Question:

I am the owner of a small company. I want to provide some financial incentives for my key employees without giving them an ownership interest in the company. Is there a way to do this?

Answer:

Yes. Nonqualified deferred compensation arrangements are a great way to provide retirement, incentive or other compensation for key employees in your business without giving away ownership of the business, and are a great recruiting tool for high-level employees. Unlike traditional “qualified” retirement plans, nonqualified deferred compensation arrangements can be creatively designed to fit your business needs.

“Qualified” or “Nonqualified” Plan?
The primary goal of deferred compensation plans is the deferral of taxation. Both qualified and nonqualified deferred compensation plans can achieve this goal. Aside from this important similarity, there are many differences between “qualified” and “nonqualified” plans. Nonqualified plans are best understood when compared to qualified plans.

Qualified retirement plans are designed to comply with certain provisions of the Internal Revenue Code regarding minimum employee coverage and nondiscrimination requirements, limitations on the amounts of benefits provided, minimum funding requirements and other complexities that make qualified plans expensive to implement and administer. An example of a qualified plan is a 401(k) plan. The benefit to the employer of establishing a qualified plan is that the employer may deduct amounts contributed to the plan at the time they are contributed, even though the employees are not taxed on the amounts until they are distributed from the plan.

Nonqualified deferred compensation arrangements are not subject to the same requirements as qualified plans. They can be designed to cover only a select group of employees. These plans can provide benefits in excess of the limitations imposed on qualified plans. There are no funding requirements. These arrangements can be structured in whatever form best achieves the goals of the parties. Another key difference between qualified plans and nonqualified plans is that under a nonqualified plan, the employer is not entitled to a deduction for amounts allocated to the plan until the benefits are paid out to employees.

Why Should I Consider a Nonqualified Deferred Compensation Plan?
Nonqualified deferred compensation arrangements can be designed very creatively. Similar to a traditional qualified retirement plan, reaching retirement age can trigger payment to employees. Alternatively, the arrangement can be designed as a bonus plan, and payments can be triggered if the company reaches certain performance goals. Since these plans are not subject to the same requirements as qualified plans, key employees can defer much larger amounts of compensation under the nonqualified arrangement, and the company needn’t worry about most of the compliance requirements for qualified plans.

What’s the Catch?
There are some drawbacks to nonqualified deferred compensation arrangements, and these must be examined when considering the adoption of any nonqualified plan.

Constructive Receipt
With nonqualified plans, an employee’s tax treatment is based on the doctrine of constructive receipt. Constructive receipt provides that in certain circumstances a taxpayer may be taxed on an amount prior to actually receiving the amount. To avoid constructive receipt, nonqualified plans must place limitations on an employee’s ability to receive plan benefits. Additionally, amounts set aside for the employee must remain available to the company’s creditors. This is generally accomplished through the use of a “Rabbi trust,” a trust established for the payment of benefits under a nonqualified deferred compensation arrangement.

ERISA Considerations
All retirement plans are generally subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”). ERISA is a complex statute that imposes additional requirements (beyond the Internal Revenue Code requirements discussed above) on retirement plans. However, “top hat plans” are exempt from almost all of ERISA’s substantive requirements. In order to qualify as a “top hat plan,” an arrangement must be unfunded and must be maintained by an employer primarily for a select group of management or highly compensated employees. Nonqualified deferred compensation arrangements are usually designed to fall within the “top hat plan” exception.

Summary

Nonqualified deferred compensation arrangements can be used to attract, retain, incentivize and provide retirement income and the deferral of taxation for key employees. These arrangements are exempt from most complex Internal Revenue Code and ERISA requirements, and allow flexibility in employee benefits that many employers appreciate. You may wish to contact your tax and legal advisor to determine if a nonqualified deferred compensation arrangement is appropriate for your company.
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