This article is the second in a three-part series. Part one is available here and part three will be available next week.
The traditional nonqualified deferred compensation plan is a legally binding contractual agreement (plan) between an employer and one or more of its key personnel or independent contractors. In general, the employer makes a naked, unsecured, legally binding promise to pay future benefits, subject to all the terms of the contractual agreement.
Although the IRS historically used the term “deferred compensation” to describe all types of arrangements that defer earnings, compensation, or income out into the future, there are only two major categories of deferred compensation, after the enactment of Code section 409A: nonqualified deferred compensation plans and qualified deferred compensation plans, which are specifically exempted from section 409A coverage.
Most nonqualified plans are designed to be unfunded plans and may be viewed in two parts:
1. the “plan” itself; and
2. the employer’s general asset reserve (if any) that is used to informally finance the liabilities created by the plan.
The “plan” is the legal benefit contract between a plan participant and the plan sponsor that is outlined in the plan document. It spells out the participant’s benefits (or crediting to deferral accounts), the distribution opportunities, the vesting and forfeiture conditions (if any), and many other important details of this pension-benefit-type plan. In contrast, the general asset reserve is not the plan, despite how closely the plan and these assets might be associated.
The general asset reserve is merely the manner in which the sponsor is addressing the General Accepted Accounting Principles (GAAP) liabilities produced by the plan, whether taxable assets such as mutual funds, employer-owned life insurance, or both are used. In fact, if the plan and these assets become too closely associated, a “top-hat” plan may become funded for both federal income tax and ERISA purposes and change the expected and desired federal income tax and ERISA consequences of the plan for both the plan participant and the plan sponsor.
When should nonqualified plans be considered?
Qualified retirement plans — including pension, profit sharing plans, and 401(k) plans — are plans that satisfy extensive requirements imposed by the Internal Revenue Code in return for special corporate federal income tax treatment, including a current business expense deduction for plan contributions and deferred federal income taxation for participants.
Nonqualified deferred compensation plans have several advantages that, in certain circumstances, can outweigh the loss of favorable tax treatment. Nonqualified plans are an increasingly important component of the compensation and benefit package for key executives. They can be used to:
avoid the many restrictions of qualified plans;
freely design plans that favor highly compensated employees (HCEs);
help bridge the projected retirement income gap face by HCEs; and
retain key executives.
Traditional non-equity, nonqualified retirement plans are plans that do not seek the federal income tax benefits of qualified plans or trusts, and generally try to escape the major administrative burdens and liabilities of qualified plans by fitting into certain “safe harbors.” This approach exempts the plans from all or most of the burdensome funding, participation, vesting, and disclosure requirements imposed by the Employee Retirement Income Security Act of 1974 (ERISA) on qualified retirement plans.
What types of nonqualified plans are most commonly used?
Most nonqualified plans fall into one of three broad categories:
unfunded employee account balance deferred compensation plans (which largely encompass voluntary deferral plans);
unfunded employer account balance deferred compensation plans (which include employer contribution matching and defined contribution supplemental plans, frequently referred to as supplemental executive retirement plans (SERPs)); and
unfunded employer non-account balance deferred compensation plans (which largely encompass defined benefit supplemental plans, also frequently referred to as SERPs).
Employee and employer account balance plans are defined contribution plans, in which the accrued benefit is the account balance in a defined contribution plan as of a specific date. Non-account balance plans are defined benefit plans, in which the accrued benefit is a portion of the total retirement benefit earned based on years of service or years of participation as of a specific date.
Employee account balance plans, often referred to as “voluntary deferral plans,” provide an employee with the opportunity to elect to receive deferred benefits in lieu of a portion of current compensation, a raise, or a bonus.
Such plans may also provide for an employer match or contribution, and a plan that “mirrors” a company’s qualified 401(k) plan typically does so. But the primary source of monies in the plan is typically compensation voluntarily deferred by an employee.
Employer-paid account balance plans, also called “defined contribution SERPs,” are compensation benefits provided by the employer to an employee in addition to all other forms of compensation. The employer promises to pay a deferred benefit, but there is no corresponding reduction in the employee’s compensation.
Non-account balance plans, also called “defined benefit SERPs,” are employer-paid plans that promise to pay a future benefit, typically a function of compensation and service at the time of benefit commencement. There is no reduction in current compensation and no taxation to the participant until benefits are received.
Taxation of nonqualified plans
Code section 409A has greatly expanded the scope of the term “nonqualified deferred compensation plan” and requires an entire reconceptualization of what constitutes nonqualified deferred compensation for federal income tax purposes.
Code section 409A is important because plans subject to 409A must comply with documentary and operational guidelines, or a plan participant may be subject to immediate federal income taxation and penalties. In the worst case scenario, violations generate the normal individual federal income tax on the plan benefits, late interest penalties of 1 percent (back to the date of the intended deferral), and a 20 percent additional excise tax on the includable taxable amount.
Tax deferment is not achieved if, prior to the actual receipt of payments, the employee is in constructive receipt of the income under the agreement. Income is constructively received if the employee’s control of its receipt is subject to substantial limitations or restrictions. Treasury Regulation sections 1.451-1 and 1.451-2 specify that so long as the employee’s rights are forfeitable, there can be no constructive receipt.
However, various revenue rulings have held that even if the employee’s rights are nonforfeitable, the employee will not be in constructive receipt of the income if the agreement is entered into before the compensation is earned and the employer’s promise to pay is not secured in any way.