How to Set Up a Non-Qualified Deferred Compensation Plan

A non-qualified deferred compensation (NQDC) plan is a contractual arrangement between an employer and an employee to pay compensation in a future tax year. This type of plan serves as a flexible tool in executive compensation strategies. It allows for the deferral of income that would otherwise be immediately taxable, helping high-earning individuals manage their tax liability. These arrangements supplement traditional retirement plans, offering additional financial benefits.

Core Concepts and Purpose of Non-Qualified Deferred Compensation Plans

Non-qualified deferred compensation plans differ from qualified retirement plans, such as 401(k)s, because they are not subject to the Employee Retirement Income Security Act of 1974 (ERISA). This non-qualified status provides employers flexibility in designing and implementing these plans, allowing them to selectively offer benefits to specific individuals or groups. NQDC plans are typically used by companies to attract, retain, and motivate key executives, highly compensated employees, and sometimes independent contractors or directors. They offer an incentive beyond the contribution limits of qualified plans.

From an employee’s perspective, a primary benefit is the ability to defer federal and state income taxes until the funds are received. This allows for tax-deferred growth on deferred amounts, similar to qualified plans, but without the same contribution limits. Employees generally pay Social Security and Medicare taxes (FICA) on deferred amounts at the time of deferral or when they become vested, whichever is later.

For employers, the tax deduction for deferred compensation is generally taken when the employee includes the amount in their taxable income, typically at distribution. NQDC plans are “unfunded” for tax purposes, meaning the deferred compensation remains a general asset of the employer and is subject to the claims of the employer’s general creditors. This structure is essential for maintaining the employee’s tax-deferred status.

The Internal Revenue Code (IRC) Section 409A governs NQDC plans, imposing specific requirements on deferral elections and distribution timings. Failure to comply with Section 409A can result in immediate taxation of all deferred amounts, along with a 20% penalty and interest charges for the employee. Adherence to these rules is paramount to realizing the intended tax benefits.

Designing Your Non-Qualified Deferred Compensation Plan

Establishing an NQDC plan requires careful consideration of design elements to align with employer objectives and employee needs. One initial decision involves defining participant eligibility. NQDC plans can be selectively offered, often limited to a “select group of management or highly compensated employees” or key executives. This allows companies to tailor benefits to individuals most impactful to the organization, avoiding broad non-discrimination rules.

Next, determining the types of deferrals is a significant design aspect. NQDC plans can permit deferrals of various forms of compensation. Common examples include base salary, annual bonuses, long-term incentive awards, commissions, and stock-based compensation. Employers may also make matching or discretionary contributions to participants’ accounts, often subject to specific vesting conditions.

Vesting schedules define when deferred amounts become non-forfeitable for the employee. Employee deferrals are typically 100% vested immediately. Employer contributions often include a vesting schedule, which could be time-based (e.g., cliff vesting or graded vesting) or performance-based. The vesting schedule incentivizes employees to remain with the company.

Defining distribution triggers is a sensitive area due to Section 409A compliance. Payments from an NQDC plan can only occur upon certain permissible events, which must be specified in the plan document at the time of deferral. These events commonly include separation from service, death, disability, a change in control, or a specified date or fixed schedule. An unforeseeable emergency may also be a permissible trigger, subject to strict IRS definitions.

The payment methods for distributions also require careful planning. Participants typically elect the form of payment at the time of deferral, which can be a lump sum or installments over a specified period. Once elected, these payment terms are generally irrevocable and cannot be accelerated or delayed, except under limited circumstances permitted by Section 409A.

To manage the employer’s future liability, companies often utilize informal funding approaches. These are internal strategies to set aside assets to cover future obligations. A common method is a “rabbi trust,” an irrevocable trust established by the employer to hold assets designated for NQDC benefits. Assets within a rabbi trust remain subject to the claims of the employer’s general creditors in the event of bankruptcy or insolvency. Another vehicle is corporate-owned life insurance (COLI), where the employer owns life insurance policies on participating executives. The cash value of these policies can grow tax-deferred, providing a potential source of funds to meet future NQDC obligations, while death benefits can offset liabilities upon an executive’s passing. These arrangements offer psychological assurance to employees but do not provide legal protection from the employer’s creditors.

Formalizing and Funding Your Non-Qualified Deferred Compensation Plan

Once the design elements of an NQDC plan are determined, the next phase involves formalizing the arrangement through legal documentation and setting up any informal funding mechanisms. The foundation of any NQDC plan is a formal, written plan document. This document outlines the comprehensive terms and conditions governing the plan, including eligibility, types of compensation that can be deferred, vesting schedules, distribution triggers, and payment methods. It must explicitly comply with the detailed requirements of Section 409A, as drafting errors can lead to severe tax penalties for participants. Legal counsel specializing in executive compensation and tax law is typically engaged to draft these documents.

In addition to the master plan document, individual deferral agreements are necessary for each participating employee. These agreements formalize the employee’s election to defer a specific portion of their compensation. They typically specify the exact amount or percentage of salary or bonus being deferred, the chosen distribution event, and the form of payment. Deferral elections must generally be made irrevocably before the calendar year in which the compensation is earned. For performance-based compensation, a deferral election may be made up to six months before the end of the performance period.

The adoption and approval of the NQDC plan by the employer often involves formal action by the company’s board of directors or a designated compensation committee. This typically takes the form of a board resolution or a unanimous written consent, which formally establishes the plan and authorizes its implementation.

Following formal documentation, the employer proceeds with implementing any chosen informal funding mechanisms. If a rabbi trust is selected, the employer works with a trustee to establish the trust agreement. This agreement specifies that assets held in the trust are irrevocably set aside to pay NQDC benefits but remain subject to the claims of the employer’s general creditors. Funds are then contributed to this trust, often invested according to participant-directed notional investment choices. Similarly, if corporate-owned life insurance (COLI) is used, the company purchases and becomes the owner and beneficiary of life insurance policies on participating executives. The premiums are paid by the company, and the cash value growth and death benefits are designed to help offset future NQDC liabilities. The implementation of these informal funding vehicles is an internal corporate decision and does not alter the “unfunded” status of the NQDC plan for tax purposes.

Finally, participant enrollment involves presenting the NQDC plan to eligible employees and guiding them through the election process. This includes providing them with the plan document, deferral election forms, and educational materials explaining the plan’s features and tax implications. Employees then make their deferral elections, specifying the compensation amounts, distribution triggers, and payment methods, and execute the individual deferral agreements.

Administering Your Non-Qualified Deferred Compensation Plan

Once an NQDC plan is established, ongoing administration ensures compliance and proper management of deferred amounts. Meticulous record keeping is fundamental. Employers must maintain accurate records of each participant’s deferred compensation, including contributions, earnings, vesting status, and scheduled distribution dates. This detailed tracking is essential for internal accounting and demonstrating regulatory compliance.

Providing annual reporting and statements to participants is common practice. These statements typically summarize the participant’s deferred account balance, any earnings or losses, and their current vesting status. Regular communication keeps participants informed about their deferred compensation.

Compliance considerations under Section 409A are an ongoing responsibility. Employers must ensure the plan’s operations align precisely with its written terms and the requirements of Section 409A. This includes adhering to strict rules regarding the timing of deferral elections, permissible distribution events, and the prohibition against accelerating or impermissibly delaying payments. Failure to maintain operational compliance can trigger severe penalties for participants.

Distribution management involves executing payments to participants when a specified trigger event occurs, such as separation from service, death, or a pre-determined date. The employer must ensure distributions are made according to the payment schedule and method elected by the participant and specified in the plan document. This process requires coordination among relevant departments or a third-party administrator.

From time to time, amendments and terminations of the NQDC plan may become necessary due to changes in business strategy or tax laws. Amending a plan requires careful consideration to avoid triggering adverse tax consequences under Section 409A. Terminating an NQDC plan also involves specific rules under Section 409A, often requiring that all similar plans be terminated and payments made within a defined period, generally 12 to 24 months after the termination decision. Employers must also typically refrain from adopting a similar NQDC plan for a period, often 36 months, after a termination.