What is Nonqualified Deferred Compensation?

Congress and the current Administration are constantly reviewing proposals regarding the tax treatment of nonqualified deferred compensation arrangements. Some proposals currently under review, focused on stopping abusive compensation practices, could increase taxes on arrangements that are not abusive. If they are successful, this would have a severe impact on all participants of nonqualified plans, regardless of compensation levels.

Nonqualified deferred compensation is a contractual arrangement between and employer and employee where the employee elects to defer a portion of salary until a future date. These arrangements are a supplement to qualified retirement plans including 401(k)s and others that have limitations and restrictions. Employers, both large and small, view these plans as a valuable employee retention tool.

There are several manners in which a nonqualified deferred compensation agreement can be constructed including having the employer defer a specific percentage of an employees current salary to see how hypothetical earnings on the deferred amounts would compute. In other cases, the agreement specifies a rate of return on the deferred amounts. A third variation exists where employees maintain a hypothetical account in which they may make hypothetical investments that dictate what they will ultimately receive.

Employers have to consider that a nonqualified deferred plan is not eligible for the tax benefits granted to qualified plans. A significant difference is that in a n nonqualified plan, the employer may NOT deduct the deferred compensation as they would in a qualified plan. Instead, the employer’s deduction is postponed until the employee’s receipt of the compensation.

Another significant difference is that amounts deferred in a nonqualified plan are not protected in the event of the employer’s bankruptcy. The assets in the plan remain subject to claims of the employer’s general creditors. Therefore, if the employer defaults, there are no assurances that the deferred amounts will ever be paid to the employee. In this scenario, the employee becomes another unsecured creditor of an insolvent company.

One method commonly used by an employer offering a nonqualified deferred compensation plan is to setup a trust in order to meet its future obligations to pay the compensation to its employees. “Rabbi trusts” comes from an early IRS ruling involving a rabbi, are constructed in accordance with longstanding tax-law guidelines. The details of how a rabbi trust are implemented are beyond the scope of this document. However, rabbi trusts have been known to provide a great deal of comfort to employees knowing there is a third party involved in paying them their deferred income. The rabbi trust also protects the employee in the event of a change in control at the company or a change in management to make these payments when they become due. However, a rabbi trust is by no means a silver bullet, because it does not protect the individual if the employer becomes insolvent. The terms of the trust provide that the assets are subject to the claims of creditors in the case of bankruptcy.

Top executives are not the only employees able to participate in deferred compensations plans. Nearly one-half of Fortune 1000 companies that have deferred compensation arrangements extend participation to non highly compensated individuals. The reason many employees that are not highly compensated individuals can afford to put additional money away can be for many reasons including multiple income households or an inability to fully contribute to the company’s qualified plan.

A nonqualified plan might be an ideal way to entice both your executive, highly compensated employees, as well as other loyal employees that would require retirement income in the future. This is just another benefit you can offer to your employees as a way to improve employee retention.

While some policy makers have proposed to change the longstanding tax treatment of nonqualified deferred compensation, there is nothing improper about the current tax law governing these arrangements.

The tax law governing deferred compensation matches the employer deduction with the employee income inclusion. The employee generally is taxed on the compensation at time of receipt. Likewise, the employer’s deduction comes at the time the deferred amounts are paid. Thus, an employer entering into the arrangement is foregoing an immediate deduction for the pay, thereby increasing it current tax liability. The employer is willing to make this sacrifice in order to attract and retain its best employees. This matching of deductions and income inclusion effectively eliminates any revenue concerns on the part of the federal government.

The doctrine of “constructive receipt” is one of the key principles that guides the present law treatment. Deferred compensation will be taxed currently if the individual is determined to have constructively received these amounts. An amount is constructively received if the individual is able to draw on it, without restriction, at any time, even if the individual has not received the income.

Some of the tax-increase proposals that have been discussed to date would ignore the policy of constructive receipt. That is, an individual would be subject to current tax on deferred compensation amounts whenever – under some proposals – the arrangement involves use of a rabbi trust. These proposals would tax individuals currently on amounts they have not yet received, do not yet have a right to receive, and may never even receive (e.g. if the company becomes insolvent).

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