Why create a non-qualified deferred compensation plan?
There are many reasons that companies adopt these plans, but the primary reason for implementing non-qualified deferred compensation plans is to attract and retain talent, usually at the executive level. Many executives are interested in an opportunity to defer current compensation, to defer taxes, and supplement future earnings, perhaps into retirement. Many companies, both large and small, use non-qualified deferred compensation as an effective retention tool. For example, a simple plan might provide for payment of fixed installments of cash in future years if the executive remains continuously employed with the company through a future date. This creates a simple and powerful retention tool. Of course, there are many variations to the design of non-qualified deferred compensation, but this “golden handcuffs” feature is very common.
Who’s afraid of non-qualified deferred compensation?
Unfortunately, compliance with deferred compensation rules has become significantly more complicated, creating additional cost for employers implementing those plans and risk for executives if the plans are not properly documented and operated. This increased compliance burden was a response to some of the corporate governance scandals of the Enron era. Congress and the Treasury Department introduced law and regulations under Sections 409A to limit flexibility to accelerate and defer compensation under non-qualified plans.
Section 409A does not limit the amount of compensation that can be deferred by or for the benefit of employees, but it does impose a number of statutory and regulatory requirements to defer the income tax on deferred compensation. If a plan is not written and operated in compliance with Section 409A, all the amounts deferred under the plan will be included in income in the year of the violation, even though the compensation may not be payable until a future year. Additional interest may apply, and there is a 20 percent penalty on the executive.
Section 409A is not a reason to avoid creating non-qualified deferred compensation plans for key executives. But it does make it very important to know when a compensation agreement, plan, or other arrangement is non-qualified deferred compensation so it can be designed, documented and operated to comply.
How is a non-qualified deferred compensation plan created?
Despite the increased compliance burden associated with non-qualified deferred compensation, there is still a great deal of flexibility available in the design of these programs. In most cases, non-qualified deferred compensation is created with a written plan document and/or written award agreements. Such agreements or plans can be customized to individual executives or designed to apply to a key group of executives. There is usually a single, limited filing with the government – but no annual tax return. There are reporting rules that apply to accruals and payments of non-qualified deferred compensation. As mentioned, Section 409A does not limit the amount of deferred compensation, nor does it dictate payment schedules or vesting returns. Generally speaking, once compensation has been deferred under a non-qualified deferred compensation plan, it cannot be further deferred or accelerated, but there is a great deal of flexibility to the initial design.
Can I still elect to defer compensation?
Yes. Section 409A applies to both elective and non-elective deferred compensation arrangements. There are detailed rules that must be followed to make an effective deferral election. It is also worth noting that the doctrine of constructive receipt continues to apply. Essentially, that is the long-standing rule that says you cannot defer income tax on compensation that you have already earned and is currently available to you. That said, many companies continue to provide their executives with opportunities to defer payments and the tax on those payments that may be earned in the future.
What other tax or legal considerations apply to non-qualified deferred compensation?
Non-qualified deferred compensation payments are taxed at ordinary income rates. Properly designed and operated, non-qualified deferred compensation is taxable to the executive in the year paid to the executive. The company’s deduction, like the income inclusion, is deferred until the year of payment. Non-qualified deferred compensation payments are also wages for purposes of FICA tax, and subject to special timing rules. Essentially, non-qualified deferred compensation is includable in the FICA wage base in the year it is earned or vests (i.e., is no longer subject to substantial risk of forfeiture). This may be many years before the year in which the non-qualified deferred compensation is paid, so companies and executives must plan accordingly.
Non-qualified deferred compensation plans are most often structured to be exempt from most of the requirements of the Employer Retirement Income Security Act (ERISA). In order to properly structure a plan to be exempt from ERISA, the plan must be reviewed by experienced ERISA counsel and may require a government filing.
For many companies, the cash flow impact of the ultimate payments under the non-qualified deferred compensation plan can be a significant event that needs to be anticipated. These plans cannot be formally funded without incurring the adverse tax consequences, but many employers utilize so-called “Rabbi trusts” or other vehicles to hold funds in anticipation of the ultimate payout. Of course, non-qualified deferred compensation is an obligation of the company, so the accounting impacts should be understood at the outset.
Tax-exempt employers need to contend with additional requirements under the tax code to design and operate effective non-qualified deferred compensation plans.
Are companies still using non-qualified deferred compensation?
In light of the increased legal and regulatory burden and complexity associated with designing, drafting and administering non-qualified deferred compensation plans, you might expect that there has been a decline in the use of non-qualified deferred compensation. The need to provide very customized and effective compensation programs to executives has not, however, diminished, so non-qualified deferred compensation remains an important component of compensation programs at many companies.
It is also true that many companies maintain deferred compensation arrangements without knowing it. It may be that they have designed an equity program that includes a deferral feature, not intending to create deferred compensation. Or, the company may offer an expense reimbursement arrangement that creates an inadvertent deferral. Again, it is for this reason that many companies subject all of their compensation arrangements to a Section 409A review.
Agreements and plans can be drafted to provide very effective deferral opportunities for executives, if the company knows going into the process that the agreement or plan will be subject to Section 409A. It is much harder, and often impossible, to bring an existing agreement or plan into compliance with Section 409A, if it is discovered a year or two into the term of the agreement or plan that it is non-qualified deferred compensation.