Executive Deferred Comp.

Nonqualified deferred compensation arrangements are all compensation arrangements in which the employee defers reporting the income, but which are not “qualified” under the Internal Revenue Code. Qualified arrangements, an example of which is a 401(k) plan, allow for immediate employer deductions of amounts set aside for employees, despite the employees not having to take those amounts into income, as well as tax free “inside build up” of income accrued on the assets set aside for the employees. In other words, qualified plans allow a radical mismatch of the timing of income to the employee and a deduction to the employer. Nonqualified plans, in contrast, allow for half a loaf, deferral of income by the employee, but no immediate deduction to the sponsoring company.

Qualified plans entail a considerable compliance burden on the part of the employers and are subject to both dollar limitations, that is to say, limitations on how much the people running the company can grab, and so called “nondiscrimination” rules, which are also designed to insure that the benefits of the deferred plan are not skewed toward highly compensated employees.

Nonqualified deferred compensation plans are, in contrast, cheaper to set up and administer than qualified plans, and are subject to no limitations relating to either the amount of compensation or who can or cannot participate. (Except, generally speaking, the benefits cannot be made available company-wide. Company-wide deferred compensation arrangements must be administered as qualified plans). The disadvantages consist of, first, foregoing the tax benefits described above, and, second, that, generally speaking, the funds “set aside” for the benefit of the employee are subject to the claims of the creditors of the employer. In other words, retirement benefits accumulated under a nonqualified plan are not as safe as benefits set aside in a qualified plan.

The touchstone of any nonqualified deferred compensation plan is the issue of “constructive receipt.” If cash, stock or other property is “constructively received” by an employee, that employee has to pay taxes on the amount deemed received. Nonqualified deferred compensation plans that work as designed allow the employee in question to accrue a benefit, but not be deemed to have constructively received that benefit for tax purposes.

Nonqualified deferred compensation plans vary because there is no one way to design around the constructive receipt doctrine, and each employee and each company has different needs and limitations. Such plans are often paired with qualified plans, so that top management is in the same boat as lower paid employees for purposes of a qualified plan or plans sponsored by the company, but then enjoys additional, less highly tax favored compensation, in the form of either stock options or a promise to receive, at some point, stock, stock options or cash. In all events, the promise must be unsecured, that is to say the beneficiary of the promise is left to the vicissitudes of the company’s fortune. As between the employee and third party creditors, third party creditors will enjoy equal or superior status to the executive’s deferred compensation claim. Note, however, that as between the employee and the company, the company can agree to set aside funds so that, short of bankruptcy, receivership or attachment by creditors, the company will have no ability to divert the assets pledged to the employee under the deferred compensation plan. This arrangement may involve the establishment of a trust, such as a “rabbi trust,” so named because the first ruling issued by the IRS approving this arrangement involved a deferred compensation arrangement between a rabbi and his congregation.

There is much to be said about nonqualified deferred compensation plans, but all of it depends upon the resources and needs of each company and of the employee or set of employees considering such a plan.

That being said, three illustrative plans are as follows:

1.  The company annually credits a fictional account on behalf of an executive, with the payment measured against the company’s performance for that year. The accrued benefit, with or without an interest factor, would be paid to the executive either in a lump sum or over a period of years, starting on either a date certain in the future, or the date of that employee’s termination, retirement or death. The executive has income, and the company has a compensation deduction when the money is given to the executive.

2.  The company issues stock to the executive. The stock is (1) subject to restrictions on assignability; and (2) subject to forfeiture in the event of some undesirable happening, such as the executive leaving the firm before a prescribed number of years.

The executive has income (and the employer a deduction) when the restrictions lapse.

3.  The company issues options to the executive which entitle the executive to purchase stock in the company. Although such an arrangement is not “qualified” in the sense discussed above, there are two kinds of stock options, one of which is confusingly referred to as a qualified stock option and the other of which is known as a nonqualified stock option. The formal name for qualified stock options is incentive stock options, or ISO’s. ISO’s are, from the executive’s point of view, taxed more favorably than are nonqualified options. There are lots of nonqualified options and lots of ISO’s in the world, because there are advantages to both.