Nonqualified Deferred Compensation Plans
Why you might consider one
Attracting, keeping and rewarding talent is a key element for a successful enterprise, especially when that talent is instrumental in maintaining an important client base or building new prospects and revenues. This talent comes at a cost -- compensation. For privately-held and family-owned companies, founding owners might be tempted to issue stock or other equity investment, like LLC ownership interests, to incentivize top employee talent. However, a deferred compensation arrangement may be a suitable alternative.
Deferred compensation comes in many forms: postponed payments, excess benefit plans, phantom stock, nonqualified options, sale-of-company units, shadow 401(k) plans, etc. In essence, deferred compensation is a legally-binding promise to pay compensation at a later date. It is often referred to as “nonqualified deferred compensation” (also called a “top hat” plan) to distinguish it from qualified retirement plans, like 401(k) plans, with all their qualifying conditions, testing, and coverage requirements.
Deferred compensation has some costs (explained below), but the advantages may be worth it:
- no equity/ownership dilution
- no stock/voting rights or minority owners
- no dissenters’ rights and access to company-wide information
- management control (voting) can be retained
In a typical deferred compensation plan, top employees are issued “units” which reflect an amount of deferred compensation. These units are earned by the employee if various conditions and objectives (sales, profits, new customers) are attained. Earned and vested units are later converted to cash payout upon certain Tax Code-permitted triggering events. Deferred compensation plans can be a single agreement with one individual employee or with several employees.
There is wide latitude and flexibility in establishing the amounts and conditions for payment – – unlike qualified retirement plan requirements – – as long as those factors and conditions are clearly and precisely drafted into a written document. For example, in place of actual equity ownership, deferred compensation units might mirror a company’s stock performance in a way which generates an equal return for a recipient of deferred compensation. Ambiguity in drafting and failure to address contingencies may lead to tax penalties and adverse tax consequences.
In considering a deferred compensation plan, you should be aware of the regulatory environment and certain disadvantages (at least to the employee), as follows:
(1) U.S. Department of Labor oversight if the arrangement is considered an ERISA plan (see below)
(2) Compliance with Tax Code Section 409A(see below)
(3) For the employee, deferred compensation converts what otherwise might be capital gain treatment (at lower capital gains rates) compared to deferred compensation which is taxed at ordinary income (wage) rates
(4) No portability on receipt of deferred compensation, meaning no tax-free IRA rollovers (and preservation of the tax shelter) when deferred compensation is paid out
(5) Deferred tax deduction to the employer (generally when deferred compensation is paid)
(6) Potential for creditor attachment of the employee’s deferred compensation benefit (even for so-called rabbi trusts, see below).
Tax Code. Since 2005, deferred compensation plans have been governed by Tax Code Section 409A. Prior tax law also generally applies to unfunded deferred compensation arrangements. Tax Code 409A establishes significant restrictions and penalties for failure to address tax requirements.
First and foremost, 409A deferred compensation may only be paid out upon the following events, each of which is subject to lengthy regulatory conditions of the Internal Revenue Service:
- separation from service
- disability (statutorily defined)
- specified time or fixed schedule
- unforeseeable emergency
In addition, once the plan is established and the deferred compensation agreement reached with an employee, any changes to the timing or form of payout may only be made under certain circumstances and with certain consequences -- most importantly, a 5-year delay in starting deferred compensation payouts. Once deferred compensation is fixed, Tax Code 409A prevents acceleration of benefit payments except for certain limited circumstances.
Tax Code 409A has numerous regulatory conditions and various exceptions. A commonly used exception is for “short term deferrals”. If deferred compensation is paid by March 15 (calendar year taxpayers) of the year after the amount is earned and vested, then Tax Code 409A does not apply. As indicated, general tax law relating to deferred compensation would continue to apply and may require other forms of compliance.
Funding. Many (most) deferred compensation plans do not fund, or set aside, any company funds for subsequent payout. Indeed, the Tax Code limits the extent and degree of such funding and specific funding vehicles. Assets are not set aside, typically, in any funded arrangement, and deferred compensation recipients are considered general unsecured creditors of the company. This, of course, discourages most employees from deferring their own (earned) compensation given the potential risk of loss coupled with lack of control of the company. In most cases, companies show the liability for deferred compensation as a bookkeeping account only.
A rabbi trust may be used to establish certain legal protections for an employee’s deferred compensation benefit, but assets remain attachable by company creditors. Keep in mind, a rabbi trust establishes legal rights, duties and protections for your employee, and you will still need to find a trustee and custodian to hold any funds set aside for payment of deferred compensation. Life insurance is also an option if properly structured.
ERISA. ERISA is a federal law which establishes rights for employees and imposes disclosure, reporting and fiduciary obligations on employers and fiduciaries. A nonqualified deferred compensation arrangement, even a single employment contract for one employee, can be an ERISA plan depending on its provisions. Careful consideration should be given to ERISA coverage and compliance.
Conclusion. Deferred compensation may be suitable for your needs in retaining and rewarding superior talent. The most attractive feature of non-qualified deferred compensation is its flexibility in how amounts and qualifying conditions can be set up and selection of which employees may participate. That flexibility, however, must be aligned with legal (Tax Code and ERISA) compliance considerations.
Alan D. Pauw is a member of Reed Weitkamp Schell & Vice PLLC’s health care, corporate and estate planning sections. He concentrates his practice in the areas of tax qualified and non-qualified deferred compensation plans and employee benefit matters for private and public employers, estate planning, ERISA compliance and enforcement, physician practices, corporate, tax, and health care law. He also oversees design, administration, operation and termination of tax-qualified and non-qualified deferred compensation plans and employee benefit matters for private and public (governmental) employers.
Mr. Pauw can be reached at (502) 589-1000 firstname.lastname@example.org
This article is intended for informational purposes only and does not represent legal advice. You should contact legal counsel for specific inquiries and compliance with legal requirements pertaining to individual circumstances and applicable law.