Nonqualified Deferred Compensation Plans

If your business has certain executives who are vital to its success, providing them with a nonqualified deferred compensation (NQDC) plan could be a winning strategy to keep them with your company. Such a plan represents an agreement whereby one person (or legal entity) promises to compensate another for services to be rendered currently, with actual payment for those services delayed until sometime in the future. As an employer, you are offering an employee extra income that will not be taxed until some future date, usually upon retirement or death, disability, or termination of employment.

From a business standpoint, creating the funding mechanism to help ensure NQDC benefits are there when the employee is entitled to them is the foundation of any plan. From a tax standpoint, making sure that the employee’s benefits are taxed when received, and not before, is equally critical. It is particularly important to get professional advice on the Internal Revenue Service’s “constructive receipt doctrine,” as well as other tax issues related to NQDC plans.

It’s likely that your company already offers a qualified retirement plan, such as a 401(k), which provides the employer with tax deductions for contributions up to a certain limit made to a participant’s retirement account. While these contributions certainly help employees reduce their taxable incomes and defer taxes on earnings from contributions, qualified plans do not pack the financial wallop highly paid executives are seeking. This is because qualified plans usually limit the compensation base used to determine the maximum annual contribution. With no limit on the compensation base, deferred compensation plans can transform a standard benefits package into a financially appealing savings vehicle for selected employees.

A Tender Tether

Explicit in the deferred compensation plan is a contractual promise to provide future payment for ongoing services. Tethering an employee to the company through a vesting agreement is often included in a plan, although many plans offer immediate vesting, which is to the employee’s advantage.

For example, an employer may stipulate that the employee stay with the company for a certain number of years before the employee is entitled to the compensation. Such an agreement encourages loyalty and commitment on the part of the employee. Prohibiting employment with a competitor (a noncompete agreement) can be another condition of the agreement.

What’s in the Pipeline?

The agreement you make with an employee will specify the type of benefits and how and when they will be made available. Salary continuation—say, providing $10,000 per month for life beginning at retirement—and annual contributions to an investment account where the balance is then paid at retirement—are typical benefit formulas of NQDCs. Whether the money is actually set aside into an account, or merely exists on your books, is up to you. Employers who offer these plans, however, must be confident that the future profitability of their businesses will cover promised payments.

Employees, for their part, will want assurance that their compensation will be there for them. One method of providing assurance is to set up a rabbi trust, which is a type of escrow account that provides some protection for the deferred compensation funds in the event of a hostile takeover or other type of management change (but is not protected from the claims of the employer’s general creditors). The protected funds may be invested in many ways, for example in mutual funds and in individual stocks and bonds, or may be used to purchase life insurance or annuity products. (Investors should be aware that investment returns and principal values of mutual funds and other securities will fluctuate due to market conditions. Therefore, when shares are redeemed, they may be worth more or less than their original cost.)

As Americans take on more responsibility for funding their own retirement, NQDCs may become a standard component of benefit packages. Because these plans are not governed by federal pension laws, they can be extremely flexible. Their very flexibility—and their associated risks— however, mean that you should seek professional counsel from tax, legal, and financial professionals prior to implementation.