Executive Compensation Tools: A Look at the Non-Qualified Deferred Compensation Plan
There’s a good chance that organizations are going to have a recruiting and retention problem in the near future.
Right now businesses are concentrating on making it through the pandemic, but when things improve, there will be opportunities for employees to go elsewhere. Work-from-home and other flexibility policies have proven to be effective during the pandemic and may be more widely spread in the future, forcing businesses who were innovative with their work and benefits strategy to find other ways to compete for top talent. And, let’s face it — your 401(k) vesting schedule isn’t enough to keep anyone around!
Let’s talk about the Non-Qualified Deferred Compensation plan, a great tool for compensating executives and key employees. There are two parts to observe in the title:
Non-qualified, meaning it does not have to meet the majority of requirements under ERISA or IRS code that are imposed on tax-favored (“qualified”) plans.
Deferred compensation, meaning the employee has earned compensation but has not yet received it from the employer.
What is it? This is a plan that is set up to cover only a small subset of key employees — not everyone. It is inherently discriminatory by nature, so there are specific rules that need to be followed for the IRS to allow the plan to exist. In short, it’s a promise by the employer to pay certain compensation to an employee in the future.
Employees are allowed to defer part of their compensation and/or the company can contribute, much like a qualified retirement plan, and the employee receives that compensation later in the future, according to the terms of the plan. In the meantime, the employee does not pay taxes on the deferred compensation and gets tax-deferred growth on it. The key difference is the money stays on the company books as an asset belonging to the company and is technically “at risk,” meaning if the company ends up in financial difficulty or bankruptcy, those assets are up for grabs by creditors.
This type of plan is incredibly flexible in design. There’s no discrimination testing or annual reporting requirements. The corporation is allowed to fund the plan with bonuses or a match or other contributions and gets to decide under what circumstances the employee receives those contributions. The employee can elect to contribute as well if the plan allows for it. This is a way for a company to promise to pay more compensation in the future or when certain milestones are reached. As you might suspect, there is a plan document that governs the provisions of the plan, including conditions of how the compensation is earned and the timing of the payout.
Other design features like vesting or payout schedules can be set to drive certain behavior, such as encouraging staying employed for a particular period of time. Employers can make it less appealing for employees to leave their employment due to the amount of money they’d be leaving behind (i.e. golden handcuffs), making this an ideal benefit for their retention strategy.
Retention is one of the main reasons for an NQDC plan, but other reasons it is put in place include:
Helping key employees save more. At a certain point, it becomes mathematically impossible for a highly paid employee to save enough in a qualified plan to replace their income in retirement. These plans help bridge the savings gap. If the 401(k) or other qualified plan is failing nondiscrimination testing, the NQDC plan allows employees to save the contributions they would have received in refunds or allows the company to restore matching benefits the employee would be unable to receive due to testing or compensation limits.
Tax control. For situations where employees have fluctuating income or particular savings goals, this is a way for them to control when or how much they are paid and thus control their annual tax bill now or in retirement.
Ownership strategy. ESOP or other employee ownership scenarios may not be advantageous to the company, but this type of plan is a way to create an ownership experience without dilution through phantom shares, facilitate change in control events such as a sale to insiders or outside companies, or enhance compensation dependent on company profits or value.
These types of plans have clear advantages for employers in both retaining and recruiting top talent, and are perceived as a valuable benefit by employees. The downside (it’s all relative) to employers is that corporation doesn’t get the tax deduction for those funds until the employee receives them. If the funds are invested, there is tax due on the gains that the corporation has to pay (S Corps, watch out). The employer needs to make sure to operate the plan within Internal Revenue Code Section 409A, and will need the assistance of outside professionals to do so. The employer maintains the cost of administering the plan; however, it is often significantly less than the cost of a qualified plan.
What’s the downside for the employees? The employee benefits from reduced taxable income and possibly a lower tax bracket than they would have if they had received the compensation. There are also strict rules on when the compensation can be received which are governed by the rules in the plan document. Employees do not get the benefit of choosing when to liquidate, for example when the market looks high instead of low. There are also no ERISA protections for employees on the funds (subject to creditors) and no early withdrawal options, such as loans or certain hardship withdrawals.
You might be asking what’s happening with these plans now. Do consider that they are technically “unfunded,” which means that corporations do not have to make real contributions — the liability is still maintained on the books. IRS Notice 2050 clarified coronavirus distribution eligibility for CARES Act, and under Section 409A of the Internal Revenue Code, an employer may cancel an employee’s deferral election under its nonqualified deferred compensation plan if the employee takes a hardship distribution from its qualified retirement plan. The Notice provides that the new coronavirus distribution is treated as a hardship withdrawal for purposes of this rule, and the employer may cancel deferral elections under their nonqualified plans for employees that take a coronavirus distribution from their 401(k) plan account. As always, seeking the advice of professionals and legal counsel is advised.
The key takeaway is that the NQDC plan is an extremely flexible tool that companies have for recruiting and retaining top talent. If this is something you think your company can benefit from and want more information, reach out and book a call with us to discuss.