Nonqualified deferred compensation

In the United States, the question whether any compensation plan is qualified or non-qualified is primarily a question of taxation under the Internal Revenue Code (IRC). Any business prefers to deduct its expenses from its income, which will reduce the income subject to taxation. Expenses which are deductible ("qualified") have satisfied tests required by the IRC. Expenses which do not satisfy those tests ("non-qualified") are not deductible; even though the business has incurred the expense, the amount of that expenditure remains as part of taxable income. In most situations, any business will attempt to satisfy the requirements so that its expenditures are deductible business expenses.

A non-qualified deferred compensation plan or agreement simply defers the payment of a portion of the employee's compensation to a future date. The amounts are held back (deferred) while the employee is working for the company, and are paid out to the employee when he or she separates from service, becomes disabled, dies, etc. As will be discussed later, one of the keys in designing a non-qualified deferred compensation plan is making sure that the employee will not be required to pay income tax on those deferred amounts until the amounts are actually paid to the employee.

In describing a "non-qualified deferred compensation plan", we can consider each word.

There are two general types of unfunded deferred compensation plans:

Deferred compensation plans offer flexibility for both the employer and the employee.

Unfunded deferred compensation plans offer very flexible benefit structures compared to qualified retirement plans, even after the enactment of new Internal Revenue Code IRC §409A (discussed below).

Account-based plans: Elective deferrals are credited to an account in the participant's name along with any company contributions (such as matching contributions). Earnings may be credited to the plan with interest at a set rate or flexible rate, or treated as if the deferred amounts were invested in specific investments designated by the employee.

Non-account plans (defined benefit plans): The benefit amount may also be a specified dollar amount payable annually after retirement or termination. Payments continue as specified in the plan, usually over the life of the employee or the joint lives of the employee and the employee's spouse.

Generally, deferral elections are required to be on file with the employer before the employee has a "legally binding right" to the compensation.

Election filed prior to the calendar year salary, commission and some bonuses are earned.

Later elections for certain types of contingent compensation ("performance-based" pay earned over 12 months or more, rights subject to forfeiture, etc.) Sign-on, retention, spot bonus, project bonus, severance at the time the compensation is awarded or negotiated.

With unfunded deferred compensation plans, the employer may purchase insurance to help satisfy its obligations under the plan, but the nonqualified deferred compensation plan should not tie the amount of benefits directly to the amounts payable under the life insurance policy. Note that the employee should have only the rights of an unsecured general creditor.

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