Nonqualified deferred compensation plans Featured

7:41am EDT June 19, 2006
For many companies, nonqualified deferred compensation plans are an important incentive tool for luring and keeping key employees. Qualified plans like 401(k) limit the amount of money employees — especially highly compensated employees — can defer. Nonqualified deferred compensation plans are a good supplement to qualified plans for key employees, and can offer substantial tax benefits.

Thanks in part to recent corporate scandals like Enron, new regulations for nonqualified deferred compensation plans went into effect beginning Jan. 1, 2005. There are several important changes that companies and executives alike must be made aware of, according to Paul Ryan, a partner in the executive compensation and employee benefits practice at Gambrell & Stoltz.

“Many companies are operating with the same plans they’ve had in place since the early 1990s and haven’t kept up with the changes in the law,” he says. “But because it’s the executive who pays the price, it’s important that executives retain their own counsel to review these plans and their elections to ensure they are up-to-date with current regulations.”

Smart Business spoke with Ryan about the recent changes in regulations for nonqualified deferred compensation plans and what companies and executives alike should know about the new regulations.

What is a nonqualified deferred compensation plan?
Nonqualified deferred compensation plans can only be offered to a select group of management or highly compensated employees. Under a new law, any plan or arrangement that results in the deferral of compensation other than qualified plans like 401(k) and profit-sharing plans and bona fide sick leave, vacation, death and disability plans, are considered a nonqualified deferred compensation plan and subject to the new rules.

It is important to note that the definition of a nonqualified deferred compensation plan includes plans, such as certain severance arrangements, that have not traditionally been considered to result in the deferral of compensation.

What requirements does the tax code impose on nonqualified deferred compensation plans?
Internal Revenue Code Section 409A specifically deals with these types of plans and imposes requirements on the election to defer compensation and on the payout of the deferrals. The law, which went into effect in 2005, clarifies that the deferral of compensation must occur in the year prior to the year in which the money is earned, except in the case of a new employee who can defer within 30 days of becoming eligible.

Another key requirement is that the payout for these plans is only upon specified events like severance from employment, death, disability, a change in company ownership, an unforeseeable emergency and the occurrence of a specified event that must be elected at the time the deferral is made. A lot of plans previously allowed the employee to take out money during employment when needed. An executive may elect to have the money paid out at a specified time, such as age 55, or over the course of several years. This must be established when the deferral election is made.

For example, if an executive had a lot of money saved up in one of these plans and wanted to use the money to pay for a child’s college education, the plan would often allow him to take that money out, with perhaps a 10 percent penalty. This is no longer possible under the new regulations, unless this payout was specifically established at the time of the deferral.

Furthermore, 409A applies to all companies, whether publicly traded or not, but there is a six-month waiting period imposed on certain key employees who terminate employment from a public company. This includes not only companies whose stock is directly traded, but subsidiaries of foreign companies whose stock is traded on another country’s exchange.

Can an executive ever change this election?
Yes, but there are stringent requirements governing these changes.

First, the change cannot take effect until 12 months after the date on which the election is made.

Second, except in the case of termination, death, disability or a change in the control of the company, the change must postpone the payment for at least five years from the date the payment was scheduled to be made.

Lastly, the election has to be made at least 12 months prior to the date of the first scheduled payment.

What are the penalties if an executive violates these rules?
Penalties to the executive, not the company, are severe. Not only will the executive be fully taxed on the deferral amount, but additional interest and penalties could add up to another 30 percent or more of the deferral amount.

Although compliance started for all amounts deferred or not vested by Jan. 1, 2005, the actual plan documentation must occur by the end of 2006.

PAUL RYAN is a partner in Gambrell & Stoltz’s executive compensation and employee benefits practice. Reach him at (404) 223-2209 or pryan@gambrell.com.