Non-qualified Deferred Compensation Non-qualified deferred compensation plans are traditionally used to defer taxes and build wealth for key executives. These plans are quite flexible and can be used to meet tax planning and compensation objectives for specific employees or groups of employees. When combined with the use of company stock, non-qualified plans are ideal for providing key executives with a long-term incentive to help build shareholder value over the course of their career with the company.
Deferred compensation arrangements fundamentally consist of an agreement between an employer and an employee that payments due for current services will be made at a future date. The employee's tax objective is to defer taxes on the compensation, including any increase in the value of the amount deferred, until the payments are actually received. For the company, the result is a positive cash flow impact due to the delay in the payment of compensation and a tax timing change. The company forgoes current compensation deductibility and receives tax deductibility at the time of the payout.
With these plans, eligibility is typically restricted to a select group of management and highly compensated employees who wish to defer compensation. The employee would initially elect to defer a portion of his future compensation (salary and/or bonuses). The company establishes an account to track the amount deferred by the employee.
There are various informal funding strategies that can be used to manage the employee's account. One of the most popular strategies for funding deferred compensation plans is through a Rabbi Trust. A Rabbi Trust is an irrevocable trust in which assets are set aside for the exclusive use of satisfying an employer’s contractual obligation to pay deferred compensation.
The deferred compensation plan specifies when the distribution will be made to the employee and when the distribution is made, the employee pays ordinary income taxes on the value of the distribution and the company qualifies for a corresponding tax deduction.
Because these plans are typically intended to benefit a select group of key executives, it is important that they be structured to qualify for exemptions from ERISA (so that the plan does not have to be provided to all employees) and to avoid having contributions to the plan and earnings on plan assets become subject to current taxation. In order to avoid current taxation, the employee must elect to defer the compensation before it is actually earned and the plan must specify a pre-determined date when the deferred income will be paid.
Deferred compensation plans are typically designed to supplement the benefits that key employees receive under qualified plans such as 401(k) plans and ESOPs, as well as defined benefit pension plans. Benefits can be provided by the employer, in which case the term SERP (supplemental executive retirement plan) is more commonly used, or through the employee’s own salary or bonus contributions, in which case the plan is more often referred to as a “deferral” or “deferred compensation” plan. Alternatively, a plan can provide benefits from both corporate and employee contributions, an arrangement known as a “top-hat” plan.
Because the requirements of a top-hat plan are unique and complex, it is generally preferable to seek the advice of an attorney or compensation consultant when establishing these plans.
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