A nonqualified deferred compensation plan (often called a NQDC) is a contractual arrangement between a company and an employee. It allows the employee to defer the receipt of income that is currently earned.
These plans are in addition to other qualified retirement plans that the company may have. However, they have different rules and requirements.
In this post, we will discuss the tax and legal strategies that should be considered when setting up a deferred compensation plan. Let’s dive right in.
Table of Contents- How do deferred compensation plans differ from qualified retirement plans?
- What is the difference between a funded versus unfunded deferred compensation plan?
- Deferred Compensation Income Tax Issues
- Who can adopt a Deferred Compensation plan?
- Types of deferred compensation plans
- How to implement a deferred compensation plan
- Advantages of deferred compensation plans
- Disadvantages of deferred compensation plans
How do deferred compensation plans differ from qualified retirement plans?
A qualified retirement plan allows the company to take an immediate tax deduction for contributions made into the plan. The company gets the tax deduction, and the employee will not be taxable until he or she withdraws the money from the plan.
But to qualify for a qualified plan, you must comply with strict compliance and IRS rules. The plan typically must cover a large portion of employees, and it will be subject to limitations on owner contributions. These limitations will often restrict contributions by the owner and other highly compensated employees, which is why some companies turn to deferred compensation plans as an added employee benefit.
A deferred compensation plan can be structured to allow a tax deferral to the company while avoiding most of the burdensome requirements of ERISA.
There are no funding limits applied to deferred compensation plans, although compensation must be reasonable to be tax-deductible. You can also provide benefits to certain employees without including all company employees, even at the lower levels.
What is the difference between a funded versus unfunded deferred compensation plan?
Defined compensation plans fall into two main categories: (1) funded; and (2) unfunded. A plan is considered funded if the funds are placed irrevocably and unconditionally with a third party, typically in an escrow or trust account. These funds are set aside to pay the deferred compensation benefits. They are also outside of your control and provided creditor protection. Said differently, if your employees are guaranteed to receive their benefits under the contractual arrangement, the plan is considered to be funded.
The plan’s funded status makes sense if employees may be concerned that benefits might not be received in the future due to adverse business consequences, or a change in control, or other liquidity issues. Because the company cannot touch the assets in the funding plan, these arrangements provide participants with a high level of security that benefits will be paid. However, thundered plans tend to be rare because they provide only limited options for tax deferral and can also follow under ERISA requirements.
Unfunded plans are much more popular because they allow the tax deferral but avoid almost all ERISA requirements. For an unfunded plan, the company will generally not set aside assets to pay future benefits. Instead, they pay plan benefits out of current cash flow or identify certain assets to be allocated to plan benefits. The assets R typically subject to credit or claims.
Often, a rabbi trust is established to hold the deferred compensation assets, but those funds often remain subject to bankruptcy and creditors. A rabbi trust will generally protect employees against any company issue but not for any change in finances that could lead to insolvency or bankruptcy.
To obtain the tax deferral and avoid ERISA, the deferred compensation plan must be unfunded and maintained for a discretionary group of officers or highly compensated employees. While there is no legal definition of a select group of employees, it generally means a small percentage of overall employees who are officers or key employees with high salaries.
Deferred Compensation Income Tax Issues
As a general rule, you cannot take an income tax deduction for amounts contributed to a deferred compensation plan until the employees are taxed on the contributions. This could be several years.
Employees will typically not include contributions to an unfunded deferred compensation plan, or other plan earnings, in taxable income until the benefits are actually received.
However, the taxation of funded deferred compensation plans is a bit more complex. Employees will typically include contributions in taxable income as soon as they vest. The taxation of plan earnings will depend on plan structure. In certain situations, employees will include earnings in their current taxable income. But under certain conditions, they are not taxed until payments are received from the plan.
Who can adopt a Deferred Compensation plan?
Deferred compensation plans work well for C-Corporations. For S-corporations and other flow-through entities, not so much. Business owners are generally unable to defer income taxes on shares of business income.
S corporations, partnerships, and sole proprietors can adopt deferred compensation plans for employees who have no equity in the company. These plans work well for companies that are well established with expectations of continued profitable operations.
Since deferred compensation plans are more affordable to implement compared to qualified plans, they can be a great strategy for a company that is growing with limited current cash flows.
Types of deferred compensation plans
Remember that a deferred compensation plan is a contractual arrangement between a company and an employee. As such, these plans can be customized with almost unlimited variations. In most situations, the plans are combined with supplemental executive retirement plans (“SERPs”). The company is simply deferring the payment of current compensation (usually a salary or bonus) to a future date. A SERP is generally used to supplement other employee-qualified plans.
How to implement a deferred compensation plan
An ERISA attorney can draft a plan and guide the company through all the tax and legal requirements. The plan is typically approved by the board of directors.
If you select an unfunded plan, ERISA generally only requires is that the company sends a basic statement to the Department of Labor that will inform them of the plan document and give them the number of participants.
Advantages of deferred compensation plans
- Less expensive and simpler to maintain compared to a qualified retirement plan
- It can be done on a discriminatory basis (excluding certain employees)
- Benefits can essentially be unlimited
- Allows control of timing and benefit receipt
- Ability to attract and retain certain key employees
Disadvantages of deferred compensation plans
- Employee taxation will generally control the timing of tax deduction
- Security concerns for employees in an unfunded plan
- Typically do not work well for S-corporations, partnerships, or sole proprietorships
- Usually more expensive to the employer than paying current compensation
