What Is Nonqualified Deferred Compensation?

What Is Nonqualified Deferred Compensation? • An arrangement whereby an employer promises to pay an employee in the future for services rendered currently • The plan is generally set up to provide for the employee’s salary to be continued over a period of years after retirement or other termination of employment • The plan is “nonqualified” because it does not attempt to meet the stringent coverage and contribution requirements necessary to gain government approval and the very favorable tax treatment available only to qualified plans

When Is Use Of Nonqualified Deferred Compensation Appropriate? • A business does not have a government approved qualified retirement plan to offer key employees and would like to provide those key employees with retirement benefits • A business has a qualified retirement plan and would like to provide additional retirement benefits for key employees above and beyond those permissible under a qualified plan

When Is Use Of Nonqualified Deferred Compensation Appropriate? • A highly paid employee or executive would like to defer the taxation on income from peak earning years to a future date when he might be in a lower income tax bracket (e.g. retirement) • When an executive or other highly paid employee would like to use his employer to provide a forced savings program for his retirement

When Is Use Of Nonqualified Deferred Compensation Appropriate? • When the corporate rates at the top brackets are lower than individual rates at the top bracket • When there are stringent limitations on the maximum benefits under qualified plans, the use of nonqualified plans will be stimulated • An employer would like the ability to pick and choose who will be covered and determine on a person-by-person basis the benefit levels and terms and conditions of coverage

What Are The Requirements? • To successfully defer income tax and avoid constructive receipt of income • The agreement should contain a contingency that may cause the employee to forfeit rights to future payments • An employee will not be deemed to be in constructive receipt of income if • The agreement is entered into before the employee earns the compensation in question, and • The employer’s promise to pay is not secured in any way • The agreement cannot be formally funded without causing the money to be immediately taxable

What Are The Requirements? • It is permissible for a corporation to finance its obligation under the agreement by • Purchasing a life insurance contract, annuities, mutual funds, securities, or a combination thereof • Assets used to finance the employer’s obligation must remain the unrestricted property of the corporation, subject to claims of corporate creditors • Employee must not be given an interest or specific rights in the assets set aside to meet the obligation

What Are The Requirements? • Use of a “Rabbi Trust” is permissible to provide some protection of loss of benefits in the event of a hostile takeover, but does not protect against the employer’s general creditors in the case of insolvency • All agreements must now comply with the requirements of IRC Section 409A to achieve deferral and avoid penalties and interest

How Is It Done? Example: • Selected employee enters into an employment contract with his employer • Contract stipulates payments will be made to the employee or the employee’s beneficiaries in the event of death, disability, or retirement • In exchange for the employer promised benefits, the employee agrees to continue in the service of the company • Employer will purchase life insurance or other savings vehicles to provide for the required benefits • Employer maintains ownership and is the beneficiary of the life policy • Cash values can be used to pay retirement or disability benefits, and • Death proceeds can be used to make required payments to the deceased employee’s family

How Is It Done? Example: • Assume a premium of $3,300 would purchase approximately $185,000 of whole life insurance on a male age 45 • If the employee under a deferred compensation arrangement dies at age 50, after five years of premium payments the following would result • Corporation would receive $185,000 of tax free policy proceeds • Corporation would have paid five years of premiums totaling $16,500, and • Under the agreement corporation is obligated to pay the employee’s spouse $5,000 per year for 5 years, totaling $25,000 • Company’s after-tax cost of payments to deceased employee’s spouse is only $16,500 (66% of $25,000) • Result: A net gain to the company of $152,000

Tax Implications - IRC Section 409A • The American Jobs Creation Act of 2004 created new IRC Section 409A that imposes new rules on non-qualified plans: • Limitations on distributions • Limitations on deferral elections • Limitations on funding • Penalties and Interest

Tax Implications - IRC Section 409A • Limitations on Distributions • A participant may only receive a distribution of previously deferred compensation upon • Separation from service • The date the participant becomes disabled • Death • A fixed time (or pursuant to a fixed schedule) • A change in ownership or effective control of the corporation • The occurrence of an unforeseeable emergency • Key employees (IRC Section 416(i)) of publicly traded companies may not take distributions until six months after separation from service (or, if earlier, the date of death of the employee)

Tax Implications - IRC Section 409A • Limitations on Deferral Elections • Participants must generally make elections to defer compensation prior to the end of the preceding taxable year • New participants may make an election within 30 days of eligibility, but only with respect to services performed subsequent to the election • Plans may allow participants to subsequently elect to delay distributions or change the form of distributions • The new election must be made at least 12 months in advance • Any delayed distribution must occur at least 5 years from the date of the new election

Tax Implications - IRC Section 409A • Limitations on Funding • Securing or distributing deferred compensation based upon the employer’s falling net worth or other financial events is not permitted • This includes hybrid rabbi/secular trust arrangements that distribute assets from nominal rabbi trusts to secular trusts upon the occurrence of triggering events • Setting aside assets in an offshore trust to directly or indirectly fund deferred compensation is not permitted

Tax Implications - IRC Section 409A • Penalties and effective date • Any violation of the requirements results in retroactive constructive receipt of the deferred income • The previously deferred income is subject to a 20% excise tax • Interest is charged at 1% higher than the normal underpayment rate • The requirements of IRC Section 409A generally apply to amounts deferred after December 31, 2004

Tax Implications - IRC Section 409A • Guidance and Proposed Regulations • The IRS released Notice 2005-1 in early 2005 • The IRS released proposed regulations in September 2005 • Final regulations issued by IRS effective January 1, 2008

Tax Implications - Employer • Premiums paid on life insurance are not deductible since the policy is an asset of the employer • When the executive reaches retirement age the employer may choose to make benefit payments out of current or accumulated earnings and continue the policy in force until the employee dies to receive death proceeds tax free, or

Tax Implications - Employer • The employer as owner of the policy may surrender the policy and choose one of the settlement options to fulfill its obligation under the deferred compensation plan • A portion of each installment payment received by the employer will be taxable to the employer under annuity rules • For a lump sum payment, that portion which exceeds the employer’s cost (net premiums paid) is treated as ordinary income

Tax Implications - Employer • At the employee’s death, the entire policy proceeds receivable by the employer are generally income tax free • When benefits are paid by the employer under the deferred compensation plan, either to the employee or the employee’s family, • Payments are deductible by the corporation provided they constitute reasonable additional compensation • Deferred payment amounts will be considered wages and will be subject to FICA tax in the year in which they are no longer subject to a substantial risk of forfeiture by the employer

Tax Implications - Employee • During employment, the employee is not taxed on amounts set aside by the employer to meet its financial obligation • Benefits received from the deferred compensation plan by the employee (or family) are taxable as compensation, subject to FICA, and ordinary income tax rates as received • Whether the OASDI portion of Social Security tax will apply depends on whether the participant’s other earnings for the year equal or exceed that year’s OASDI taxable wage base

Tax Implications - Employee • The commuted value of benefit payments remaining at a covered employee’s death will be included in the employee’s gross estate for federal estate tax purposes • This is IRD and an income tax deduction will be allowed to the recipient of such income for additional federal estate tax attributable to the inclusion of the deferred compensation • If the death benefit is payable to the employee’s spouse in a qualifying manner, there will be no estate tax due because of the unlimited marital deduction, therefore there will be no deduction of IRD

Issues In Community Property States • Earnings of a resident husband or wife are generally treated as community property • Deferred compensation paid currently would be community property • Be careful of separate property turned into community property by a “community property agreement” possibly triggering state gift tax consequences

Issues In Community Property States • If the spouses divorce or one of the spouse’s dies, it may be necessary to compute the PV of the deferred amount in order to divide the community assets Note: Current analysis establishes that there is “property” subject to division even though there is no certainty the compensation will ever be received

What Is Nonqualified Deferred Compensation?