by Charles Epstein, CLU, ChFC
The most common type of deferred compensation is the typical pension or profit sharing plan, including 401(k) plans. These are most often qualified plans, which means that the Internal Revenue Service (IRS) reviews them to make sure they meet all of the requirements for favorable tax treatment. These requirements include:
- Most nonowner employees must be covered by the plan,
- Benefits cannot take unreasonably long to vest,
- Contributions cannot be too favorable to the company’s owners, and
- Deferred compensation earned cannot be taken away from employees.
Meeting these requirements increases costs for sponsoring qualified plans. In exchange for this cost, the employer gets a current deduction for money or property used to fund the deferred compensation, the funds grow tax-deferred and the plan’s payout may be rolled over to another tax-deferred vehicle, like an individual retirement account (IRA), or may be taken out over a long period of time to lessen the employee’s tax burden.
Some family businesses find qualified plans to be too costly or too cumbersome to sponsor. Others may sponsor such plans but also want to offer key employees and owners additional benefits that are not allowed by the plan’s rules. This is where nonqualified deferred compensation plans may come into play. But, they are not for everyone.
Why Offer a Nonqualified Plan?
A nonqualified deferred compensation plan is typically only for owners and key management employees. If it also covers non-management employees, it will unwittingly fall under the same requirements as qualified plans, adding cost, complexity and reporting requirements. When the nonqualified plan covers only key management employees, it’s called a “top-hat” plan and is exempt from almost all ERISA requirements. A top-hat plan still has to file information forms (the same Form 5500 series as qualified plans). However, if the employer notifies the U.S. Department of Labor by letter of the existence of the plan, no further filing is required. The IRS has no reporting requirement for top-hat plans.
Because nonqualified deferred compensation does not have to comply with ERISA requirements, it can be designed to be flexible. The plan may cover or exclude any key management employee or owner, which means it can provide greater benefits for some employees than for others. Vesting times may vary for employees and the plan may be designed to include measurements other than compensation. One example is where an executive is in charge of a division; the deferred compensation program can be based on the division’s performance rather than on the employees’ compensation. A different executive can be compensated based on a different division or measuring stick.
Tax and Funding Issues
Because a nonqualified deferred compensation program does not have to comply with ERISA requirements, it also gets less favorable tax treatment. The most important difference is that the qualified plan allows the family business to deduct contributions made to the plan before the employee has to recognize them as income. If you sponsor a nonqualified plan, your family business cannot deduct the employee’s contributions to the plan until the year in which the employee recognizes income. For this reason, many nonqualified plans are not currently funded and amount only to a contract or agreement to pay the compensation later. Even if the nonqualified deferred compensation is funded, the key employee must hope that the employer will be able to pay the benefit in the future, because the money set aside to pay the promised benefits also must be available to pay the company’s general creditors.
For widely held or publicly traded family businesses, it’s common to use nonqualified deferred compensation as an incentive for key employees. In these cases, taxes are less important because they are spread out over many owners. Since the company will not get a current deduction for amounts set aside to fund the benefit, the owner (if the business is an S corporation or limited liability company) must bear the current tax on these incentives. When the company pays the incentives to the key employee, which could be many years later, it can then take the deduction.
If deferred compensation is still attractive to you, you may consider using an insurance policy to fund the promised benefit. This will give you the tax-deferred buildup similar to a qualified plan, that is not available to a nonqualified plan invested in other nontax-favored investments. When the employer must pay the benefit, the employer can cash in the policy, borrow on the policy or distribute the policy to the employee.
If the family business is a C corporation, the tax burden will fall on the company, not the owner. Later, when the benefits are paid out, the corporation will have a deduction that may cause a net operating loss or may not be as advantageous as the company would have liked. If the company is relatively small, this may have a big effect on the corporation’s tax position.
Regardless of whether the family business pays its own tax or the owners pay tax on the company’s earnings, nonqualified deferred compensation usually does not make sense for the owners of a small closely held family business. It may make sense, however, if the plan is unfunded and is used to recognize certain owners’ efforts that are disproportionate to their ownership interest. Also, if the owners have been underpaid for many years and the deferred compensation would help reduce tax on the sale of the business, an unfunded nonqualified deferred compensation arrangement could make sense. In most cases though, these types of plans are best used for nonowner, key management personnel. Properly communicated and structured, a deferred compensation plan can provide a perfect incentive to keep good people.