Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
What is it?
Any employer retirement, savings, or deferred
compensation plan for employees that does NOT meet
the tax and labor law (ERISA) requirements that apply
to qualified pension and profit sharing plans
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
When is it indicated?
To provide:
– deferred compensation to executives and key employees
only
– additional deferred compensation to executives receiving
maximum qualified plan benefits
– deferred compensation to select key employees with
different terms or conditions than others have
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
When is it indicated?
And when
– executive or key employee wants to leverage employer tax
savings for future benefits
– employer needs to recruit, retain, reward, retire executive
talent
– closely-held corporation wants to attract and hold
nonshareholder employees
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Advantages
1. flexible plan design
2. minimal IRS, ERISA, and other governmental
regulatory requirements to meet
3. tax deferral for employees
4. marginal tax rates has favored corporate financing of
deferred compensation in lieu of cash bonuses (but
not at present)
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Advantages
5. employer can use as ‘golden handcuffs’
6. use of informal financing arrangements (e.g.
corporate owned life insurance) can provide
employee with greater confidence of future payment
than employer’s unsecured promise
7. assets set aside in some types of informal financing
arrangements can still be used by corporation
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Disadvantages
1. Employer’s tax deduction deferred until income
taxable to employee
2. plans often rest on employer’s unsecured promise
to pay and do not have protection of tax and labor
law
3. accounting treatment may reduce confidentiality of
arrangement
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Disadvantages
4. some employers lack the structure necessary to
successfully use nonqualified deferred
compensation plans
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–
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S corporations
businesses that may be short-lived
tax exempt or government organizations
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Objectives in Plan Design
Employer Objectives:
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hire key employees
retain key employees
provide performance incentive
control timing of and access to plan funds
tax deferral
benefit certainty
have funds available during employment to extent possible
under tax law
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Types of Benefit and Contribution Formulas
Common Benefit Formulas
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salary continuation formula
salary reduction formula
excess benefit plan
stock appreciation rights
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Types of Benefit and Contribution Formulas
Form of Benefits
– lump sum or series of annual payments at retirement
– life annuities or joint and survivor annuities
– must try to avoid ‘constructive receipt’ or benefits will be
taxed before received
– must try to avoid penalty for accelerated payments
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Withdrawals during employment
Penalty free distributions for these events
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separation from service
disability, usually strictly defined
death of employee
time specified under the plan
change in business ownership or control
unforeseeable emergency
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Withdrawals during employment
“haircut” provision no longer allowed
– allowed employee to withdraw amounts from plan without
restriction except for small penalty
– employee could ‘rescue’ funds from failing or hostile
corporate environment
– Congress now deems an abuse
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Termination of Employment
Usually established in employer’s favor with benefits
lost or reduced if terminate before retirement
Can impose lengthy vesting schedule
Often make special arrangements for disability
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Funded vs Unfunded Plans
Funded plans
a plan is formally funded if employer has set aside
money or property to pay plan benefits through some
means that restricts access to the fund by employer’s
creditors
– Subject to tax and ERISA regulations
– Provides employee with greater confidence of future
payment
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Funded vs Unfunded Plans
Unfunded plans
a plan is unfunded if the funds that the employer plans
to use are accessible by employer's creditors
– Avoids tax and ERISA regulations
– Provides little security for employee
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Financing Approaches
• reserve account maintained by employer
• employer reserve account with employee investment
direction
• corporate owned life insurance
• Rabbi trust
• third party guarantees
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Tax Implications
constructive receipt doctrine
an amount is treated as received for tax purposes if ‘credited to
employee account, set aside, or otherwise made available’ even
if amount is not actually received
economic benefit doctrine
employee taxed when vested in contributions made to fund for
employee even though employee cannot yet withdraw cash
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Income Taxation of Benefits and Contributions
• employees pay ordinary income tax on benefits from
unfunded nonqualified deferred compensation plans
in the first year in which the benefit is actually or
constructively received
• death benefits payable to a beneficiary from
nonqualified plans are taxable as income
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Social Security (FICA) Taxes
• social security taxes payable when executive can no
longer lose interest in plan
• FICA taxes could become payable before year of
actual receipt
• social security taxable wage base has an upper limit
but Medicare does not
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Federal Estate Tax Treatment
• death benefit under nonqualified deferred
compensation generally included in estate of
deceased at its then present value
• recipient can receive an income tax deduction
• payments made to spouse may qualify for unlimited
marital deduction, eliminating any federal estate tax
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Taxation of the Employer
employer tax deduction delayed until compensation
included in employee’s taxable income
unfunded plans – year funds actively or
constructively received
formally funded plans – year employee becomes
substantially vested
Amounts deducted must be ‘reasonable’
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
ERISA Requirements
Plans eligible for at least partial exemptions from ERISA
requirements:
– unfunded excess benefit plan
– top-hat plan
A plan that is not exempt must comply with most ERISA
provisions for qualified plans including vesting, fiduciary,
minimum funding, and reporting and disclosure
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
True or False?
1. Both qualified and nonqualified deferred
compensation plans allow an employee to defer
income tax to a future time.
2. A nonqualified deferred compensation plan can be
designed to cover any group of employees or one
employee.
3. All organization except closely held businesses can
use nonqualified deferred compensation for executive
compensation.
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
True or False?
4. A salary continuation plan requires no reduction in
the covered employee’s salary.
5. Excess benefit plans are subject to Title 1 of ERISA.
6. Tom Jenkens, an executive at X Corp, withdrew
funds from his nonqualified deferred compensation
plan after an accident left him totally and permanently
disabled. Tom will have to pay a penalty for this
withdrawal.
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
True or False?
7. An employer’s creditors can access monies in a
funded nonqualified deferred compensation plan.
8. A reserve account maintained by the employer
increases benefit security for the employee.
9. John became vested in his nonqualified deferred
compensation plan this year, but will not receive the
funds until retirement. John must pay Social
Security taxes this year.
10. All nonqualified plans are exempt from ERISA
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Nonqualified Deferred
Compensation
Chapter 26
Employee Benefit & Retirement Planning
Discussion Question
When using a rabbi trust, what costs or risk are
involved? What provisions should or should not be
included?
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