What is ERISA?
ERISA stands for the Employee Retirement Income Security Act
of 1974, landmark legislation that protects workers' retirement benefits. ERISA
contains complex rules governing participation, vesting, funding, reporting,
disclosure, administration, and fiduciary activities. While ERISA governs most
qualified retirement plans, NQDC plans can be structured to avoid almost all ERISA requirements.
What is IRC Section 409A?
Section 409A is a provision of the Internal Revenue Code
that provides specific rules relating to deferral elections, distributions, and
funding that apply to most NQDC plans. If your plan fails to comply with
Section 409A requirements, your employee's NQDC plan benefits may become
immediately taxable and subject to significant penalties and interest charges.
It is very important for you to be aware of and follow the rules in IRC Section
409A when establishing or maintaining an NQDC plan.
Nonqualified Deferred Compensation (NQDC) Plans: A Primer for Business Owners
A nonqualified deferred compensation (NQDC) plan is an
arrangement between an employer and one or more employees to defer the receipt
of currently earned compensation. You might want to establish an NQDC plan to
provide your employees with benefits in addition to those provided under your
qualified retirement plan, or to provide benefits to particular employees
without the expense of a qualified plan.
NQDC plans vs. qualified plans
A qualified plan, such as a profit-sharing plan or a 401(k)
plan, can be a valuable employee benefit. A qualified plan provides you with an
immediate income tax deduction for the amount of money you contribute to the
plan for a particular year. Your employees aren't required to pay income tax on
your contributions until those amounts are actually distributed from the plan.
However, in order to receive this beneficial tax treatment, a qualified plan
must comply with strict and complex ERISA and IRS rules, and the plan must
generally cover a large percentage of your employees. In addition, qualified
plans are subject to a number of limitations on contributions and benefits.
These limitations have a particularly harsh effect on your highly paid
In contrast, NQDC plans can be structured to provide the
benefit of tax deferral while avoiding almost all ERISA burdensome
requirements. There are no dollar limits that apply to NQDC plan benefits
(although compensation must generally be reasonable in order to be deductible).
And you can provide benefits to your highly compensated employees without
having to provide similar benefits to your rank-and-file employees.
Funded vs. unfunded NQDC plans
NQDC plans fall into two broad categories — funded and
unfunded. An NQDC plan is considered funded if you have irrevocably and
unconditionally set aside assets with a third party (e.g., in a trust or escrow
account) for the payment of NQDC plan benefits, and those assets are beyond the
reach of both you and your creditors. In other words, if participants are
guaranteed to receive their benefits under the NQDC plan, the plan is
You might consider establishing a funded plan if your
employees are concerned that their plan benefits might not be paid in the
future due to a change in your financial condition, a change in control, or
your change of heart. Because the assets in a funded plan are beyond your
reach and the reach of your creditors, these plans provide employees with
maximum security that their benefits will eventually be paid. Funded plans are
rare, though, because they provide only limited opportunity for tax deferral
and may be subject to all ERISA requirements.
Unfunded plans are by far more common because they can
provide the benefit of tax deferral while avoiding almost all ERISA
requirements. 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 ("informal
funding"), with the property remaining part of your general assets and subject
to the claims of your general creditors. You can set up a trust ("rabbi trust")
to hold plan assets, but those assets must remain subject to any claims of your
bankruptcy and insolvency creditors. A rabbi trust can protect your employees
against your change of heart or change in control, but not against a change in
your financial condition leading to bankruptcy.
In order to achieve the dual goals of tax deferral and
avoidance of ERISA, your NQDC plan must be both unfunded and maintained solely
for a select group of management or highly compensated employees. These
unfunded NQDC plans are commonly referred to as "top-hat" plans.
While there is no formal legal definition of a "select group
of management or highly compensated employees," it generally means a small
percentage of the employee population who are key management employees or who
earn a salary substantially higher than that of other employees.
Income tax considerations
Generally, you can't take a tax deduction for amounts you
contribute to an NQDC plan until your participating employees are taxed on those
contributions (which can be years after your contributions have been made to
Employees generally don't include your contributions to an
unfunded NQDC plan, or plan earnings, in income until benefits payments are
actually received from the NQDC plan. The taxation of funded NQDC plans is more
complex. In general, your employees must include your contributions in taxable
income as soon as they become nonforfeitable (i.e., as soon as they vest). The
taxation of plan earnings depends on the structure of the plan; in some cases,
employees must include earnings in current taxable income currently, and in some cases
earnings aren't taxed until they're actually paid from the plan.
Who can adopt an NQDC plan?
NQDC plans are suitable only for regular (C) corporations.
In S corporations or unincorporated entities (partnerships or proprietorships),
business owners generally can't defer taxes on their shares of business income.
However, S corporations and unincorporated businesses can adopt NQDC plans for
regular employees who have no ownership in the business.
NQDC plans are most
suitable for employers that are financially sound and have a reasonable
expectation of continuing profitable business operations in the future. In
addition, since NQDC plans are more affordable to implement than qualified
plans, they can be an attractive form of employee compensation for a growing
business that has limited cash resources.
Types of plans
Because an NQDC plan is essentially a contract between you
and your employees, there are almost unlimited variations. Most common are
deferral plans and supplemental executive retirement plans (also known as
SERPs). In a deferral plan, your employees defer the payment
of current compensation (e.g., salary or bonus) to a future date. A SERP is
typically designed to supplement your employees' qualified plan benefits (for
example, by providing additional pension benefits).
How to implement an NQDC plan
An ERISA lawyer can guide you through the maze of legal and
tax requirements, and draft the plan document. Often the board of directors or
compensation committee must approve the plan. Your accountant or consulting
actuary can help you decide how to finance the plan. If you choose an unfunded
plan, almost all that ERISA requires is that you send a simple statement to the
Department of Labor informing it of the existence of the plan and the number
Advantages of NQDC plans
- Easier and less expensive to implement and maintain than
a qualified benefit plan
- Can be offered on a discriminatory basis
- Can provide unlimited benefits
- Allows you to control timing and receipt of benefits
- Enables you to attract and retain key employees
Disadvantages of NQDC plans
- Employee taxation controls timing of your tax deduction
- Lack of security for employees in an unfunded plan
- Generally not appropriate for partnerships, sole
proprietorships, and S corporations
- Generally more costly to employer than paying