Types of Nonqualified Deferred Compensation Plans
Nonqualified deferred compensation (NQDC) plans are designed to circumvent the limitations imposed by ERISA (Employee Retirement Income Security Act) for key employees. Key employees are defined as a small percentage of the employee population who are key managers or who earn substantially more than other employees. The courts and the Department of Labor (DOL) consider a number of factors in defining key employees:
- number of employees versus number of employees in the NQDC plan
- average salaries of select group versus average salaries of other employees
- average salary of select group compared to average salary of managers or highly compensated employees
- the salary range of employees in the select group
Additionally, the DOL also considers any employee with enough importance to negotiate their compensation plan to be part of the select group.
To be valid, an NQDC plan must conform both to the document requirements under IRC §409A and the actual operation of the fund must conform to the operational requirements under §IRC 409A(a). Additionally, all NQDC plans must be in writing, whether that writing is extensively detailed or simply referred to in the employment contract.
NQDC plans that are not subject to the creditors of the employer will be considered income to the employee, and thus taxable. If the employee has any beneficial interest in the assets, such as being able to use the assets as collateral for a loan, then the assets are includible in the income for the employee.
The economic benefit rule specifies that if the funds allocated to the employee are either transferable or not subject to a substantial risk of forfeiture, then the money is includible in the employee's income. Assets may also be includible in the employee's income under the cash equivalency doctrine, where the right to receive income in the future is both written and transferable, such as a note or bond.
Qualified retirement plans must satisfy ERISA requirements for participation testing, vesting, and funding, and a fiduciary representing the participants' interests must oversee the funding instrument. However, the top-hat exemption will allow an employer to avoid those ERISA requirements if the plan is not funded and is only available to management or highly compensated employees. Otherwise, a funded plan must generally comply with all of ERISA's requirements governing administration, disclosure, reporting, vesting, funding, participation, and fiduciary duties.
However, a top-hat plan must satisfy 2 other ERISA requirements:
- The plan administrator must send a 1-page notification letter to the DOL indicating the company's name and address, employer identification number, number and type of top-hat plans, number of participants in each plan, and the declaration asserting that the plan's purposes are to provide deferred compensation to the select group. The letter must be filed within 120 days of the plan's inception to the DOL. Otherwise the plan will be subject to ERISA's reporting and disclosure requirements.
- Because top-hat plans are subject to ERISA's administrative provisions, participants must be informed about ERISA claims procedures applicable to the plan.
NQDC Plan Types
There are two general types of NQDC plans: top-hat plans and deferred savings plans. Top-hat plans are generally paid by employers, while deferred savings plans are based on the amount of compensation deferred by each employee. Under these general categories are several subtypes: salary reduction arrangements, bonus deferral plans, supplemental executive retirement plans (SERPs), and excess benefit plans. Excess benefit plans are designed to provide benefits that exceed the limits defined in IRC §415. Phantom stock plans are also a type of NQDC plan.
With salary reduction arrangements and bonus deferral plans, employees defer a portion of their own earnings, so these plans are much like defined contribution plans. SERPs and excess benefit plans are funded by employers to provide a defined benefit in retirement, so they are equivalent to defined benefit plans.
Although top-hat plans are generally unfunded, the employee may choose a return based on the options provided by the plan. Unfunded plans have no money in them, so earnings are what the employer simply agrees to pay based on what would have been earned if the money was actually invested in the directed way. The plan is structured this way so that it does not fall under the constructive receipt doctrine, which would occur if the employee can direct actual funds in the plan to particular investments.
Deferred Savings Plans
Deferred savings plans are credited by salary reductions from the employee's pay. The plan may allow the employee to defer up to 25% of salary and up to 100% of bonuses to the plan. Taxes are assessed on the amount by the later of when the services are performed or when there is no longer a substantial risk of forfeiture. The employer may guarantee either a fixed rate of return or the return earned by a selected mutual fund or index. Additionally, the employer may offer matching contributions, profit-sharing, or incentive-based contributions. Because deferred savings plans are bookkeeping entries, the deferred contributions are not actually placed in an account that earns an actual return. Instead, the employer simply promises a specific rate of return. However, this rate of return must be reasonable; otherwise, a tax penalty will be imposed on the excess. The employer is free to determine how to fund the future obligation. The employer may choose to pay the obligation out of operational funds when it becomes due or the employer may invest the money or buy insurance products to finance the obligations. If the actual returns from the investments or insurance products is greater than the obligation, then the employer will keep the difference. However, if there is a shortfall, the employer will still be obligated to pay the return promised.
Distributions are limited by the American Jobs Creation Act of 2004 to the following triggering events:
- separation of service
- the date specified in the plan documentation
- change in company ownership or control
- an emergency as defined by statute; or
A lump sum is paid if the employee dies before retirement or is fired from the company.
Supplemental Executive Retirement Plans
A supplemental executive retirement plan (SERP) is a top-hat plan often structured as guaranteeing a certain payment in retirement, much like a defined benefit (DB) plan. Under some SERPs, the employer may pay the difference between Social Security benefits received by the employee and distributions from the employee's qualified plans with the employer, so that the employee receives a certain income. Formulas for calculating benefits vary: the participants can be paid a flat dollar amount for a certain number of years after retirement; a percentage of their salary at retirement may be multiplied by the number of years with the company; or as a fixed percentage of their salary at retirement for a specified number of years. SERPs can be funded through general assets, sinking funds, or corporate owned life insurance.
Restricted Property Plans
A common method of deferring compensation is through the use of restricted property plans, where the restricted property is usually stock of the employer. Restricted property plans defer compensation through the IRC §83 income recognition rules, where the restricted property is not taxable or deductible until the risk of forfeiture is eliminated or the property becomes transferable. The amount that is taxable to the employee and deductible to the employer is the property's fair market value when the property becomes available to the employee, less any consideration paid for the property.
If the restricted property is expected to appreciate in value until it becomes unrestricted, then it would be advantageous to claim the income immediately. IRC §83(b) allows an employee to make an election to be taxed immediately on the fair market value (FMR) of the restricted property when it is received. This election also allows the employer to immediately deduct the FMR. When the property becomes unrestricted, the employee will only have to pay the more favorable long-term capital gains tax on the difference between the FMR when the property becomes unrestricted and when it was originally received, assuming that the employee held the property longer than 1 year; otherwise the marginal tax rate for short-term capital gains applies. In any case, the employee does not pay employment taxes on the capital gain. The disadvantage of this election is that if the property is ultimately forfeited, such as would be the case if the employee left before the vestment period, then the employee cannot claim a deduction for the forfeited property even though tax was already paid on it, and the employer must recognize the original FMR as income when the property is forfeited by the employee.
Example: In 2016, you receive 1000 shares of common stock of your employer as deferred compensation. The fair market value of the stock is $10 per share on the transfer date. The agreement stipulates that the stock is not transferable and will be forfeited if you leave the company before 2030. In 2030, the shares are worth $100 per share. When you receive the shares in 2030, you're taxed on the $100,000 ( = $100 × 1000 shares) and your employer will be able to deduct the same amount. You receive dividends annually from the stock that are unrestricted, but you must pay tax on them every year.
Case 2: You elect to be taxed immediately on the stock in the year that is received, so you pay tax on the fair market value of $10,000 and your employer gets to deduct the same amount. In 2030, when the forfeiture restrictions are lifted, the stock is worth $100,000 for which you pay the long-term capital gains tax of $90,000 (= $100,000 – $10,000).
Case 3: Same as Case #2, but you leave the company in 2025. Therefore, you never receive the stock, but you will never be able to deduct the $10,000 that you originally paid for the stock, even though you already paid tax on that amount. On the other hand, your employer must recognize $10,000 of additional income in 2025, so the $10,000 gets taxed twice: to you in 2016 when you elect to be taxed immediately on the deferred compensation and to your company in 2025 when you decide to leave the company and forfeit the stock.
Methods Used by Employers to Finance NQDC Plans
NQDC plans are future obligations of the employer, so employers must decide how to finance the obligations. Some pay the obligations out of operational funds as they become due; some employers may use a sinking fund, making annual contributions to the fund and investing the money as it chooses; other employers use insurance products to meet their obligation. There are many methods or combination of methods that can be used, some of which are discussed below.
NQDC plans involving insurance products may require underwriting. In some cases, the insurer may offer guaranteed-issue underwriting, where all of the key employees are automatically approved. In other cases, simplified-issue underwriting may be necessary, where the key employees may be reviewed based on limited criteria.
NQDC Plans Involving Life Insurance or Annuities
Corporate-owned life insurance (COLI) is one type of SERP. The company buys a life insurance policy for each key employee, then pays retirement benefits to the employee out of operating assets for a stipulated duration after retirement or until death. When the executive dies, the company receives the tax-free proceeds from the policy, compensating it for the amount paid out in benefits and for premiums. Funds in a COLI can grow tax-free until paid out either due to death or because the company canceled the policy. Although investments grow tax-free and the proceeds are tax-free, the premiums are paid with taxable income.
If the company owns the insurance policy, pays the premiums, and the employer is the sole beneficiary, then neither the economic benefit rule nor the constructive receipt rule apply. In this case, the company can also borrow from the policy.
Since 2006, the law has restricted companies to insuring only the highest paid 35% of employees, but only with their consent. Banks are major users of these insurance products, since the cash surrender value can be quickly accessed from insurance companies. Thus, the cash surrender value is categorized as Tier 1 capital. Many major banks have cash surrender values worth billions of dollars and may represent up to 25% of their Tier 1 capital.
Executive Bonus Plans
IRC §162 allows a company to favor highly compensated employees by offering a life insurance policy. An executive bonus plan (aka executive bonus life insurance plan) is a whole or variable life insurance policy bought by the employer for key employees. Consequently, the employer can deduct the payment from taxable income while the employee will receive taxable income. The employer can pay the premium either directly to the insurance company or to the employee, who would then be responsible for paying the premium to the insurance company. The employer may even pay an additional amount to cover the taxes on the premium payments. However, the employees own the policy and can name their own beneficiaries. Earnings are tax-deferred and contributions are flexible. Additionally, the employee can receive some tax-free income through partial withdrawals and loans on the policy. The main benefits to the employer is that the executive bonus plan is easy to implement and maintain and premiums are tax-deductible. Since an executive bonus plan is based on a variable life insurance policy, the employer is not obligated to continually pay premiums, but the cash value of the policy will be less without premium payments.
Partial withdrawals and loans from the policy will usually be tax-free, because distributions from the policy will be taxed on a first-in/first-out basis. Because contributions are made with after-tax dollars, any partial withdrawals or loans will generally be tax-free because they will be sourced to the contributions before being sourced to earnings. However, if the life insurance policy is considered to be a modified endowment contract, as defined in IRC §7702A, then distributions from the policy will be taxable, and if the participant is younger than 59½, then a 10% penalty may apply.
Some executive bonus plans can be arranged as a restricted executive bonus arrangement (REBA) that may include restrictive endorsements or a vestment repayment schedule. A restrictive endorsement allows the employee to change the beneficiary or reallocate investments in the policy, but withdrawing or borrowing money from the account would require the employer's consent. A vestment repayment schedule can also be part of the plan, requiring the employee to pay back any amount not vested. So if an employee left after having earned a cumulative bonus of $20,000 but was only 20% vested, then the employee would be required to pay back $16,000.