A nonqualified deferred compensation plan can help you compete for top talent.
When trying to attract executives and key employees, business owners may need to compete with the compensation or retirement benefits offered by potentially larger competitors. One way to appeal to top talent is to borrow one of their strategies.
A nonqualified deferred compensation plan can help you attract, retain and reward key employees and encourage long-term commitment.
Nonqualified deferred compensation is pay an employee earns during their working years and receives later, often at retirement, after reaching a performance milestone or when another agreed-upon event occurs.
It’s called “nonqualified” because, unlike qualified retirement plans such as a 401(k), it doesn’t qualify for tax advantages under Section 401(a) of the Internal Revenue Code (IRC). The plus side of not qualifying is avoiding the specific, strict rules governing qualified plans, such as mandatory broad employee participation.
As a result, employers can offer the benefit to selected executives or other highly compensated employees, as long as the arrangement is structured to comply with applicable rules.
Nonqualified deferred compensation, often referred to with the acronym NQDC, can help you both overcome limitations and incentivize important goals.
For example, if your business can’t match the same compensation packages of larger companies, deferred compensation may help you create a more compelling offer for top talent while tying future compensation to a particular revenue milestone.
Even if you have the funds now to offer superior compensation, NQDC lets you make the compensation contingent upon an output or outcome you want a candidate to deliver. In this way, you incentivize your new hire to help you achieve your specific goals.
You could even use NQDC to encourage key employees to stay. If an employee's NQDC vests only after a set period of continued employment or compliance with a non-compete, they have an incentive to stay with your company until vesting completes and to not join a competitor.
From an employee’s perspective, NQDC functions as a supplemental retirement plan, helping them potentially increase retirement savings beyond the annual contribution limits that apply to qualified plans. When a plan's returns are tied to company performance, it can also give employees a greater sense of ownership in the business's success.
While NQDC can provide substantial advantages, business owners should fully understand the associated obligations and risks.
Creditor exposure
Unlike qualified retirement plan assets, NQDC benefits generally remain subject to the claims of company creditors. Participants are relying on the financial strength and long-term viability of the business.
Financial statement impact
Because deferred compensation represents a future obligation, it is represented as a liability on company financials.
Tax timing
Employers generally do not receive a tax deduction until benefits are paid to participants. Understanding the timing of both deductions and distributions is essential when evaluating the economics of a plan.
Proper design and administration are critical
To receive the intended tax treatment, NQDC arrangements must be carefully structured and administered in compliance with Internal Revenue Code Section 409A.
If you decide to offer NQDC, you must document the following in your plan/offer:
There are six allowed triggering events:
As these requirements suggest, setting up an NQDC plan requires complex legal drafting as well as strict compliance with IRS Section 409A, ongoing recordkeeping and formal plan administration. But these administrative challenges may be worth it if it helps you secure needed talent.
NQDC plans are subject to the credit worthiness of the sponsoring company. NQDC plans are regulated by IRC Sec. 409(a). As such, they require a third-party administrator. Raymond James and its representatives do not give legal or tax advice. You should consult your legal or tax advisor for answers to specific tax questions.
