Deferred comp plans help retain staff, reserve cash

Using such a plan can accomplish these objectives without a current cash outlay.

In essence, an NQDC plan is a promise to pay an employee at a future date for services performed in earlier years. A plan allows the employee to defer income taxation of the compensation to the year of payment, rather than the year it is earned. The employer is not entitled to a tax deduction until the year of payment.

One common type of NQDC plan allows an employer to define the amount of deferred compensation and tie it to a vesting schedule based on some future event, such as the employee’s continued employment.

Alternatively, a plan may allow employees the option to either receive compensation (which has not been earned yet) as a current year payment or elect to defer the compensation to a future time. An elective arrangement allows employees in high income tax brackets more flexibility in current and future tax and financial planning.

An attractive aspect of these plans is the inapplicability of many Employee Retirement Income Security Act (ERISA) rules. This means a plan can be created to only benefit specific employees and also avoid the funding limits imposed on other retirement plans, such as SEP IRAs or 401(k)s. Thus, an employer has wide discretion in determining the participants and how much compensation to provide each participant.

Employees who participate in an NQDC plan carry some economic risk, because an NQDC plan cannot be “funded.” So, unlike a 401(k) or other creditor-safe qualified plan, the employer cannot guarantee the funds will be available when the employees are entitled to payment.

Such lack of certainty may turn off some employees to the plans, so many employers use a “rabbi trust” to help ease employees’ concerns. A rabbi trust allows funds to be set aside and distributed by a trustee according to the NQDC agreement, but requires these funds be available to satisfy the company’s creditors (which would include the employee, to the extent the employee is vested in the plan) in a bankruptcy situation.

For a period of time, these rabbi trusts were often moved offshore to create an additional hurdle for creditors, but new rules imposed in 2004 discourage offshore rabbi trusts.

Tax timing
The timing of Social Security tax, Medicare tax and unemployment tax payments is also important. Deferred compensation is subject to employment taxes at the earlier of either the time the employee earns the compensation under the NQDC plan, or the compensation is no longer subject to a substantial risk of forfeiture. Understandably, no additional employment taxes are assessed when the deferred compensation is actually paid. Therefore, deferred compensation subject to employment taxes in a year when the employee’s compensation outside the NQDC plan exceeds the Social Security tax wage limit will never be subject to such taxes, regardless of the employee’s compensation in the year of receipt.

Additionally, the NQDC plan must specify when the compensation is to be paid, either as determined by the employer, or at a time elected by the employee. Fixed dates, such as the year an employee turns 55, are acceptable, but using a future event which has an indeterminable date, such as the birth of the employee’s first child, does not meet the requirements.

If the payout date is not specified, the plan will fail to defer compensation. If the company’s plan allows employees to electively defer compensation, specific timelines must be met for the deferral to be valid. These date-sensitive requirements help ensure that an employee’s deferral is not made using hindsight.

Some specific situations allow early distributions without imposing a penalty, such as the death of the employee, separation from service, the employee’s disability, a change in control of the company or an unforeseeable financial emergency for the employee. Each early distribution provision must be stated within the deferred compensation agreement in order to be valid.

Tax code changes
Be aware that in 2004, significant changes were made in the tax code and all plans must meet these new requirements to effectively defer taxation. Grandfather provisions for plans in place before the new law only apply to amounts deferred before October 2004, and only if the plan is not significantly modified. There may be significant tax consequences for additional deferrals to old plans which do not comply with the new rules.

In addition, many older plans provided an opportunity for employees to withdraw money from the plan early. For example,  many older plans have a “haircut provision” that allows the employee to withdraw cash early if an economic penalty is incurred.  Such provisions are no longer acceptable. If your plan fails to meet the new requirements, not only will the deferral be ineffective, but also a 20 percent penalty will be imposed. Therefore, all NQDC plans in place before 2005 should be reviewed to ensure compliance.

(Note: Any tax advice in this article is not intended and cannot be used to avoid penalties imposed under the U.S. Internal Revenue code, or promote, market or recommend to another person any tax-related matter.)

These rules apply in more situations than just an employee/employer relationship, and your plan should be tailored to meet your organization’s specific goals.

Beware penalties
It is important that you seek the help of a qualified professional with respect to either new or existing NQDC plans so that the organization’s employee recruiting and retention goals can be achieved. Otherwise, such unintended consequences as penalties and interest assessed by the Internal Revenue Service may result.