There is much more flexibility in nonqualified deferred compensation plan design than in qualified plan design. For instance, an employer can pick and choose who will be covered, the levels of coverage (subject to the reasonable compensation limits on deductibility), and the terms and conditions of coverage. Also, an employer can provide that plan benefits attributable to employer contributions will be forfeited entirely according to any vesting schedule or upon any reasonable contingency. For instance, an employer can cut off all benefits attributable to employer contributions if the employee terminates prior to a specified age or if the employee goes to work for a competitor. This means a nonqualified deferred compensation plan can be highly effective with respect to both costs and taxes.
Restrictions can be placed in the plan that will enable the employer to either: (a) achieve its business goals; or (b) recoup its funds, so that either the plan accomplishes what it was intended to accomplish or the employer gets its money back.
Nonqualified plans can escape (completely or in large part) a variety of government requirements imposed upon qualified plans, such as reporting and disclosure requirements, participation and vesting requirements, and fiduciary responsibility requirements.
In general, covered employees are not taxed on benefits under nonqualified plans until they actually receive a distribution. Dollars growing over the deferral period currently grow tax free and, therefore, typically grow beyond the level that the employee would have realized, had the employee invested the after-tax dollars.
Employers using properly arranged nonqualified deferred compensation plans financed with life insurance are not currently taxed on the earnings, because tax on the inside buildup of cash surrender values is deferred until distribution. Note that business owned annuities do not enjoy this same tax deferred growth.
The employer’s deduction generally may be based upon benefits paid out of the plan, rather than upon contributions paid into the plan (this does not apply to a funded nonqualified deferred compensation plan). Consequently, the employer’s deduction may be based upon an amount that is much larger than its original investment. So, if the employer’s tax rates do increase between the date when the contributions are made to the plan and the payment of benefits, the value of the employer’s deduction–and therefore its leverage—also increases.
The employee and employer may also take advantage of additional tax leverage. At the time when the payout period begins, the employer takes the cash it has and pays it out as tax deductible salary. Because of the employer’s deduction, it can pay a larger amount to the employee. For example, if an employer is in a combined 40 percent state and federal bracket and is obligated to pay out $10,000 a year, the after-deduction cost is only $6,000. But the employer could choose to incur a cost of $10,000 a year–and in fact pay out $16,667 [$16,667 – (0.40 × $16,667) = $10,000].
The formula in the agreement between the employer and the covered employee could provide that the corporation would pay out a given percentage of earmarked cash funds on hand each year, multiplied by a fraction reflecting the employer’s tax bracket that year.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM