Overview: Employee fringe benefits are considered an essential part of attracting and retaining key employees and executives. However, because the rules for qualifiedplans place a limitation on contributions to retirement plans, many employers look to nonqualifiedplans to help key employees and executives postpone payment of some compensation until the need exists and the tax consequences may be more favorable.
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- True or False. Nonqualified deferred compensation has tax consequences that generally depend on the application of the doctrine of constructive receipt.
- True or False. In an unfunded, unsecured plan, the employer usually makes only a bookkeeping entry, a mere promise to pay in the future, resulting in the deferral of income recognition for the employee and the postponement of employer deductions until the compensation is actually paid.
- True or False. To help meet its obligations under a nonqualified deferred compensation plan, the employer frequently attempts to informally “fund” such plans with the owner’s personal assets, such as real estate or marketable securities.
Read here to learn more about nonqualified deferred compensation.
Nonqualified deferred compensation plans escape restrictive IRC (Internal Revenue Code) requirements, such as nondiscrimination and “top-heavy” rules, which apply to qualified plans, giving employers the flexibility to provide additional benefits to key employees. They do, however, have tax consequences that generally depend on the application of the doctrine of constructive receipt.
Constructive receipt usually refers to access and degree of control. If access to a deferred benefit by the employee is subject to substantial limitations or restrictions, constructive receipt generally does not exist. An employee is subject to a substantial limitation or restriction if control of the receipt of a deferred benefit requires a trade-off of a valuable right in exchange for plan benefits. A valuable right might be an employee’s right to be a part of the plan in the future. Thus, constructive receipt is generally avoided if benefits are agreed upon before any actual employment begins, and the employer does not guarantee any benefits.
Variations of Plan Design
How a plan is designed will result in different tax and benefit trade-offs. In an unfunded, unsecured plan, the employer usually makes only a bookkeeping entry, a mere promise to pay in the future, resulting in the deferral of income recognition for the employee and the postponement of employer deductions until the compensation is actually paid. Constructive receipt generally will not apply because the employee has no control over, or right to receive, the deferred compensation until some defined point in the future. This is nonqualified deferred compensation in its purest form.
However, an unfunded promise to pay results in an increasing liability to the company, a promise that depends on the company’s solvency and ability to pay in the future. Consequently, the employee bears the risk that the company will be unable to meet its future obligation. Moreover, in the event of bankruptcy, the unsecured nature of the promise could leave the employee vulnerable to default.
To help meet its obligations under a nonqualified deferred compensation plan, the employer frequently attempts to informally “fund” such plans with the use of life insurance, with the main features being: no current income tax on cash values; and an income tax-free death benefit that is triggered by the employee’s death. In addition, some employers have used “triggers”—clauses that require immediate payment of benefits to the participant upon the occurrence of certain events—to give employees a greater sense of security. The degree to which some immediate economic benefit is conveyed to the employee and the degree to which the employee’s rights to such benefits are superior to those of the employer’s general creditors will come under scrutiny.
The design of employee benefit plans should be based on an evaluation of the employer’s intent, the needs of various employees, and an understanding of the benefit trade-offs. Nonqualified deferred compensation may be particularly attractive as a supplement for key employees who have a greater need for future income, but whose retirement benefits are limited under the rules for qualified plans.
Quiz Answers: 1) True; 2) True; 3) False.