Disadvantages of Nonqualified Deferred Compensation

Income Deferral

The employer’s income tax deduction is ordinarily deferred until the year in which income is taxable to the covered employee. This may be as many as twenty or more years from the time when the employer begins financing the obligation (for example, by paying premiums on a life insurance policy). However, if cash flow is a problem, the employer can reduce the contribution to the amount equal to the net, post-deduction contribution cost that the employer would have incurred, had an immediate deduction been available. For example, if the employer is in a 40 percent bracket (federal and state), and a deduction were allowed immediately, a contribution of $10,000 would result in a $4,000 deduction and an after-deduction cost of $6,000. So, in this example, a solution to cash flow problems might be to contribute only $6,000 each year.

Uncertainty

From the employee’s perspective, the right to assets in a nonqualified plan is ordinarily less than bulletproof. The executive is relying mainly on the employer’s unsecured promise to pay.

To prevent current taxation of the employee, the plan is technically unfunded (i.e., no money or other assets are placed beyond the claims of the employer’s other creditors). In essence, even if the employer has been regularly paying life insurance premiums to finance its obligation under the agreement, the employee relies not on the life insurance policy, but rather on the naked (albeit contractual) promise of the employer to pay the designated benefits.

Other than that contractual promise, the employee has no assurance of being paid. When the time for payments comes, the employer may not be willing to make promised payments, or may not have enough money to make them. Furthermore, if there is a corporate takeover, future management may not keep the prior management’s promises, or at least not without a long, expensive, grueling lawsuit. The bottom line is that a nonqualified deferred compensation plan is generally not as secure as a qualified plan, from the retiring employee’s perspective.

The current solution of choice to this lack of security is the rabbi trust (so called because the first such trust was established to provide post-retirement security for a rabbi). A rabbi trust is generally an irrevocable trust that holds the assets of the plan apart from the employer, but not apart from the employer’s creditors. The employer gives up the use of plan investments and cannot reclaim those plan assets until all plan obligations have been met. Trust assets are dedicated solely to providing benefits to the employees covered under the plan, with one major exception: if the employer becomes insolvent or bankrupt, the assets become available to the general creditors of the employer, so that covered employees are compelled to line up with all other general creditors of the employer.

In short, the rabbi trust will protect employees against the employer’s change of heart, and against change of management, but not against the employer’s insolvency.

Lack of Confidentiality

Required accounting disclosure reduces confidentiality.5 A complete discussion of accounting for deferred compensation is beyond the scope of this book, and plan sponsors should consult an accounting professional for advice regarding accounting for deferred compensation. However, in general nonqualified plans entail obligations that must be reflected on the employer’s books and may therefore be subject to scrutiny under certain circumstances. This is compared to many forms of qualified plans in which the employer is free of any accounting responsibilities once a contribution has been made to a third-party plan provider.

Limited Availability

Not all employers can or should take advantage of these plans. Pass-through entities such as an S corporation, a partnership, Limited Liability Company (LLC), or a sole proprietorship generally cannot effectively utilize a nonqualified plan for owner employees (with the possible exception of minority owners), so that the use of such a plan is generally limited to a C corporation if the intent is to include an owner employee. Thus, the use of these plans with pass-through entities is limited to a select group of nonowner key employees.

Nonprofit corporations and governmental organizations can use these plans, but they are subject to special, highly restrictive rules under Code section 457. Second, there should be a high probability that the corporation will be fiscally sound long enough to be around when the promised payments are to be made. A nonqualified plan is of no use to either the employer or the covered employee if the business is no longer in existence when the distribution date arrives.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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