Rainier Group | Non-Qualified Deferred Compensation
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Non-Qualified Deferred Compensation

Non-Qualified Deferred Compensation

Non-qualified deferred compensation plans are designed to provide incentive and reward key employees and are not governed by the special tax rules for ‘qualified’ plans, such as 401 (k) and other profit-sharing arrangements. Unlike qualified plans, which are deductible to the company when funded, but only taxed to the participant at withdrawal, non-qualified plan payments are not deductible to the company until funds are actually paid to the participants. Their non-qualified nature, however, allows much more flexibility in participant selection, vesting schedules and forfeiture rules.

Plan Basics

While more flexible than qualified plans, non-qualified plans must follow the rules in code section 409A, and in ERISA. Several points to keep in mind when putting a non-qualified plan in place:
  • No special tax treatment: As noted above, benefit payments are deductible from the company only when paid to the participants, not when funds are set aside for their future payment.
  • Select group as participants: To avoid having to follow the more restrictive ERISA requirements, non-qualified plans are normally set up with a select group of participants, not the larger population of employees, to qualify for the “Top-Hat” exception.
  • Little payment flexibility: Once benefits are earned, there is very little discretion on the part of the company or participant on when or in what manner benefits are paid. The employee cannot choose to ‘withdraw’ funds or defer them for a longer period. The payment provisions must be set at the time funds are deferred and followed thereafter.
  • Unfunded plan: Unlike qualified plans, where contributions are set aside in a trust for the benefit of the participants, shielded from company creditors, a non-qualified plan must remain ‘unfunded’. Assets can be set aside for future payment to the participants, but these assets must be subject to the claims of creditors and cannot be secured.
  • High contribution flexibility: Non-qualified plans do not have to follow the anti-discrimination rules or contribution limits of qualified plans. This means that the allocation of benefits can be based on any number of factors, from a simple percentage of salary’ basis, to benefits based on the growth of the company, to a fully discretionary employer contribution.
  • High vesting flexibility: If exempt from ERISA guidelines, the plan vesting schedule
  • can be set as desired by the company.
High flexibility in setting payment provisions: Although the company and participants can have no discretion in starting benefit payments, the benefit payment provisions in the plan itself can be very flexible. Benefit payments can be triggered at a set time, at retirement, at termination, at death or disability, at a company change of control, or for ‘financial emergency’. These payment provisions are set up at the time of the plan’s drafting.

Phantom Stock

The employee is “credited” with an ownership stake equal to a certain percentage of the company but does not receive any shares. At some point in the future this stake is “re-purchased” by the company. The value of the company, and the portion of that value attributed to the employee’s phantom shares, determines the amount of the payment.

Example

The company is valued at $15,000,000. The employee is credited with a 1% phantom ownership in the company (then worth $150,000) at the plan’s inception. The plan promises to pay the benefit over 5 years beginning at the employee’s retirement provided certain conditions are met. Assuming the conditions are met, and employee retires 13 years later when the company is valued at $50,000,000, the employee would be paid 1% of that value ($500,000) over 5 years.

Items Worth Noting

  • The employee pays income tax on the value of the compensation received. As long as specific rules regarding “constructive receipt” are followed and the plan is “unfunded”, tax is due as payments are actually received by the employee.
  • The employer receives a tax deduction for the compensation paid to the employee.
  • The employer is required to withhold taxes.
  • The terms are completely flexible at the plan’s inception. At the beginning of the plan, the employer determines the size and timing of all phantom stock grants, contractual conditions, payment terms, etc.
  • The company’s obligation to pay is usually carried on the company’s financials as a liability.
  • Avoids providing employees with actual ownership in the company.
  • Allows an employee to obtain the benefit of stock ownership without making an investment.

Key Features

  • Phantom stock plans emphasize a feeling of ‘ownership’.
  • There is an immediate (but unvested) benefit at grant.

Stock Appreciation Rights (SARS)

In concept, a SAR plan works much like options do in the context of a publicly traded company. Each participant is issued several Stock Appreciation Rights (SARs) in the company. At the time of issue, the rights are worth nothing: the ‘execution price’ (analogous to a strike price in an option) of the SAR is the same as the current SAR value of the company. As the company grows, the difference between the current value and the execution price enables the participant to benefit from the growth in value of the company.

Example

The company is valued at $15,000,000. The employee is credited with appreciation rights on 1% of the company at the plan’s inception. The Stock Appreciation Rights (SARs) are worth zero at inception as the execution price is set at the current value of the shares. The plan promises to pay its benefit over 5 years beginning at employee’s retirement provided certain conditions are met. The employee retires 13 years later when the company is valued at $50,000,000. The employee is paid $350,000 for the appreciation in value ($500,000 – $150,000 = $350,000) over 5 years.

Items Worth Noting

  • The employer receives a tax deduction for the compensation paid to the employee. The employer is required to withhold taxes.
  • The terms are completely flexible at the plan’s inception. At the beginning of the plan, the employer determines the size and timing of all phantom stock grants, contractual conditions, payment terms, etc.
  • The company’s obligation to pay is typically noted on the corporate financial statements and may even be carried as a liability in some circumstances. Valuing this obligation for financial reporting is difficult to impossible.
  • Avoids providing employees with actual ownership in a company.
  • Allows an employee to obtain the benefit of stock appreciation without making an investment.
  • The agreement need not make provision for proportional distribution of earnings to phantom unit holders.

Key Features

  • SARs emphasize company growth. The largest benefits are generated when the employees grow the company.
  • There is no immediate benefit at grant.
  • SARs mirror options and are often useful in competing for good employees with public competitors who offer options in their compensation packages.

Conclusion

Non-Qualified Deferred Compensation Plans can be a great way to both incentivize and retain your key employees. However, identifying the right plan for your business requires careful planning and proper implementation. Our process helps owners overlay the pros and cons of each strategy as well as understand the financial obligation that will be placed on the business.