At times, a business owner may find it advantageous to defer compensation until the future. In those cases, some closely held businesses prefer to use a strategy called “Non-Qualified Deferred Compensation” (NQDC).
NQDC plans come in two basic forms. The first is often referred to as a “Supplemental Executive Retirement Plan” or SERP. As the name implies, a SERP is an agreement in which the business promises to supplement the executive’s income at retirement.
The second form of NQDC plan is commonly referred to as a “Salary Reduction/Deferral Plan.” As the name implies, the executive defers his or her own salary to fund the plan. The salary amounts deferred are not currently taxable to the executive, but will be at retirement and then deductible by the business.
Part One: Advantages to the Business
Unlike qualified retirement plans, which include rigid coverage and participation rules, the business owner has the flexibility to decide who, among its executives and highly compensated employees, are allowed to participate in a non-qualified deferred compensation plan.
Deferred compensation plans provide a business with an excellent tool to recruit, retain and reward employees who are vital to its business. Salary reduction plans coordinate with existing qualified plans and can be individually tailored to complement other benefit programs. The company retains significant flexibility regarding funding options. Benefits are tax-deductible by the business when paid.
Where corporate-owned life insurance is used to informally fund the plan:
Tax-deferred accumulation and high, early cash value can offset the impact to earnings charges;
Policy cash values are subject to business control and can be used for general business purposes;
Death benefits are generally received income-tax free (subject to alternative minimum taxes);
Any excess insurance proceeds left over after all benefit obligations are satisfied can be retained by the business;
And with the proper plan design, plan expenses can be fully recovered by the business from the insurance death benefit proceeds.
A vesting schedule can ensure that employees who leave the business receive no benefits, and delayed vesting schedules can encourage participants to stay with the business. The plan can be designed with a “cost of money” factor so the business can actually profit from the plan. Compared with qualified retirement plans, there is minimal government reporting requirements. The plan can help to align a participant’s job performance with long-term corporate goals, and helps to maintain corporate continuity and stability within the business’s senior management team.
In part two, we will consider the advantages to the participants.