Broadly defined, a nonqualified deferred compensation (NQDC) plan is a contractual agreement in which an employer agrees to pay an employee later for services rendered currently. The NQDC benefits typically commence upon the employee’s retirement (after attaining a specified age), disability or death before retirement. Instead, the promised future benefits are in addition to current compensation. This article deals with the salary continuation type of NQDC plan where the employee does not defer current compensation, but instead the promised future benefits are in addition to current compensation.

Comparison to Qualified Plans.

Qualified retirement plans such as pension, profit sharing and 401(k) plans are subject to many restrictions under the Employee Retirement Income Security Act of 1974 (ERISA). In contrast, NQDC plans can be discriminatory, do not have to have a vesting schedule, do not require a trust fund arrangement, and have no limits on how long benefits can be deferred or when the benefits must be taken. But there are limits on how many employees can be covered – just a select group of highly compensated or management employees (a so-called "top-hat" plan).

Income Taxes.

Since the strict rules of ERISA do not apply to NQDC plans, the tax treatment of such plans is not as favorable as for qualified plans. The employer is not entitled to an income tax deduction until the benefits are actually paid to the employee. Under the "constructive receipt" doctrine, NQDC benefits are taxable to the employee when the employee has the right to receive the benefits – even though actual payment has not occurred. Another disadvantage of an NQDC plan is that the employer’s obligation to pay the benefits must merely be an "unfunded and unsecured" promise to pay. Thus, the employee runs the risk that the employer will not have the funds to pay the benefits when due.

Use in Family Businesses.

An NQDC plan can be used in a family business for several purposes. First, senior family members facing retirement may need NQDC benefits for their retirement. Second, in an attempt to treat all children equally (or at least fairly) family business owners may want to sell (as opposed to gift) the business to those children active in the business. But gifting (as opposed to selling) the business to the active children may be more income and transfer tax efficient. Therefore, combining a gifting program with an NQDC plan (for the senior family members) may be more tax advantageous to the family in general. Finally, an NQDC plan for key employees can provide a "golden handcuff" to ensure such employees remain with the family business during the transition period when the business moves down to the next generation.

General Rules.

Following is a brief summary of the rules for NQDC plans:

1. The employee is not taxed until the benefits are actually paid, even though the benefits may be vested, as long as the plan is an unfunded and unsecured promise to pay by the employer.

2. The employer can only deduct the benefits when they are included in the employee’s income. But the payments must also be reasonable compensation in order to be deductible.

3. If the plan is "funded", the employee’s right to benefits must be subject to a substantial risk of forfeiture (i.e., conditioned on future services) and it must not be transferable. Otherwise, the benefits become currently taxable.

4. The employer can pick and choose which employees to benefit. However, if they are not part of a select group of highly compensated or management employees, the plan may be subject to ERISA’s requirements.

5. Permitted distribution events are limited to separation from service, death, disability (generally defined as 12 months), a specified time or fixed schedule, change in control, or unforeseen emergency. Neither the employee nor the employer can accelerate benefits, but acceleration of vesting is permitted.

Informal Funding with Life Insurance.

As mentioned above, in order to defer the income tax to the employee (until the benefits are actually paid) the NQDC plan must be unfunded. However, that does not mean that the employer may not set aside a reserve fund to meet its future obligations under the NQDC plan. It simply means that such fund must remain a general asset of the employer and, therefore, subject to the claims of the employer’s creditors.

Cash value life insurance is an excellent vehicle to "informally" fund an NQDC plan. Life insurance is unique in that it can provide the funds for a pre-retirement death benefit under the plan, help recover the plan costs, or both. The cost recovery results from the income tax-free death proceeds being paid out in benefits that are tax deductible to the employer. Life insurance also provides tax deferred cash value accumulation to help pay a retirement or disability benefit. By withdrawing the policy’s cash value up to the employer’s cost basis in the policy and by borrowing the excess, funds can be made available to pay benefits – income tax-free to the employer. The employer should be the owner, beneficiary and premium payer of the policy.

THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION.