My feature article in this issue on advanced planning techniques for small businesses only fleetingly touches on a key tool for compensating corporate executives: non-qualified deferred compensation plans. That likely won’t surprise advisors who have, in past years, found the market for such plans limited among very small businesses.
Why should that be case? Producers I’ve spoken to have most often cited the higher administration costs and the greater complexity of rules relative to other non-qualified executive compensation plans.
Internal Revenue Code Section 409A, an outgrowth of the American Jobs Creation Act of 2004, imposes restrictions on NQDC plans in respect to the timing of distributions, acceleration of benefits and the timing of deferral elections. Among them: Distributions can only be payable upon the employee’s separation from service, disability or death; a fixed time or schedule specified under the plan; a change in ownership or control of the business; a change in the ownership of a substantial portion of the assets of the business; or the occurrence of an unforeseeable emergency.
Plan participants also have to weigh the prospect of Congressional legislation that would make the plans financially unpalatable; executives will be less willing to defer compensation if, when they begin taking distributions, they’ll subject to higher income tax rates.
Additionally, the recession of 2007-2009 dampened plan adoption among financially strapped firms. Those with cash to spare tended to fund business operational needs and expansion plans at the expense of executive perks.
Despite these issues, NQDC plans remain a primary vehicle for compensating executives among most businesses. That’s the conclusion of a new survey from MullinTBG, a Los Angeles-based Prudential Financial company, which notes that companies are turning to NQDC plans to restore retirement savings eroded during the recent financial crisis.
Why? The short answer is tax benefits. When informally funded with corporate-owned, cash value life insurance, the plans let highly compensated employees defer more pre-tax compensation than they can in 401(k) qualified plans, significantly reducing current-year tax liabilities. Income taxes on investment returns are also deferred until plan benefits are distributed.