Nonqualified deferred compensation.

A nonqualified deferred compensation plan is any plan that provides deferred compensation to employees and does not fall under the rigorous Internal Revenue Code rules for qualified plans.

Establishing a Nonqualified Deferred Compensation Plan The key to any nonqualified arrangement is that the compensation is not taxable until constructively received by the employee. Constructive receipt is defined as the time at which the right to receive or transfer an interest in the amount by the employee is controllable by the employee. In other words, the employee must include the amount in his income when the barriers to receiving the amount (such as the performance of substantial services) are removed.

There are two major categories of nonqualified deferred compensation plans, funded and unfunded. An unfunded deferred compensation arrangement is simply an unsecured promise to pay the employee a specific amount of compensation for services prior to the performance of the services. The agreement may be part of a plan or simply part of an individual's compensation arrangement. Since the compensation is unfunded and unsecured, there is usually no difficulty in avoiding constructive receipt and therefore deferring taxation.

For deferred compensation plans, the IRS has specified certain requirements in Rev. Proc. 92-65 that it will consider in determining if an unfunded plan is valid. Under these criteria, it is possible to set aside assets to pay for an unfunded plan, despite the fact that it remains unfunded. Since careful planning is required to avoid taxation at the time the funds are set aside, these criteria are important to follow in setting up an unfunded plan:

[] The eligible employees must elect the deferral of a certain portion of their compensation before the period of service, typically a calendar year. If the election is not on the calendar year, it must be made before the period of service covered by the deferred compensation plan.

[] The plan must define the time and method for payment of deferred compensation for each event (such as termination of employment, regular retirement, disability retirement or death) that entitles a participant to receive benefits. The plan may specify the date of payment or provide that payments will begin within 30 days after the occurrence of a stated event.

[] The plan may provide for payment of benefits in the case of an "enforceable emergency." "Unforeseeable emergency" must be defined in the plan as an unanticipated emergency caused by an event beyond the control of the participant or beneficiary, and that would result in severe financial hardship to the individual if early withdrawal were not permitted. The plan must further provide that any early withdrawal approved by the employer is limited to the amount necessary to meet the emergency.

[] The plan must provide that participants have the status of general unsecured creditors of the employer and that the plan constitutes a mere promise by the employer to make benefit payments in the future. If the plan refers to a trust, the plan must also provide that any trust created by the employer and any assets held by the trust to assist it in meeting its obligations under the plan will conform to the terms of the model trust. Generally, setting aside the funds for paying an unfunded arrangement in an irrevocable trust (a rabbi trust) is used.

[] The plan must state that it is the intention of the parties that the arrangements be unfundded for tax purposes and for purposes of Title I of ERISA.

[] The plan must provide that a participant's rights to benefit payments under the plan are not subject in any manner to anticipation, alienation, sale, transfer, assignment, pledge, encumbrance, attachment or garnishment by creditors of the participant or the participant's beneficiary.

A funded deferred compensation plan sets aside assets not subject to the employer's creditors for the employees. The typical funding vehicles for these plans are trusts, annuities, insurance contracts and escrow accounts. Income tax on the compensation is deferred as long as the employees' rights to the assets are nontransferable and subject to forfeiture. As the employee meets the requirements to receive the deferred compensation, the employee vests in the assets and reports taxable income. A funded plan is useful when the employees will not vest in the compensation for a number of years.

Advantages and Disadvantages of Nonqualified Deferred Compensation Plans

The advantage to employees is that they may elect to defer income subject to taxation to future years. The plan can be flexible enough to allow each employee to choose the length of deferral and the amount and type of compensation to be deferred, as well as allow them to elect in and out of the plan each year. This flexibility is especially helpful to employees if they want to shift income from a high-earning time frame to a low-earning period (such as their retirement years). The earnings on the deferred income can also be deferred so that the investment grows at a pretax rate until the amount is ultimately received by the employee and recognized into income.

A disadvantage to the employee is that the deferred compensation is not easily available to the employee. Any draws on the compensation must first be approved, and they become immediately taxable. Also, unless undue hardship is the reason for the withdrawal, a penalty must be imposed. Usually, this penalty will be in the form of disallowing the individual from further participation in the plan for a specified period of time. Finally, deferred income is unsecured in unfunded deferred compensation plans. It must be taken into account that amounts placed into the plan for the employee are subject to claims from the company's creditors.

One advantage of nonqualified deferred compensation plans for the company is that, unlike qualified plans, the company may limit the individuals eligible for the deferred compensation arrangement. The company may also influence the amount and type of compensation to be deferred, as well as the deferral period. Another advantage to the company is that nonqualified plans are exempt from many of the rules of ERISA, thus saving the company from compliance with all but the most minimal of reporting requirements.

The disadvantage to the company is that, until the compensation is paid and reported by the employee as income, a compensation deduction is not allowed for Federal income tax purposes. Since the deferred compensation is essentially still held by the company, the company is liable for the taxes on any amounts earned in the plan.

Despite the disadvantages, nonqualified deferred compensation plans are an extremely useful and popular tool for companies to assist highly compensated employees in deferring income to future years. The ability of employees to plan their recognition of taxable income to meet their financial objectives is an advantage that typically far outweighs the disadvantages. For the company, non-qualified deferred compensation plans are often a low-cost option for providing a fringe benefit to top management and key employees.