A nonqualified deferred compensation (NQDC) plan is an arrangement between an employer and employee that defers the receipt of currently earned compensation. A NQDC plan doesn't need to comply with the discrimination and administrative rules that govern qualified plans, such as Section 401 of the Internal Revenue Code. And if the NQDC plan is "unfunded" (most are) the plan avoids the burdensome requirements of the Employee Retirement Income Security Act of 1974 (ERISA). Since an NQDC plan doesn't have to comply with these regulatory requirements, it's a flexible form of employee compensation that allows employers to tailor the benefit amounts, payment terms, and conditions of the plan to their needs. In addition to its flexibility, an unfunded NQDC plan can provide significant tax benefits: Unlike cash compensation, which the IRS taxes currently, deferred compensation generally isn't subject to federal income taxes until you begin receiving distributions from the NQDC plan.
Funded versus unfunded plans
It is important for you to understand whether your NQDC plan is "funded" or "unfunded" in order to understand how the federal tax laws and ERISA apply to the plan for employees. Most NQDC plans are unfunded. The reason is that employers usually adopt NQDC plans in order to provide their employees with the benefit of tax deferral while avoiding the often burdensome requirements of ERISA.
Tip: ERISA does not apply if your employer is a church or a state or local government. If you're employed by a state or local government your NQDC plan is subject to a special set of rules under IRC Section 457, and this article does not generally apply.
An unfunded plan avoids most ERISA requirements, and benefits are usually not subject to federal income tax until received. A NQDC plan is unfunded if either assets have not been set aside by you to pay plan benefits (that is, your company pays benefits from its general assets on a "pay as you go" basis), or assets have been set aside but those assets remain subject to the claims of your creditors (often referred to as an "informally funded" plan). In general, when a plan is unfunded you must rely solely on your unsecured promise to pay benefits at a later date. As a result, some employees may be fearful that when it comes time for them to receive the deferred compensation, you may be unwilling or unable to pay the deferred compensation or that a creditor may seize the funds through foreclosure, bankruptcy, or litigation. Unfunded plans must generally be limited to a select group of management or highly compensated employees, and are often called "top-hat" plans.
Tip: Although there is no formal legal definition of "select group of management or highly compensated employees," it generally means a small percentage of the employee population who are key management employees or earning a salary substantially higher than the average salary for all management employees. Generally, courts will look at the number of employees in the firm versus the number of employees covered under the top-hat plan, the average salaries of the select group versus the average salaries of other employees, and the extent to which the select group can negotiate salary and compensation packages.
If employees fear losing their deferred compensation benefits (for example, if you become insolvent or declare bankruptcy) you may want to consider offering a funded NQDC plan. These are unusual, because funded NQDC plans generally must comply with all of ERISA's requirements, and your plan benefits are subject to federal income tax as soon as they are vested. In general, a plan is considered "funded" if assets have been irrevocably set aside with a third party (for example, in a trust) by you for the payment of your NQDC plan benefits, and those assets are beyond the reach of you and your creditors. In other words, if your employees are guaranteed to receive your benefits under the NQDC plan, the plan is considered funded. This is also sometimes referred to as "formal funding." One of the most common methods of formally funding a NQDC plan is the secular trust. But again, unfunded plans are far more common than funded plans.
Informally funded plans
While most companies want to avoid formally funding their NQDC plans in order to avoid ERISA while providing the benefit of tax deferral, they often want to accumulate assets in order to ensure they can meet their benefit obligations when they come due. This is called 'informally funding" a NQDC plan. Even though you set aside funds, the NQDC plan is not considered formally funded because the assets remain part of your general assets, and can be reached by your creditors. Informal funding allows you to match assets to future benefit liabilities, and provides your employees with psychological assurance (at least) that your benefits will be paid when due. The most common method of informally funding a NQDC plan is the rabbi trust, discussed more fully below. An irrevocable rabbi trust, adequately funded, can provide your employees with the assurance that their benefits will be paid in all events other than the insolvency or bankruptcy.
Tax treatment — unfunded plan
Any amount you promise to pay your employees from an unfunded NQDC plan is generally not subject to federal income tax until your employees actually receive payment of your benefits from the plan. This is true whether or not you choose to informally fund the NQDC plan (for example, through contributions to a rabbi trust). However, there are instances in which NQDC plan benefits may be taxed prior to actual receipt of the funds.
Under the doctrine of constructive receipt, the IRS can tax your employees prior to your "hands-on" receipt of funds if the funds are credited to your account, set aside, or otherwise made available without substantial restriction. In other words, once the funds have been earned and are payable to your employees on demand, they must report the income even if they choose not to actually accept current payment of the funds. The constructive receipt doctrine has been codified in part by Internal Revenue Code (IRC) Section 409A.
Section 409A of the Internal Revenue Code
IRC Section 409A provides specific rules relating to deferral elections, distributions, and funding that apply to most NQDC plans. If your NQDC plan fails to follow these rules, your NQDC plan benefits for that year and all prior years may become immediately taxable, and subject to penalties and interest charges. It is very important that your aware of, and follow the rules in, IRC Section 409A, when establishing a NQDC plan.
Tax treatment — funded plan
Your contributions to a funded NQDC plan are generally taxable to your employees once they become vested in the contributions — that is, when the benefits are no longer subject to a substantial risk of forfeiture. This is true even if they don't yet have a right to receive payment from the plan. If the plan is funded with a secular trust, your employees may be entitled to a distribution from the trust to pay the taxes. Or you may decide to pay a cash bonus that covers your tax liability. The tax treatment of benefits paid from a NQDC plan funded with a secular trust can be quite complex.
NQDC plan issues that concern key employees
Sometimes, highly compensated employees are adversely affected by the dollar limitations on contributions to and benefits payable from qualified plans. As a result, they don't receive as high a percentage of their compensation as do lower-paid employees under a qualified plan. A NQDC plan can help solve this problem.
Tip: The compensation limit (which is indexed for inflation) is $280,000 for 2019 (up from $275,000 for 2018).
Generally, a key employee is subject to a higher income tax rate. As a result, a key employee can benefit from deferring compensation, since he or she is likely to be in a lower tax bracket during retirement, when the deferred compensation is finally received.
Tip: Although the rabbi trust assets are held apart from your other assets, the funds are still subject to the claims of your general creditors. For this reason the NQDC plan is considered unfunded (or informally funded) for tax and ERISA purposes.
Tip: A rabbi trust can be in the form of either a revocable or irrevocable trust. If a rabbi trust is irrevocable, you give up the use of the NQDC plan assets and can't get them back until all plan benefits have been paid. The assets are there to cover your employees, except in the case of bankruptcy or insolvency. If bankruptcy or insolvency occurs, the assets become accessible to your general creditors (including you), and the NQDC plan benefits may be lost.
Why would you want to establish a rabbi trust?
A rabbi trust is a trust that you establish in order to satisfy its obligation to provide you with benefits under an NQDC plan. It's called a rabbi trust because a rabbi was the beneficiary of the first such trust to receive a favorable IRS ruling. The primary reasons for establishing a rabbi trust are for you to provide you with assurance that assets will be available, and that payment of your employees' deferred compensation will be made when due under the terms of the NQDC plan (except in the event of your employer's insolvency or bankruptcy).
The rabbi trust is a major step forward in providing benefit security for plan participants. An irrevocable rabbi trust, adequately funded, can largely eliminate the risk of nonpayment for every reason but bankruptcy or insolvency. For employees who worry about nonpayment primarily by reason of a hostile takeover or a similar occurrence whereby the employer refuses to pay, the rabbi trust is an ideal device.
IRS tax treatment
A NQDC plan informally funded with a rabbi trust is considered "unfunded" for federal income tax purposes. Even though your employees' NQDC plan benefits may be payable from rabbi trust assets, their benefits are generally not subject to income tax until they are actually paid to them. See "Tax treatment — unfunded plan," above.
Caution: IRC Section 409A provides specific rules that govern rabbi trusts. For example if you fund a rabbi trust while maintaining an at-risk defined benefit plan, or you invest rabbi trust assets off-shore, you could be subject to immediate taxation and penalties.
NQDC plans and corporate-owned life insurance (COLI)
Corporate-owned life insurance (COLI) is a life insurance policy that you can take out on your employees' lives. You are both the owner and the beneficiary of the policy. As owner of the policy, you are responsible for paying the premiums. As beneficiary of the policy, you retain all rights to the benefits under the policy. Other than being named as the insured, your employees have no interest in the policy. COLI can be used for a variety of reasons, and the use of COLI may or may not bear any relationship to the actual financial loss you may anticipate incurring upon death. For example, COLI is commonly used as a funding vehicle for NQDC plans. When used as a funding mechanism for an NQDC plan, you can borrow against the cash value that accumulates under the policy. You can then use the borrowed funds to pay the COLI premium payments or to fund the NQDC plan.
Tip: The Pension Protection Act of 2006 requires you notify your employees: (a) that they may be insured under a COLI policy, (b) of the maximum amount of coverage you may take out on their lives, and (c) that you will be the beneficiary of the death proceeds. The Act also requires that you get your employees' written consent to being insured. If you fail to comply with these rules, the amount you can exclude from income as a tax-free death benefit will generally be limited to the premiums you paid for the contract. Some state laws may also require your employees consent before they can be insured under a COLI contract.
Why would you want to purchase COLI?
As an informal funding mechanism for NQDC plans, the COLI policy provides your employees with psychological assurance that you will have assets available when benefit payments are due under the plan.
Risks associated with COLI
A number of risks are associated with using COLI to fund an NQDC plan. First, if the insurance company experiences severe financial difficulties, you may be unable to access the policy's cash value to pay the plan benefits. In addition, the disparity between the estimated earnings (earnings projected when the policy is issued) and the actual earnings may leave you with insufficient cash value to pay plan benefits when due. Also, the COLI policy remains part of your general assets, and therefore is subject to the claims of your creditors in the event of bankruptcy or insolvency. And if the COLI policy is held directly by you, the policy could be cashed out at any time.
NQDC plans and split dollar life insurance
Another informal funding vehicle for NQDC plans is split dollar life insurance. In general, split dollar is an arrangement whereby you and your employees share the premium cost and/or death benefits of a life insurance policy issued on their life. Split dollar life insurance allows you to fund NQDC plan benefits with the proceeds you receive from the life insurance policy. While there are a number of variations, one way you can accomplish this is by establishing an unfunded nonqualified plan to provide your employees with a promised level of deferred compensation benefits. You then purchases a life insurance policy on their lives.
The premiums may be split between you and your employees in any way desired. Typically your employees are entitled to a death benefit from the policy equal to some multiple of their compensation, for example three times pay. The face amount of the policy, however, is usually greater than that amount. Each year, you credit your nonqualified plan account with an amount specified in the NQDC plan. When distribution is scheduled to occur, you pay your employees the NQDC plan benefits from his or her general assets. Upon their death, their beneficiary receives the promised level of death benefits from the life insurance policy, and you receive the balance of the policy proceeds. The life insurance benefits are tax-free. By funding an NQDC plan with split dollar life insurance, your employees can receive death benefit protection under the life insurance policy along with deferred compensation under the NQDC plan, and you can recoup all or part of the cost of providing these benefits.
Caution: Be sure to consult your legal and financial advisors before implementing a split dollar plan. The IRS has issued regulations that have significantly changed the tax treatment of split dollar life insurance. Also, in some cases, the Sarbanes-Oxley act may prohibit public companies from implementing certain forms of split dollar plans.
Tip: Although you establish the secular trust for your employees' benefit, they may be treated, for tax purposes, as having established the trust.
Why would you want to establish a secular trust?
A secular trust is an irrevocable trust that you establish with a third party to hold assets for the exclusive purpose of paying for your emplpyees' NQDC plan benefits. A significant feature of the secular trust is that participants generally have a nonforfeitable and exclusive right to the contributions made to the trust and to the earnings on those contributions. This stands in contrast to the rabbi trust, where plan assets remain subject to the claims of your general creditors, and your employees' benefits may be lost in the event of your insolvency or bankruptcy.
A secular trust can provide your employees with the assurance that your NQDC plan benefits will not be at risk as a result of your unwillingness or financial inability to pay the benefits at a future time. Unlike assets that are within a rabbi trust, secular trust assets are not subject to your creditors' claims. The secular trust assets must be used for the exclusive purpose of paying benefits due under the NQDC plan.
Disadvantages of a secular trust
The IRS taxes your employees each year on what could be sizable income. Unfortunately, they don't receive the cash to pay the tax on that money until NQDC plan distributions are scheduled to occur. However, the plan may be designed so that they may receive a distribution from the trust to pay the taxes. Alternatively, you may pay your employees a bonus that covers their tax liability.
Types of secular trusts
There are two types of secular trusts: an employer secular trust and an employee secular trust. An employee secular trust arrangement allows employees to choose to receive cash compensation or contributions to an irrevocable trust that you establish for their exclusive benefit. The trust is not subject to your creditors, and your role is as administrator of the trust. An employer secular trust is similar, but your employees don't have the choice to receive cash instead of your contribution to the irrevocable trust. In both cases the trust assets are placed beyond the reach of creditors.
IRS tax treatment
The use of a secular trust creates a funded plan for tax purposes. In general, this means that your contributions to a secular trust are includable in your employees' income in the year they're made to the trust or, if later, in the year they become vested in the contributions. The taxation of secular trusts is complex.
A secular annuity may be used in lieu of a secular trust, or in conjunction with a secular trust. A secular annuity is an annuity you purchase in your employees' names that is either a standalone benefit, or secures the benefit promised under a related NQDC plan. While there are a number of variations, typically your employees own and control the annuity contract, and you must rely on the premature withdrawal tax and the policy surrender charges to deter them from surrendering the contract for its cash value. If you want more control over when your employees can receive the annuity proceeds, you might place the secular annuity inside a secular trust. By doing this, your employees would generally not be entitled to distributions until the time specified in the plan and trust documents.
A secular annuity creates a funded plan for tax and ERISA purposes. The use of a secular annuity places the NQDC plan assets beyond the reach of your creditors and provides full security to you that your NQDC plan benefits will be paid (subject to the solvency of the insurer). However, placing the assets beyond the reach of your creditors generally causes your employees to be immediately subject to federal income tax on your premium payments. Any increase in the cash surrender value is generally tax deferred until employees begin receiving payments from the annuity contract.
Caution: Distributions from a secular annuity may be subject to a 10% early distribution penalty if made before you reach age 59½, unless an exception applies.
Caution: Any guarantees are subject to the financial strength and claims-paying ability of the insurer.
What is a supplemental executive retirement plan (SERP) plan?
A supplemental executive retirement plan (SERP) is simply an unfunded NQDC plan that provides your employees with benefits that supplement benefits they are entitled to receive under your qualified retirement plan. A SERP can be either a defined benefit plan or a defined contribution plan.
Tip: The term SERP is also sometimes used more broadly to refer to any NQDC plan that provides unfunded deferred compensation benefits to a select group of management or highly compensated employees (i.e., a top-hat group).
What is an excess benefit plan?
An excess benefit plan is a special kind of NQDC plan. An excess benefit plan is designed solely to provide your employees with NQDC plan benefits in excess of the limits that apply to qualified plans under IRC Section 415. Section 415 limits contributions to defined contribution plans [such as 401(k) plans and profit-sharing plans] to the lesser of $56,000 in 2019 (up from $55,000 in 2018) or 100% of pay (plus any age-50 pre-tax catch-up contributions). Section 415 limits benefits from defined benefit plans to the lesser of $225,000 in 2019 (up from $220,000 in 2018) or 100% of your average compensation for your high three years. Excess benefit plans are different from other NQDC plans because, if unfunded, they are entirely exempt from ERISA, and even if funded are exempt from most ERISA requirements. Also, unlike other unfunded NQDC plans, an unfunded excess benefit plans does not need to limit participation to a select group of management or highly compensated employees, even though typically only highly compensated employees will be impacted by the Section 415 limits.
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