A nonqualified deferred compensation plan (“Nonqualified Plan”) is legally defined as “any plan that provides for the deferral of compensation, other than: (a) a qualified employer plan; and (b) any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan.” See 26 USC 409a (d)(1).” Under this broad definition, one would consider stock options and other long-term equity-based pay as nonqualified deferred compensation.
For our discussion, we are disregarding equity-based pay and keeping with standard industry terminology. Therefore, a nonqualified plan is better defined as a contract between an employer and one or more select “Key Employees” (highly compensated employees or independent contractors) in which the Key Employees defer a portion of their salary, bonus, or other compensation until some future date based on the terms of a legal plan document.
Nonqualified plans are typically unfunded based on the law. The Key Employee controls the notional investment of their account similar to a 401 (k). However, when a plan is unfunded, the employer does not actually invest the Key Employee’s deferred compensation in the market. It instead grows based on the performance of a benchmark. The Key Employee can generally change the investment at any time.
Contributions to an unfunded nonqualified plan generally are not deductible for the employer as compensation. However, the employer will get a deduction when the Key Employee recieves the compensation.
Key Employee Tax Benefits
The tax purpose of a nonqualified plan for a Key Employee is multifaceted. First, the amount deferred by the Key Employee is likely not taxable until the Key Employee receives it. Therefore, the Key Employee will pay less in taxes in any year in which they defer compensation.
Second, the Key Employee will likely be in a lower tax bracket when they eventually receive the compensation. Additionally, any growth in the Key Employee’s account is tax-deferred. This means the Key Employee will not pay tax on the principal and the income it generates until the Key Employee “receives” it.
This deferral is done based on the belief that deferring tax on the principal amount deferred and the income on such principal will yield more after-tax income in the future as compared to paying tax currently on the principal and investing the after-tax remainder.
In order to better understand nonqualified plans, it helps to break down the terminology.
Nonqualified – a “non-qualified” plan does not meet all of the technical requirements imposed on “qualified plans” (401k, pension plans, profit-sharing plans, etc.) under the Internal Revenue Code (IRC) or the Employee Retirement Income Security Act (ERISA). Therefore, plans generally are not subject to the fiduciary, nondiscrimination, coverage, funding, vesting, distribution, reporting, disclosure, and almost all other requirements applicable to tax-qualified deferred compensation plans.
Deferred – The deferral limit for a 401K in 2019 is $19,000. While substantial, this might not be a significant amount for a Key Employee. There are no limitations on deferred amounts and no minimum distribution rules for nonqualified plans. This makes these plans a useful tool for attracting and retaining top talent.
Compensation – A Key Employee can defer salary, bonuses, or any other type of compensation to fund the plan. The plan offers long-term tax-deferred savings. This incentivizes Key Employees to participate in a nonqualified plan. However, the Key Employee’s participation limits the employer’s tax deduction until after the Key Employee receives the compensation.
Plan – Employers establish nonqualified plans for any number of Key Employees. Non-qualified deferred compensation plans are so flexible they can even include independent contractors, including directors.