Module 1: OVERVIEW OF NONQUALIFIED PLANS
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In the employer-employee relationship, nothing says "I love you" more than compensation. A pat on the back or some token of appreciation are nice, but let's face it: The essence of the employer-employee relationship is based on an exchange of the employee's services for the employer's money or similar form of tangible compensation. Usually, the higher the value of an employee is, the more compensation the employee gets from the employer.
Compensation, of course, can take many forms. In addition to regular wages, employers often offer their employees compensation packages that may include a mixture of such benefits as health insurance, paid time off, tuition reimbursement and qualified plans that help to save for retirement. When it comes to qualified retirement plans, the rules generally require that an employer's basic compensation package be equally available to all employees in order to get the associated tax benefits (though the benefits employees receive can be provided in proportion to their wages).
If an employer really and truly loves an employee, however, the employer will compensate the employee above and beyond the basic compensation package provided to rank-and-file employees. This is where nonqualified deferred compensation plans come in. An employer can use a nonqualified plan to provide added incentives to attract and retain key executives and employees.
A nonqualified plan is an employer-sponsored retirement or other deferred compensation plan that does not meet the tax-qualification requirements under Internal Revenue Code Sec. 401 (i.e. qualified plan requirements). A nonqualified plan also does not refer to a tax-sheltered annuity (TSA), a simplified employee pension (SEP) plan, a savings incentive match plan for employees (SIMPLE) account, or a 457 governmental plan. Retirement plans like TSAs, SEPs, and SIMPLEs are governed by their own rules.
A nonqualified plan allows an employee to defer the receipt of taxable wages or bonuses until some future year when (hopefully) the employee is in a lower tax bracket, thereby paying less in taxes when the compensation is received. Although nonqualified plans are easier to set up than qualified plans, there are specific rules that must be followed to achieve the objective of deferring an employee's taxable compensation. All nonqualified plans must satisfy the following three requirements:
The deferred compensation arrangement between the employer and the employee must be entered into before the compensation is earned by the employee.
The deferred compensation cannot be available to the employee until a previously agreed upon future date or event.
The amount of the deferred compensation cannot be secured (i.e. it must remain available to the employer's creditors).
Nonqualified Plan Advantages
From an employee's perspective, getting more compensation is always a good thing. Ultimately, however, it is the employer that makes the final determination whether a nonqualified deferred compensation plan fits its needs. The following are the major advantages associated with a nonqualified plan that should be considered in the decision-making process:
Easy plan adoption. Because there are few formalities involved in setting up a nonqualified deferred compensation plan, it is simpler to adopt. Conversely, a qualified plan must meet certain formal requirements. For instance, it must be written, must be accompanied by a trust, must be formally communicated to employees and must meet participation, vesting and funding requirements. Nonqualified plans generally need not meet these formal requirements.
Coverage and design flexibility. Because there are no coverage, eligibility or participation requirements, an employer can decide to provide nonqualified deferred compensation benefits only to a select group of executive or highly compensated employees. This allows the employer to provide rewards and incentives based on an executive-by-executive approach.
Vesting and forfeiture flexibility. Under a nonqualified plan, an employer may give the employee an immediate right to the benefits or subject the benefits to forfeiture provisions, depending on the employer's needs.
Exemption from burdensome tax requirements. Nonqualified plans are exempt from statutory limits on annual contributions and benefits, funding rules, qualified joint and survivor rules, and other provision of the tax code. In addition, employees who receive benefits can defer income into future years so long as the benefits are subject to a substantial risk of forfeiture.
Partial exemption from ERISA. Nonqualified plans that are unfunded and that provide benefits to a select group of employees are exempt from most of the Employee Retirement Income Security Act (ERISA) requirements, such as those involving funding and reporting and disclosure.
Cash compensation option. At some point, an executive may prefer receiving cash compensation instead of having a deferred arrangement. The nonqualified deferred compensation plan allows for that option, generally without any penalty. A qualified plan will not allow the same freedom.
Supplement to qualified plans. Nonqualified plans allow contributions beyond the caps set for a qualified plan. For example, the tax code limits the maximum amount that can be added to a qualified defined contribution plan and the maximum benefit that can be offered by qualified defined benefit plan. Furthermore, the tax code limits the amount of employee compensation an employer may consider when calculating its contributing to an employee's qualified plan. All of which severely limits retirement savings for highly-paid employees. The nonqualified deferred compensation plan may, therefore, be used to supplement a qualified plan and provide greater benefits to the executive employee.
Nonqualified Plan Disadvantages
Despite their numerous advantages, nonqualified deferred compensation plans do have some disadvantages too. The following are the major drawbacks to consider when evaluating such plans:
New rules modify tax treatment of deferrals. As a result of the American Jobs Creation Act of 2003 and generally effective beginning in 2005, nearly all nonqualified deferred compensation plans will be subject to new tax rules that significantly modify the tax treatment of deferrals. The new rules impose election, distribution, and funding restrictions on nonqualified plans. Individuals who defer compensation under plans that fail to comply with the new rules will be subject to current taxation on all deferrals and to enhanced penalties.
Please note: The tax consequences resulting from a plan's failure to comply with the changes under the American Jobs Creation Act of 2003 will be borne exclusively by the individual plan participant to whom the deferral relates. At the same time, the failure to comply with the governing rules will not subject either the plan or the sponsoring employer to tax and penalties. It is crucial, therefore, that any participant in a nonqualified deferred compensation plan have their situation reviewed by a tax professional to make sure that everything is in order
Current tax deduction unavailable to employer. An employer cannot claim a current deduction for any nonqualified deferred compensation amounts until the employee receives the amount as income. For example, employer contributions to a nonqualified deferred compensation trust established for deferrals by key employees are not considered transfers of property or gross income for plan participants until the tax year in which the amounts are transferred, paid, or otherwise made available to participants. Similarly, the mere maintenance of unfunded bookkeeping accounts under a nonqualified deferred compensation plan created for highly compensated employees is not a transfer of property or gross income to the participants until amounts from the accounts are actually transferred or paid.
Deferred amounts may evaporate. Deferred amounts under a nonqualified deferred compensation plan are merely an employer's promise to pay the employee sometime in the future. In order to allow employees to defer income tax until the amounts are received, these amounts must remain subject to the claims of the employer's creditors in the event of insolvency (i.e., they must be unsecured). This means that an employer's promise to pay may become an empty promise if the employer becomes insolvent. (There are methods available to minimize this risk, such as rabbi and secular trusts or life insurance policies.) .............for details on creditor protection
Registration required for unsecured obligations. Voluntary nonqualified deferred compensation arrangements may have to be registered with the Securities and Exchange Commission (SEC) as securities since they are unsecured obligations. Employees that are offered deferred compensation could be considered investors subject to registration protections. However, if the employer does not have publicly traded securities in its company, then the SEC would not be involved and no registrations would be required.
Shareholders may challenge executive compensation as excessive. Shareholders have this funny notion that their investment in a company should be rewarded by an adequate rate of return. If lukewarm or decreasing corporate profits are accompanied by increasing executive compensation, they are not shy about taking legal action challenging the executive compensation plan as wasteful and excessive.
A nonqualified plan based on pay-for-performance usually is able to withstand the legal challenges of shareholder activism. The executive compensation should be linked to corporate financial growth and paid on the basis of solid corporate performance. As such, equity and equity-based compensation techniques, like long-term incentive stock options, are increasingly becoming more popular.
Types of Nonqualified Programs
Contracts versus Plans
Nonqualified deferred pay plans are either in the form of an individual contract or an employer plan. When a contract is involved, the contractual arrangements will vary to suit the parties' needs. For example, a contract may provide for installment payments of a fixed amount over a period of years or payments only after retirement. Another contractual provision may require the purchase of an annuity or an endowment policy for the executive or key employee.
Although nonqualified deferred compensation arrangements may not be subject to tax code restrictions, a nonqualified deferred compensation arrangement involving a contract is subject to state contract law and, therefore, court enforcement and interpretation.
If the nonqualified compensation is provided by means of a plan, many options are available. They include: excess benefit plans: top-hat plans, deferred bonuses, salary continuation plans, executive bonuses, and anti-takeover measures such as golden (silver, tin or pension) parachutes.
A nonqualified plan may also center on the use of life insurance. The most common types of insurance arrangements used in such situations are key-employee insurance, group-term life insurance, split-dollar plans, and reverse split-dollar plans.
This course will explore deferred compensation programs, executive bonuses, group carve-outs and golden parachutes.
Funded vs. unfunded nonqualified plans
A nonqualified deferred compensation plan may be funded or unfunded. A funded nonqualified plan is one where the employer maintains it by making contributions to a trust or by paying premiums on an annuity contract. The employee may or may not have to pay current tax on the contributions depending on the employee's vested rights in the contributions.
If a nonqualified plan is unfunded, the plan merely involves the employer's present promise to pay amounts to the employee in the future. The employee is taxed only when those amounts are actually or constructively received.
The funded versus unfunded nonqualified plan distinction is important to keep in mind as you look at the various types of nonqualified plans.