Definition of Deferred Compensation Plan

Retirement

A deferred compensation plan is an arrangement under which employees or owners agree to have income earned in one period paid at a later specified date, or deferred. There are two types of deferred compensation plans, those that satisfy all the requirements of Internal Revenue Code Section 401(a), entitled "Qualified pension, profit-sharing, and stock bonus plans," and those that do not.

Section 401(a)

Under Section 401(a), trusts that are part of a stock bonus, pension or profit-sharing plan set up by an employer exclusively for the benefit of his employees and/or its beneficiaries are qualified trusts if they meet certain standards, including the minimum participation standards of Section 410 of the IRS Code; and that the contributions or benefits provided under the plans do not discriminate in favor of highly compensated employees.

Benefits of Qualified Plans

Both employer and employee contributions to qualified plans are tax-deductible in the year in which they are made, and earnings on the contributed funds are exempt from taxes. The employee does have to pay taxes on money he withdraws from the fund--but the presumption is that he will be in a lower income tax bracket after retirement when the money is withdrawn.

Non-qualified Plans

Non-qualified deferred compensation (NQDC) plans also pay employees in the future for work performed in the current period. Unlike qualified plans, these plans can be targeted at certain employees or certain categories of employees such as upper management, and there are no nondiscrimination requirements. Employers only get to subtract payments from their taxes once the funds are paid to the employee.

Benefits of NQDC Plans

The primary benefit of NQDC plans is that they can be targeted to highly compensated employees, and the firm is not obligated to offer them to all employees. They can also be used for purposes other than tax planning, such as the retention of qualified personnel. Contributions to NQDC plans are not taxed if benefits under the plan are only payable upon retirement, death or separation from service and are not subject to assignment.

Unfunded Plans

One category of NQDC plans is unfunded plans, which are exempt from Employee Retirement Income Security Act of 1974 standards as long as their primary purpose is deferring compensation for certain management or highly compensated employees. Under an unfunded plan, no contributions are made to a plan during the employee's service--it is a pure contract.

Conditional Plans

Another way to ensure that NQDC plans do not generate currently-taxable income to the employee is to include a forfeiture provision in the contract--the employee's right to receive employer contributions will be conditioned on his term of service, her rendering ongoing consulting and advisory services, or his refraining from disclosing trade secrets.

References

• Internal Revenue Code Title 21, Sec. 401(a)
• Internal Revenue Service: Nonqualified deferred compensation audit techniques guide
• "The CPA Journal:" Employee benefit plans