Nonqualified Plans

April 13, 2006

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In some cases, you may want to provide supplementary compensation for key executives or employees, and you may want to defer payment into the future. For example, you may want to induce a particularly valuable employee to remain with you for a certain number of years ("golden handcuffs"). In that case, you could offer the employee a deferred compensation plan that would pay the employee additional compensation upon the completion of a certain number of years service to you. In other cases, you may want to defer compensation for yourself, or for yourself and your partners, to avoid paying taxes on it this year.

You cannot achieve these goals through a traditional retirement plan (assuming you want the tax advantages) because the laws require you to provide benefits that are uniform and that don't discriminate too much in favor of key executives. The best arrangement, then, for accomplishing your goals may be through a nonqualified plan.

By "nonqualified," we mean simply that the plan is not subject to certain federal pension law provisions, such as the ones on nondiscrimination, eligibility, funding, and vesting. As a result, it doesn't get as many tax breaks as regular pension plans do. You should not be lulled into believing that nonqualified plans are not subject to any of the provisions that govern qualified plans; they are in fact generally subject to all of the provisions except those mentioned above.

Too good to be true? At this point, you're probably thinking, "This sounds too good to be true — there must be a downside." If you are, you'd be right. There is a downside. If there weren't, every plan would be nonqualified. The main downside is that your business income tax deduction is also deferred; your business is not entitled to a deduction for the deferred compensation until the funds are available to the recipient, which could be years away.

Terminology. The world of nonqualified plans has a colorful language all its own. There are

Top-hat plans: A top-hat plan is an unfunded plan maintained primarily to provide deferred compensation to a select group of management or highly compensated employees. Special reporting and disclosure rules apply.
Rabbi trusts: A rabbi trust is a nonqualified deferred compensation arrangement in which amounts are transferred to an irrevocable trust to be held for the benefit of executive employees. The funds in the trust can still be reached by creditors of the company; for example, in a bankruptcy.
Golden parachutes: A golden parachute is an agreement between companies and their key personnel under which the corporation agrees to pay these key individuals certain amounts, often in excess of their usual compensation, if control of the corporation changes. They became popular during the time when hostile takeovers were common.
Golden handcuffs: A golden handcuff is an agreement between companies and their key executives under which the executives are paid supplemental retirement benefits if they meet certain conditions, such as if they remain with the company until a certain age. Golden handcuffs are designed to encourage long-term employment relationships.

Behind the interesting language, however, are all the familiar (and complex) pension concepts. This is especially true in light of the funding and distribution restrictions on nonqualified plans. The failure to comply with these rules could subject participants who defer compensation through a nonqualified plan to current taxation and/or penalties. Because this area is so complex, you should discuss with your attorney or accountant whether a nonqualified plan is appropriate for you.