Non Qualified Deferred Compensation
Table of ContentsOverview
NQDC and Federal Income Tax
Years until Breakeven for Deferred Compensation (table)
NQDC and Social Security Taxes
Rabbi Trusts, Secular Trusts, etc.
Split Dollar Life Insurance Plan
Excess Benefit Plans, Top-Hat Plans, or Supplemental Executive Retirement Plan's
Non-Qualified Deferred Compensation (NQDC) can be a powerful retirement planning tool, particularly for owners of closely held corporations (for purposes of this article, I'm only going to deal with IRS Subchapter "C" corporations). Non-Qualified Deferred Compensation plans are not qualified for two things; some of the income tax benefits afforded qualified retirement plans and the employee protection provisions of the Employee Retirement Income Security Act (ERISA). What Non-Qualified Deferred Compensation plans do offer is flexibility which is something qualified plans lack. For the Present Law and Background Relating to Executive Compensation click here
With Non-Qualified Deferred Compensation plans, the employer can discriminate freely. The employer can pick and choose from among employees, including him/herself, and benefit only a select few. The employer can treat those chosen differently. The benefit promised need not follow any of the rules associated with qualified plans (e.g. the 25% or $44,000 limit on contributions to defined contribution plans). The vesting schedule can be whatever the employer would like it to be. By using life insurance products, the tax deferral feature of qualified plans can be simulated. Properly drafted, Non-Qualified Deferred Compensation plans do not result in taxable income to the employee until payments are made.
To obtain this flexibility both the employer and employee must give something up. The employer loses the up-front tax deduction for the contribution to the plan. However, the employer will get a deduction when benefits are paid. The employee loses the security provided under ERISA. However, frequently the employee involved is the business owner which mitigates this concern. Also there are techniques available to provide the non-owner employee with a measure of security. By the way, the marketing guys have gotten hold of Non-Qualified Deferred Compensation plans, so you'll see them called Supplemental Executive Retirement Plans (SERP) or Excess Benefit Plans among other names.
A Non-Qualified Deferred Compensation plan is a written contract between the corporate employer and the employee. The contract covers employment and compensation that will be provided in the future. The Non-Qualified Deferred Compensation agreement gives to the employee the employer's unsecured promise to pay some future benefit in exchange for services today. The promised future benefit may be in one of three general forms. Some Non-Qualified Deferred Compensation plans resemble defined benefit plans in that they promise to pay the employee a fixed dollar amount or fixed percentage of salary for a period of time after retirement. Another type of Non-Qualified Deferred Compensation resembles a defined contribution plan. A fixed amount goes into the employee's "account" each year, sometimes through voluntary salary deferrals, and the employee is entitled to the balance of the account at retirement. The final type of Non-Qualified Deferred Compensation plan provides a death benefit to the employee's designated beneficiary.For more on Defined Benefit plans click here
For a comparison of defined benefit vs defined contribution click here
The fundamental goal of any deferred compensation plan (qualified or non-qualified) is the deferral of tax. The taxation of Non-Qualified Deferred Compensation plans is perhaps best understood through a comparison with qualified plans.
A qualified plan is one which meets certain requirements imposed by the IRS. These requirements include minimum coverage and nondiscrimination requirements prohibiting an employer from providing benefits for "highly compensated employees" to the exclusion of other employees, and limitations on the amount of benefits that can be provided. In exchange for compliance with these requirements, certain favorable tax treatment is afforded. Specifically, the employer is entitled to a tax deduction for amounts contributed to the plan, benefits within the plan grow on a tax-deferred basis, and plan participants are not taxed on the benefits until they are actually paid from the plan. Further, distributions from qualified plans are generally eligible for rollover to an IRA or other qualified plan, thereby permitting further tax deferral.
A non-qualified plan is not subject to the same minimum coverage and nondiscrimination requirements. Therefore, a non-qualified plan can be designed to cover a limited group of employees. Also, a non-qualified plan can provide benefits in excess of those permitted under the qualified plan limits. Since the strict qualified plan rules do not apply to non-qualified benefits, however, the tax treatment of a non-qualified plan is not as favorable.
First, an employer is not entitled to a tax deduction until such time as the benefits are actually paid to the employee. Second, under the tax doctrine of constructive receipt, non-qualified plan benefits are taxable to the employee at such time as the employee has the right to receive the benefits (without regard to when the benefits are actually paid), unless the employer's obligation to pay the benefits remains merely an "unfunded and unsecured" promise to pay.
If the service by the employee necessary to earn the deferred compensation has yet to be performed it clearly may be deferred and taxation delayed until actual receipt, even if the employees right to receive said amount was nonforfeitable. However where the plan was installed after the required labor, the IRS stipulates that substantial risk of forfeiture provisions be instituted in order to defer taxation of said compensation until the year it actually was received. Substantial risk of forfeiture could include the requirement that the employee refrain from competing with the employer and to render consulting services at the employer's request, only however if the facts indicate that an actual forfeiture was likely to occur.
There are special rules for stockholder-employees since they are in control of the corporation, they easily could agree to simply continue their lofty salaries after semi-retirement even though actual duties are curtailed. However, reasonableness of compensation is monitored quite closely by the IRS under these circumstances. Where there has been clear curtailment of services and no reduction of salary, the IRS is likely to find a portion of the salary to be unreasonable and treat that portion as a constructive dividend. As a dividend it would be ordinary income to the recipient and allow no deduction to the corporation.
For qualified retirement plan consideration compensation for the purpose of determining benefits or employer contributions typically includes total cash compensation. The IRS permits the inclusion of Non-Qualified Deferred Compensation credits of benefits in the definition of compensation where discrimination in favor of officers, stockholders, supervisors, and highly paid employees does not exist.
*Number of years = Natural log of (new tax rate/current tax rate)/natural log of (1 + interest rate)
This is a hypothetical illustration and is not intended to reflect the actual performance of any particular plan.
This is a hypothetical illustration and is not intended to reflect the actual performance of any particular plan.
Generally, the amount of a Non-Qualified Deferred Compensation benefit is limited by an employer because of the relationship between the benefit payment and the timing of the employer's tax deduction. However, since tax-exempt employers are not concerned with tax deductions, the Code imposes special rules on non-qualified plan benefits paid by tax-exempt entities. Non-Qualified Deferred Compensation plan benefits paid by tax-exempt entities will be taxed when paid (as opposed to the time of deferral) only if the plan meets the requirements of IRS Code Section 457, including an annual contribution limit of $15,000 (in 2006 as indexed for cost-of-living increases NOTE: for those over 50 a catch-up contribution of $5,000 may be added to this amount). Benefits under plans providing deferred compensation in excess of $15,000 per year become taxable when they are no longer subject to a "substantial risk of forfeiture" (e.g., a requirement that an employee remain in the employ of the employer for a fixed number of years).For 457 plan FAQs click here
Employers and employees should also be aware of the special timing rule which applies for purposes of Social Security (FICA) taxes. Although an amount deferred under a Non-Qualified Deferred Compensation may not be subject to income tax until actually paid, the amount is subject to FICA tax when it is no longer subject to a substantial risk of forfeiture. This result is both good and bad.
The old-age portion of the FICA tax (7.65 percent on the employer plus 7.65 percent on the employee) is subject to a taxable wage base ($94,200 in 2006). Therefore, if an employee has current compensation in excess of $94,200, the accrual of a Non-Qualified Deferred Compensation benefit does not increase the 7.65 percent tax. On the other hand, the Medicare portion of the FICA tax (1.45 percent on the employer plus 1.45 percent on the employee) is not subject to any wage base. Therefore, the full deferred compensation obligation can be subject to Medicare tax prior to actual payment of the benefit.
Another area in which Non-Qualified Deferred Compensation differ significantly from qualified plans is the area of benefit security. Federal laws governing qualified plans require that all qualified plan contributions be set aside in trust, beyond the reach of creditors of the employer as well as creditors of the employee. Therefore, a vested participant in a qualified plan can take comfort in the fact that his or her benefits will eventually be available for their intended purpose.
As stated above, in order to meet the goal of tax deferral, non-qualified plans must remain unfunded and unsecured. This means that all assets used to fund non-qualified plan benefits must remain assets of the employer, subject to claims of the employer's general creditors. Thus, non-qualified plan participants must face the very real possibility that they might never receive the amounts deferred under a non-qualified plan. This holds true for voluntary salary deferrals elected by the individual as well as contributions made by the employer.
Non-qualified trusts are being used with frequency to help executives enforce payment in the event of a refusal to pay or inability to pay by the employer. These trusts may be designed as unfunded or funded for tax and ERISA purposes, with the degree of security varying accordingly. The trusts may be revocable or irrevocable. The executive's interest may be subject to substantial risk of forfeiture. There are three basic types of trusts being used - the Rabbi trust, the Secular trust and the Rabbicular trust.
A Rabbi trust is usually an irrevocable trust created by the employer in which assets are irrevocably segregated by the employer in a separate trust administered by an independent Trustee. The trust assets remain the property of the employer and can be seized by the employer's creditors and applied to pay claims if the employer becomes bankrupt. However, the assets are not available to the employer for its general use. A properly drafted Rabbi trust is not a "funded" plan for ERISA purposes. These trusts have become so popular that the IRS has released a model trust instrument to aid taxpayers and expedite IRS ruling requests. Although the Rabbi trust does not shield plan benefits from the employer's creditors, it does protect the executive from nonpayment due to a change of control in the employer's management or ownership or a "change of heart" on the employer's part as to its promise to pay benefits.
A Secular trust is a trust in which the executive's interest vests either immediately or upon the happening of one or more events, such as the attainment of a stated age, change of control, termination of employment, death, disability, etc. The trust assets are separate from the company's assets and cannot be seized by the employer's creditors. Thus, a Secular trust may provide protection to the executive against the company's nonpayment of benefits due to both a refusal to pay and an inability to pay. If the Secular trust provides full and immediate vesting, it is probably "funded" for tax and ERISA purposes and contributions by the employer would be currently deductible and taxable to the employee.
A Rabbicular trust is a hybrid of the Rabbi Trust and Secular trust. The trust is designed as a Rabbi trust until the occurrence of an event indicating financial difficulty of the employer (short of bankruptcy), such as a stipulated decline in debt-equity ratios, net worth, gross sales, earnings per share, etc., and when the event occurs, the trust becomes a Secular trust and the executive is given the right to withdraw benefits. The objective is to protect the assets from the claims of the employer's creditors if events occur which make insolvency likely, but to take advantage of the tax deferral and ERISA exemptions until that time. However, federal bankruptcy laws permit the bankruptcy Trustee to reclaim any transfer made within ninety (90) days of the employer's bankruptcy (or within one (1) year for transfers to insiders).
There are other hybrids such as a Springing trust or using Bankruptcy Insurance with a Rabbi Trust. For more on Rabbi Trusts, Secular Trusts, Etc. Click here for more on using bankruptcy insurance with a rabbi trust click here
Split dollar life insurance is not a type of insurance, it is a way to fund insurance. Split dollar insurance involves the purchase of life insurance where the ownership of the policy cash value and death benefit is divided. The executive owns a portion of each, and the company, which typically pays most or all of the premium, owns the remainder. The insurance can build an executive-owned cash value that, over time, produces security for the non-qualified benefits. For more information on Split Dollar Insurance click here
What is a "Section 162" executive bonus plan? Section 162 of the Internal Revenue Code allows deductions by a business for reasonable compensation, including salaries and bonuses to its employees. As a result of this section, disability income insurance can be purchased in a very attractive manner: The employer pays as a bonus the amount of the disability premium to its employee and takes a deduction for that amount on its corporate income tax return. The employee then takes that amount into income. If disability benefits are paid to the employee under this strategy, they are received totally income tax-free. For more on Disability Insurance click herefor more on section 162 plans click here
Excess Benefit Plans, Top-Hat Plans, or Supplemental Executive Retirement Plans (SERP) are Non-Qualified Deferred Compensation arrangements designed to supplement qualified retirement plans. They accomplish this by making up for the benefits unavailable to the base qualified plan due to benefit restrictions on the qualified plan. The non-qualified plan usually covers only the few highest paid employees. The plan can be funded or non-funded. If it is funded, a Rabbi Trust may be recommended to avoid current tax on the plan assets.
Non-Qualified Deferred Compensation arrangements for executives have become very popular due to federal pension law (ERISA) limits on the amount of contributions and benefits available under traditional qualified retirement plans. For example, it is common for total retirement income from a combination of tax-qualified plans and Social Security to constitute 70%-75% of pre-retirement income for non-executive employees but only 30%-35% of pre-retirement income for executives. Additionally, certain Non-Qualified Deferred Compensation plans can avoid ERISA minimum coverage and nondiscrimination rules, vesting and funding rules and reporting requirements. Non-Qualified Deferred Compensation plans can be limited to selected employees rather than the entire workforce and benefits may vary among covered employees.
The two primary goals of most Non-Qualified Deferred Compensation plans are to defer tax on benefits payable to covered employees and to avoid coverage under ERISA rules and regulations. A quote;top-hat" or supplemental executive retirement plan can achieve both objectives if properly drafted and implemented. Generally, a top-hat plan is in the form of a defined benefit plan in which the employer promises to pay on an unsecured and unfunded basis a benefit equal to a specified dollar amount or a percentage of final compensation (or of final 3 or 5-year average compensation). Typically, the benefit is subject to a vesting schedule and may be 100% forfeited if the executive terminates employment prior to a designated age for reasons other than death, disability or change of corporate control.
A top-hat plan is not subject to ERISA (except reporting and disclosure requirements) if it is unfunded and is limited to management or highly compensated employees. A funded top-hat plan or an unfunded top-hat plan which covers one or more employees who do not qualify as management or highly compensated employees is subject to ERISA's participation, vesting, funding, reporting and other rules.
Although a top-hat plan may qualify for exemption from most of ERISA rules, an unfunded top-hat plan is required to file an annual report on Form 5500. In addition to IRS penalties, failure to file can result in Department of Labor penalties as high as $300 per delinquent day per plan, up to $30,000. Top-hat plans are eligible for a full exemption from filing Form 5500 if they file a simple statement with Department of Labor within 120 days after the adoption of the plan disclosing the name, address and IRS identification number of the employer, a declaration that the employer maintains the plan primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees and the number of employees in the plan.
In most cases, executives really don't want to defer compensation; they want to defer the tax on compensation. Deferring the receipt of compensation is the price paid to achieve tax deferral. Normally, an employer's unsecured promise to pay an employee compensation at some future time does not result in taxable income to the employee until the compensation is actually received. The IRS can tax compensation to the employee before it is actually received if it is credited to his account, or otherwise made available so that he may draw upon it at any time, that is, if the employee's interest is substantially vested when payment by the employer is made. An interest is substantially vested if it is freely transferrable or not subject to a substantial risk of forfeiture. However, the IRS has ruled that even though an employee's rights may be or become nonforfeitable, the employee will not be currently taxable if the deferred compensation agreement is entered into before the compensation is earned, the employer's promise to pay is not secured in any way and the employee's rights to benefits under the plan are non-alienable and non-transferrable. Thus, a typical unfunded top-hat plan should accomplish tax deferral for the employee.
Unlike the tax treatment under qualified retirement plans, the employer is not entitled to a tax deduction until the year the employee includes the payment in his income. However, to be deductible, the benefit payments must represent reasonable compensation and constitute an ordinary and necessary business expense. Hefty deferred compensation benefits to a shareholder-employee could be construed by the IRS as a nondeductible dividend to the shareholder rather than compensation, especially if the Non-Qualified Deferred Compensation plan is instituted just prior to the shareholder employee's retirement.
Executives covered by Non-Qualified Deferred Compensation plans, especially unfunded plans, face the risk that the employer may refuse to pay benefits (for example, a change of heart or following a corporate change of control) or that the employer may be unable to pay benefits due to a change in financial conditions. Accordingly, there is a growing trend to attempt to "informally fund" or secure the promise to pay Non-Qualified Deferred Compensation without jeopardizing the tax deferral to the employee or ERISA exemption.
Permanent cash value life insurance is a popular method of informally funding Non-Qualified Deferred Compensation plan's. The employer is the owner and beneficiary of a policy on the executive's life and pays the premiums. The Department of Labor has indicated such an arrangement is not a "funded" plan for ERISA purposes. If the employee dies while employed, the employer receives the insurance proceeds to pay any death benefit due to the executive's beneficiary. The cash surrender value of the policy is available to the employer to pay lifetime benefits to the former executive. Assuming the executive has no vested right to receive payment from the policy, the premium payments should not be taxable to the employee nor deductible by the employer. However, benefit payments should be deductible by the employer but taxable to the recipient when paid.
Non-Qualified Deferred Compensation agreements provide opportunities to compensate executives without having to cover all other employees. However, if the plan and its implementation are not handled properly, the goals of tax deferral and ERISA exemption may be jeopardized. Non-Qualified Deferred Compensation agreements should be reviewed before implementation by competent legal counsel to assure the desired benefits.
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