What is it?

1. What is it? Any employer retirement, savings, or deferred compensation plan for employees that does NOT meet the tax and labor law (ERISA) requirements that apply to qualified pension and profit sharing plans

2. When is it indicated? To provide: • deferred compensation to executives and key employees only • additional deferred compensation to executives receiving maximum qualified plan benefits • deferred compensation to select key employees with different terms or conditions than others have

3. When is it indicated? And when • executive or key employee wants to leverage employer tax savings for future benefits • employer needs to recruit, retain, reward, retire executive talent • closely-held corporation wants to attract and hold nonshareholder employees

4. Advantages • flexible plan design • minimal IRS, ERISA, and other governmental regulatory requirements to meet • tax deferral for employees • marginal tax rates has favored corporate financing of deferred compensation in lieu of cash bonuses (but not at present)

5. Advantages • employer can use as ‘golden handcuffs’ • use of informal financing arrangements (e.g. corporate owned life insurance) can provide employee with greater confidence of future payment than employer’s unsecured promise • assets set aside in some types of informal financing arrangements can still be used by corporation

6. Disadvantages • Employer’s tax deduction deferred until income taxable to employee • plans often rest on employer’s unsecured promise to pay and do not have protection of tax and labor law • accounting treatment may reduce confidentiality of arrangement

7. Disadvantages • some employers lack the structure necessary to successfully use nonqualified deferred compensation plans • S corporations • businesses that may be short-lived • tax exempt or government organizations

8. Objectives in Plan Design Employer Objectives: • hire key employees • retain key employees • provide performance incentive • control timing of and access to plan funds • tax deferral • benefit certainty • have funds available during employment to extent possible under tax law

9. Types of Benefit and Contribution Formulas Common Benefit Formulas • salary continuation formula • salary reduction formula • excess benefit plan • stock appreciation rights

10. Types of Benefit and Contribution Formulas Form of Benefits • lump sum or series of annual payments at retirement • life annuities or joint and survivor annuities • must try to avoid ‘constructive receipt’ or benefits will be taxed before received • must try to avoid penalty for accelerated payments

11. Withdrawals during employment Penalty free distributions for these events • separation from service • disability, usually strictly defined • death of employee • time specified under the plan • change in business ownership or control • unforeseeable emergency

12. Withdrawals during employment “haircut” provision no longer allowed • allowed employee to withdraw amounts from plan without restriction except for small penalty • employee could ‘rescue’ funds from failing or hostile corporate environment • Congress now deems an abuse

13. Termination of Employment Usually established in employer’s favor with benefits lost or reduced if terminate before retirement Can impose lengthy vesting schedule Often make special arrangements for disability

14. Funded vs Unfunded Plans Funded plans a plan is formally funded if employer has set aside money or property to pay plan benefits through some means that restricts access to the fund by employer’s creditors • Subject to tax and ERISA regulations • Provides employee with greater confidence of future payment

15. Funded vs Unfunded Plans Unfunded plans a plan is unfunded if the funds that the employer plans to use are accessible by employer's creditors • Avoids tax and ERISA regulations • Provides little security for employee

16. Financing Approaches • reserve account maintained by employer • employer reserve account with employee investment direction • corporate owned life insurance • Rabbi trust • third party guarantees

17. Tax Implications constructive receipt doctrine an amount is treated as received for tax purposes if ‘credited to employee account, set aside, or otherwise made available’ even if amount is not actually received economic benefit doctrine employee taxed when vested in contributions made to fund for employee even though employee cannot yet withdraw cash

18. Income Taxation of Benefits and Contributions • employees pay ordinary income tax on benefits from unfunded nonqualified deferred compensation plans in the first year in which the benefit is actually or constructively received • death benefits payable to a beneficiary from nonqualified plans are taxable as income

19. Social Security (FICA) Taxes • social security taxes payable when executive can no longer lose interest in plan • FICA taxes could become payable before year of actual receipt • social security taxable wage base has an upper limit but Medicare does not

20. Federal Estate Tax Treatment • death benefit under nonqualified deferred compensation generally included in estate of deceased at its then present value • recipient can receive an income tax deduction • payments made to spouse may qualify for unlimited marital deduction, eliminating any federal estate tax

21. Taxation of the Employer employer tax deduction delayed until compensation included in employee’s taxable income unfunded plans – year funds actively or constructively received formally funded plans – year employee becomes substantially vested Amounts deducted must be ‘reasonable’

22. ERISA Requirements Plans eligible for at least partial exemptions from ERISA requirements: • unfunded excess benefit plan • top-hat plan A plan that is not exempt must comply with most ERISA provisions for qualified plans including vesting, fiduciary, minimum funding, and reporting and disclosure

23. True or False? • Both qualified and nonqualified deferred compensation plans allow an employee to defer income tax to a future time. • A nonqualified deferred compensation plan can be designed to cover any group of employees or one employee. • All organization except closely held businesses can use nonqualified deferred compensation for executive compensation.

24. True or False? • A salary continuation plan requires no reduction in the covered employee’s salary. • Excess benefit plans are subject to Title 1 of ERISA. • Tom Jenkens, an executive at X Corp, withdrew funds from his nonqualified deferred compensation plan after an accident left him totally and permanently disabled. Tom will have to pay a penalty for this withdrawal.

25. True or False? • An employer’s creditors can access monies in a funded nonqualified deferred compensation plan. • A reserve account maintained by the employer increases benefit security for the employee. • John became vested in his nonqualified deferred compensation plan this year, but will not receive the funds until retirement. John must pay Social Security taxes this year. • All nonqualified plans are exempt from ERISA

26. Discussion Question When using a rabbi trust, what costs or risk are involved? What provisions should or should not be included?