefit obligations
when they come due. This is commonly referred to as "informally
funding" a NQDC plan. Even though you set aside funds, these plans are not
considered formally funded because the assets remain part of your general
assets and can be reached by your creditors. Informal funding allows you to
match assets with your future benefit liabilities, and provides your employees
with psychological assurance (at least) that their benefits will be paid when due.
The most common methods of informally funding NQDC plans are corporate-owned
life insurance (COLI) and the rabbi trust, discussed below.
Example(s): Widget Corporation wishes to establish a NQDC plan for its
executives. To fund the plan, it establishes a rabbi trust (a particular type
of irrevocable grantor trust approved by the IRS). Although Widget Corporation
has set aside these assets solely for the employees of its plan, the funds
contained in this trust must remain subject to the claims of all of Widget's
creditors. The plan will therefore be considered unfunded from an ERISA
perspective.
Why would an employer establish a
funded NQDC plan?
In
general, you might choose to establish a funded plan, instead of an unfunded
plan, if benefit security is your employees' main concern. In unfunded plans,
any assets set aside to pay benefits must remain subject to the claims of your
general creditors. This lack of security may make employees fearful that when
it comes time to receive the deferred compensation, you may be unwilling (due
to a change of heart or change in control) or unable (due to a change in
financial condition) to pay the deferred compensation, or that a creditor may
seize the funds through foreclosure, bankruptcy, or liquidation. Since funded
plans are generally protected from the claims of your creditors, they provide
maximum security to employees that their benefits will be paid when due. You
may also want to establish a funded plan to provide deferred compensation
benefits to an employee who does not qualify as a member of the top-hat group.
Employee tax treatment--unfunded plans
In general
Generally,
there are no income tax consequences to your employee until benefits are paid
from the plan. Your employee must then include the full amount received in his
or her gross income. However, there may be times when the IRS taxes an employee
on contributions made to an NQDC plan prior to the receipt of plan assets.
Constructive receipt doctrine
Under
the doctrine of constructive receipt, the IRS can tax your employee before he
or she receives funds from the plan if the funds are credited to the employee's
account, set aside, or otherwise made available to the employee without
substantial restrictions or limitations. In other words, once the funds have
been earned and are available, your employee must report the income even if the
employee has chosen not to actually accept current payment of the funds.
The
doctrine of constructive receipt is most relevant to NQDC plans that permit the
employee to elect to defer receipt of compensation or would allow the employee
to elect to receive previously deferred compensation. Under IRS guidelines, an
employee can avoid constructive receipt by making his or her election to defer
compensation before the year he or she performs the services that earn the
compensation. Also, to avoid constructive receipt, the employee generally can't
have any right to elect to receive payment of his or her deferred compensation
before payment is due under the terms of the NQDC plan.
Section 409A of the Internal Revenue
Code
IRC
Section 409A provides specific rules relating to deferral elections,
distributions, and funding that apply to most NQDC plans, and in part codifies
the constructive receipt rules described above. If your NQDC plan fails to
follow these rules, the NQDC plan benefits of affected participants, for that
year and all prior years, may become immediately taxable and subject to
penalties and interest charges. It is very important that you be aware of and follow
the rules in IRC Section 409A when establishing a NQDC plan.
Employee tax treatment--funded plans
In
general, your employee must include your contributions to a funded NQDC plan in gross income
in the year they are made or, if later, in the year your employee becomes
vested in the contributions--that is, when the employee's benefit is no longer
subject to a substantial risk of forfeiture. However, the specific tax
consequences depend on the type of funding vehicle used.
Caution: Your employees may be taxed on your contributions to a
funded NQDC plan, as well as investment earnings, prior to their actual receipt
of the plan funds. If desired, you can pay your employee a cash bonus to cover
his or her tax liability. Or, if your plan is funded with a secular trust, your
employee can receive a distribution from the trust in order to pay the taxes.
Tip: A funded NQDC plan can provide the benefit of tax deferral
only if the employee's benefit is subject to a substantial risk of forfeiture.
In contrast, an unfunded NQDC plan can provide the benefit of tax deferral even
if the employee's benefit is fully vested.
Tip: Some NQDC plans are designed so that a change in control of
the employer triggers accelerated vesting or distribution of benefits. In these
cases, the "golden parachute" rules of Internal Revenue Code Section
280G may apply.
Employer tax treatment
Unfunded plan
In
general, you receive a tax
deduction in the taxable year an amount attributable to your contribution
is included in your employee's gross income. This means that you receive the
deduction in the year your employee actually receives the plan benefits. You
can deduct the total amount paid to your employee, including any earnings on
your contributions.
An
additional tax consideration is that if the employer sets aside funds for the
purpose of paying future benefits under the NQDC plan (for example, in a rabbi
trust), the employer must pay income tax on any earnings attributable to those
allocated funds. For that reason, NQDC plans are often informally funded with
corporate-owned life insurance (COLI), because policy earnings (the increase in
the cash value) are generally not subject to current income taxation (unless
the alternative minimum tax (AMT) rules apply).
Funded plan
In
general, you are entitled to a tax deduction in the taxable year an amount
attributable to your contribution is included in your employee's gross income.
This means that you are entitled to the deduction in the year you make your
contributions to the plan, or if later, when your employee becomes vested in
the contributions. You are generally not entitled to a deduction for any
earnings on your contributions to a funded plan.
Caution: In order for you to be able to receive a deduction for
contributions to a NQDC plan funded with an employer secular trust you may need
to maintain separate accounts for each employee when more than one employee
participates in the plan.
Caution: Further, a deduction is permitted only to the extent that
the contribution or payment is both reasonable in amount and an ordinary and
necessary expense incurred in carrying on a trade or business.
Caution: Publicly-held companies can't deduct total compensation in
excess of one million dollars in any one year for certain executives.
"Top-hat" plans
In general
As
discussed earlier, most NQDC plans are unfunded in order to provide employees
with the benefits of tax deferral while avoiding ERISA's most burdensome
requirements. In order to achieve these goals, unfunded NQDC plans must be
maintained for a select group of management or highly compensated employees.
This is the most common type of NQDC plan. When discussing unfunded NQDC plans
in the balance of this article, we are referring to NQDC plans maintained for a
select group of management or highly compensated employees. Such a plan is
commonly referred to as a top-hat plan.
What constitutes a "select group
of management or highly compensated employees?"
While
there is no formal legal definition of a "select group of management or
highly compensated employees," it generally means a small percentage of
the employee population who are key management employees or who earn a salary
substantially higher than that of other employees. Over the years, the courts
and the Department of Labor (DOL) have looked at one or more of the following
factors: the number of employees in the firm versus the number of employees
covered under the NQDC plan; the average salaries of the select group versus
the average salaries of other employees; the average salary of the select group
versus the average salary of all management or highly compensated employees;
and the range of salaries of employees in the select group.
The
DOL has also indicated that the phrase refers only to the group of employees
who, by virtue of their position or compensation level, have the ability to
affect or influence the design or operation of the deferred compensation plan.
In other words, according to the DOL, the select group should consist of
employees who would typically be in a position to negotiate their compensation
packages. Under this view, a NQDC plan could benefit only a very small
percentage of the employee population. However, the courts have typically been
more liberal than the DOL.
ERISA considerations
If a
NQDC plan is unfunded (i.e.,
a top-hat plan) then generally only two ERISA requirements apply. First, you
(or more specifically, the plan administrator, which is typically the employer)
must send a one-page notification letter to the DOL indicating your company's
name and address, your company's employer identification number, the number of
top-hat plans you maintain, the number of participants in each plan, and a
declaration that the employer maintains the plan(s) primarily for the purpose
of providing deferred compensation for a select group of management or highly
compensated employees. The letter must be filed with the DOL within 120 days of
the plan's inception; otherwise the plan will be subject to all of ERISA's
reporting and disclosure requirements. Second, since top-hat plans are subject
to ERISA's administrative provisions, you must inform plan participants about
the ERISA claims procedures that apply to your plan (these will generally be
described in the NQDC plan document).
If a
plan is funded, it must generally comply with all of ERISA's requirements. This
includes ERISA's rules governing administration, reporting, disclosure,
participation, vesting, funding, and fiduciary activities.
Caution: It is not clear if ERISA applies to a NQDC plan funded with
an employee secular trust. ERISA applies only to plans established or
maintained by an employer or employer organization, and employee secular trusts
are deemed to be created by the participating employees for tax purposes.
Tip: ERISA doesn't apply to governmental and most church plans,
plans maintained solely for the benefit of non-employees (for example, company
directors), plans that cover only partners (and their spouses), and plans that
cover only a sole proprietor (and his or her spouse).
Social Security tax (FICA and FUTA)
Social Security tax actually
consists of several different component taxes: the Federal Insurance
Contribution Act (FICA) taxes for old age and disability benefits, the hospital
insurance or Medicare tax, and the unemployment tax (FUTA). Both FICA and FUTA
taxes may be due currently on amounts deferred to a NQDC plan. However, FICA
and FUTA don't have as significant an impact on NQDC plans as you might think.
FUTA tax applies only to a limited amount of an employee's compensation. And
most employees deferring compensation into a NQDC plan exceed the Social
Security wage base ($118,500 in 2015, $117,000 in 2014). Compensation exceeding
this amount would only be subject to the 1.45 percent Medicare tax rate that
applies to both the employer and the employee.
Caution: The details regarding FICA and FUTA taxes as they apply to
NQDC plans are very complicated. You should consult additional resources that
specifically address this issue for further information.
Who can adopt a NQDC plan?
In general
Although
many entities can adopt a NQDC plan, they're most suitable for entities that
are financially sound and have a reasonable expectation of continuing
profitable business operations in the future. In addition, since NQDC plans are
more affordable to implement than qualified plans, it can be an attractive form
of employee compensation for a new business that has potential but limited cash
resources.
Business owners
If
you're a business owner, NQDC plans are suitable only for regular or C
corporations. In S corporations or unincorporated entities (partnerships or
proprietorships), business owners generally can't defer taxes on their shares
of the business income. However, S corporations or unincorporated businesses
can adopt NQDC plans for regular employees who have no ownership interest in
the business.
Caution: NQDC plans covering controlling shareholders may be subject
to attack by the IRS under the constructive receipt doctrine because of the
shareholder's control over the corporate employer.
Government and tax-exempt organizations
A
government or tax-exempt organization may adopt a NQDC plan. However, such
organizations must follow Section 457 of the Internal Revenue Code, which
limits the amount and timing of payouts or in some cases may require current
taxation of the employee with respect to the present value of his or her rights
to deferred compensation.
Advantages of a NQDC plan
Supplements an employee's qualified
benefits
Qualified plans are subject to a
number of limitations on contributions and benefits. These limitations have a
particularly harsh effect on highly paid executives. For example, the total
amount of employer and employee contributions plus forfeitures that may be
contributed to a participant's annual account in a qualified defined
contribution plan is limited to the lesser of $53,000 (for 2015, $52,000 for
2014) or 100 percent of the participant's compensation income. Employees age 50
and older can defer up to $6,000 to a 401(k) plan in excess of these dollar
limits in 2015 ($5,500 in 2014). In addition, the maximum annual compensation
that can be considered when making these calculations is $265,000 (for 2015,
$260,000 for 2014). And the maximum employee salary deferral in a 401(k) plan
is limited to $18,000 (for 2015, $17,500 for 2014) (plus catch-up
contributions). These are only a few of the restrictions on contributions for
qualified benefit plans. NQDC plans allow you to provide deferred compensation
to your employees in excess of these qualified plan limits.
Example(s): Richard and Mary work at BCD Corporation. Richard earns
$300,000 in 2015 while Mary earns $100,000. They both participate in a defined
benefit plan that provides a general benefit of 50 percent of their salary.
Though the plan formula dictates that Richard should get a benefit of $150,000
(50 percent of $300,000), he actually is only allowed to receive $132,500 (50
percent of $265,000) because $265,000 is the maximum compensation amount that
may be used in calculating the benefit in 2015. Conversely, Mary is entitled to
$50,000 (50 percent of $100,000) because her entire annual salary can be taken
into account as it is below $265,000. As a result, Richard may only receive
44.2 percent of his pay while Mary may receive the 50 percent as dictated by
the plan formula. Richard is adversely impacted by the $265,000 limit while
Mary is not.
Easier and less expensive than a
qualified benefit plan
Because
qualified benefit plans must follow complex IRS and ERISA rules, they're
usually more expensive (and complicated) to implement and maintain than a NQDC
plan. If you can't afford to maintain a qualified plan but wish to offer your
select group of management or highly compensated employees the ability to
receive tax-deferrable retirement benefits, you may want to consider
implementing a NQDC plan. This way, you will be able to provide your key
employees with retirement benefits while avoiding the administrative costs and
complexities of qualified plans.
Can be offered on a discriminatory basis
Qualified plans are subject to
specific discrimination and participation rules that require you to provide
proportionate benefits to non-highly compensated employees. A NQDC plan isn't
subject to these same rules. As a result, you can decide to allow a few or even
one highly compensated employee to participate in the NQDC plan. You're not
obligated to cover anyone.
Can provide unlimited benefits
Subject
to the reasonable compensation requirement for deductibility, you can provide
unlimited benefits to your employees.
Allows employer to control timing and
receipt of benefits
Because
ERISA's vesting rules don't apply to NQDC plans that aren't formally funded,
you as the employer can control the timing and receipt of employee benefits
payable under the plan. You therefore have considerable flexibility in
determining conditions and times when employees will be entitled to their
benefits.
Allows employer to attract and retain
key employees
For
obvious reasons, many employers strive to attract, recruit, and retain
executives and other qualified key employees. A NQDC plan that provides future
retirement benefits, whether in lieu of or in addition to a qualified plan, can
offer an added incentive for these key employees to come to work for and remain
with an employer.
Disadvantages of a NQDC plan
Employee controls timing of employer's
tax deduction
The
employer generally can't deduct a contribution made to a NQDC plan until the
year income is actually received from the plan by the participating employee.
More often than not, this will be several years away, particularly in the case
of employees who choose to defer receipt of the income until retirement. In
effect, employers have no control over when they will be entitled to take these
tax deductions.
Lack of security for employees
From
the standpoint of the participating employees, a NQDC plan isn't as secure as a
qualified plan. Employees who participate in a NQDC plan generally have to rely
on an employer's unsecured promise to pay benefits at a later time (except in
the case of a formally funded NQDC plan). Most ERISA protections such as
participation, vesting, fiduciary responsibility, and funding standards don't
apply.
Generally not appropriate for
partnerships, sole proprietorships, and S corporations
Partnerships,
sole proprietorships, and S
corporations can certainly establish NQDC plans to benefit key employees.
However, the plan will be of little benefit to the owners themselves, since
income earned by the organization is immediately taxed to the business owner.
In other words, the business owner can't defer taxation of amounts contributed
to the NQDC plan on his or her own behalf.
Generally more costly to employer than
paying compensation currently
An
unfunded NQDC plan defers the employer's payment and the deduction for
compensation that might otherwise have been paid and deducted when earned. The
deferred compensation is normally increased by some amount similar to interest
or investment earnings. Until payment is actually made, the employer may
realize investment income (or defer a deduction) with respect to the deferred
amount that is subject to tax. Since the employer's deduction for both the
deferred amount and the investment earnings is deferred until the actual
payment of benefits, the employer incurs a greater net after-tax cost for the
NQDC than for a payment of current compensation. This additional employer cost
should be taken into account as the terms for any NQDC plan or agreement are
considered and agreed upon by the employer.
How does a NQDC plan work?
In general
It
depends on the particular type of NQDC plan, the specifics of the agreement
itself, and how the plan is funded. In a typical unfunded NQDC plan (i.e., a
top-hat plan) you pay the benefits provided under the plan out of your general
assets at the time the payments become due. As a result, the executive must
rely solely on your unfunded promise to pay the benefits and assumes the risk
that these benefits may not be paid at all. To provide your employees with varying
degrees of assurance that the promised benefits will be paid, you can choose to
informally fund your top-hat plan with a rabbi trust or corporate-owned life
insurance. However, any vehicle you use to informally fund your top-hat plan
must remain subject to the claims of your general creditors. Therefore, your
employees may lose their benefits in the event of your insolvency or
bankruptcy. From your employee's perspective, this is one of the major
disadvantages of an unfunded NQDC plan.
Caution: Top-hat plans must be sure to comply with the rules of IRC
Section 409A that govern NQDC plan deferral elections, distributions, and
funding.
Employee elective salary and bonus
deferrals
A
top-hat plan can be structured to allow participants to elect to defer a
portion of their salary and/or bonus into the NQDC plan. This is often referred
to as an "elective" NQDC plan, as compared to a "nonelective" plan,
which provides benefits financed solely by the employer. The election must
generally be made in writing before the tax year that the compensation is
actually earned. In some cases, elections to defer bonuses can be made as late
as six months prior to the end of the performance period, if the performance
period is at least 12 months. In general, an employee must also elect the
timing and form of payment at the time he or she elects to defer the
compensation. Unlike a qualified plan, a top-hat plan may allow a participant
to defer up to 100 percent of compensation into the plan. Participants are
usually fully vested in their own elective deferrals, and any related earnings.
Discretionary employer contributions
A
top-hat plan can also provide for employer contributions in addition to, or
sometimes in place of, employee salary deferrals. Such employer contributions
are generally discretionary. That is, most plans are set up to allow an
employer to make contributions at the employer's complete discretion. No
deposits are required to be made by the employer in any given year. Employer
contributions are often subject to a vesting provision. For example, a plan may
require that employer contributions and related earnings are forfeited if an
employee fails to work for the employer for a particular number of years, or
terminates employment before a specified age.
Accounting and investment control
There
are two main types of unfunded NQDC plans--defined contribution (or individual
account) plans and defined benefit plans. Defined benefit plans pay a
pension-like benefit, often based on years of service and/or final average pay.
Often the plan will provide benefits in excess of what can be provided under an
employer's qualified pension plan. In an individual account plan, the
employee's benefit depends entirely on the value of his or her individual
deferred compensation account. This is not a real, funded account, but is a
bookkeeping account that is credited with employee deferrals and employer
"contributions" and investment earnings. These are often referred to
as "hypothetical" or "notational" earnings to reflect the
fact that they are simply credits to the participant's NQDC plan bookkeeping
account. Often employees can "direct" the investment of their
individual account. Usually, the employer (or trustee in a NQDC plan informally
funded with a rabbi trust) is not obligated to actually invest any assets in
the manner selected by the participant. The participant's investment election
merely controls the amount of hypothetical earnings that the employer agrees to
credit to the participant's bookkeeping account on a periodic basis. The IRS
has suggested in the past that if the employer (or trustee) is obligated to
actually invest assets as directed by the participant, this "dominion and
control" by the participant may result in immediate taxation under the constructive
receipt or economic benefit theories.
Top-hat plans that supplement qualified
plan benefits
A
common form of nonelective top-hat plan provides for a post-retirement pension
benefit that supplements the employee's qualified plan benefits and Social
Security benefits. These plans are often called supplemental executive retirement
plans, or SERPs. Such SERPs may, for example, calculate a certain pension
for the employee, then offset that by the benefits the employee actually
receives from the employer's qualified plans and Social Security; the resulting
difference is the NQDC plan retirement benefit paid by the employer to the
employee after the employee's retirement. These plans often include a vesting
provision, or are tied to the vesting schedule in the employer's qualified plan.
Payment of benefits
As
the employer, you can structure a top-hat plan to pay benefits upon retirement,
separation from service, disability, death, unforeseen emergency, or at a
specified time. Benefits can be paid either in a lump sum or in a series of
annual payments. Life annuities or payments for a fixed number of years (such
as 5 or 10 years) are common. Since most ERISA requirements will not apply if
you structure the plan correctly, you generally have some flexibility in establishing
your own vesting schedule and forfeiture provisions. For example, you can
stipulate that employees will forfeit their rights to benefits if they fail to
work for your company until retirement age. However, you must make sure the
distribution provisions in your NQDC plan satisfy the requirements of IRC
Section 409A.
Types of NQDC plans
In general
Since
a NQDC plan is essentially a contract between employer and employee, there are
almost unlimited variations of NQDC plans. In addition, the phrase
"nonqualified deferred compensation" may be used to encompass various
concepts. For example, stock plans can be forms of NQDC plans. Similarly,
severance plans such as golden parachutes are generally considered forms of
NQDC plans.
It's
also important to note that NQDC plans established by government and tax-exempt
organizations are governed by Internal Revenue Code Section 457. Although these
plans also classify as NQDC plans, they're more commonly referred to as Section
457 Plans.
The
discussion here is primarily focused on the kinds of NQDC plans that are
sometimes known as compensation deferral or supplemental plans. These plans
represent non-stock-based compensation agreements between employer and employee
and are often the result of the compensation bargaining process. While there is
sometimes significant overlap, the major plans that fall into this category are
briefly described in the following sections. Except for excess benefit plans,
NQDC plans are almost always unfunded top-hat plans.
Deferral plan
Deferral plans provide employees
with deferred benefits in lieu of current compensation, a raise, or a bonus. A
typical example of such a plan is the salary reduction plan, in which employees
are able to defer dollars that could be received currently as income.
Supplemental executive retirement plan
(SERP)
A
SERP is generally a NQDC plan that provides participants with deferred
compensation benefits that supplement the employer's qualified plan benefits. A
SERP can be either a defined benefit plan or a defined contribution plan. The
term SERP is also sometimes used more broadly to refer to any top-hat plan.
Wraparound 401(k) plan
A
wraparound 401(k) plan is often referred to as a mirror 401(k) plan or
executive 401(k) plan. These plans imitate the employer's qualified 401(k)
plan, allowing deferrals in excess of the qualified plan limits. Under the
typical plan design, an employee will determine how much he or she wants to
defer for the year. The entire deferral will first flow into the nonqualified
wraparound plan. Then, at year-end, when the 401(k) plan's discrimination
testing is complete, the maximum amount the employee is eligible to defer to
the 401(k) plan is transferred from the wraparound plan. This ensures the
employee is able to defer exactly the amount he or she wishes, while making the
maximum permitted contribution to the 401(k) plan.
Excess benefit plan
An excess benefit plan is designed
solely to provide benefits in excess of the limits that apply to qualified
plans under Internal Revenue Code (IRC) Section 415. In general, Section 415
limits contributions to defined contribution plans to the lesser of $53,000
(for 2015, $52,000 for 2014) or 100 percent of pay, and limits benefits from
defined benefit plans to the lesser of $210,000 (for 2014 and 2015) or 100
percent of final three year average pay. Excess benefit plans are different
from other NQDC plans because if unfunded, they are entirely exempt from ERISA,
and even if funded, they are exempt from most of ERISA's requirements. Also,
excess benefit plans need not be limited to a top-hat group of employees
(although typically only highly compensated employees will be impacted by the
Section 415 limits).
Ways to "secure" the NQDC
plan benefit
Employees
are often concerned that the promised benefits under a NQDC plan may not be
paid, either because of the employer's change of heart, a change in control of
the employer, a change in the employer's financial position, or the employer's
bankruptcy. The following are some methods of providing employees with varying
degrees of assurance that their NQDC benefits will in fact be paid :
·
Secular
trusts
·
Secular
annuities
·
Rabbi
trusts
·
Rabbicular
Trusts (SM)
·
Corporate-owned
life insurance (COLI)
·
Split
dollar life insurance
·
Surety
bonds, indemnity insurance
·
Third-party
guarantees
IMPORTANT
DISCLOSURESBroadridge Investor Communication Solutions, Inc. does not provide
investment, tax, or legal advice. The information presented here is not
specific to any individual's personal circumstances.To the extent that this
material concerns tax matters, it is not intended or written to be used, and
cannot be used, by a taxpayer for the purpose of avoiding penalties that may be
imposed by law. Each taxpayer should
seek independent advice from a tax professional based on his or her individual
circumstances.These materials are provided for general information and
educational purposes based upon publicly available information from sources
believed to be reliable—we cannot assure the accuracy or completeness of these
materials. The information in these
materials may change at any time and without notice.
