Module 1 — Introduction to Nonqualified Plans

In the employer-employee relationship, nothing says “I love you” more than compensation. The essence of the employer-employee relationship is based on an exchange of the employee’s services for the employer’s money or similar form of tangible compensation. Usually, the higher the value of an employee, the more compensation the employee gets from the employer.

Compensation can take many forms. In addition to regular wages, employers often offer employees compensation packages that may include health insurance, paid time off, tuition reimbursement, and qualified plans that help to save for retirement. When it comes to qualified retirement plans, the rules generally require that an employer’s basic compensation package be equally available to all employees in order to get the associated tax benefits.

If an employer really and truly loves an employee, however, the employer will compensate the employee above and beyond the basic compensation package provided to rank-and-file employees. This is where nonqualified deferred compensation plans come in. An employer can use a nonqualified plan to provide added incentives to attract and retain key executives and employees.

A nonqualified plan is an employer-sponsored retirement or other deferred compensation plan that does not meet the tax-qualification requirements under Internal Revenue Code Sec. 401. A nonqualified plan also does not refer to a tax-sheltered annuity (TSA), a simplified employee pension (SEP) plan, a savings incentive match plan for employees (SIMPLE) account, or a 457 governmental plan.

A nonqualified plan allows an employee to defer the receipt of taxable wages or bonuses until some future year when the employee is in a lower tax bracket, thereby paying less in taxes when the compensation is received. Although nonqualified plans are easier to set up than qualified plans, there are specific rules that must be followed. All nonqualified plans must satisfy the following three requirements:

• The deferred compensation arrangement between the employer and the employee must be entered into before the compensation is earned by the employee.
• The deferred compensation cannot be available to the employee until a previously agreed upon future date or event.
• The amount of the deferred compensation cannot be secured — it must remain available to the employer’s creditors.

From an employee’s perspective, getting more compensation is always a good thing. Ultimately, however, it is the employer that makes the final determination whether a nonqualified deferred compensation plan fits its needs. The following are the major advantages:

Because there are few formalities involved in setting up a nonqualified deferred compensation plan, it is simpler to adopt. Conversely, a qualified plan must be written, accompanied by a trust, formally communicated to employees, and must meet participation, vesting, and funding requirements. Nonqualified plans generally need not meet these formal requirements.

Because there are no coverage, eligibility, or participation requirements, an employer can decide to provide nonqualified deferred compensation benefits only to a select group of executives or highly compensated employees. This allows the employer to provide rewards and incentives on an executive-by-executive basis.

Under a nonqualified plan, an employer may give the employee an immediate right to the benefits or subject the benefits to forfeiture provisions, depending on the employer’s needs.

Nonqualified plans are exempt from statutory limits on annual contributions and benefits, funding rules, qualified joint and survivor rules, and other provisions of the tax code. Employees who receive benefits can defer income into future years so long as the benefits are subject to a substantial risk of forfeiture.

Nonqualified plans that are unfunded and that provide benefits to a select group of employees are exempt from most ERISA requirements, such as those involving funding, reporting, and disclosure.

At some point, an executive may prefer receiving cash compensation instead of a deferred arrangement. The nonqualified deferred compensation plan allows for that option, generally without any penalty — a qualified plan will not allow the same freedom.

Nonqualified plans allow contributions beyond the caps set for a qualified plan. The tax code limits the maximum amount that can be added to a qualified defined contribution plan, the maximum benefit from a qualified defined benefit plan, and the amount of employee compensation an employer may consider when calculating its contributions. All of which severely limits retirement savings for highly-paid employees. The nonqualified deferred compensation plan may therefore be used to supplement a qualified plan and provide greater benefits to executive employees.

Despite their numerous advantages, nonqualified deferred compensation plans do have some disadvantages to consider when evaluating such plans:

As a result of the American Jobs Creation Act of 2003, and generally effective beginning in 2005, nearly all nonqualified deferred compensation plans are subject to new tax rules that significantly modify the tax treatment of deferrals. The new rules impose election, distribution, and funding restrictions on nonqualified plans. Individuals who defer compensation under plans that fail to comply with the new rules will be subject to current taxation on all deferrals and to enhanced penalties.

An employer cannot claim a current deduction for any nonqualified deferred compensation amounts until the employee receives the amount as income. Similarly, the mere maintenance of unfunded bookkeeping accounts under a nonqualified deferred compensation plan is not a transfer of property or gross income to the participants until amounts from the accounts are actually transferred or paid.

Deferred amounts under a nonqualified deferred compensation plan are merely an employer’s promise to pay the employee sometime in the future. In order to allow employees to defer income tax until the amounts are received, these amounts must remain subject to the claims of the employer’s creditors in the event of insolvency — they must be unsecured. This means that an employer’s promise to pay may become an empty promise if the employer becomes insolvent. (Methods available to minimize this risk include rabbi and secular trusts or life insurance policies.)

Voluntary nonqualified deferred compensation arrangements may have to be registered with the Securities and Exchange Commission (SEC) as securities since they are unsecured obligations. However, if the employer does not have publicly traded securities in its company, then the SEC would not be involved and no registrations would be required.

If lukewarm or decreasing corporate profits are accompanied by increasing executive compensation, shareholders are not shy about taking legal action challenging the executive compensation plan as wasteful and excessive. A nonqualified plan based on pay-for-performance is usually able to withstand such legal challenges. As a result, equity and equity-based compensation techniques, like long-term incentive stock options, are increasingly becoming more popular.

Nonqualified deferred pay plans are either in the form of an individual contract or an employer plan. When a contract is involved, the contractual arrangements will vary to suit the parties’ needs. For example, a contract may provide for installment payments of a fixed amount over a period of years or payments only after retirement. Another contractual provision may require the purchase of an annuity or an endowment policy for the executive or key employee.

If the nonqualified compensation is provided by means of a plan, many options are available, including: excess benefit plans, top-hat plans, deferred bonuses, salary continuation plans, executive bonuses, and anti-takeover measures such as golden parachutes.

A nonqualified plan may also center on the use of life insurance. The most common types of insurance arrangements used in such situations are key-employee insurance, group-term life insurance, split-dollar plans, and reverse split-dollar plans.

This course will explore deferred compensation programs, executive bonuses, group carve-outs, and golden parachutes.

A nonqualified deferred compensation plan may be funded or unfunded. A funded nonqualified plan is one where the employer maintains it by making contributions to a trust or by paying premiums on an annuity contract. The employee may or may not have to pay current tax on the contributions depending on the employee’s vested rights.

If a nonqualified plan is unfunded, the plan merely involves the employer’s present promise to pay amounts to the employee in the future. The employee is taxed only when those amounts are actually or constructively received.

The funded versus unfunded nonqualified plan distinction is important to keep in mind as you look at the various types of nonqualified plans.