A nonqualified deferred compensation plan (“Nonqualified Plan”) is legally defined as “any plan that provides for the deferral of compensation, other than: (a) a qualified employer plan; and (b) any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan.” See 26 USC 409a (d)(1).” This broad definition includes stock options and other long-term equity-based pay as nonqualified deferred compensation.
For our discussion, we are simply considering standard industry terminology. Therefore, a nonqualified plan is better defined as a contract between an employer and one or more select “Key Employees” (highly compensated employees or independent contractors) in which the Key Employees defer a portion of their salary, bonus, or other compensation until a future date based on the terms of a legal plan document.
Nonqualified plans are typically unfunded based on the laws that govern them. At the same time, the Key Employee controls the investment of their account similar to a 401(k). However, when a plan is unfunded, the employer does not actually invest the Key Employee’s deferred compensation in the market. Instead, the Key Employee’s account grows theoretically based on the performance of the benchmarks. The Key Employee can generally change the investment allocation at any time.
Contributions to an unfunded nonqualified plan generally are not deductible for the employer as compensation. However, the employer will get a deduction when the Key Employee recieves the compensation.
Key Employee Tax Benefits
The tax purpose of a nonqualified plan for a Key Employee is multifaceted. First, the amount deferred by the Key Employee is likely not taxable until the Key Employee receives it. Therefore, the Key Employee will pay less in taxes in any year in which they defer compensation.
Second, the Key Employee will likely be in a lower tax bracket when they eventually receive the compensation. Additionally, any growth in the Key Employee’s account is tax-deferred. This means the Key Employee will not pay tax on the principal and the income generated until the Key Employee “receives” it.
Terminology
In order to better understand nonqualified plans, it helps to break down the terminology.
Nonqualified – a “non-qualified” plan does not meet all of the technical requirements imposed on “qualified plans” (401(k), pension plans, profit-sharing plans, etc.) under the Internal Revenue Code (IRC) or ERISA. Therefore, plans generally are not subject to the fiduciary, nondiscrimination, coverage, funding, vesting, distribution, reporting, disclosure, and almost all other requirements applicable to tax-qualified deferred compensation plans.
Deferred – The deferral limit for a 401K in 2020 is $19,500. While substantial, this might not be a significant amount for a Key Employee. There are no limitations on deferred amounts and no minimum distribution rules for nonqualified plans. This makes these plans a useful tool for attracting and retaining top talent.
Compensation – A Key Employee can defer salary, bonuses, or any other type of compensation to fund the plan. The plan offers the long-term tax-deferred savings described above. This incentivizes Key Employees to participate in a nonqualified plan. However, the Key Employee’s participation limits the employer’s tax deduction until after the Key Employee receives the compensation.
Plan – Employers establish nonqualified plans for any number of Key Employees. Non-qualified deferred compensation plans are so flexible they can even include independent contractors, including directors.
Chasen Cohan, Esq. is the founder of Cohan PLLC. Mr. Cohan is a licensed attorney who also possesses FINRA Series 7 (Registered Representative) and Series 63 (Uniform State Representative) licenses, state insurance licenses, and State Securities Registrations in Nevada, Missouri, and North Carolina. Mr. Cohan is admitted to practice law before the Nevada Bar, all Nevada State and Federal Courts, and the United States Court of Appeals for the Ninth Circuit.
Mr. Cohan’s representative clients have included: Wal-Mart Stores, Inc., Sam’s West, Inc., MGM Grand Resorts International, New York-New York Hotel & Casino, Mandalay Corp., The Treasure Island Hotel and Casino, The Cosmopolitan of Las Vegas, The Mirage Casino-Hotel, South Point Hotel & Casino, American Express, Barclays, US Bank, Wells Fargo, Citibank, and various life insurance companies and service providers.
Mr. Cohan is a Las Vegas native who graduated with honors from UCLA with a Bachelor of Arts degree in Political Science. Mr. Cohan received his Juris Doctorate from the University of Texas School of Law. During law school, Mr. Cohan served as a clerk for the Office of the Texas Attorney General and a Judicial Extern for United States District Court Judge James R. Nowlin.
Clients from global brands and middle-market companies to innovative startups and individuals trust Cohan PLLC to resolve their trickiest legal disputes. Whether that’s litigation in state or federal trial and appellate courts in Nevada; investigations and enforcement actions before government agencies; or mediation, arbitration, and regulatory agency proceedings. Cohan PLLC has litigated hundreds of millions in dollars of claims on behalf of corporate litigants. As a result of this experience, Cohan PLLC has been afforded the opportunity to selectively act as Plaintiff’s counsel on complex, personal injury matters.