Non-Qualified Deferred Compensation: Overview. Michael E. Morris, AIF, CRPS Director Institutional Consulting Ross, Sinclaire & Associates, LLC

Transcription

1 Non-Qualified Deferred Compensation: Overview Michael E. Morris, AIF, CRPS Director Institutional Consulting Ross, Sinclaire & Associates, LLC

2 Who is a prospect for non-qualified planning? Private companies S Corp, LLC, LLP with owner executive team. Tax deferral is not possible. S Corp, LLC, LLP with non-owner executive team. Costly due to flow through design of non-taxpaying structure. Company owners absorb additional taxation of nondeductable deferrals. Large C corp. with many non-owner executives. Same as above, owners absorb additional taxation. Large C corp. with public company (or foreign company) parent. Great prospect. 2

3 Who is a prospect for non-qualified planning? Public companies Tax payer, if they don t pay taxes, there is no need for COLI funding. Last 3 years profitability is a good indicator Financially sound. Participants will not risk deferring/investing in a company where their future distributions are at risk. Management understands the need to provide additional benefits to key people. Does the 401(k) plan fail discrimination testing? If so, key employees receive little value from 401(k) plan. 3

4 NQDC Design

5 ERISA Regulations ERISA In 1974, the Employee Retirement Income Security Act, known as ERISA was passed into law The act was intended to regulate the activities of employers as related to their handling of retirement pension and savings plans ERISA was enacted to protect the rank and file from the potential abuses by senior management 5

6 401(k) Plans 401(k) Plans Retirement plans deemed to be qualified under ERISA include the 401(K) 401(k) plans limit the amount highly compensated employees can contribute to their plans ($16,500 in 2010)* *IRC 402(g), 2010 contribution limits to 401(k) plans 6

7 ERISA Solution How to address the problem created by ERISA companies Provide executives a nonqualified savings plan Give participant the ability to defer over IRS limits ($16,500 in 2010), and Provide a plan that is not subject to filing, funding or fiduciary responsibilities under Title I of ERISA 7

8 The NQDC Plan Design NQDC Plan The participant is not taxed on the amounts deferred until distributions are received The company sponsoring such a plan cannot take a current tax deduction for amounts deferred, but rather books a deferred tax asset equal to the tax deduction on amounts deferred. Once distributions are made to the participant, an actual tax deduction is taken. The NPV of the future tax deduction (in most cases) is greater than the current tax deduction (asset appreciation rate verses discount rate). The company also records the deferral as a liability on its balance sheet. This records the promise to pay. 8

9 The NQDC Plan Design Asset/Liability Separation Once a plan is implemented, a liability must be recorded for the amount due to the participant It is a corporate decision to set up a reserve/sinking fund to provide liquidity for future benefit payments The assets must be kept separate from the liabilities. Benefits must never be tied to specific assets. This is where the term un-funded comes from. All NQDCPs are unfunded. If not, all deferrals become taxable 9

10 The NQDC Plan Design Distribution Options One of the attractions of deferred compensation plans is the distribution options Each amount deferred can have its own payout schedule Participant can take short-term distribution (i.e. as early as 3 years from the year of deferral election) Re-deferral features are common, allowing participants more flexibility (restricted by 409A) Retirement benefits can be paid in a lump sum or over 5, 10, 15 or 20 years (with tax-deferred on unpaid balance) When a participant receives a distribution from the plan, taxes are due and the company takes a corresponding tax deduction These plans are generally low cost and structured to attract, retain and/or motivate those eligible to participate 10

11 NQDC Eligibility Who is Eligible to Participate in Nonqualified Plans? Plan must be for a select group of management and/or highly compensated employees As a rule of thumb, these are employees who earn in excess of the Section 414(q)(1)(B) limit for HCEs currently $110, limit doesn t always work to define eligibility As opposed to qualified retirement savings plans, non qualified plans must be unfunded 11

12 NQDC Funding Options

13 NQDC Unfunded Unfunded means money deferred by participants goes into the company s general account and cannot be set aside to guarantee the plan s future obligations If a company sponsoring such a plan becomes bankrupt, the amounts set aside are considered part of the company s assets and therefore subject to the claims of creditors (in 401(k), this is not the case) 13

14 NQDC Unfunded The unfunded feature is what gives the NQDC plan its tax-deferred status The general creditor risk is why only those who are highly compensated may participate. They are deemed to have more control over company decisions. The Department of Labor (DOL) believes that those who are highly compensated are capable of understanding the risk 14

15 NQDC Informal Funding Formal funding is required with qualified plans money is set aside outside company s general creditors (i.e. 401(k)) Informal Funding is where the company uses deferrals to set up a sinking fund to help match the plan assets to its liability Informally funded assets are general assets of the company (even if held in a Rabbi Trust) 15

16 NQDC Informal Funding Company can invest in any asset, but most common choices are mutual funds or Corporate Owned Life Insurance (COLI) COLI products are popular because of the tax advantages they provide to the corporation Any investment gains, dividends or interest earned within COLI held until maturity are tax-free to the company whereas mutual fund gains are taxable at the company s ordinary tax rate. 16

17 NQDC Informal Funding Most companies also place their investments in an irrevocable grantor trust referred to as a Rabbi Trust Rabbi Trust protects participants against all contingencies short of bankruptcy The Rabbi trust is the primary benefits security device used by companies to protect plan assets 17

18 NQDC Security: The Plan and It s Promise

19 The Promise Behind the Plan When the executive defers, the company makes a promise to pay in the future That promise is unsecured and subject to the companies general creditors The promise is what allows for tax deferral The company is not permitted to set the money aside, unreachable by the company s creditors The only thing the executive receives for his or her deferral is a "promise to pay by the company 19

20 The Promise Behind the Plan There are two other caveats that must be understood in order to maintain the tax advantage status of deferred compensation plans Constructive receipt, must follow rules under IRS Section 409A to determine when you can defer and receive payouts Economic benefit, while money is deferred you cannot receive any incidental ( economic ) benefit 20

21 Designing Your Own Plan

22 Plan Design Objective The key to the design process is to determine the company s objectives Nonqualified plans with their unrivaled flexibility can be designed to satisfy a myriad of objectives, but at their core they are put in place to Recruit key employees Retain key employees Motivate key employees Reward key employees Even though nonqualified plans satisfy all four, you need to rank them to maximize plan design 22

23 Attract, Retain, and Reward All nonqualified plans aid in the areas of attracting, retaining, and rewarding key employees. However, the plan can be structured to emphasize one of these areas over another. 23

24 Attract Plan is designed with few, if any, vesting requirements and offers no penalty for voluntary termination of employment. Plan can be structured to allow for deferring signing bonus (with tight vesting schedule). 24

25 Retain Plan design offers provisions that result in the creation of golden handcuffs vesting schedules, preferential treatment of payouts and company contributions can be treated differently to provide disincentive to leave company. 25

26 Reward Plan is designed to reward executives in a tax-advantaged environment. Company contributions are discretionary. Contributions can be made to any participant, for any reason and at any time. Vesting requirements may or may not be imposed. 26

27 What You Need to Know Nonqualified plans allow companies to discriminate, in favor of highly compensated employees Each participant could be subject to different restrictions or lack thereof You could have different classes of employees based on any factor (i.e. title, years of service, age, etc.) 27

28 Summary

29 Summary Nonqualified plans allow companies to be selective Plan can help companies attract, retain, and reward key employees Through proper funding, the plan can be cost neutral to shareholders 29

30 Management Support Sales & Marketing Fee Benchmarking and RFPs Plan Service & Employee Communication Investment Due Diligence Operations Compliance 30