Now that it looks like they’ve been spared from elimination in the most recent version of tax reform, it’s worth taking a look at nonqualified deferred compensation plans (“NQDC plans”). NQDC plans take different forms, including salary reduction arrangements, bonus deferral plans, excess benefit plans, and supplemental executive retirement plans. For some clients, this may be a way to defer a greater percentage of income than under traditional qualified plans. It is also a way to attract and retain key employees. These types of plans will be paired with traditional qualified plans to maximize tax savings.
While there are numerous differences between qualified and nonqualified plans, one of the biggest differences is that nonqualified assets are subject to a company’s general creditors. ERISA’s creditor protections do not apply. Instead, participants are treated as unsecured general creditors of the company in the event of bankruptcy. Therefore, before participating in a NQDC plan, a participant should be mindful of the current, and future, financial position of the company. Below, we’ll discuss some of the basic rules for NQDC plans.
Deferral & Payment Elections
Like qualified plans, deferral elections into NQDC plans must be made before the compensation is earned. The timing rules differ depending on whether the compensation is considered base pay or performance based. Elections for base pay must be made before the beginning of the plan year. For calendar year plans, this is December 31st. Elections on performance-based compensation can be made as late as 6 months before the end of the performance period (which must be 12 months). Once made, a deferral election cannot be changed except under limited conditions.
However, unlike qualified plans, a payment election must also be made at the same time as the deferral election. The participant must elect both the time and form of payment. The permissible distributable events include the standard trio of death, disability, and separation from service. However, they also include a change in company ownership, an unforeseeable emergency, or pursuant to a fixed time and schedule. However, unlike a qualified plan, an NQDC plan can limit distribution options. Commonly, you will see key employees choosing the fixed time and schedule option, and planning distributions around major life events, such as retirement, college education for children, or other personal needs. For example, someone might elect substantially equal installment payments on a quarterly basis beginning in 10 years.
Once a payment election is made, it cannot be accelerated. Any change in a payment election must be made at least 12 months prior to the first payment and must postpone the first payment a minimum of 5 years. For example, suppose a participant initially elected to receive deferred compensation in a lump sum at age 65 but now wants to receive installment payments. The participant must make the new payment election by age 64 and cannot receive the first installment payment until age 70.
Tax Consequences for the Individual
An unfunded NQDC plan operates much the same as a qualified plan for participants. As long as the individual is neither in constructive receipt of, nor derives any economic benefit from, the benefits or contributions accumulated under the plan, federal income tax is not assessed. Additionally, contributions provided and interest or investment income generated in the plan do not create a current tax liability to the individual if the benefits are considered unfunded. Instead, the participant would be taxed on the benefit upon receipt.
Payroll taxes, however, are different. FICA and FUTA taxes are assessed at the later of when the services are performed or when there is no substantial risk of forfeiture with respect to the employee’s right to receive the deferred amounts in a later calendar year. As a result, amounts are subject to FICA and FUTA at the time of deferral, unless the participant is required to perform substantial future services before having a legal right to the future payment. If the employee is required to perform future services in order to have a vested right in the future payment, the deferred amount (plus earnings up to the date of vesting) is subject to FICA/FUTA taxes when all the required services have been performed. FICA taxes apply up to the annual wage base for Social Security and without limitations for Medicare taxes. FUTA taxes apply up to the FUTA wage base. This withholding treatment works best for the participant when their compensation in the vesting year is greater than the retirement taxable wage base for FICA withholding. In this situation, only Medicare taxes would be withheld on the NQDC amounts.
Tax Consequences for the Employer
The tax consequences to the employer are substantially different from qualified plans. For example, contributions to a NQDC are not a current deductible expense. Instead, corporations can take a deduction at the point the key employee is subject to tax on the benefits. Additionally, the employer will pay its portion of the FICA/FUTA withholding taxes at the same time the participant becomes subject to those taxes. Finally, because either the employer or a rabbi trust remain the owner of the assets, the employer must also pay tax on the investments based on their character.
For example, if the corporation informally sets aside funds in mutual funds or other taxable investments, any dividends, capital gain distributions, or realized gains and losses flow through as taxable income to the corporation. As a result, the company usually ends up paying income tax long before receiving a tax deduction. There are ways to alleviate this mismatch, including using insurance funding strategies or delaying payment until death.
An NQDC plan for key employees can be a cost-effective, flexible, and powerful tool to provide additional and appropriate rewards for valuable leadership within an organization. However, bear in mind that there are other non-NQDC incentive based programs that could achieve the same goals. Therefore, it is vital that an employer undertake a careful study to determine what type of incentive plan best achieves the objectives of its organization.