|JOHN C. BOMA,
CPA, is a principal of Scott, Doerschler, Messner &
Gauntlett in Kalamazoo, Michigan. He is a member of the American
Institute of CPAs employee benefits taxation committee and
chairs the nonqualified executive compensation working group.
MICHAEL D. ROSENBAUM, CPA, JD, is a partner in the law firm of Gardner, Carton & Douglas in Chicago.
When 401(k) plans were introduced in 1984, most executives took full advantage of the opportunity to defer current income (then taxed at marginal rates of over 50%) into the future, usually until retirement, when tax rates were expected to be much lower. These plans were important investment opportunities because executives could invest a significant amount of income on a pretax basis. However, since their introduction, Congressalmost on an annual basishas passed laws to reduce the amount of 401(k) and other qualified plan benefits (profit sharing, money purchase pension, defined benefit) that companies can provide to highly compensated and midlevel executives. As a result of those legislative changes, qualified plans, while still attractive, are only a starting point in successful executive retirement benefit planning.
Nonqualified deferred compensation plans often are the benefit of choice to supplement qualified plan benefits. Regulations issued by the Department of Labor, the Internal Revenue Service and the Securities and Exchange Commission as well as several high-profile court cases have had a significant impact on the design, taxation and structure of nonqualified plans. As a result of these developments, many employers have unwittingly put their nonqualified plans in danger of incurring undesired tax and legal consequences. To help ensure compliance with the applicable rules, CPAsboth inside and outside a companymust assume an increasing responsibility for the design, development and oversight of nonqualified retirement plans.
The Uses Of Nonqualified Plans
Companies use nonqualified plans for a variety of reasons. The principal one is to allow a select group of executives to defer income beyond the limits imposed by Congress on qualified plans. Some examples of these limitations are summarized in exhibit 1, page 48. Other reasons companies offer nonqualified plans include avoiding discrimination testing, providing new or additional incentive compensation and targeting benefit dollars to a select group of executives. It is important to note, however, that nonqualified plans are not the same as qualified retirement plans and typically a company should use them only after maximum contributions have been made to qualified plans. For a comparison of the key differences between nonqualified and qualified plans, see exhibit 2, page 49. (As exhibit 2 shows, different and more restrictive rules apply to plans sponsored by tax-exempt organizations.)
Plan Design Issues
To maximize the effectiveness of a nonqualified plan, employers and their advisers must consider a number of factors, including issues of participation, taxation, funding, security and distributions.
|Retirement Ready or Not?|
In a survey of 400 Americans aged 65
Source: ReliaStar Financial Corp.
Participation. Under the Employee Retirement Income Security Act of 1974, a typical nonqualified plan may be offered only to a select group of management or highly compensated employees (often referred to as the top-hat or select group). However, the DOL has not yet provided a definition of what constitutes a select group. As a result, a company has no choice but to review the DOLs earlier formal and informal guidance and make a good-faith effort to comply with the select group rules.
Federal income taxation. Avoiding taxation at the time of deferral is essential when a company designs a nonqualified plan. The IRSs general position is that income may not be deferred once it has been earned. To satisfy the IRS, an employees election to defer compensation must be made before the period in which the income will be earned. For salary deferrals, this requirement is satisfied if an employees election for the following year is made before January 1.
Bonus deferrals pose more problems. The current IRS position treats a bonus as earned during the entire period and thus requires that a deferral election be made before the period in which the bonus is earned. For example, if a corporation pays a bonus to an executive in February 1998 based on the results of the fiscal year ended December 31, 1997, the employees election to defer that bonus must have been made before the beginning of fiscal year 1997 (before January 1, 1997). The courts have been more lenient in applying these rules in the executives favor.
|Exhibit 1: Legislative Limitations on Qualified Plans|
Security and funding. A nonqualified plan must be unfunded to avoid applying ERISA. For purposes of a nonqualified plan, unfunded means
- Each participant is a general unsecured creditor of the employer.
- Even though the employer may set up a bank account, accounting reserve, annuity or any other fund to reflect the deferred compensation under the plan, the corresponding assets must remain general assets of the employer (subject to the claims of the companys general creditors).
- No current beneficial interest may be created on any plan participants behalf in any assets.
|Exhibit 2: Key Features of Qualified and Nonqualified Retirement Alternatives|
The unfunded nature of nonqualified plans may cause executives to be concerned about two risks: the risk the employer cannot afford the future payment of benefits and the risk the employer will not pay the benefits for nonfinancial reasons. If the employer maintains an unfunded liability, it will require future management to pay benefits attributable to past periods. To address these risks, many employers establish informal funding vehicles such as a Rabbi trust, secular trust, offshore Rabbi trust, life insurance or indemnity insurance. The key characteristics of these and other vehicles are summarized in exhibit 3, page 50. Such funding strategies and the knowledge the employer has set aside funds to meet these future obligations will increase an executives sense of securityespecially since it often is part of the executives own compensation that is deferred under a nonqualified plan.
Distributions. One parameter that causes the most headaches for plan participants is the IRS rules for nonqualified plan distributions. The IRS safe-harbor rules require that a participant elect a distribution method when the deferral election is made. This requirement makes it difficult for younger executives to plan for future retirement distribution needs. While the IRS takes a very restrictive position, the courts have been more flexible and in many cases have supported taxpayers ability to change their elections at a date later than the date on which they made the deferral election, as in Martin v. Commissioner (96 TC 814). Surveys of plan sponsors indicate that more plans are allowing participants to change or make their elections after the deferral election.
The past few years have seen a flurry of activity regarding the rulings and regulations under which nonqualified plans operate. CPAs need to be aware of these developments, which have come from a variety of sources.
401(k) qualified/nonqualified combination plan ruling. In private letter ruling 9530038, the IRS ruled on a plan that combined the deferral elections for a qualified 401(k) plan and a nonqualified plan. The ruling allowed an executive to make a single election to defer compensation into a nonqualified plan throughout the year. At the end of the year, when discrimination testing was complete, the amount that could be contributed to the 401(k) plan was transferred from the nonqualified plan to the qualified plan. Any excess contributions, which otherwise would have to have been paid back to the executive and been taxable, remained tax deferred in the nonqualified plan.
Employment taxes. The IRS also released proposed regulations on the taxation of deferred compensation for FICA, FUTA and Medicare (employment tax) purposes. Nonqualified plan contributions are to be taken into account for employment tax purposes when the contributions are earned and no longer subject to a substantial risk of forfeiture (that is, when vested). Once taken into account, these amounts are not subject to future employment taxes (such as when benefits are actually paid). Similarly, the interest earned also escapes employment taxes, if it is not deemed excessive. However, payments from a nonqualified plan are subject to federal income tax.
Nonresident state taxation. Retirees who have moved but continue to draw monthly pension checks from their home states sometimes have faced a source tax on such payments. Some states have taxed retirement payments employers made to former residents as income earned while employed in that state. A new law, effective in 1996, prohibits states from taxing individuals who are no longer legal residents of those states.
|Exhibit 3: Devices for Security of Executive Benefits|
Under the 1996 law, states may not tax nonqualified plan distributions that only provide benefits in excess of the limitations imposed on qualified plans (excess plans). However, if the nonqualified plan is not an excess plan, the state may impose a source tax unless certain exceptions are satisfied (distributions are made at least annually and over a period of at least 10 years). If a lump-sum distribution from a nonqualified plan combines excess plan benefits and other nonqualified benefits, all benefits may be subject to the source tax.
SEC registration. The SEC announced its intention to publish its position that, absent an applicable exemption, certain nonqualified elective deferred compensation plans would be required to register under the Securities Act of 1933 if the plans create a security. The SEC is likely to require registration if the plan is designed as an investment plan rather than as a tax deferral strategy.
While this potential registration issue is one employers should consider, we expect very few will have to register their nonqualified plans with the SEC as there are a number of exemptions from the acts registration requirements. The exemption that most closely serves the needs of the majority of employers is the private placement exemption, which exempts every transaction not involving a public offering. This exemption often is used to avoid registering nonqualified plans that cover a select group of management or highly compensated employees. Consequently, even if a companys nonqualified plan is considered to be a security, this private placement exemption, or one of several other exemptions, should be available.
Proxy disclosure. SEC regulations adopted in 1992 require public companies to disclose nonqualified plans in the new summary compensation tables of their annual proxy statements. The amount deferred must be included in the summary compensation table (salary deferrals in column c, bonus deferrals in column d). Excess interest credited must be disclosed in all other compensation (column I). Excess interest is defined as any interest credited to the nonqualified plan greater than 120% of the long-term applicable federal rate.
Replacing Lost Opportunities
401(k) and other qualified plans wereand remaineffective retirement vehicles for all employees. However, qualified plans may not completely meet the needs of highly compensated executives due to increased restrictions and reduced contribution amounts. Employers and executives often choose nonqualified plans to help replace the opportunities lost as a result of these restrictions and limitations. This means nonqualified plans will play a greater role in the retirement planning of most executives in years to come. So that CPAs can provide their employers and clients with the best possible advice, it is critical that they have a thorough understanding of the tax, legal, design, funding, security and regulatory issues concerning nonqualified plans described in this article.