Nonqualified Deferred Compensation

Emory Fairbanks, a senior executive at Ashgrove Metals, is offered a nonqualified deferred compensation arrangement instead of a larger qualified plan benefit. Compared with the company's qualified 401(k), the nonqualified arrangement:

1. A.Must be funded in an irrevocable trust that places the assets beyond the reach of the employer's creditorsFormally funding the promise beyond creditors' reach would trigger immediate taxation to the executive.
2. B.May be offered selectively to a chosen group of executives and escapes nondiscrimination testing, but the deferred amount remains an unsecured claim exposed to the employer's creditorsCorrect. Selectivity is the benefit; creditor exposure is the cost of keeping the deferral untaxed.
3. C.Gives Ashgrove an immediate tax deduction in the year the deferral is creditedThe employer's deduction is deferred until the executive includes the compensation in income.
4. D.Must cover every employee who satisfies the plan's age and service requirementsThat is a qualified plan coverage rule; nonqualified arrangements are deliberately selective.

Why: A nonqualified deferred compensation plan is deliberately outside the qualified plan rules. The employer may offer it selectively to a hand-picked group of executives, so it escapes the coverage, participation and nondiscrimination testing that constrain qualified plans. The price of that flexibility is security: to keep the deferral untaxed, the promise must remain an unfunded, unsecured obligation, leaving the executive a general creditor of the employer if the company fails. The employer's deduction is likewise deferred until the executive includes the amount in income.

Corvina Steel offers its five most senior executives a nonqualified deferred compensation arrangement, on top of the 401(k) plan available to all employees. The chief financial officer asks how the nonqualified plan differs. Which statement is correct?

1. A.It must satisfy the same coverage and nondiscrimination testing as the 401(k), which is why participation is limited to five executives.Incorrect. Escaping those tests is the entire point of going nonqualified; the small group is a choice, not a testing result.
2. B.It may cover a select group of highly compensated executives only, it is generally an unfunded promise leaving participants as unsecured general creditors, and the employer deducts the compensation only when it is paid.Correct. Selective coverage, creditor exposure and a deferred employer deduction are the three defining features of a nonqualified arrangement.
3. C.Deferred amounts are held in a trust for the exclusive benefit of participants and are therefore protected from company creditors in bankruptcy.Incorrect. That describes a QUALIFIED plan. Nonqualified deferrals generally remain company assets subject to creditor claims.
4. D.The employer deducts the deferred compensation in the year it is credited, and the executive is taxed in that same year.Incorrect. Employer deduction and executive taxation both wait until the compensation is actually paid.

Why: A nonqualified deferred compensation plan is deliberately outside the qualified plan rules, which is why it can be offered to a hand-picked group of executives without meeting coverage and nondiscrimination testing. The price of that flexibility is security: the arrangement is generally an unfunded contractual promise, so if the company fails, the executives stand in line with other unsecured general creditors. Timing follows the same logic. The executive is not taxed until the deferred amounts are actually or constructively received, and the employer cannot deduct them until that same point.

Ravensmere Tooling promises its chief engineer's family a stream of payments for a period after his death, payable out of company funds under a written agreement. To recover its cost, the company buys a policy on his life that the COMPANY owns, pays for and is beneficiary of. The engineer has no rights in the policy and cannot assign or borrow against it. What has the company created, and how is it treated?

1. A.A nonqualified SALARY CONTINUATION, or death-benefit-only, arrangement: the company's premiums are not deductible, the proceeds it receives are its own, and the payments it later makes to the family are deductible by the company and taxable to them.Correct. Employer ownership of the policy makes the premium nondeductible and the proceeds corporate funds; the separate promise to the family is compensation, deducted when paid and taxed to the recipients.
2. B.A qualified plan, because the promise is in writing and the benefit is definitely determinable.A qualified plan must be funded through a trust for the exclusive benefit of participants and must satisfy participation, coverage, vesting and nondiscrimination rules. A selective corporate promise backed by a company-owned policy meets none of those.
3. C.A Section 162 executive bonus plan.Under a Section 162 bonus the EXECUTIVE owns the policy and the employer's premium payment is a currently deductible bonus that is currently taxable to him. Here the executive owns nothing.
4. D.Group term life insurance subject to Section 79.Section 79 applies to group term life carried by an employer for a group of employees, with the employee able to name the beneficiary. This is a single company-owned contract on one life with the company as beneficiary.

Why: This is a nonqualified SALARY CONTINUATION arrangement, often called a death-benefit-only plan. Because the employer owns the policy and is its beneficiary, premiums are not deductible and the death proceeds it collects are its own money. The separate contractual payments the company later makes to the family are deductible by the company as compensation when paid and are taxable income to the family. Because the arrangement is nonqualified, the employer may select who participates without coverage or nondiscrimination testing, but the promise is an unsecured one.

Bramwell Foundry promises four senior executives deferred compensation payable at retirement and funds the promise by contributing to an irrevocable RABBI TRUST. An executive asks his IAR whether the trust makes the benefit secure and whether it changes when he is taxed. Which statement is correct?

1. A.The trust protects the benefit against the employer changing its mind or being acquired, but the assets remain reachable by the employer general creditors, and that continuing exposure is what preserves deferral until benefits are paid.Correct. Creditor exposure is the feature, not the flaw: removing it would trigger current taxation on the amounts set aside.
2. B.Because the trust is irrevocable, the assets are beyond the reach of the employer creditors, and the executive is taxed only when benefits are actually paid.Incorrect. Rabbi trust assets remain subject to general creditor claims. Shielding them from creditors would accelerate taxation.
3. C.Funding the trust causes the executive to be taxed immediately on the amounts contributed, in the year of each contribution.Incorrect. That is the outcome for a SECULAR trust. The rabbi trust structure is designed specifically to avoid current taxation.
4. D.The trust converts the arrangement into a qualified plan, so the benefit is protected by ERISA fiduciary and vesting rules.Incorrect. A rabbi trust does not make a nonqualified plan qualified. Deferred compensation for a select group of senior executives remains nonqualified.

Why: A rabbi trust is an irrevocable trust that holds assets earmarked for a nonqualified deferred compensation promise. It solves one problem well: because the employer cannot take the assets back, it protects the executives against a later change of heart by management or by an acquirer following a change of control. It deliberately does NOT solve the other problem. The trust assets remain part of the employer general assets and stay subject to the claims of the employer general creditors in insolvency. That exposure is not an oversight; it is the essential feature. If the assets were shielded from creditors, the executive would be treated as having received an economic benefit and would be taxed currently on the amounts set aside. Because the risk of forfeiture to creditors persists, taxation is deferred until the benefit is actually paid, at which point it is ordinary compensation income. A SECULAR trust does protect against employer insolvency, and the price of that protection is exactly the current taxation a rabbi trust avoids.