If certain executives are critical to the success of your business, providing them with a nonqualified deferred compensation (NQDC)plan could be an effective retention strategy. Such a plan represents an agreement whereby one person (or legal entity) promises to pay compensation at some time in the future. The plan is a contractual agreement between the employer and an employee, which specifies when and how future compensation will be paid. When the plan is properly arranged, the employee defers taxation until benefits are actually paid.
Because these plans are not governed by Federal pension laws, they are considered “nonqualified,” and they can be extremely flexible. Their very flexibility—and the associated risks—means that professional guidance from tax, legal, and financial professionals is required. From a business standpoint, it is important to establish an informal funding mechanism to help ensure the benefits are available when the employee is entitled to them. From a tax standpoint, it is important to ensure that the employee’s benefits are taxed upon receipt, and not before. Professional advice is advised to ensure compliance with all tax issues related to NQDC plans, including the Internal Revenue Service’s “constructive receipt doctrine” and IRC Section 409A, the latter of which prescribes rules regarding the timing of deferral elections, acceleration of benefits, and distribution of deferred amounts.
Beyond the 401(k)
It’s likely that your company already offers a qualified retirement plan, such as a 401(k), which provides the employer and employee with tax deductions based on the amount of contributions. In addition to reducing taxable income, employees also defer taxes on earnings until withdrawals are taken from the account. However, qualified plans may limit the financial benefit sought by highly paid executives. This is because qualified plans usually restrict the compensation base used to determine the maximum annual contribution. With no limit on the compensation base, NQDC plans can transform a standard benefit package into an attractive savings vehicle for select employees.
A NQDC plan is a legal agreement to provide future payment for services rendered. NQDC plans are typically unfunded because of the tax advantages unfunded plans afford participants. An unfunded arrangement is one where the employee has only the employer’s promise to pay the NQDC in the future, and the promise is not secured in any way. Binding an employee to the company through a vesting agreement is often included in a plan, although some plans offer immediate vesting, which is to the employee’s advantage.
For example, an employer may stipulate that the employee must stay with the company for a certain number of years before being entitled to the compensation. Such an agreement promotes loyalty and commitment on the part of the employee. A non-compete agreement that prohibits the employee from working for a competitor can be another condition of the agreement.
What’s in Store?
The agreement will specify the type of benefits and how and when they will be available. For example, a salary continuation agreement could provide $10,000 per month for life beginning at retirement, or annual contributions could be made to an investment account, the balance of which could then be paid to the employee at retirement. Whether the money is actually deposited into a separate account or not is left to the employer’s discretion. Employers who offer these plans, however, must be confident that the future profitability of their businesses will cover promised payments.
Employees will want assurance that their compensation will be there for them at the agreed-upon time. One method of providing that assurance is to establish a rabbi trust, which is a type of trust that provides protection for the deferred compensation funds in the event of an acquisition or other managerial change. (Trust assets are subject to the claims of the employer’s general creditors.) The trust funds may be invested or used to purchase life insurance or annuity products.
As employees take on the responsibility of funding their own retirement, NQDCs may become a standard component of benefit packages. These plans may make it easier for your business to attract and retain talented executives.