Strategic Compensation Planning with Non-Qualified Deferred Compensation in Family Enterprises

Understanding Non-Qualified Deferred Compensation Plans

A Non-Qualified Deferred Compensation (NQDC) plan is a contractual agreement where an employer commits to pay an employee at a later date for services currently rendered. These plans are particularly advantageous for family businesses as they offer a means to compensate and retain key employees without immediate cash outlay.

Key Differences from Qualified Plans

NQDC plans stand in contrast to qualified retirement plans, such as pensions and 401(k)s, which are subject to the Employee Retirement Income Security Act of 1974 (ERISA). Unlike qualified plans, NQDC plans:

• Can favor certain employees, often limited to a "top-hat" group of highly compensated or management personnel.
• Do not require a vesting schedule.
• Are not obligated to establish a trust fund.
• Have no prescribed limits on deferral duration or benefit commencement.

Tax Considerations for Employers and Employees

The tax treatment of NQDC plans is less favorable than that of qualified plans due to their exemption from ERISA's stringent rules. Employers cannot claim a tax deduction until the benefits are paid out, and employees may face taxation under the "constructive receipt" doctrine when they gain the right to receive benefits, even if payment is deferred. Additionally, the employer's promise to pay must be "unfunded and unsecured," posing a risk to employees if the employer cannot fulfill its obligations.

NQDC Plans in the Context of Family Businesses

NQDC plans can serve multiple purposes in a family business setting:

1. Providing retirement income for senior family members.
2. Balancing the treatment of children involved and not involved in the business.
3. Offering a "golden handcuff" to ensure key employees stay during generational transitions.

Combining a gifting strategy with an NQDC plan can be a tax-efficient solution for transferring business ownership while ensuring financial security for retiring family members.

General Rules Governing NQDC Plans

The following summarizes the key rules for NQDC plans:

• Employees are taxed upon actual payment, provided the plan remains unfunded and unsecured.
• Employers can deduct benefits when they are included in the employee's income, as long as they constitute reasonable compensation.
• If the plan is "funded," benefits must be at risk of forfeiture and non-transferable to avoid immediate taxation.
• Employers have the discretion to select beneficiaries, but non-highly compensated employees may trigger ERISA compliance.
• Distribution events are limited and cannot be accelerated, although vesting acceleration is allowed.

Informal Funding Strategies

While NQDC plans must be unfunded to defer employee taxation, employers can create reserve funds as general assets, subject to creditor claims. Life insurance is a popular method to informally fund NQDC plans, providing pre-retirement death benefits and aiding in cost recovery through tax-free death proceeds. Employers can access the policy's cash value tax-free up to their cost basis and borrow against it to fulfill benefit obligations.

Conclusion

NQDC plans offer a strategic tool for family businesses to manage compensation and succession planning. However, the complexity of tax rules and the need for careful design to avoid unintended consequences require professional advice. Employers should consult legal and tax advisors to tailor NQDC plans to their specific needs and ensure compliance with applicable regulations.

Please note that this article is for informational purposes only and is not intended as legal or tax advice. Taxpayers should seek personalized guidance from their legal and tax professionals.

IRS guidelines on NQDC plans ERISA information from the U.S. Department of Labor Life insurance as a funding strategy