Many businesses like to provide their employees with some form of retirement benefit or deferred compensation. This could be for employee retention, attracting new employees, or for tax advantages associated with deferring compensation. For many of these businesses, it either is not worth the time, effort, and money to set up traditional ERISA governed retirement plans such as 401(k) plans due to the complexities of maintaining compliance with both ERISA and the Internal Revenue Code (the “Code”) or they wish to provide opportunities to employees for contribution amounts over the limits imposed on qualified plans. Fortunately for those wishing to provide excess deferred compensation but not fall under many provisions of ERISA and the Code, a nonqualified deferred compensation (“NQDC”) plan could be an attractive option. There are different types of NQDC plans that may have different requirements and benefits depending on the situation. While many ERISA and Code Sections may not apply to NQDC plans, those plans must be designed correctly to achieve favorable tax treatment and remain outside of the strict requirements of ERISA.
Most NQDC plans are “unfunded” and is why they are exempt from many of the stringent requirements under ERISA and the Code. For a plan to be considered “unfunded”, there must not be funds set aside for the employee that are exempt from claims of the employer’s general creditors. This can mean that there are no assets set aside to pay the benefits when it is time for them to be paid or that the plan can be “informally funded.” A plan is informally funded if there are funds set aside for the plan but they are still subject to the claims of the employer’s general creditors. Common ways to informally fund a plan are through the use of corporate owned life insurance policies on the employees or specially designed trusts known as rabbi trusts. While this allows for favorable tax treatment of the plan, it means that in the event of the employer’s bankruptcy or insolvency the employee may not receive any benefits from the plan.
Typical unfunded plans are what are known as “Top-Hat Plans.” Top-Hat Plans are stand alone NQDC plans that must be provided solely for a select group of highly compensated employees as that term is defined in Code Section 414(q). Maintaining an unfunded NQDC plan that meets the requirements of a Top-Hat Plan allows for the NQDC plan to operate with favorable tax treatment without having to adhere to ERISA’s minimum participation and vesting rules, its funding rules, and its fiduciary responsibility rules and trust requirement. Unfunded NQDC plans (generally Top Hat Plans) allow for the employee to defer the recognition of income until the funds from the plan are actually or constructively received. The difference between a NQDC plan and a qualified plan is that the employer only gets a deduction attributable to its contribution in the year the employee recognizes the income. If a NQDC plan is informally funded using a rabbi trust the employer will have to pay any income taxes attributable to earnings on the funds in the trust and is why it may be preferable to use corporate-owned life insurance instead. A NQDC plan may also lose tax favorable treatment if it does not adhere to the requirements of Code Section 409A or under the constructive receipt doctrine.
- Code Section 409A
Code Section 409A imposes various requirements and restrictions on any NCQDC plan. Failure to follow the requirements of Code Section 409A results in immediate taxation of the funds designated for the NQDC plan to the employee plus an additional 20% income tax plus an additional surtax. Given that an important tax objective of a nonqualified plan is to defer the payment of taxes by the employee, compliance with the requirements of Code Section 409A is vital. Generally, to be compliant with Code Section 409A, a NQDC plan must be (i) in writing, (ii) the plan documents must specify at the time an amount is deferred the amount to be paid, the payment schedule and the permissible triggering event (as defined by Code Section 409A) that will result in payment, and (iii) the employee makes an irrevocable election to defer compensation before the year in which the compensation is earned.
- Constructive Receipt Doctrine
Under the constructive receipt doctrine, an employee may be taxed on the benefits he or she is to receive from a NQDC plan if the funds in the plan are credited to the employee’s account, set aside, or otherwise made available to the employee without substantial restrictions or limitations. Frequently, this issue arises when a NQDC plan permits an employee to elect to defer the receipt of compensation. To maintain deferred income taxation, the employee must make such election before the year he or she performs the services that earn the compensation. Another important consideration is that the employee generally must not be able to elect to receive payment of the deferred compensation before payment is due under the terms of the NQDC plan. While not required in unfunded NQDC plans, to prevent the inclusion of the benefits as income to the employee, restrictions could be put in place to prevent the receipt of the benefits before completing some requirement or failing to fulfill a requirement that amount to a “substantial risk of forfeiture.” This would include, for example, the employee must work for ten years before he or she is able to receive the benefits from the NQDC plan.
Another form of NQDC plans are considered funded plans. Funded plans are essentially the opposite of unfunded in that they have funds set aside for the plan and the plan participants that are outside of the general assets of the employer and protected from its general creditors. It is important to be aware that if employees have legal rights to specific assets that are set aside such that they have priority over the employer’s general creditors the plan will likely be considered funded as well.
Employees are taxed on the contributions to the funded NQDC plan in the year they are made or in the year the employee becomes vested in the benefit without any substantial risk of forfeiture (as mentioned above). The actual taxation to the employee depends on the vehicle used to fund the plan. Again, the deduction for contributions to the plan is only available to the employer when the employee is taxed on them. Also, the deduction is permitted only to the extent that it is reasonable in amount and an ordinary and necessary expense incurred in carrying on a trade or business.
Generally funded NQDC plans must adhere to all of the requirements of ERISA including those regarding administration, reporting, disclosure, participation, vesting, funding, and fiduciary activities. Because of the ERISA requirements imposed on funded plans generally, the question becomes why an employer would set up a funded NQDC plan. If benefit security is a primary concern, then a funded plan would be better than an unfunded arrangement as the benefits to the employees would be essentially guaranteed. Funded plans may also allow for benefits to more employees as the specific group of highly compensated employees requirement is not applicable. While it seemingly still presents a question of why an employer would set up a funded NQDC plan versus a qualified plan, funded NQDC plans are frequently seen in plans known as excess benefit plans. These are plans that specifically provide benefits to employees in excess of the limits imposed by the Code. Unlike other NQDC plans, they are exempt from all ERISA requirements if unfunded and most ERISA requirements if funded. They do not have to be provided solely to a select group of highly compensated employees and therefore are a typical mechanism used to provide excess deferred compensation benefits to employees.
NQDC plans are a great way for business to retain key employees, attract new employees, and provide for loyal employees without many of the burdensome requirements imposed on qualified retirement plans by the Code and ERISA. While this article does not in any way cover every type of NQDC plan, it serves as a summary for many of the most common ways to create and maintain NQDC plans and the various requirements and restrictions imposed on such plans. It is vital to make sure NQDC plans follow the relevant Code and ERISA requirements to prevent adverse tax and other consequences. Setting up and maintaining NQDC plans can be complex. The attorneys at Hickmon & Perrin, P.C. are available to assist businesses looking to create and maintain NQDC plans.
The content on this article is offered only as a public service to the web community and does not constitute legal advice or create an attorney-client relationship. This information should not be used as a substitute for obtaining legal advice from an attorney authorized to practice in your jurisdiction. You should always consult a suitably qualified attorney regarding any specific legal problem or matter.