A nonqualified deferred compensation (NQDC) plan is an arrangement between an employer and an employee to defer the receipt of currently earned compensation. While NQDC plans do not have the tax-favored benefits of qualified retirement plans, most NQDC plans do not have to comply with the participation, vesting, funding, distribution, and reporting requirements that apply to qualified plans. This makes NQDC plans a flexible form of employee compensation, allowing you to tailor a plan to both you and your employee’s needs.
Funded vs. Unfunded Plans
NQDC plans fall into two broad categories—funded plans and unfunded plans:
Funded Plans
A NQDC plan is funded if assets have been irrevocably and unconditionally set aside with a third party for the payment of NQDC plan benefits (for example, in a trust or escrow account) and those assets are beyond the reach of both you and your general creditors. In other words, if participants are guaranteed to receive their benefits under the NQDC plan, the plan is considered funded. Funded plans are generally subject to ERISA requirements, and provide limited opportunity for tax deferral.
Unfunded Plans
With an unfunded plan, you don’t formally set aside assets to pay plan benefits. Instead, you either pay plan benefits out of current cash flow (“pay-as-you-go”) or you earmark property to pay plan benefits, with the property remaining part of your general assets, subject to the claims of creditors. Unfunded plans are much more common than funded plans because they provide greater opportunity for tax deferral, and are subject to few ERISA requirements. To avoid ERISA, participation in unfunded NQDC plans generally must be limited to a select group of management or highly compensated employees. Such plans are commonly referred to as “top-hat plans.”
Advantages
- Helps attract and retain key employees
- Can supplement a qualified retirement plan
- Flexible—can be offered to a select group of employees
- Unfunded NQDC plans are subject to fewer requirements than qualified retirement plans
- Unfunded NQDC plans provide opportunity for participants to defer taxes
- Can provide potentially unlimited benefits
- You control timing and receipt of employee’s benefits
Disadvantages
- Generally no tax deduction until employees recognize income
- Unfunded plans provide little security to employees—just a promise to pay future benefits (use of a rabbi trust can protect against “change of heart” or a change in control)
- Funded plans secure benefits, but are subject to ERISA requirements and offer little tax benefit
- NQDC plans can benefit employees of partnerships, S corporations, and sole proprietorships, but generally not the owners
- NQDC plans are subject to the complex requirements of IRC Section 409A
If you have questions, contact our experts: experts@henssler.com or 770-429-9166.