Non-Qualified Deferred Compensation

Nonqualified Deferred Compensation NQDCP’s allow employees to postpone current taxation of wages. Similar to qualified plans (i.e. 401k) Do not have to meet requirements of a qualified plan

Tax Strategy Employee elects to defer wages – avoid constructive receipt – wages are included in taxable income when tax rates are lower Deferred amounts are subject to FICA but not FWT – wages are subject to FICA in year regular wages exceed Social Security wage limit; subject to Medicare only

Covered Employees Highly compensated EE’s Key EE’s Select management EE’s EE’s with limited qualified benefits EE’s the ER wishes to reward Plan can be discriminatory

Types of NQDC Plans Salary Reduction Bonus Deferral SERP Excess Benefit

NQDC Funds Unfunded Funded Not secured Secured Remains ER asset Creditor accessable Funded Secured EE has access

Arrangements Rabbi Trusts Secular Trusts Deferred Comp. Ins. Surety Bonds Letters of Credit

Plan Requirements Plan must be in writing and include: Method for determining amount to be deferred When deferred amounts may or will be paid How deferred amounts may or will be paid Treas. Reg. §31.3121(v)(2)-1(b)(2)(i)

Election Requirements Timeliness of the election: Generally, election must be made before calendar year in which income is earned Exceptions: New plan – election must be made within 30 days of plan’s inception First year of eligibility – election must be made within 30 days of becoming eligible Rev. Proc. 71-19 and 92-65

Election Requirements Specification of Amount Deferred: Specified in dollars, or Specified by formula

Election Requirements Specification of Payout Method: Specify how deferred compensation is to be paid (i.e. lump sum, amount per month) Right to change payout timing may result in constructive receipt

Account Balance Plan An accounting record is kept for each participant on company books Amount deferred is credited to the account Related earnings are credited to the account Bookkeeping entry only – funds are not set aside Earnings are not subject to FICA Treas. Reg. §31.3121(v)(2)-1(c)(1)

Non-Account Balance Plan Amount deferred is not an amount the worker has elected not to receive Amount deferred is present value of payments the worker has the right to receive in the future Subject to FICA at the time the amount to be received is ascertainable Treas. Reg. §31.3121(v)(2)-1(c)(2)

ET Taxes – Special Timing Rule FICA and FUTA The later of: Services performed OR No substantial risk of forfeiture IRC §3121(v)(2) and §3306(r)(2) FITW When actual or constructive receipt

Advantages ER No rules (prior to §409A) No current spending Attract EE’s Early retirement incentive EE Supplement qualified retirement plan Personally customized Current tax deferral Tax-free growth Possible reduced taxation No early distribution tax

Disadvantages ER EE May be taxed on deferral build-up Expense deduction follows income inclusion EE ER retains asset Mere ER promise No control of investment Elections made prior to services

IRC §409A Added to Code by Section 885 of AJCA of 2004 Provides that amounts deferred under a NQDCP are includable in income unless certain requirements are met Provides for substantial penalties Does not affect IRC §3121(v) Effective for amounts deferred after 12/31/2004

IRC §409A Notice 2005-1 provides guidance New rules for: Distributions Elections Offshore and “financial health” trusts Withholding and reporting requirements

IRC §409A Distributions must be for: Separation from service Death Disability Pursuant to a fixed schedule or at specified times Following a change of ownership or control of the corporation The occurrence of an unforeseeable emergency IRC §409A(a)(2)(A)

IRC §409A Deferral Election Rules (IRC §409A(a)(4)(B)) Must be made by the close of the taxable year preceding the year in which the services are performed, or Within 30 days EE becomes eligible to participate in the plan Exception: Election to defer performance-based compensation for services performed over a period of at least 12 months can be made no later than 6 months before the end of the service period.

IRC §409A Distribution Election Rules (IRC §409A(a)(4)(c)) Timing and form of distributions must be specified at the time of the initial deferral Election can be changed if: Made not less than 12 months before a scheduled payment Not effective until at least 12 months after the election, and Provides for an additional deferral of at least 5 years

IRC §409A Offshore and Financial Health Trusts (IRC §409A(b)) Offshore Trust – funds put in a foreign trust are includable in income tax wages Exception: Not taxable if services are performed in the foreign country Financial Health Trust - ??? Ask Counsel if you find one of these

Reporting Information Form W-2 Box 1 Gross Income Tax Box 3 SS Wages Box 5 Medicare Wages Box 12 Deferrals – code Y Distributions – code Z

IRC §409A Failure to Satisfy New Rules Amount deferred is includable in income in the year earned (i.e. no deferral) Amount deferred is subject to both FICA and FWT Subject to an additional 20% tax Subject to interest penalty (interest at underpayment rate plus 1%)