I understand that you are considering adopting a nonqualified deferred compensation plan for some of your highly compensated employees. This letter is in response to your request for general information on the way participants would be taxed under such an arrangement.
A nonqualified deferred compensation plan is a plan, agreement, method, or arrangement between an employer and an employee to pay the employee compensation some time in the future. Nonqualified deferred compensation plans generally fall into four categories:
- salary reduction arrangements, which defer the receipt of otherwise currently includible compensation by allowing the participant to defer receipt of a portion of his or her salary;
- bonus deferral plans, which are similar to salary reduction arrangements, except that they allow participants to defer receipt of bonuses;
- top-hat plans, also known as supplemental executive retirement plans (SERPs); and
- excess benefit plans, which provide benefits solely to employees whose benefits under the employer’s qualified plan are limited by the Code Section 415 limitations on benefits and annual additions. Because of the combined effect of the Code’s tax provisions and the requirements under the Employee Retirement Income Security Act of 1974 (ERISA), most nonqualified plans of private employers limit participation to a select group of management or highly compensated employees.
Nonqualified deferred compensation plans may be formal or informal, and they need not be in writing. Some plans are set out in extensive detail, while others are reflected by only a few provisions in an employment contract. Also, nonqualified plans may be either funded or unfunded.
An unfunded arrangement is one in which the employee has only the employer’s “mere promise to pay” the deferred compensation benefits in the future, and the promise is not secured in any way. The employer may simply keep track of the benefit in a bookkeeping account, or it may voluntarily choose to invest in annuities, securities, or insurance arrangements to help fulfill its promise to pay the employee. Alternatively, the employer may transfer amounts to a trust that remains a part of the employer’s general assets, subject to the claims of the employer’s creditors if the employer becomes insolvent (a so-called rabbi trust) to help it keep its promise to the employee. To effect an income tax deferral under any of these alternatives, it is important that the deferred amounts not be set aside from the employer’s creditors for the exclusive benefit of the employee; otherwise, the plan will be considered “funded,” and an employee may have currently includible compensation. As long as the plan is considered unfunded, the employee generally must include the deferred compensation in income for the tax year in which he or she actually receives it or the deferred amount is:
- credited to his or her account,
- set apart for the employee; or
- otherwise made available so that the employee may draw upon it at any time, or so that he or she could have drawn upon it during the tax year if notice of intention to withdraw had been given. Additional constructive receipt rules may apply.
A funded arrangement generally exists if assets are set aside from the claims of the employer’s creditors, for example in a so-called secular trust (as opposed to a rabbi trust) or escrow account. A plan is generally considered funded if assets are segregated or set aside so that they are identified as a source to which participants can look for the payment of their benefits. What matters is whether the employee has a beneficial interest in the assets. In a funded plan, employer contributions to a nonqualified plan trust are generally included in the employee’s income at the earlier of the time when the employee’s right to the deferred amount is not subject to a substantial risk of forfeiture or the time when the employee’s right to the deferred amount is freely transferable. Then, when the deferred amounts are actually distributed to the employee, they are subject to tax under the annuity rules. The income inclusion rules are different for highly compensated employees (HCEs) if one of the reasons the plan is not a qualified plan is that it fails to meet certain qualified plan coverage or minimum participation requirements. In that case, an highly compensated employees highly compensated employees (HCEs) must include in gross income for the tax year in which the trust’s tax year ends an amount equal to the highly compensated employees (HCEs) vested accrued benefit (including accrued earnings, and reduced by the highly compensated employees highly compensated employees (HCEs) basis in the contract) as of the close of that tax year of the trust.
Please call me at your convenience so we can discuss in more detail the tax implications of adopting a nonqualified deferred compensation plan.
Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.
DON FITCH, CPA
74478 Highway 111 #3
Palm Desert, CA 92260
Toll Free: (877)CPA-Help or (877)272-4357
P.S. My firm is based upon referrals. Please feel free to refer my firm to anyone you know that is looking for a new CPA and/or tax preparer. Thank you in advance.
(Updated 05022021-4 320-318)