Bar News - February 18, 2015
Tax Law: Using Nonqualified Deferred Compensation to Benefit Employees
By: John E. Rich Jr.
Since the 2008 recession, tax attorneys have increasingly seen employers using non-qualified deferred compensation arrangements. Although stock option plans remain popular, there are other types of deferred compensation that do not involve stock options or transferring stock to employees that still provide economic benefits to workers.
Under a nonqualified deferred compensation plan, an employee has a legally binding right in one year to compensation that is, or may be, payable in a later taxable year. There are different types of arrangements, including supplemental executive retirement plans (SERPs), stock appreciation rights plans (SARs), and phantom stock, but common to all is that the employee is paid a future amount taxable as ordinary income based on a formula or criteria set forth in a written plan.
These are extremely flexible arrangements and have a variety of purposes, such as providing additional compensation for retention purposes, providing the economic benefits of ownership without diluting the owners, or incentivizing employees to help the business grow more profitable. There is no annual benefit limit, no required vesting, or required minimum distributions as in tax-qualified plans like 401(k)s. However, Tax Code Section 409A requires that, unless an exemption is available, payments to be made only at certain specified events. Specific definitions must be used for separation from service, change of control, and other payment events. The failure to comply with Tax Code Section 409A results in employees being taxed on awards upon vesting, even if not paid, and paying an additional 20 percent excise tax.
These nonqualified plans must be discriminatory to avoid violating the Employee Retirement Income Security Act of 1974, as amended (ERISA). The plans must be limited to a select group of management or highly compensated employees (HCEs), the so-called “top hat” group. Tax-exempt employers also have Tax Code Section 457(f) to consider, which requires both a substantial risk of forfeiture during employment to avoid current income tax recognition and taxation on vesting, which significantly limits tax-deferral opportunities following termination of employment.
Typical Bonus or Incentive Plan
A business owner wants to provide additional compensation to a group of management employees to reward them for past service and provide an incentive to continue to work for the business. One option is for a fixed award for past service, along with future awards tied to the performance of the business, based on an objective measure.
Normally, there will be a vesting period, so that payment of the awards will not occur unless the employee works a period of years. Unlike tax-qualified retirement plans, there is no maximum vesting period, and yearly awards can have their own vesting schedule to provide retention incentives.
To comply with Tax Code Section 409A, payment must be made starting at either a fixed time, or at another 409A payment event, such as separation from service, death or disability. Payment can be made in a lump sum or over a period of years, but the payment schedule must be stated in the plan and acceleration of payments cannot occur.
One of the drawbacks of any deferred compensation arrangement is that employees are unsecured creditors of the employer, subject not only to the solvency and credit risks of the employer, but also to the employer’s good faith payment.
To provide security to employees, an irrevocable trust can sometimes be used. An irrevocable trust, because of retained administrative powers by the employer, is treated as a grantor trust for Tax Code purposes. The trust assets are considered the employer’s assets rather than the employees’, or those of a separate taxable entity. The trust assets may be used by the trustee only to pay the promised benefits or to pay the claims of creditors. The trust is called a “rabbi” trust because the first IRS ruling on this technique involved a congregation that used such an arrangement to support its retirement obligations for its Rabbi.
Another common scenario is a business owner who anticipates selling the business in five or more years and wants to provide incentives to key employees to grow the business to where it becomes attractive to a third party. Often in this situation, the deferred compensation plan will pay a benefit only when the business is sold. We refer to this as a change-of-control plan. The key is deciding how much of the sale price will be shared with employees. Sometimes a pool will be created equal to a percentage of the deal price allocated among employees based on various criteria.
Another option is to award employees phantom stock or units based on stock appreciation. Phantom stock bases the transaction payment on hypothetical shares awarded to employees and the value of the stock at the sale date, or the appreciation in the value from the date of the award. The payment terms for change-of-control arrangements can be fairly complex to account for different types of transactions and the possibility of consideration other than cash being received over a period of time. Tax Code Section 409A requires very specific change-of-control definitions.
Lastly, Tax Code Sections 280G and 4999 must be considered in connection with large payments made to management or owners in connection with a change of control. These rules limit corporate deductions for excess parachute payments and impose an excise tax of 20 percent on the employee.
In summary, although deferred compensation arrangements offer considerable flexibility to provide benefits, there are several Tax Code and ERISA rules to consider in connection with their implementation.
|John E. Rich Jr.
John E. Rich Jr. is a Director at the McLane law firm. He specializes in employee benefits, pension, ERISA and tax-related matters. He can be contacted directly at (603) 628-1438, or by email.