By Sheldon M. Geller, Esq.
Nonqualified deferred compensation plans are flexible and have a wide range of purposes other than reducing tax liability. Properly designed, a deferred compensation arrangement can provide benefits comparable to those available under a qualified 401(k) plan.
Combine qualified and nonqualified plans. Coupling a nonqualified plan with a qualified 401(k) plan may help mitigate the effect of the IRC limits on the amounts that can be deferred under 401(k) plans: A highly compensated employee can defer salary into the nonqualified plan after reaching the limit on elective deferrals for a particular year under the 401(k) plan. The nonqualified plan can be designed to take into account matching contributions attributable to 401(k) contributions that are made to the nonqualified plan as a result of plan limitations. The nonqualified plan may also permit employees to irrevocably elect to receive their bonuses currently or in the form of deferred compensation. The nonqualified plan would include a “rabbi trust” in order to protect plan assets from all creditors except bankruptcy creditors.
Avoid constructive receipt of deferred compensation. The IRS has ruled that employee deferrals and employer matching contributions to a nonqualified plan do not trigger constructive receipt, and thus a taxable event, where benefits under the nonqualified plan are payable upon retirement, death, separation from service, or an unforeseen emergency and such benefits are not subject to assignment or otherwise alienable. Accordingly, deferred compensation arrangements can be an important method for compensating key personnel in both public and private companies. These arrangements do not have to meet the funding, employee coverage, and other requirements that qualified plans must satisfy under the IRC.
Employers can set up automated voice response systems and interactive websites that allow employees to direct the investment of their account balances without resulting in constructive receipt. The participant investment direction needs to be maintained as a record-keeping function; plan assets cannot be physically segregated at the trust level. The mere maintenance of “unfunded” bookkeeping accounts under a nonqualified plan created for highly compensated employees is not gross income to the participants until amounts are actually paid or made available to the participant.
Use unfunded, nonqualified plans for select personnel. ERISA exempts from virtually all of its requirements unfunded arrangements that are maintained “primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.” The employer may design a nonqualified plan to permit selective recognition of its key personnel.
Consider conditional deferred compensation. For many years, cautious counsel advised that the employee’s right to receive deferred compensation payments should be forfeitable in order to avoid the risk of current taxation. Although forfeiture provisions may no longer be necessary to avoid current federal income taxation, these provisions are desirable if the nonqualified plan includes significant employer contributions for key personnel. The nonqualified plan may provide that the employee’s right to receive deferred compensation payments attributable to employer contributions will be conditioned on the employee’s agreement to work for the employer for a specified number of years or until retirement, to render consulting and advisory services upon request, and to refrain from disclosing trade secrets or other information valuable to the business of the employer or to refrain from engaging in a competitive business.
Offer equalization for lost benefits. The nonqualified plan can be set up to provide benefit replacement to the executive for benefits lost under the 401(k) plan because of the limitations under the IRC. Furthermore, the nonqualified plan can provide benefit equalization as a result of the limitations on annual additions and compensation.
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