Nonqualified Deferred Compensation
©2013 by Michael Gray, CPA
With the increases in individual income tax rates for high-income taxpayers enacted in the American Taxpayer Relief Act of 2012 (Fiscal Cliff legislation) and the 3.8% Medicare surtax on investment income, both effective January 1, 2013, high-income taxpayers will be seeking alternatives to keep their income below the thresholds, including deferring income to retirement years when their income may not be so high.
The first alternative is to use a qualified retirement plan, such as a 401(k) plan or profit sharing plan. The advantage of these plans is the contribution to the plan is tax deductible for the employer and tax-deferred for the employee. (Contributions to Roth 401(k) accounts aren’t tax-deferred for the employee.) The disadvantages are there are limitations on the amount of the contributions and the plans must be nondiscriminatory. Since most employees must participate, qualified plans are expensive for businesses with many employees.
Another alternative is nonqualified deferred compensation.
Benefits from nonqualified deferred compensation plans aren’t tax deductible for the employer until they are paid to the employee (or successor). The earnings on amounts set aside for these plans is taxable to the employer until the benefits are paid. These plans can be discriminatory. There is no limitation on the amount that can be deferred.
In order for the compensation to be deferred, any amounts set aside to pay the benefits must be subject to the general creditors of the employer. This means the employee has a risk that the benefits may be lost if the employer suffers a financial reversal or bankruptcy.
Special trusts, called Rabbi Trusts, have been designed to provide some protection for employees when setting aside funds for deferred compensation benefits. The plan is still subject to claims of employer creditors when these trusts are used. Offshore Rabbi Trusts no longer qualify for tax deferral.
Another type of trust for holding deferred compensation funds is called a secular trust. It is an irrevocable trust controlled by an independent trustee. Neither the employer nor its creditors have access to the trust funds. These trusts don’t qualify for tax deferral unless the employee has a risk of forfeiture (the benefits are unvested.) As the benefits vest, they become taxable to the employee. If the employee isn’t treated as the owner of the trust, both the employee and the trust could be subject to income tax on the trust’s earnings.
Before 2004, the rules for nonqualified compensation plans were informal. After the scandals and losses to employees at Enron and Worldcom, Congress enacted more formal requirements in Internal Revenue Code Section 409A, and the IRS has spelled the requirements in detail in Treasury Regulations. Section 409A is effective for amounts deferred in tax years after 2004, but deferrals made before 2004 may be subject to its rules if the plan under which the deferral was made is materially modified after October 3, 2004.
Under the Section 409A requirements, the plan must be in writing.
The time for distribution should be specified at the time of deferral. The time can be after separation from service (six months later for key employees of publicly-traded corporations), or at the death of the employee. Benefits may also be distributable when the employee is disabled.
The employee must generally elect to defer compensation before the end of the year preceding the year the services are performed, or, if later, within 30 days after the date the employee first becomes eligible to participate. Under a special rule, an election may be made at least six months before the end of the period on which the pay is based for performance-based compensation based on services performed for at least 12 months.
A severe 20% penalty is imposed on the employee when the requirements under Section 409A aren’t met.
Nonqualified deferred compensation may be subject to employment taxes like Social Security, Medicare and Federal Unemployment taxes as earned instead of when the benefits are paid. The employee may be required to pay the employee share of the taxes to the employer.
This article only includes the highlights of the benefits and requirements of nonqualified deferred compensation plans. Such a plan should be designed and implemented under the guidance of an attorney who is knowledgeable about the requirements.
With the increased tax rates from recent federal legislation and from state tax legislation like California’s Proposition 30, I expect nonqualified deferred compensation plans will become much more widely used.
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