Nonqualified deferred compensation agreements.

Over the last several years, changes in the tax law have increased the overall taxation of high income individuals and have made it more difficult to avoid larger tax liabilities. One of the few devices still available is the nonqualified deferred compensation agreement.

DEFINITION

A nonqualified deferred compensation agreement is a contract under which an employee or independent contractor agrees to be paid in the future for services currently rendered to an employer. Payments generally start on pre-retirement death or disability or termination of employment (usually retirement) when the taxpayer will be in a lower marginal tax bracket.

TYPES OF AGREEMENTS

Elective deferral plans involve deferring some portion of salary or other form of compensation, based on a deferred amount plus an interest factor, elected before the income is earned and fully vested and payable in the event of pre-retirement termination of employment for virtually any reason. Nonelective plans, often used by larger businesses for key employees, are typically set up as additional compensation, not reducing current compensation, based on salary for a specified number of years and including a substantial risk of forfeiture if the employee leaves his or her position.

ERISA CONSIDERATIONS

Because these agreements involve the deferral of income and a benefit payable after retirement or termination of employment, they are subject to the provisions of the Employee Retirement Income Security Act of 1974 (ERISA). As such, these plans may be subject to burdensome and expensive compliance requirements, but there are two exceptions.

A "top-hat" plan, unfunded and maintained primarily for a select group of management or highly compensated employees, is exempt from many ERISA requirements, although it is still subject to reporting and disclosure rules. However, the determination of which employees can make up this "select group" is not clearly defined and may be subject to question.

An excess benefit plan is maintained by an employer to provide benefits for certain employees in excess of the Internal Revenue Code's limits for qualified plans. While ERISA's participation and funding standards do not apply, if the plan is funded many other requirements are applicable, thereby lessening its appeal and use.

TAX CONSIDERATIONS

Under a proper plan, the employee receives only an unsecured promise from the employer to pay benefits in the future. As long as the employee's contractual rights cannot be assigned, such rights will not be considered a cash equivalent and will not be currently includable in income.

Similarly, a mere promise to pay benefits, not represented by notes or secured in any way and payable only out of the employer's general assets, will not be considered constructively received by the employee.

Payments under these plans also may be subject to taxation under an economic benefit doctrine; even if the employee had no actual or constructive right to assets, if (and to the extent that) money or property was legally set aside from the claims of an employer's creditors, the value could be taxable to the employee. To avoid this, the employer's obligation can be financed through life insurance or annuity contracts. The policy or contract must be the sole property of the employer and must constitute a general asset subject to claims by its creditors. Another method is the establishment of a "rabbi" trust, under which the assets placed in trust remain subject to claims by the employer's general creditors should the employer become insolvent or file for bankruptcy.

POSSIBLE USES

Deferred compensation plans may play a larger role in providing compensation and retirement benefits by serving as supplements to qualified plans, inducements for recruiting and retaining key employees and incentives for early retirement.

At the same time, the use of these plans may add complexity, risk, loss of other benefits and more burdens. Consider the advantages and disadvantages carefully before making any decision.

For a detailed discussion of these plans and their ramifications, see "Nonqualified Deferred Compensation Agreements," by Mark Altieri and David Kirch, in the August 1995 issue of The Tax Adviser.