Despite limitations added by new Code Section 409A, nonqualified deferred compensation plans still have a vital role in executive compensation planning for key executives.

They provide benefits beyond those offered by qualified plans that rarely meet retirement savings needs for top executives. Qualified plans have restrictions on withdrawals during employment, while scheduled in-service withdrawals (such as for college tuition or the purchase of a retirement home) are allowed without penalty from nonqualified plans.

Nonqualified plans can provide “golden handcuffs” that encourage loyalty as well as a parachute for executives in the event of a change in control. Most importantly, nonqualified plans are discriminatory. Only a select group of key management should be eligible, so employers can provide tailored incentives to key employees without having to do the same for all.

Once a company has identified a need for a nonqualified plan, the next step is to determine the best plan type to use. A defined benefit structure often is wrapped around a pension plan to pay executives benefits that exceed qualified pension plan limits, when the sole purpose of the plan is to provide supplemental retirement benefits. Given the increasing obsolescence of pension plans, other plan designs may be more useful.

A nonqualified defined contribution plan can provide contributions based on compensation over the qualified plan limit. It also can allow executives to defer significant amounts of income to later years. However, Section 409A limits the employer’s and executive’s flexibility.

Equity-based compensations, such as incentive stock options and nonqualified stock options, are popular forms of executive compensation because they tie executive compensation to stock price increases. As long as the option exercise price is equal to or above market value on the grant date and the option does not allow the executive to extend the option’s life or otherwise defer receipt of income after exercise, options are exempt from 409A.

The same rules apply to stock appreciation rights, whether they are settled in cash or employer stock. Options or stock appreciation rights based on below-market value, as of the grant date, must comply with 409A.

An increasingly popular form of executive compensation is restricted stock. A grant of restricted stock will not be subject to 409A as long as the stock is both nontransferable and not vested. It is important to note that once it vests, restricted stock becomes taxable income. Deferred stock units are subject to 409A. Despite this, they are gaining in popularity as the right to payment can vest, while the actual receipt of income can be deferred to a later year.

In addition to considering whether to implement new plans, employers must review all of their existing executive compensation arrangements for 409A compliance. This review should cover employment agreements and severance arrangements; stock-based arrangements for public and private companies, including options; phantom stock plans and deferred stock unit plans; supplemental executive retirement plans; plus executive deferred compensation arrangements.

The good news is that amendments to make existing plans comply with 409A are allowed through 2006. To the extent a pre-2005 arrangement had non-vested benefits as of Dec. 31, 2004, the employer has two choices. The first is to apply the pre-2005 rules that violate 409A to pre-2005 vested balances or benefits and then apply the 409A rules to the rest. The other is to amend the arrangement to meet 409A requirements for all years.

Whether it is better to preserve the pre-409A rules for pre-2005 vested balances depends on the employer’s goals. A single set of rules promotes administrative simplicity and uniformity, but conforming pre-2005 plans to 409A requirements could eliminate some of the popular features of the plan, such as the ability to take an unscheduled withdrawal with only a small “haircut” or the ability to elect subsequent year-to-year deferrals of deferral account balances.

One fact is certain: 409A covers many arrangements that are not automatically associated with deferred compensation. To avoid significant penalties for noncompliance, all employment contracts, severance packages and other arrangements must be reviewed by counsel with expertise in 409A compliance to determine whether 409A applies.

How should nonqualified deferred compensation proposals be presented to current or prospective clients? First, the financial consultant must determine what objectives the client seeks to achieve and which cannot be achieved through qualified plans. Then, the consultant should identify nonqualified plan solutions to achieve the client’s objectives.

The consultant should emphasize that nonqualified plans may be the most effective and flexible way to meet the company’s objectives, not the least of which is the need to attract and retain top executive talent. Although all existing arrangements must be reviewed to avoid penalties, the IRS guidance eliminates uncertainty in tax treatment and provides templates for plans that clearly withstand IRS challenge, such as participant-directed investment options.