If your business has certain executives who are critical to its success, providing them with a nonqualified deferred compensation plan (NQDC) could be a winning strategy to keep them with your company. Such a plan represents an agreement whereby one person (or legal entity) promises to compensate another for services to be rendered currently, with actual payment for those services delayed until sometime in the future. As an employer, you are offering an employee extra income that will not be taxed until some future date, usually upon retirement, death, disability, or termination of employment.
Because these plans are not governed by Federal pension laws, making them “nonqualified,” they can be extremely flexible. Their very flexibility—and the associated risks—means that you should seek professional guidance from tax, legal, and financial professionals. From a business standpoint, creating the funding mechanism to help ensure the benefits are there when the employee is entitled to them is the foundation of any plan. From a tax standpoint, being sure that the employee’s benefits are taxed when received, and not before, is equally critical. It would be particularly valuable to get professional advice on the Internal Revenue Service’s “constructive receipt doctrine” (as well as other tax issues related to NQDC plans), establishing the timing for the plan’s agreement date, the length of the deferral period, and the benefit payment schedule.
It’s likely that your company already offers a qualified retirement plan, such as a 401(k), which provides the employer with tax deductions for contributions up to a certain limit made to a participant’s retirement account. While these contributions certainly help employees reduce their taxable income, and defer taxes on earnings from contributions, qualified plans may limit the financial benefit sought by highly paid executives. This is because qualified plans usually restrict the compensation base used to determine the maximum annual contribution. With no limit on the compensation base, deferred compensation plans can transform a standard benefits package into a financially appealing savings vehicle for select employees.
Explicit in the deferred compensation plan is a contractual promise to provide future payment for ongoing services. Tethering (binding) an employee to the company through a vesting agreement is often included in a plan, although many plans offer immediate vesting, which is to the employee’s advantage.
For example, an employer may stipulate that the employee must stay with the company for a certain number of years before the employee is entitled to the compensation. Such an agreement encourages loyalty and commitment on the part of the employee. Not going to work for a competitor (a noncompete agreement) can be another condition of the agreement.
The agreement you make with an employee will specify the type of benefits and how and when they will be made available. Salary continuation—such as, providing $10,000 per month for life beginning at retirement—and annual contributions to an investment account whose balance is then paid at retirement are typical benefit formulas of NQDCs. Whether the money is actually put into an account, or merely exists on your books, is up to you. Employers who offer these plans, however, must be confident that the future profitability of their businesses will cover promised payments.
Employees will want assurance that their compensation will be there for them. One method of providing assurance is to set up a Rabbi Trust, which is a type of escrow account that provides some protection for the deferred compensation funds in the event of a hostile takeover or other type of management change. (Protection does not apply to the claims of the employer’s general creditors.) The protected funds may be invested or used to purchase life insurance or annuity products.
As Americans take on more responsibility for funding their own retirement, NQDCs may become a standard component of benefit packages. Forward-looking financial institutions have packaged these plans to make it easy for your company to attract and retain talented executives. When creating your company’s benefits package, NQDCs can play a valuable role.