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NQDC

Nonqualified deferred compensation strategies

Nonqualified deferred compensation (NQDC) is an unsecured and unfunded promise to pay a future benefit for a select group of management or highly compensated employees.

There are two parts to the NQDC:

  1. The employer and employees agree to defer a portion of the  compensation to some  point in the future  (i.e., retirement), and
  2. The employer informally funds the promised benefit.

Why choose an NQDC?

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Target employer

Generally appealing to companies that:

  • Are financially strong
  • Would like to provide an incentive for key executives to stay with the company
  • Need to be selective in offering the plan

While these characteristics generally indicate an NQDC strategy may be an effective solution, additional insights will help identify which specific strategy could be most appropriate.

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Target employee

Candidates

  • Sales professionals
  • Managers Executives
  • Other highly compensated employees

Not considered candidates

  • Business owners
  • Rank-and-file employees
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Features

Employers can choose a number of different financial instruments to informally fund the NQDC plan. However, for some employers, permanent life insurance can be an attractive option. Because its cash value grows tax-deferred, the employer can access cash value in a tax-advantaged manner, and the death benefit can be income tax-free.

A bonus deferral strategy may be sought by a company:

  • Willing to provide this incentive as an additional bonus (no contribution from employee) 

An employer match strategy may be sought by a company:

  • Already offering a qualified plan, but key individuals are limited in their contributions 

A SERP or Protection SERP strategy may be sought by a company:

  • Willing to provide this incentive as an additional bonus (no contribution from employee)
  • Desiring complete control of the plan and assets
  • Seeking cost recovery of plan outlay
  • Not needing immediate tax deduction
  • Willing to fully fund the plan with company money

Key characteristics of an NQDC Strategy:

  • Reduces key employees’ current taxable income in exchange for a promise to pay benefits sometime in the future (typically retirement)
  • Effective when a company offers a qualified plan but key employees are limited in their contributions
  • May provide for golden handcuffs, allowing a company to recover all or a portion of employer’s contributions to the plan if employee leaves before a particular date
  • Companies can select specific key employees to whom it offers the plan
  • Commonly funded with permanent life insurance: Employer owns, is beneficiary of and makes annual premium payments on life insurance policy on employee

There are four basic NQDC plan designs

Number one

Employee deferral

  1. Employer agrees to provide employee with annual bonus that will be deferred, or employee may defer a portion of current salary
  2. At a future date (typically retirement), employer pays employee the deferred bonus with interest
  3. Employer may then deduct bonuses paid, and employee must report as taxable income

Bonus deferral

1. Company and key employee implement an agreement, drafted by a licensed attorney, specifying:

  • The time at which the key employee can elect to defer compensation.
  • The circumstances under which deferred compensation can be paid to the key executive (i.e., separation of service, death, disability, financial emergency, change of control of employer or a specified date).
Nqdc bonus deferral agreement

2. Company determines how the plan will be funded:

  • The plan must be unfunded in order to obtain the preferable tax and ERISA treatment.
  • The company should consider an informal funding method to meet its obligations under the plan. As an informal funding vehicle, permanent life insurance offers tax-deferred growth potential and tax-advantaged access to policy values:
    • Company is owner and beneficiary of the policy. The employee is typically the insured but has absolutely no rights or ownership in the life insurance policy.
    • Company may choose to provide NQDC retirement benefits on a tax-advantaged basis through policy loans and withdrawals.
Nqdc bonus deferral agreement serp funding

If the company chooses to pay retirement benefits using existing funds and hold the policy until the insured dies, internal gains are not taxed.

Number two

Employer match

  1. Plan is drafted outlining contribution amounts, match, vesting schedule, distribution, etc.
  2. Employee defers a portion of income or a bonus
  3. Employer provides a percentage match of employee’s deferral
  4. Employer purchases permanent life insurance to informally fund the nonqualified liability
  5. At employee’s retirement, employer pays an annual amount to employee
  6. Employer may then deduct amount paid, and employee must report as taxable income

Employer match

1. Company and key employee implement an agreement, drafted by a licensed attorney, specifying (among other provisions):

  • The time at which the key employee can elect to defer compensation.
  • The circumstances under which deferred compensation can be paid to the key executive (i.e., separation of service, death, disability, financial emergency, change of control of employer or a specified date).
  • The executive’s deferred salary.
  • The employer’s contribution.
  • A vesting schedule, if desired.
  • Notice and consent requirements.1
  • Designated beneficiaries.
NQDC employer matching contribution

2. Company determines how the plan will be funded:

  • The plan must be unfunded in order to obtain the preferable tax and ERISA treatment.
  • The company should consider an informal funding method to meet its obligations under the plan.
  • As an informal funding vehicle, permanent life insurance offers tax-deferred growth potential and tax-advantaged access to policy values:
    • Company is owner and beneficiary of the policy. The employee is typically the insured but has no rights or ownership in the life insurance policy.
    • Company may choose to provide NQDC retirement benefits on a tax-advantaged basis through policy loans and withdrawals.
NQDC bonus deferral agreement funding, cash funding, retirement benefit

If the company chooses to pay retirement benefits using existing funds and hold the policy until the insured dies, internal gains are not taxed.

1. Section 101(j) of the Internal Revenue Code (IRC) requires that an employer must provide notice and seek consent before placing life insurance on the life of an employee.

Number three

Supplemental executive retirement plan (SERP)

  1. Employer agrees to pay employee additional benefits in the form of a future retirement payment based on salary and years of service
  2. Employee receives benefits upon retiring and satisfying vesting schedule
  3. Employer may then deduct amounts paid, and employee must report as taxable income

Supplemental executive retirement plan (SERP)

1. Company and key employee implement an agreement, drafted by a licensed attorney, specifying:

  • The plan type — defined contribution or defined benefit — details of employer contributions, a method of crediting earnings and a vesting schedule if desired.
  • The benefit that will be paid to the executive at retirement.
NQDC bonus deferral agreement between employer and employee

2. Company determines how the plan will be funded:

  • The plan must be unfunded in order to obtain the preferable tax and ERISA treatment.
  • The company should consider an informal funding method to meet its obligations under the plan.
  • As an informal funding vehicle, permanent life insurance offers tax-deferred growth potential and tax-advantaged access to policy values:
    • Company is owner and beneficiary of the policy. The employee is typically the insured but has absolutely no rights or ownership in the life insurance policy.
    • Company may choose to provide SERP retirement benefits on a tax-advantaged basis through policy loans and withdrawals.
Nqdc bonus deferral agreement serp funding
Number four

Protection SERP

Combines features of endorsement split-dollar (death benefit protection for employee during working years) and SERP (employer-contributed NQDC benefit with no employee deferral)

Protection SERP

1. Company and key employee implement an endorsement split-dollar agreement, drafted by a licensed attorney, specifying:

  • The plan type — defined contribution or defined benefit — details of employer contributions, a method of crediting earnings and a vesting schedule if desired.
  • The benefit that will be paid to the executive at retirement.
NQDC bonus deferral agreement between employer and employee

2. Company determines how the plan will be funded:

  • The plan must be unfunded in order to obtain the preferable tax and ERISA treatment.
  • The company should consider an informal funding method to meet its obligations under the plan.
  • As an informal funding vehicle, permanent life insurance offers tax-deferred growth potential and tax-advantaged access to policy values:
    • Company owns and pays premiums on a life insurance policy insuring the key executive’s life. It also endorses a portion of the death benefit to the executive as a pre-retirement survivor benefit for the executive’s beneficiaries.
    • Key executive pays tax on the premium or contributes an amount equal to the reportable economic benefit for the amount of premium. The reportable economic benefit is a calculation of the tax obligation for the death benefit provided in a split dollar arrangement. It’s calculated using term life insurance rates.

If the executive dies while employed by the company, the company receives a portion of the death benefit to recover its costs; the executive’s beneficiaries receive the balance.

Key person plus

When the executive retires, the split-dollar agreement terminates. The company may use the policy cash value to pay supplemental retirement income.

NQDC bonus deferral agreement funding, cash funding, retirement benefit

Taxation

Key employee income taxes

Deferrals

  • The employer awards additional future compensation without current income taxation to the key employee.
  • Deferrals into a NQDC plan are not currently subject to income taxation.
  • The key employee may defer current compensation to lower income taxation.

NQDC benefit payments

  • NQDC benefit payments to the key employee will be subject to ordinary income taxation at the time received.
  • To avoid income taxation on the entire lump sum of the benefit, the plan may be structured to spread out benefit payments over a period of years.
  • The benefits received by the key employee each year will be subject to ordinary income tax in that year.

Survivor benefit payments

  • Survivor benefit payments to the key employee’s heirs will be subject to ordinary income taxation.
  • A life insurance policy informally funding an NQDC plan is subject to the notice and consent rules for EOLI. Failure to comply with those rules will subject the death benefit to income tax.

Withholding

  • The amount deferred is required to be taken into account for purposes of the Federal Insurance Contributions (FICA) or Federal Unemployment Tax acts (FUTA) as of the later of:
    • The date on which the services creating the right to that amount are performed, or
    • The date on which the right to that amount is no longer subject to substantial risk of forfeiture.
  • For instance, when an individual becomes vested in a plan, the NQDC benefit is no longer subject to a substantial risk of forfeiture.

Employer income taxes

When examining the tax consequences of an NQDC plan, the informal funding vehicle must be distinguished from the plan benefits promised to the key employee(s). The informal funding vehicle possesses distinct tax characteristics from the NQDC plan itself:

Deferrals/contributions

  • Any deferrals into an NQDC plan are not currently income tax-deductible.
  • Therefore, contributions will be deductible to the employer when the executive receives plan benefits.

Premium payments

  • Premium payments by the employer may not be deducted for income tax purposes.
  • Life insurance used to informally fund an NQDC plan is an asset of the employer.

Retirement benefit payments

  • The employer may take an income tax deduction for reasonable compensation paid in the year when that amount is actually paid to the key employee.
  • The compensation paid must be reasonable.

Survivor benefit payments

  • Survivor benefits paid to the beneficiaries of a deceased key employee are deductible for income tax purposes as an ordinary and necessary business expense.
  • The compensation paid must be reasonable.

Withholding

  • The amount deferred under an NQDC plan is required to be taken into account for purposes of FICA or FUTA as of the later of:
    • The date on which the services creating the right to that amount are performed, or
    • The date on which the right to that amount is no longer subject to substantial risk of forfeiture.
  • For instance, when an individual becomes vested in a plan, the NQDC benefit is no longer subject to a substantial risk of forfeiture.

Reasonable compensation

  • Even if the key employee has reported the income for tax purposes, the employer’s deduction must still fulfill one more test in order to receive an income tax deduction.
  • The payment made to the plan participant must qualify as an ordinary and necessary business expense.

Income taxes — the unfunded requirement

The NQDC plan must be unfunded. The definition of “unfunded” is critical, because it determines whether any assets purchased for meeting eventual obligations will be considered plan assets subject to current income taxation to the key employee/ participant and ERISA requirements.

Generally, the employer may meet the unfunded requirement by not dedicating funds to pay plan obligations with any specific assets. Also, the arrangement must not place the funds beyond the reach of its creditors.

It’s critical that the employer does not give the key employee any beneficial interest in any particular asset. If these guidelines are met, the plan will likely remain unfunded.

NQDC benefits

Employer

  • Selective participation
  • Golden handcuffs may be an option
  • Access to cash value
  • Retention of asset and potential recovery of costs if employee leaves the company
  • Cost control possible when employee defers salary
  • Income tax-free death benefit

Employee

  • Deferral of income taxes on bonuses
  • Tax-deferred growth
  • Overcomes qualified plan limitations
  • Supplemental retirement income

NQDC considerations

Employer

  • Deferred income tax deduction (increases current taxable income)
  • Greater administrative costs
  • Subject to 409A, as well as 101(j) Notice and Consent rules

Employee

  • Subject to creditors of employer
  • No guarantee employer will be around to pay benefit in future

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Life insurance products contain fees, such as mortality and expense charges, (which may increase over time) and may contain restrictions, such as surrender periods.

Please keep in mind that the primary reason for purchasing life insurance is the death benefit.

Additional agreements may be available. Agreements may be subject to additional costs and restrictions. Agreements may not be available in all states or may exist under a different name in various states and may not be available in combination with other agreements.

Policy loans and withdrawals may create an adverse tax result in the event of lapse or policy surrender and will reduce both the surrender value and death benefit. Withdrawals may be subject to taxation within the first fifteen years of the contract. Clients should consult their tax advisor when considering taking a policy loan or withdrawal.

The Policy Design chosen may impact the tax status of the policy. If too much premium is paid, the policy could become a modified endowment contract (MEC). Distributions from a MEC may be taxable and if the taxpayer is under the age of 59 ½ may also be subject to an additional 10% penalty tax.    

An annuity is intended to be a long-term, tax-deferred retirement vehicle. Earnings are taxable as ordinary income when distributed, and if withdrawn before age 59½, may be subject to a 10% federal tax penalty. If the annuity will fund an IRA or other tax qualified plan, the tax deferral feature offers no additional value. Qualified distributions from a Roth IRA are generally excluded from gross income, but taxes and penalties may apply to non-qualified distributions. Please consult a tax advisor for specific information. There are charges and expenses associated with annuities, such as surrender charges (deferred sales charges) for early withdrawals.

This information may contain a general discussion of the relevant federal tax laws. It is not intended for, nor can it be used by any taxpayer for the purpose of avoiding federal tax penalties. This information is provided to support the promotion or marketing of ideas that may benefit a taxpayer. Taxpayers should seek the advice of their own tax and legal advisors regarding any tax and legal issues applicable to their specific circumstances.

For financial professional use only. Not for use with the public. This material may not be reproduced in any form where it is accessible to the general public.

DOFU 9-2022

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