According to one America College text, ‘…some qualified plans …aren’t necessarily intended to provide a pension at retirement. Unlike (certain) pension plans …401(k) plans and SEPs are often designed to distribute organizational earnings on a tax-sheltered basis with only a partial regard to meeting retirement needs.’[i] Moreover, qualified plans are subject to strict regulations, such as limits on the amount of salary reduction and nondiscrimination tests that prohibit the plans from discriminating in favor of owner-employees and key employees. Now, for employees saving for future needs, they should take advantage of these plans, especially when the employer is matching funds.
However, for the business owners or company board of directors who want to further compensate an owner-employee, key executive, or key employee without having to meet participation requirements or being subjected to strict regulations, a non-qualified deferred compensation (NQDC) plan may be what you are looking for. It has been said that life insurance is one of the ‘last tax shelters.’ Thus, by funding a NQDC agreement with a permanent life insurance policy many businesses have been able to meet the retirement needs and estate planning needs for certain employees on a tax-sheltered basis.
According to the IRS article Nonqualified Deferred Compensation Audit Techniques Guide (02-2005), ‘A nonqualified deferred compensation (NQDC) plan is any elective or nonelective plan, agreement… or arrangement between an employer and an employee to pay the employee compensation some time in the future. NQDC plans do not afford employers and employees with the tax benefits associated with qualified plans because …NQDC plans do not satisfy all of the requirements of section 401(a). …NQDC plans typically fall into four categories:
Salary Reduction Arrangements simply defer the receipt of otherwise currently includible compensation by allowing the participant to defer receipt of a portion of his or her salary. Bonus Deferral Plans …enable participants to defer receipt of bonuses. Top-Hat Plans (aka Supplemental Executive Retirement Plans or SERPS) are …primarily for a select group of management or highly compensated employees. Finally, Excess Benefit Plans …provide benefits solely to employees whose benefits under the employer’s qualified plan are limited by section 415…
NQDC plans are either funded or unfunded… An unfunded arrangement …has only the employer’s ‘mere promise to pay’ the …benefits in the future… The employer …may choose to invest in annuities, securities or insurance… subject to the claims of the employer’s creditors if the employer becomes insolvent… To obtain the benefit of income tax deferral, it is important that the amounts are not set aside from the employer’s creditors for the exclusive benefit of the employee… A funded arrangement generally exists if assets are set aside from the claims of the employer’s creditors, for example in a trust or escrow account.’
- HOW IT CAN WORK:
A profitable company with 150 employees and several million dollars in assets wants to retain and reward an owner-employee and a key executive, both of which have been with the company about 20 years. The board of directors approves an agreement that would offer these men a choice of $ 75,000 going into a fixed deferred annuity (taxed deferred with a guaranteed minimum 3% rate of return) to be turned over to the employee after another 10 years of service; or $ 10,000 each year for ten years going into a permanent life insurance policy (with them as the insured) that would be given to them after another 10 years of service, with options for additional deferral and payments for extra years of service. Depending on the age and health of the insured, and type of life insurance plan, the employee could receive the policy when it has as much as $ 200,000 in cash value and much more in death benefits.
- TAX CONSEQUENCES:
NQDC plans are not deductible to the employer as salary disbursements until the employee takes ‘constructive receipt’ of the policy. However, if the employee gains control over how to manage the plan, or takes receipt of any benefits, they become taxable as income. Furthermore, with the annuities and over-funded tax-deferred life insurance plan, its withdrawals are subject to 10% penalties before age 59 ½ and subject to income taxes and taxes on modified endowments as usual. Profitable employers often double bonus the employee to pay a portion of the taxes due; nevertheless, employers should seek the counsel of their accountant or advisor or lawyer as to the tax consequences and requirements of setting up a NQDC arrangement.
The BODs or employer should ask about the ‘constructive receipt doctrine’ and unfunded plans, or the ‘economic benefit’ doctrine and funded plans. They should research how to write up a NQDC contract. They should ask about provisions in the event of the employee’s ‘disability,’ ‘death,’ ‘retirement,’ and about the rights and objections of each party. They should gain an understanding of ‘acceleration of benefit payment options,’ ‘assignability,’ and notify the owner-employee or key executive of the creditor risk of unfunded contracts, and the irrevocable nature of funded contracts.