Using deferred compensation plans to reward key employees

Are you looking for ways to reward key employees to encourage retention and induce loyalty?

Would you like certain employees to feel they have a stake in your company without giving up any ownership?

Would you like to provide larger bonuses to high performing employees but do not have the current cash flow?

If you answered yes to any of the above questions, your business may want to consider adopting a nonqualified deferred compensation (NQDC) plan. Such a plan is simply an agreement between an employer and an employee to pay the employee compensation in the future.

NQDC plans differ from “qualified plans,” such as pension and profit sharing plans, in that they are exempt from the strict non-discrimination, vesting, funding, reporting and disclosure rules imposed by the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act (ERISA). While an NQDC plan’s “non-qualified” status means that an employer cannot take a tax deduction until the participant is taxed, the many benefits of an NQDC plan often outweigh the delayed deduction.

Employer selects participants
To avoid being subject to ERISA, an NQDC plan must limit participation to a “select group of management or highly compensated employees.” However, within that group the employer has the discretion to choose to benefit one or all such employees and may even set up a different plan for each.

Employer has tremendous flexibility as to benefit design
The NQDC plan can promise annual benefit accruals, a single benefit paid after a set amount of years, or a payment only in the event of sale of the company. Benefits may be based upon individual performance, company profitability or years of service. Vesting schedules can exceed the six-year-graded schedules dictated in a qualified plan. Formulas can be simple or complex. All that limits this benefit is your imagination.

Employer may attach strings
The benefit can be forfeitable for any number of reasons such as termination for cause, employee resignation or employment with a competitor.

No current requirement to fund the plan
In fact, to remain exempt from ERISA such plans must officially remain unfunded and subject to the general creditors of the company. An exception to this is the establishment of what is referred to as a “rabbi trust,” a trust established by the company to hold assets of an NQDC plan. Such a trust will not protect a participant from the risk of his employer becoming insolvent and unable to meet its obligations under an NQDC plan. However, if properly structured, a rabbi trust will provide a participant with significant protection from a change in the control of the employer, or from the employer attempting to avoid making payments due under the plan.

To ensure that assets promised under such plans fall outside the current control of the participant, new statutes have been drafted over the past 10 years that limit both the employee’s and the employer’s ability to modify certain terms of these plans after initial adoption. However, with proper planning and careful legal drafting of these plans at the forefront, NQDC plans can provide employers with a very cost effective way to reward and retain key employees.

Feel free to contact us for additional information regarding planning ideas.

Client alert authored by: Patricia Cadagin O'Brien, Principal

This alert originally appeared in the Fall 2016 Corporate Focus Newsletter.