Employer considerations for nonqualified deferred compensation plans
INSIGHT ARTICLE |
Authored by RSM US LLP
This article was originally published on December 6, 2018 and has been updated.
Compensation plays a critical role in attracting, motivating and retaining the highly qualified executives and management teams necessary to achieve a company’s goals. When structuring a compensation package, companies should understand the various compensation choices available: base salary, annual bonuses, nonqualified deferred compensation, equity compensation and fringe benefits.
Nonqualified deferred compensation (NQDC) is a general term that includes plans that provide equity compensation, plans that provide additional retirement benefits and plans that provide mid-term and long-term incentive payments.
Although NQDC plans have fewer restrictions than ”qualified” broad-based retirement plans such as section 401(k) plans, NQDC plans must also satisfy a number of conditions. Failing to understand these rules breeds expensive and painful situations for an employer and employees. Within the limitations, the NQDC plan rules provide employers with a number of fairly flexible and useful choices for attracting, retaining and motivating top employees.
When setting up a NQDC plan, employers often have one or more of the following questions:
What is a nonqualified deferred compensation plan?
A nonqualified deferred compensation (NQDC) plan is a broad, general description for any arrangement under which the employer or the employee can defer taxation of compensation that is earned in one year so that it becomes included in taxable compensation in a later year (because payment occurs more than 2½ months after the year in which the benefit is earned). The NQDC rules apply to employees and other “service providers,” such as a director or a partner providing service to a partnership; for simplicity this discussion uses the term “employee” rather than “service provider.”
Some NQDC plans only provide for employee elective contributions, permitting employees to elect to defer compensation earned in one year until a later time or event as stated in the plan. Other NQDC plans provide for employer-only or employee and employer contributions. NQDC plans can provide for a single benefit (such as payment in a lump sum after retirement, on reaching a stated event, or at a specified date) or can allow the employee to choose among various payment choices (such as an employee choice between benefit payments after three, five or seven years and employee choices between lump sum payments or payments over a stated period of time.
Employers typically offer NQDC plans only to top management or other highly compensated employees and generally should not cover nonhighly compensated employees.
What are the advantages of using a NQDC plan?
As a tool for attracting and retaining top talent, a NQDC plan offers several advantages compared to qualified deferred programs. Since NQDC rules exempt plans from most ERISA and reporting requirements, no limitations on deferred amounts and no minimum distribution rules apply to these plans. Also, a NQDC plan can discriminate in favor of higher compensated employees and amongst employees in various compensation levels, which becomes problematic in a qualified retirement plan.
For companies experiencing temporary cash flow issues, NQDC plans offer convenient opportunities when the company expects an improvement in cash flow in later years and wants to continue with promised benefits but cannot currently pay the benefits.
Further, by design, NQDC plans can reward employees for meeting specific performance metrics (either individual metrics or company metrics) and can provide for vesting over time or only on the occurrence of events stated in the plan. This gives a company flexible methods for awarding the type of behavior that is likely to bring about desired company results (such as increasing stock value or selling for a good price).
What are the tax consequences of NQDC?
The tax rules for a NQDC plan depend on whether the NQDC plan is “funded” or “unfunded.” Very few employers establish “funded” NQDC plans in the US because of the significantly unfavorable tax rules (income tax occurs before receiving the money) that apply to NQDC funded plans – this discussion does not address funded plans.
Most employers implement “unfunded” NQDC plans in the US. Some companies choose to establish grantor trusts into which they contribute NQDC amounts, so the plans look “funded,” but the assets in such grantor trusts remain available to the creditors of the company in bankruptcy and thus the plans are “unfunded.”
An employer can design a plan to vest over time, vest at the time of grant, or without vesting conditions. In a properly designed plan in compliance with the section 409A rules, the promised amount becomes includable in the employee’s taxable income as the amount is paid (or becomes available) to the employee. Like other compensation, employers report the distributed amount as taxable compensation. If a NQDC plan provides for contributions and “earnings” on the contributions, both the contributions and the earnings are eventually taxed as compensation.
While a NQDC plan offers long-term tax-deferred savings for employees, the deferral also applies to the employer’s tax deduction, which limits deductions until employees include the amounts in taxable compensation. Under a qualified retirement plan (such as a 401(k) plan), employers deduct expenses in the year they remit payments to the trust, even though employees will not recognize income until the later years upon receipt of distributions from the plan. Under a NQDC plan, employers can only deduct the benefit as the employee includes the benefit in taxable income. The deduction amount is the total amount included in the employee’s taxable compensation, which includes any earnings on the employer contributions.
How do payroll taxes apply to NQDC?
NQDC plans rules impose federal (and generally state) income tax withholding requirements in each year in which employers distribute and include amounts in employee compensation. For employees or former employees, employers report the NQDC distributions on Form W-2.
However, a special rule for Social Security and Medicare taxes (payroll tax) under the Federal Insurance Contributions Act (FICA) applies to some NQDC plans. For payroll tax purposes, employers generally take into account NQDC amounts as FICA wages at the later of 1) when the employee performs services, or 2) when the employee vests in the right to receive the deferred amounts. As a result, payroll taxes typically apply to NQDC before the employee receives payment, and before income tax applies. As an added benefit, any earnings accruing under the plan after the vesting dates will not be subject to payroll taxes.
However, this special payroll tax rule does not apply to a “short term deferral” plan (that is, a plan that pays out the benefit within the year of vesting or no later than 2½ months after the year of vesting). Payroll tax withholding applies at the time of distribution for a short-term deferral plan.
As with other compensation, payroll taxes apply up to the annual wage base for Social Security taxes and without limitations for Medicare taxes.
Employers generally arrange to withhold or collect the employee’s share of payroll tax at the time of the deferral, or later vesting year, if the plan provides for benefits that vest over time. Employers may choose to do this by requiring the employees to pay in the amount to the employer, by withholding it from other payments due to the employee or some other method.
What decisions must employers make when setting up a NQDC plan?
Before offering a NQDC plan, an employer must determine the company’s overall business strategy, and how NQDC obligations work with the company’s overall compensation philosophy. In general, NQDC plans fall into five categories:
- Salary reduction arrangements (sometimes with employer matching contributions).
- Deferred bonus plans.
- Supplemental executive retirement plans.
- Supplements to normal compensation.
- “Excess benefit plans,” which solely provide benefits to employees, due to benefit limitations under the employer’s qualified plan.
Some companies use more than one type of NQDC plan. For example, an employer might allow executives to elect to defer compensation and match the contributions, but separately provide for short- or mid-term deferred bonuses for a broader management group, payable over three to five years and also provide an executive supplemental retirement plan for a limited number of executives.
Employers need to decide whether one or more types of NQDC plans may be appropriate for their management compensation package to achieve the desired results. In addition, employers must decide:
Participation: Employers usually reserve NQDC plans for only highly compensated employees, such as executives or key management employees in order to avoid ERISA’s requirements for vesting, testing, and funding for qualified plans. An employer could possibly offer a different NQDC plan, such as a deferred bonus plan, to a broader group of highly compensated employees.
Certain types of NQDC plans, such as elective deferral plans, do not work well for partners in smaller partnerships. However, if one partner provides significant services and the partnership chooses to reward that particular partner if he or she continues to work for a period of years, the partnership can certainly provide a promised payment to that partner, which may be a NQDC plan paid as a guaranteed payment to the partner.
Vesting: Employers can establish vesting schedules that serve their particular purposes. The employer may design the plan to set vesting of five or even 10 years, ultimately based on what employees actually value as an incentive. Alternatively, an employer may choose to set certain performance goals to encourage specific behavior or add noncompete clauses for a specific period or geographic location after termination (only considered to the extent enforceable). In general, most vesting schedules run for a period of two to six years.
Amount: With regard to salary or bonus elective deferrals, technically, so long as the employee has enough current compensation to pay for any payroll withholding due, no limitations apply to the deferred amount. Some considerations that may affect the structure of the arrangement include the current and future income needs of the employee, the desired tax treatment of deferred amounts, and the desire for payment assurance of the deferred amounts. In addition, the employer may want current tax deductions for much of the compensation, which can further limit the deferred amounts.
Payment timing: Many employers design plans to pay deferred amounts very soon after the vesting date. Some employers design plans to pay deferred amounts only at the earliest of death, disability or separation from service with the company. However, quite a few employers instead intend to use plans as mid-term or long-term incentives that help retain and reward the employee without making the employee wait until separation from service. For example, long-term incentive plans may have payment events after three to five years while a few might go out as far as seven years. Even a plan that pays only at a specific event, such as at sale or initial public offering of the company, often limits the period during which the promise remains in effect (“if a sale takes place within the next six years, the company will pay the employee $X”). Often employers design supplemental retirement plans to pay only after the employee reaches retirement with the company and thus may accrue for many years for a long-term employee.
These decisions balance the employee’s desire for rewards earlier and the employer’s desire for retention, and also balance tax inclusion and tax deductions.
Another consideration is whether an employer could have cash-flow issues if several employees retire or choose a payout at the same time. A sudden need for cash may arise requiring the employer to handle a large cash outflow at once, and borrow funds to satisfy the terms of the NQDC agreements.
What about section 409A?
Although NQDC plans generally provide more flexibility in design than qualified plans, employers have to consider the rules under section 409A. In order to avoid deferred compensation being unexpectedly included in gross income before payment, the arrangement must meet requirements under section 409A (or satisfy one of the 409A exemptions), both in form (i.e., written) and in operation as it relates to:
- Distributions – amounts deferred must be payable only upon specific events stated in the plan (certain types of plans must use section 409A defined events (such as section 409A change in control)) and only payable within a stated time period once the distribution event is reached;
- Acceleration – the plan must not permit the acceleration of any payment under the plan (however, the regulations describe a number of exceptions);
- Elections to defer (if the plan allows employee deferral elections) – elections must be made prior to the beginning of the tax year in which the amounts will be earned, and elections regarding payment type and timing must generally be made by that date. Thus, if an employee will earn a bonus based on service in 2019 and the bonus is otherwise payable in early 2020, in most cases the employee’s deferral election must be made by the end of 2018.
The failure to comply with section 409A leads to severe consequences to the employer and can cause inclusion of income for all compensation deferred under the plan, plus interest and a 20 percent additional income tax to the employee. Although these adverse tax consequences fall on the employee, the employer must report section 409A failures and may face penalties for failure to withhold income and employment taxes. Therefore, both the employer and employees have an interest in making sure that any arrangement that results in the deferral of compensation is either exempt from, or in compliance with, the requirements of section 409A.
Are there any exceptions to section 409A?
- Yes, exceptions to section 409A include (but are not limited to) the following arrangements:
- Short-term deferrals – payments received no later than 2½ months after the end of the taxable year of vesting.
- Bona fide severance payments – severance payments equal to no more than twice the lesser of: 1) two times the employee’s annualized base salary for the prior year, or 2) an indexed amount that is paid out by the end of the second tax year following the year of separation.
- Stock options and stock appreciation rights granted at fair market value (that meet certain other requirements).
- Qualified plans and certain welfare benefit plans.
- Restricted stock plans.
- Grandfathered arrangements earned and vested before 2005.
When implementing plans or arrangements that might meet an exception from section 409A, employers should carefully review the requirements of the exception given the costly nature of section 409A violations.
If you consider offering NQDC arrangements, you should discuss the deferral arrangements with your tax advisor to ensure that the tax rules will support the type of deferral you have in mind, and that you consider all of the requirements and analyze the value the opportunity may provide your employees while driving your company’s performance.
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This article was written by Anne Bushman, Karen Field and originally appeared on 2021-09-14.
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