Nonqualified Deferred Compensation Plans

A General Overview of Nonqualified Deferred Compensation Plans with an Emphasis on Small Business Top Hat Plans
By Jeffrey A. Duling, Esq.

What is a Nonqualified Deferred Compensation Plan (NQDCP)?
A NQDCP is a contractual agreement between an employer and an employee where an employee agrees to be paid at a later date for work completed. The payments are usually triggered by termination of the employment (i.e. retirement, firing without cause or closing of the business), disability, or death. The goal of the NQDCP is to allow the employee to defer receipt of compensation until such time as they will be in a lower tax bracket. Additionally, employers may defer their out-of-pocket costs depending on the funding arrangements. The employer is also deferring their tax deductions until the compensation is deemed to be received.

What are the Internal Revenue Service requirements for a NQDCP?
IRC § 409A is the primary code section governing the general terms of an acceptable NQDCP. Additionally, IRC § 83, the Constructive Receipt Doctrine, and the Economic Benefit Doctrine come into play in designing these plans. A NQDCP requires that the compensation due to the employee be subject to risk of forfeiture. This means that the only right that an employee has to the compensation is contractual. The employee may not have a secured interest in any property or financial product and may not be the named beneficiary of any insurance policy. The compensation is also nontransferable.

A NQDCP must be in writing. The amount of compensation deferred and the timing of any payments and or triggering events must be specified. Employer and employee must execute the plan document and make a timely election. Payments must be made in accordance with the plan.

The triggering event for the paying of compensation must be: termination, death, disability, a fixed time, change in control or ownership of the company or an unforeseeable emergency (i.e. the death or disability of a spouse or dependant).

What are the Department of Labor's requirements for a NQDCP?
Generally, all employer sponsored employee pension plans are subject to Employee Retirement Income Security Act of 1974 (ERISA), including NQDCPs. The reporting, disclosure, participation, vesting, benefit accrual, funding, and fiduciary responsibility requirements imposed by ERISA are burdensome and would make NQDCPs an impractical tool for most small businesses. Fortunately, excess benefit plans and "top-hat" plans are exempt from most of the ERISA requirements.

An excess benefit plan is a plan providing pension and retirements benefits in excess of the IRC § 415 limits. These are the limits applicable to contributions made under qualified plans like a 401(k) or an IRA.

Top-hat plans provide deferred compensation to a select number of employees. Generally, these employees are upper-level or administrative personnel. Often these plans are funded with the proceeds of a corporate-owned life insurance (COLI) policy. These plans require that the proceeds of the COLI are payable only to the employer and the employee may not be a named beneficiary, the policy is subject to the claims of employer's creditors, no representation is made to the employee that the COLI will be used exclusively for funding of the NQDCP, the benefits of the NQDCP are in no way tied directly to the proceeds of the COLI, and employees are not required or allowed to make contributions to the COLI.

When may NQDCP benefits be terminated?
The benefits under a NQDCP may be terminated if the employee discontinues employment prior to the vesting date for the plan (if there is a vesting provision), if the employee is terminated prior to retirement, death or disability, if the employee quits and enters into competition with employer, or if the employee is terminated for cause. Any termination policy must be in writing and contained in the plan document. Generally, benefits are not terminated unless the NQDCP is an excess benefit plan. If the deferred compensation is earned then it is rare for termination provisions to be present.

Bottom Line:
1) Employee defers compensation and taxation.
2) Acceleration of payments to employee is not allowed except in limited circumstances, otherwise steep penalties are enforced.
3) Employer defers deductions.
4) Employee is an unsecured creditor and may not have any security interest or right to underlying funding instruments.

If you are considering using a nonqualified deferred compensation plan as a means of rewarding your employees, please seek competent legal advice. These plans must meet strict statutory and regulatory requirements and should not be attempted by those unfamiliar with their drafting.