Nonqualified Deferred Compensation Plans
Qualified retirement plans have many tax advantages, but there are certain disadvantages for the employer and for highly compensated employees (HCEs) or business owners. For the business, qualified retirement plans require nondiscrimination and minimum coverage rules, and require top-heavy testing to ensure that rank-and-file employees are not discriminated in favor of key employees. Disadvantages for key employees include limits on annual contributions, required minimum distributions after reaching a certain age, and a 10% penalty for early withdrawals.
Consequently, some employers use a nonqualified deferred compensation (NQDC) plan for their key employees. The main purpose of using deferred compensation plans over qualified retirement plans is to be free of ERISA (Employee Retirement Income Security Act) restrictions that limit the amount that can be deferred and that prohibit favoring key employees over rank-and-file employees. However, ERISA does not apply to most government and church plans nor for plans for nonemployees, such as company directors or partners or sole proprietors.
Nonqualified deferred compensation is earned in one year but received in a later year. It is a contractual agreement in which a participant agrees to be paid some of his compensation in a future year for services rendered this year. However, the employer cannot deduct the compensation as wages until the employee receives it as taxable income. IRC §409A lists the rules relating to deferral elections, distributions, and funding that apply to most NQDC plans. The NQDC plan must conform to IRC §409(a); otherwise, the deferred compensation may be subject to a 20% additional income tax and an underpayment interest rate that is 1% higher than the regular rate. Furthermore, if the plan does not conform to §409A at any time during the year, then all nonforfeitable compensation that was not included in gross income under the plan for all years will become includable in the year of the nonconformance.
Generally, deferred compensation is placed in a bank account, life insurance product, or other money market instrument earning interest that accrues during the holding period. The employer must continue to pay taxes on the earnings every year and on the principal when the compensation was deferred. When the employees finally receive the compensation of deferred wages plus earnings, then the company can deduct the full amount paid to the employee, and the compensation will be recognized as taxable income when the employee receives it.
There is greater flexibility with NQDC plans because they do not have to conform to most tax rules that apply to tax-advantaged accounts. Additionally, NQDC plans have lower administration expenses, because there is no discrimination or compliance testing. Nonqualified plans are generally offered to owners or key employees as a recruiting tool. Although they do not have tax advantages of ERISA accounts, they can still save the current company considerable money over offering a qualified retirement plan to all employees, which would be required for plans qualified under ERISA.
The main advantage of NQDC plans for the employee is that the deferral of income may lower the marginal tax rate for the current tax year and allow the participant to receive the deferred income in a later year, when income may be lower and, thus, subject to a lower marginal tax rate. Additionally, liability for the alternative minimum tax may be eliminated both currently and in future years. However, FICA (Federal Insurance Contributions Act) and Federal Unemployment Tax Act (FUTA) taxes must be paid when the income is earned or when there is no possibility of forfeiture of the income. Moreover, no loans are allowed and the money cannot be rolled over into an IRA or other retirement account when the compensation is paid.
Distributions can be scheduled before retirement and deferrals can be changed from year to year. Distributions depend on the triggering event specified in the plan, which is usually retirement, but may also include death, disability, some specified type of emergency, or when the business changes ownership. Nonqualified deferred compensation plans will also have provisions for preretirement death or disability, where the money would be paid to the participant or his heirs.
The American Jobs Creation Act of 2004 required companies with NQDCs to report deferred earned income to the IRS under the plan on Form W-2, Wage and Tax Statement or Form 1099-MISC, Miscellaneous Income, even if the compensation is not taxable in the current year. The Act also disallowed employers from using offshore trusts to fund deferred compensation.
For business owners, NQDC plans can only defer taxes for C corporations. With other type of business entities, such as S corporations, partnerships or proprietorships, since business income passes automatically to the business owners, such income is constructively received by the owners, and, therefore, taxable. However, the other business entities can offer NQDC plans to employees who are not business owners.
There are 2 main rules that determine whether deferred income is currently taxable to the employee: the economic benefit rule and the constructive receipt rule. The upshot of these 2 rules is that the deferred compensation becomes taxable to the employee and deductible by the employer when the employee starts to benefit or constructively receive the compensation.
If the deferred compensation plan is nonforfeitable, then the agreement must not be funded, such as transferring the assets to a trust for the employees benefit or as a negotiable note available to the employee. However, the employer can establish an escrow account on behalf of the employee that is used to accumulate and invest the deferred amounts. The employee will be taxed on the compensation and the employer can claim a deduction when the compensation is constructively received. However, the escrow account will be attachable by creditors of the employer.
Economic Benefit Rule
The economic benefit rule (IRC §83) states that income will be taxable to the employee when there is no substantial risk of forfeiture or when it becomes transferable. The employer may maintain a substantial risk of forfeiture by using longer vesting schedules, performance thresholds, or conditions where the employee does not receive the compensation, such as if the employee leaves within a certain time or goes to work for a competitor.
Additionally, income is only taxable if the current value of the NQDC account is ascertainable. If the exact amount is known and there is no risk of forfeiture to the employee, then the employer can deduct the compensation from its taxes and the employee must pay taxes on the income in the year received. So even if the money is transferred to a trust, where the distributions can only be paid to the employee, then the income is taxable to the employee since it has ascertainable economic benefit and there is no substantial risk of forfeiture.
Constructive Receipt Rule
The constructive receipt rule [IRC §451(a)] states that income is taxable to an employee when the employee constructively receives it, meaning that the money is available to the employee, whether the employee actually receives it or not. The constructive receipt rule prevents an employee from choosing to receive compensation now or later. So if an executive can choose the timing of his bonus, then the bonus will become taxable at the earliest time that the executive can receive it. If the taxpayer does not pay taxes on income that was constructively received, then they will not only have to pay regular taxes on the income, but also a 20% penalty.
To defer taxation of compensation under the constructive receipt rule, an employee must choose to defer compensation that will be earned in a future year. If the deferral choice is made in the calendar year before earning the income, then the constructive receipt rule will not apply. It also will not apply if the compensation is received within 2½ months after the year when the participant becomes vested in the compensation. Additionally, the employee cannot have any right to receive payment before it is due under the terms of the NQDC plan.
NQDC Plan Setup and Administration
There are 2 major types of NQDC plans: salary reduction plans and supplemental executive retirement plans (SERPs). With the salary reduction plan, the employer takes some of compensation that would otherwise be paid to the participant and defers it into the nonqualified plan. Unlike qualified retirement plans, there is no limit on the deferrals. On the other hand, a SERP is additional income beyond gross salary. Salary deferral plans are defined contribution (DC) plans, because they are funded with defined contributions, while SERPs are like defined benefit plans.
Forfeiture provisions are necessary for some plans to defer the taxation of the income to the employee at a later time. SERP's are more likely to have forfeiture provisions, of which there are 4 types:
- vesting schedules
- performance conditions
- post-retirement consulting requirements, and
- noncompete agreements.
Forfeiture provisions are less common in salary reduction plans. The vesting schedule for deferred compensation plans is much more flexible than for retirement plans governed by ERISA. Hence, there is no limit to the duration of the vesting schedule. Generally, non-compete clauses will not be legally enforceable unless they are restricted to a reasonable time period and to a specific geographic region.
NQDC Plans may be Funded or Unfunded
NQDC plans may require the employee to make contributions or the employer may pay the contributions. With an elective NQDC, an employee chooses to pay the contribution by receiving less current salary and bonus compensation. Non-elective NQDCs are plans in which the employer funds the benefit without reducing current compensation.
Nonqualified deferred compensation plans can be funded, unfunded, or informally funded. For funded plans, the employer establishes an irrevocable trust to receive potentially forfeitable funds for the benefit of the participants. Although this method offers the least risk to the plan participants, the funding method violates the economic benefit rule, so the money will be taxable as soon as the forfeiture risk is removed. With the unfunded plan, the employer does not set aside money, but instead simply promises to pay at some future time. Although it does not violate the economic benefit rule, an unfunded plan poses the greatest risk for the participant, since the employer may go bankrupt before the benefits are paid.
When NQDC Distributions Are Taxable to the Payee and Deductible by the Payer
- As a star athlete, you sign an agreement in 2016, where part of your agreement stipulates that you receive your $10 million signing bonus as deferred compensation in 10 annual installments of $1 million, starting in 2025.
- The compensation is nonforfeitable and unfunded.
- Each payment, including interest, will be deductible to the team and taxable to you in each of the 10 years when the payment is received.
- Your team does not receive any deductions when the money is deposited in the escrow account, only when you constructively receive it.
Informal funding also does not violate the economic benefit rule, since the employer is essentially creating a reserve account on its books to pay the future benefits. However, because the reserve can be attached by creditors of the company, it also poses a great risk to the participants.
The IRS categorizes NQDC plans using different terms, as either account balance plans or non-account balance plans. An account balance plan uses an escrow account to segregate each employee's deferred compensation account balance on the company's books. An account is kept for each participant. The amount an employee elects to defer is credited to his account, along with related earnings. The employee's future payments under the plan are based on the contributions and earnings credited to this account as deferred compensation. Account-based plans earn a fixed or variable interest rate and contributions may be matched by the company.
A non-account balance plan (aka SERP), does not use accounts nor does it record employee deferrals or contributions or even investment earnings. Instead, the employer promises to pay a future benefit of a specified amount, like a defined benefit plan. So, the amount deferred, and used for tax considerations, is the present value of the payments the plan participant has a right to receive in the future [Treas. Reg. 31.3121(v)(2)-1(c)(2)(i)].
Benefits and Security
The major problem with nonqualified deferred compensation plans is that if they are funded, the money might be taxable because of the economic benefit rule. If unfunded, then the participant must accept a risk that will depend on the employer maintaining financial solvency. To get around the taxes and security problems, there are several methods that can offer some security without creating taxable income to the participant, such as using trusts.
The Rabbi trust was 1st used in 1981 by a rabbi as a means of funding his nonqualified deferred compensation plan — hence, the name. The Rabbi trust is an irrevocable trust, but, to avoid violating the constructive receipt rule, the trust assets must be available to the creditors of the company. However, the employer cannot touch the funds once they are transferred to the trust.
An employee secular trust is also an irrevocable trust created by the participants, but funded by the employer, that is not available to the creditors of the employer. However, the funds will be taxable as soon as the risk of forfeiture is removed.
If the employer is financially secure, then the participant can mitigate risk for an NQDC plan by buying a surety bond, which is insurance that will pay the participant if the employer fails to pay them. However, the premiums will depend on the employer's financial status and the bonding company will annually review the risk of nonpayment before renewing the insurance policy.
Control of the NQDC assets by the employee are limited by IRS rules and by the NQDC plan itself. With unfunded NQDC amounts, the investment selections are actually notional, what the employer promises to pay based on the selection, such as a fixed rate of interest, or the returns of a mutual fund or a stock index.
However, the returns must be reasonable. If a NQDC plan credits the deferral with excessive interest, or pays benefits based on unreasonable actuarial assumptions, additional FICA taxes may be due on the excessive or unreasonable amounts credited to the participant's account.
Unlike tax-deferred qualified plans, NQDC plans have neither required minimum distributions nor a minimum age requirement for starting distributions. Distributions from NQDC plans are subject to taxes of the state where the participant resides, which may differ from the state where the compensation was earned.
Distributions can be scheduled for different dates, depending on requirements, using the class-year approach. Different dates can be scheduled for different accounts and different investment portfolios. Thus, a distribution from one account can be used to pay for your child's education for the years that your child will be in school, and another set of distributions can be scheduled for when you retire.
However, distribution schedules are difficult to change. For instance, a distribution election cannot allow an earlier distribution than what was the originally elected except for extreme hardship, disability, or death. Additionally, deferral rules require that any election to defer payment further into the future must be made at least 12 months before the planned date and the additional deferral must be for at least 5 years after the planned date.
Deferred compensation schemes may also have a hardship withdrawal provision, where a certain amount may be withdrawn, equal to the amount needed for the emergency. The IRC defines a hardship as financial stress caused by accident or illness to the participant, his spouse, or dependent. The hardship withdrawal amount is taxed to the employee in the year received, so the employer can deduct the amount in the same year.
NQDC plans may also have special provisions for distributions. The golden handshake pays the participant a certain amount as an inducement to take early retirement. Golden handcuffs, on the other hand, usually have a long vesting schedule or a consultant stipulation, where the participant is paid only if he consults with the employer for a certain duration after retirement.
Another possible provision is a golden parachute, which pays an additional deferred compensation when the company is sold or merged. Golden parachutes help to reduce the risk that the participant will not receive the deferred compensation if the company is bought out. Hence, golden parachute provisions generally allow additional benefits, full vesting, and immediate payout when the business changes ownership.
Remember that distributions are taxed in the state in which you reside when the distributions are received. Also, you may unexpectedly receive your non-deferred compensation as a lump-sum distribution because of a corporate event, such as the sale of the company.
Federal, state, and local taxes must be paid on deferred compensation. Additionally, these taxes are subject to tax withholding rules, where the taxes must be withheld before paying the compensation to the employee.
The employer's compensation deduction is governed by IRC §§ 83(h) and 404(a)(5). Generally, compensation cannot be deducted by the employer until it is includible in the income of the employee, which, as already stated, occurs when the employee actually or constructively receives the compensation or enjoys an economic benefit from it. Employers are required to withhold income taxes from NQDC amounts at the time the amounts are actually or constructively received by the employee.
Under the cash equivalency doctrine, any right to receive a payment that is both written and transferable, such as a note or bond, is equivalent to cash, and, thus, includible in gross income.
The timing of when there is a payment of wages for Federal Insurance Contributions Act taxes (FICA, i.e., Social Security and Medicare taxes) and federal unemployment tax (FUTA) is not affected by whether an arrangement is funded or unfunded. However, whether an amount is funded is relevant in determining when amounts are includible in income and subject to income tax withholding.
FUTA taxes are due at the later of when services are performed or when there is no substantial risk of forfeiture. So if an employee allocated 10% of his wages every year for 10 years and becomes fully vested after the 10 years, then FICA taxes will be due on the entire amount when the risk of forfeiture ceases. If FICA taxes were already paid on deferred income, then, per the non-duplication rule, no FICA taxes will be assessed when the participant receives the income.
The non-duplication rule in Treas. Reg. §31.3121(v)(2)-1(a)(2)(iii) excludes from wages, interest or earnings credited to amounts deferred under a NQDC plan. However, Treas. Reg. §31.3121(v)(2)-1(d)(2) limits the scope of the non-duplication rule to an amount that reflects a reasonable rate of return or is based on reasonable actuarial assumptions. Otherwise, earnings on NQDC plans may be subject to FICA taxes.
NQDC Plan Participation Considerations
Any employee should consider the following before agreeing to a NQDC plan:
- Contributions to qualified tax plans should be maximized, since they are more secure and offer better tax benefits.
- To ensure that the employee will receive the funds at a future date, the company must be financially secure.
- Participation makes sense if income will decline in future tax years, when the taxpayer will be taxed at a lower marginal rate.
- How flexible is the distribution schedule? Some plans allow distributions before retirement, but some do not.
- NQDC plans may have limited investment opportunities. Some offer a fixed rate of return on the deferred compensation, but most offer the same investment choices available to the company 401(k) plan or returns may be based on major stock or bond indexes.
- Early withdrawals are not possible, even if the taxpayer is willing to pay both taxes and a penalty on the withdrawal. Even in retirement, withdrawals may be limited by previous elections, plan provisions, and other rules.
- There are no legal limits on the amount that can be deferred, but NQDC plans usually have specified limits.
- Although the amount deferred can be changed year-to-year, the election must be made in the previous year, and cannot be changed during the current year.