Posted on Jan 17, 2017

Given the role that deferred compensation plans play in attracting and retaining executives and key employees, it’s important that the non-qualified plans operate according to applicable law and are designed in a way that maximizes value to participants. Unfortunately, because these plans can be complex, compliance errors, as well as administration and communication mistakes, can easily occur, negating the advantages that companies intended to provide.

Typical Non-Qualified Plans

Non-qualified deferred compensation (NQDC) plans typically fall into four categories, according to the IRS:

1. 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.

2. Bonus Deferral Plans resemble salary reduction arrangements, except they enable participants to defer receipt of bonuses.

3. Top-Hat Plans (also known as Supplemental Executive Retirement Plans or SERPs) are NQDC plans maintained primarily for a select group of management or highly compensated employees.

4. Excess Benefit Plans are NQDC plans that provide benefits solely to employees whose benefits under the employer’s qualified plan are limited by tax code section 415.

Note: Despite their name, phantom stock plans are NQDC arrangements, not stock arrangements.

The Legal Requirements

Although non-qualified deferred compensation plans are not qualified, they must follow the guidelines of Internal Revenue Code Section 409A. This tax code section covers the timing of non-qualified plan elections, funding, distributions and documentary compliance requirements.

Regulations under Section 409A are lengthy and complex. Failure to follow them can wipe out the intended tax breaks of income deferral under a non-qualified arrangement. Noncompliance can also subject amounts to a 20 percent tax penalty and interest.

Choosing the right investment vehicles for a non-qualified deferred compensation plan is critical because mistakes can result in trouble with the IRS, as well as the possibility of underperformance. If the plan is set up to mirror the company’s 401(k) plan, with administration by the plan vendor, tax problems can occur when participants reallocate their investments.

Regardless of who administers the plan, investment choices should reflect the diversification that is usually desired by top earning executives, with attention paid to avoiding investment vehicles that may appear attractive but may have unintended tax consequences. The services of an investment professional knowledgeable in non-qualified deferred compensation plans can be invaluable in avoiding pitfalls in this area.

Because non-qualified deferred compensation plan participants are high-level employees, a company sometimes assumes that they readily understand the plan. Therefore, the company may not make the same communication efforts that are generally undertaken with plans for rank-and-file employees.

Don’t underestimate the importance of clear, thorough and up-to-date communications. Participation can be hampered if eligible executives don’t understand the plan benefits. Even if executives do participate, poor communications can result in misunderstandings and, sometimes, lawsuits.

Participants should know what they have coming to them and any risks associated with participation, such as the status of their non-qualified benefits if the company becomes insolvent or what if their employment terminates before retirement.

In addition to educating executives about the plan, the sponsoring company must ensure that it realizes the full extent of the obligations the plan is creating down the road. If not managed properly, promises made to today’s executives can become burdensome to tomorrow’s shareholders, drain future corporate coffers and put a strain on the ability of the company to remain competitive in its industry.

Non-qualified deferred compensation plans can certainly enhance a company’s executive pay package and thus be an excellent executive recruitment and retention tool. However, common and easily made mistakes can turn what should be an advantage into a quagmire of unintended consequences.

Careful strategic planning, regular reviews and the assistance of qualified tax and legal counsel can help to avoid errors in compliance, administration and communications. Contact your CJ Benefit Plan Advisor with any questions.