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Should You Implement a Nonqualified Deferred Compensation Plan?

Nonqualified Deferred Compensation (NQDC) arrangements (a.k.a. nonqualified plans) allow your employees1 to defer some of their pay until later, such as retirement, death, or a specified date. Some examples of NQDC arrangements are supplemental retirement plans, equity-based incentive plans, and bonus plans. These types of plans are very different from qualified plans like 401(k)s. In this article, we’ll discuss some of the advantages and disadvantages of nonqualified plans to see if one could be right for your company.

Advantages for the Company

  • Nonqualified plans have more administrative flexibility than qualified plans because nonqualified plans are not subject to the tax-qualification requirements of the Internal Revenue Code (the Code”).
  • These plans may be easier to establish and maintain than traditional tax-qualified plans.
  • The plan sponsor may identify who may participate in the plan without having to consider the nondiscrimination, eligibility, participation, and funding requirements of the Code and, thus, can include only senior managers or key personnel.
  • The plans may be exempt from most of the plan requirements under ERISA, provided they meet certain requirements, such as being unfunded (see next). Some arrangements may be so informal that they do not even constitute a plan” as defined under ERISA.
  • Nonqualified plans can (and generally must) remain unfunded.

Advantages for the Employee

  • Typically, these programs are established by the company to provide benefits beyond the company’s tax-qualified pension and welfare benefit plans, so the participants in nonqualified plans receive benefits beyond the company’s core benefits package.
  • Depending on the plan, the employee may not be taxed on the benefits until the employee receives (or constructively receives) payment of the benefits. (This rule is different for tax-exempt entities.)

Disadvantages for the Company

  • There are no tax deductions for amounts contributed to these plans until the participants actually (or constructively) receive the plan funds.
  • Deferred compensation is a charge against earnings, a disadvantage from an accounting perspective.

Disadvantages for the Employee

  • Nonqualified plans generally must be unfunded to avoid some of the administrative burdens imposed on funded ERISA plans. As a result, these plans are essentially unsecured promises of the company to pay future benefits. Therefore, the employee only has the status of an unsecured, general creditor if the employer goes bankrupt or becomes insolvent.
  • Tax treatment of the benefits under the plans can be involved and require hiring a professional to help the employee understand the treatment.

Other Considerations

While NQDC arrangements may be beneficial to both employers and employees, there are factors that you should consider before establishing one, such as:

  • Corporate laws and the company’s governing documents
  • ERISA and its regulations
  • Federal and state security laws
  • The employer’s and employee’s tax rates
  • Inflation and the local cost of living
  • Security of the company’s promise to pay the nonqualified deferred compensation benefits (e.g., is the employer willing to establish an informal funding arrangement to protect the participants’ future benefits?)

Consequently, it is important to work with professionals before establishing a nonqualified plan to ensure that it is the right decision for your company and to avoid legal mishaps. Contact Boardman Clark’s Business Practice Group to receive assistance with this.

[1] Other service providers also can defer compensation under NQDC arrangements, but this article will focus on employees.

DISCLAIMER: The information provided is for general informational purposes only. This post is not updated to account for changes in the law and should not be considered tax or legal advice. This article is not intended to create an attorney-client relationship. You should consult with legal and/or financial advisors for legal and tax advice tailored to your specific circumstances.

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