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Non-qualified Deferred Compensation Plans

Non-qualified Deferred Compensation Plans

Qualified pension plans have many tax advantages but some disadvantages for employers and highly compensated employees (HCEs) or entrepreneurs. For companies, qualified pension plans require non-discrimination rules and minimum coverage and require rigorous testing to ensure that rank and file employees are not discriminated against in favor of key employees. Cons for key employees include:

  • Annual contribution limits.

  • Minimum distributions are required after reaching a certain age.

  • A 10% fine for early withdrawal.

As a result, some employers use an nonqualified deferred compensation plan for their primary employees. The main objective of using deferred compensation plans instead of qualified retirement plans is not to be subject to ERISA (Employee Retirement Income Security Act) restrictions limiting the amount that can be deferred and prohibits favoring key employees over rank and file employees. However, the Employee Retirement Income Security Act does not apply to most government and church plans nor plans for the unemployed, such as business managers, sole proprietors, or partners.

Non-qualified deferred compensation is earned in one year, but it is received the following year. This is a contractual agreement in which the participant agrees to receive part of his/her remuneration in a future year for the services provided in that year. The employer cannot subtract the compensation as wages until it is received as the employee's taxable income. IRC §409A lists election, distribution, and deferred funding rules that apply to most non-qualified deferred compensation plans. The non-qualified deferred compensation plan must comply with IRC §409 (a); otherwise, the deferred compensation may be subject to an added tax of 20% and an interest rate on the 1% higher than the regular rate. Additionally, if the plan does not comply with Section 409A at any time of the year, any lossless claim that has not been included in the gross income plan for all years may be includable in the year of non-compliance.

Deferred compensation is usually placed in a bank account, life insurance product, or other money market instrument with accrued interest during the holding period. The employer must continue to pay income taxes each year and capital taxes when compensation is deferred. When employees finally receive compensation for deferred wages plus earnings, the company can deduct the full amount paid to the employee. The compensation will be acknowledged as taxable income when the employee receives it.

There is more flexibility in non-qualified deferred compensation plans because they do not have to comply with most tax rules that apply to tax benefit accounts. Additionally, NON-QUALIFIED DEFERRED COMPENSATION plans have lower administration costs because there is no discrimination or compliance testing. Nonqualified plans are often offered to primary owners or employees as an employment tool. Although they do not enjoy the tax benefits of ERISA accounts, they can still save the current company a significant amount of money instead of providing all employees with a qualified retirement plan, which would be necessary for qualified ERISA plans.

The main benefit of non-qualified deferred compensation plans for the employee is that the deferred income can reduce the marginal tax rate for the current year and allow the member to receive deferred income later, when the income may be lower and therefore subject to quota taxation. Also, the alternative minimum tax debt can be eliminated now and in the years to come. However, taxes under the Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA) must be paid when you earn income or when there is no possibility of losing income. Also, no loans are allowed, and the money cannot be transferred to another retirement account or an IRA when the compensation is paid.

Distributions can be planned before retirement, and deferrals can be changed from year to year. Distributions depend on the trigger event specified in the plan, typically retirement, but can also include death, disability, emergency, or the business changes owners. Nonqualified deferred compensation plans also include pre-retirement death or disability provisions in which the money would have been paid to the participant or his/her heirs.

The American Job Creation Act, 2004 required companies with non-qualified deferred compensations to report deferred income to the IRS per the outline of Form W-2, Wages and Taxes Return or Form 1099-MISC, even if the compensation is not the taxable year. The law also prohibits employers from using offshore funds to fund deferred compensation.

For business owners, non-qualified deferred compensation plans can defer taxes only for C corporations. With other types of businesses, such as S corporations, proprietorship, or partnerships, since business income is automatically transferred to the business owners, such income is constructively received by the owners and is taxable. However, other commercial entities may offer non-qualified deferred compensation plans to non-business owners.

Two main rules determine whether deferred income is taxable for the employee: the economic benefit rule and the constructive receipt rule. The result of these two rules is that the deferred remuneration becomes taxable by the employee and also deductible by the employer when the employee benefits from or receives the remuneration constructively.


Economic Benefit Rule

The economic benefit rule (IRC §83) provides that the income is taxable for the employee when there is no substantial loss or transferable risk. The employer can maintain a substantial risk of loss by using performance thresholds, longer vesting schedule, salary limits, or conditions. The employee does not receive compensation, for example, if the employee leaves at a certain time or goes to work for a competitor.

Also, income is only taxable if the non-qualified deferred compensation account's current value can be determined. If the exact amount is known and there is no risk of loss for the employee, the employer can deduct the allowance from his taxes, and the employee must pay income tax in the year received. Therefore, even if the money is transferred to a trust, where distributions can only be made to the employee, the income is taxable to the employee because it has a verifiable economic benefit and is not taxable; there is no substantial risk of loss.


Constructive Receipt Rule

The constructive receipt rule [IRC §451(a)] provides that income is taxable to an employee when it is implicitly received, meaning that the money is available to the employee, whether he/she is receiving it or not. The constructive receipt rule prevents an employee from choosing to receive payment now or later. Therefore, if an executive can choose the timing of his/her bonus, then the bonus will be taxable the first time the executive can receive it. If the taxpayer does not pay taxes on the income constructively received, he will have to pay regular income taxes and a 20% fine.

To defer the taxation of compensation per the constructive receipt rule, the employee must elect to defer the compensation to be earned into a future year. If the deferral option is made within the calendar year prior to earning the income, the constructive receipt rule will not apply. It will also not apply if compensation is received within 2.5 months of the year in which the participant is entitled to compensation. Additionally, the employee may not be eligible to receive payment prior to the due date under the non-qualified deferred compensation plan.


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