A nonqualified deferred compensation (NQDC) plan is an elective or non-elective plan, agreement, method, or arrangement between an employer and an employee (or service recipient and service provider) to pay the employee or independent contractor compensation in the future. In comparison with qualified plans, NQDC plans do not provide employers and employees with the tax benefits associated with qualified plans because NQDC plans do not satisfy all of the requirements of IRC § 401(a).
Under a nonqualified plan, employers generally only deduct expenses when income is recognized by the employee or service provider. In contrast, under a qualified plan, employers are entitled to deduct expenses in the year contributions are made even though employees will not recognize income until the later years upon receipt of distributions.
Despite their many names, NQDC plans typically fall into four categories.
- Salary Reduction Arrangements simply defer the receipt of otherwise currently includible compensation by allowing the participant to defer receipt of a portion of his or her salary.
- Bonus Deferral Plans resemble salary reduction arrangements, except they enable participants to defer receipt of bonuses.
- Top-Hat Plans (aka Supplemental Executive Retirement Plans or SERPs) are NQDC plans maintained primarily for a select group of management or highly compensated employees.
- Excess Benefit Plans are NQDC plans that provide benefits solely to employees whose benefits under the employer’s qualified plan are limited by IRC § 415.
Despite their name, phantom stock plans are NQDC arrangements, not stock arrangements.
Unfunded V. Funded Plans
NQDC plans are either funded or unfunded, though most are intended to be unfunded because of the tax advantages unfunded plans afford participants.
An unfunded arrangement is one where the employee has only the employer’s “mere promise to pay” the deferred compensation benefits in the future, and the promise is not secured in any way. The employer may simply keep track of the benefit in a bookkeeping account, or it may voluntarily choose to invest in annuities, securities, or insurance arrangements to help fulfill its promise to pay the employee. Similarly, the employer may transfer amounts to a trust that remains a part of the employer’s general assets, subject to the claims of the employer’s creditors if the employer becomes insolvent, in order to help keep its promise to the employee. To obtain the benefit of income tax deferral, it is important that the amounts are not set aside from the employer’s creditors for the exclusive benefit of the employee. If amounts are set aside from the employer’s creditors for the exclusive benefit of the employee, the employee may have currently includible compensation.
A funded arrangement generally exists if assets are set aside from the claims of the employer’s creditors, for example in a trust or escrow account. A qualified retirement plan is the classic funded plan. A plan will generally be considered funded if assets are segregated or set aside so that they are identified as a source to which participants can look for the payment of their benefits. For NQDC purposes, it is not relevant whether the assets have been identified as belonging to the employee. What is relevant is whether the employee has a beneficial interest in the assets, such as having the amounts shielded from the employer’s creditors or the employee has the ability use these amounts as collateral. If the arrangement is funded, the benefit is likely taxable under IRC §§ 83 and 402(b).
NQDC plans may be formal or informal, but they must be in writing. While many plans are set forth in extensive detail, some are referenced by nothing more than a few provisions contained in an employment contract. In either event, the form (in terms of plan language) of a NQDC arrangement is just as important as the way the plan is carried out. Review the plan documents to identify provisions that fail to comply with the requirements of IRC § 409A (document compliance). The NQDC plan must also comply with the operational requirements applicable under IRC § 409A(a) (operational compliance). That is, while the parties may have a valid NQDC arrangement on paper, they may not operate the plan according to the plan’s provisions.
A NQDC plan examination should focus on when the deferred amounts are includible in the employee’s gross income and when those amounts are deductible by the employer. Two principle issues stemming from deferred compensation arrangements include the doctrines of constructive receipt and economic benefit. The Examiner should also address if deferred amounts were properly taken into account for employment tax purposes. The timing rules for income tax and for FICA/FUTA taxes are different. Each of these concerns is discussed below.
It is important to note that § 885 of the American Jobs Creation Act of 2004 changed the rules governing NQDC arrangements significantly. See § VI in the General Audit Steps below.
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