NQDC Plans: Funding Options

Funded Vs. Unfunded Plans

In General

Nonqualified deferred compensation (NQDC) plans fall into two broad categories: funded plans and unfunded plans. It is important to understand the technical meaning of these terms in order to understand the tax and ERISA consequences that flow from establishing a NQDC plan. Unfunded plans are far more common than funded plans because they can provide the benefit of tax deferral while avoiding almost all of ERISA's burdensome requirements. Funded plans, on the other hand, must generally comply with ERISA, and provide only limited deferral opportunities. The following chart shows the general features of unfunded and funded plans:*

*Special rules apply to excess benefit plans, church plans, and plans maintained by governmental and tax-exempt employers. See "Special cases," below. ** Employee secular trusts may not be covered by ERISA. Whether benefits under these plans are protected from the claims of the employer's creditors may depend on state law.

When Is a Plan Considered "Funded?"

There is no specific definition of "funding" in either ERISA or the Internal Revenue Code (IRC). But the concept has been defined by court cases and guidance from the Department of Labor (DOL) and the Internal Revenue Service (IRS). In general, a plan is considered funded if assets have been irrevocably and unconditionally set aside with a third party for the payment of NQDC plan benefits (for example, in a trust or escrow account) and those assets are beyond the reach of both you and your general creditors.

In other words, if participants are guaranteed to receive their benefits under the NQDC plan, the plan is considered funded. This is also sometimes referred to as "formal funding." One of the most common methods of formally funding a NQDC plan is the secular trust.

Conversely, unfunded plans are those where either assets have not been set aside (that is, a "pay as you go" plan), or assets have been set aside, but those assets remain subject to the claims of your general creditors (often referred to as an "informally funded" plan — see discussion below). In general, in an unfunded plan, your employees rely solely on your unsecured promise to pay benefits at a later date. In order to avoid ERISA, you must limit participation in unfunded NQDC plans to a select group of management or highly compensated employees. These plans are often referred to as "top-hat plans."

Caution: Funding may also be deemed to occur if your employees have any legal rights to specific assets you set aside to meet your NQDC plan benefit obligations that are superior to those of your general creditors, or if employee communications lead employees to believe their benefits are secured by specific assets. Careful drafting of all plan documents and consultation with pension professionals is important to avoid this potential problem.

Tip: While there may be some fine distinctions between funding for tax purposes and funding for ERISA purposes, in almost all cases if a plan is considered funded for one purpose, it will be considered funded for the other.

What Is an Informally Funded Plan?

While most employers want to avoid formally funding their NQDC plans in order to avoid ERISA and provide the benefit of tax deferral, they often want to accumulate assets in order to ensure they can meet their benefit obligations when they come due. This is commonly referred to as "informally funding" a NQDC plan. Even though you set aside funds, these plans are not considered formally funded because the assets remain part of your general assets and can be reached by your creditors. Informal funding allows you to match assets with your future benefit liabilities, and provides your employees with psychological assurance (at least) that their benefits will be paid when due. The most common methods of informally funding NQDC plans are corporate-owned life insurance (COLI) and the rabbi trust, discussed below.

Example(s): Widget Corporation wishes to establish a nonqualified deferred compensation plan for its executives. To fund the plan, it establishes a rabbi trust (a particular type of irrevocable grantor trust approved by the IRS). Although Widget Corporation has set aside these assets solely for the employees of its plan, the funds contained in this trust must remain subject to the claims of all of Widget's creditors. The plan will therefore be considered unfunded from an ERISA perspective.

Why Would an Employer Establish a Funded NQDC Plan?

In general, you might choose to establish a funded plan, instead of an unfunded plan, if benefit security is your employees' main concern. In unfunded plans, any assets set aside to pay benefits must remain subject to the claims of your general creditors. This lack of security may make employees fearful that when it comes time to receive the deferred compensation, you may be unwilling (due to a change of heart or change in control) or unable (due to a change in financial condition) to pay the deferred compensation, or that a creditor may seize the funds through foreclosure, bankruptcy, or liquidation. Since funded plans are generally protected from the claims of your creditors, they provide maximum security to employees that their NQDC plan benefits will be paid when due. You may also want to establish a funded plan to provide deferred compensation benefits to an employee who does not qualify as a member of the top-hat group.

What Are The Federal Income Tax Consequences of Funding or Not Funding a NQDC Plan?

Employee Tax Treatment--Unfunded Plan

Generally, there are no income tax consequences to your employee until benefits are paid from the plan. Your employee must then include the full amount received in his or her gross income. This is true even if your employee is fully vested in his or her NQDC plan benefit.

Caution: However, there may be times when the IRS taxes an employee on contributions made to an NQDC plan prior to the receipt of plan assets. This may occur when the IRS uses certain methods to defeat the tax deferral status of a NQDC plan. These methods include the doctrine of constructive receipt, the economic benefits doctrine, and IRC Section 409A.

Employee Tax Treatment--Funded Plan

The taxation of your contributions to a funded NQDC plan depends on both the type of funding vehicle used and whether or not your employee's benefit is vested (that is, whether or not the benefit is subject to a substantial risk of forfeiture).

• Employee secular trust — If your NQDC plan is funded with an employee secular trust, your employee must include your contributions in gross income each year as they are made. Since your employee is considered the owner of the trust, he or she must also include any taxable trust earnings in gross income each year. Distributions from a NQDC plan funded with an employee secular trust are generally free from federal income tax.
• Employer secular trust — If your NQDC plan is funded with an employer secular trust, the taxation is more complicated. In general, if your employee's benefit hasn't yet vested, your contributions will have no current tax impact. However, when the benefit vests, your employee must include the entire value of his or her interest in the trust (your contributions plus any earnings) in gross income at that time. Your non-highly compensated employees must include any additional vested contributions in gross income as you make them, but any additional earnings generally aren't subject to income tax until they are distributed. Similarly, your highly compensated employees (for 2017, generally 5% owners and those employees who earned more than $120,000 in 2016) must include any additional vested contributions in gross income as you make them, but they are also taxed annually on any increase in their vested earnings, even if the increase is a result of unrealized gains, insurance contract cash value increases, or tax-exempt investments.
• Secular annuity — If your NQDC plan is funded with a secular annuity, your employees must generally include the entire value of the annuity in gross income at the time the benefit becomes vested. Any additional premium payments you make will be subject to income tax as they are made, but additional earnings generally won't be subject to tax until paid.
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Tip: Thus, in the case of a secular trust or secular annuity, your employee may be taxed on contributions to the plan, and investment earnings, prior to the actual receipt of the plan funds. If desired, you can pay your employee a bonus to cover his or her tax liability, or the plan can provide for a distribution from the trust so that your employee can pay the taxes.

Tip: A funded NQDC plan can provide the benefit of tax deferral only while the employee's benefit is subject to a substantial risk of forfeiture. This is in contrast to an unfunded NQDC plan, which can provide the benefit of tax deferral even if your employee's benefit is fully vested.

Caution: Distributions from a NQDC plan funded with an employer secular trust or secular annuity may be subject to a 10% early distribution penalty if made before age 59½, unless an exception applies.

Employer Tax Treatment — Unfunded Plan

In general, you receive a tax deduction in the taxable year an amount attributable to your contribution is included in your employee's gross income. This means that you receive the deduction in the year your employee actually receives the plan benefits. You can deduct the total amount paid to your employee, including any earnings on your contributions.

An additional tax consideration for the employer is that if the employer sets aside funds for the purpose of paying future benefits under the NQDC plan (for example, in a rabbi trust), the employer must pay income tax on any earnings attributable to those allocated funds. NQDC plans are often informally funded with corporate-owned life insurance (COLI) because policy earnings (the increase in the cash value) are generally not subject to current income taxation (unless the alternative minimum tax, AMT, rules apply).

Employer Tax Treatment — Funded Plan

In general, you are entitled to a tax deduction in the taxable year an amount attributable to your contribution is included in your employee's gross income. In general, this means that you are entitled to the deduction in the year you make your contributions to the plan, or if later, when your employee becomes vested in the contributions. You are generally not entitled to a deduction for any earnings on your contributions to a funded plan.

Caution: Funding a NQDC plan with an employer secular trust may result in double taxation of trust earnings.

In order for you to be able to receive a deduction for contributions to a NQDC plan funded with an employer secular trust, you must maintain separate accounts for each employee when more than one employee participates in the plan. It is not clear if this rule also applies to a NQDC plan funded with an employee secular trust.

Caution: Further, a deduction is permitted only to the extent that the contribution or payment is both reasonable in amount and an ordinary and necessary expense incurred in carrying on a trade or business.

Caution: Publicly held companies can't deduct total compensation in excess of $1 million in any one year for certain executives.

"At-Risk"Defined Benefit Plan

Effective August 17, 2006, the Pension Protection Act of 2006 amended Section 409A to provide that if, during a "restricted period," an employer (or a member of the employer's controlled group) sets aside assets in a trust or other arrangement for the payment of nonqualified deferred compensation benefits for an "applicable covered employee," those assets will be subject to tax as a transfer of property from the employer to the employee. Amounts included in income are also subject to an additional 20% penalty tax, plus interest. Any subsequent increase in the value of the restricted assets is treated as an additional taxable transfer.

A restricted period is (1) any period in which a qualified single-employer defined benefit pension plan maintained by the employer is in at-risk status, (2) any period in which the employer is in bankruptcy, and (3) the period that begins six months before and ends six months after the date any defined benefit pension plan of the employer is terminated in an involuntary or distress termination. The provision does not apply to assets set aside before the restricted period.

"Applicable covered employee" means any (1) covered employee of a plan sponsor; (2) covered employee of a member of a controlled group which includes the plan sponsor; and (3) former employee who was a covered employee at the time of termination of employment with the plan sponsor or a member of a controlled group which includes the plan sponsor. "Covered employees" include the chief executive officer of the employer, the four highest compensated officers for the taxable year (other than the chief executive officer), and individuals subject to section 16(a) of the Securities Exchange Act of 1934.

ERISA Considerations

If a NQDC plan is unfunded (i.e., a top-hat plan), then generally only two ERISA requirements apply. First, you (or more specifically, the plan administrator, which is typically the employer) must send a one-page notification letter to the DOL indicating your company's name and address, your company's employer identification number, the number of top-hat plans you maintain, the number of participants in each plan, and a declaration that the employer maintains the plan(s) primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.

The letter must be filed with the DOL within 120 days of the plan's inception; otherwise the plan will be subject to all of ERISA's reporting and disclosure requirements. Second, since top-hat plans are subject to ERISA's administrative provisions, you must inform plan participants about the ERISA claims procedures that apply to your plan (these will generally be described in the NQDC plan document). If a plan is funded, it must generally comply with all of ERISA's requirements. This includes ERISA's rules governing administration, reporting, disclosure, participation, vesting, funding, and fiduciary activities.

Caution: It is not clear if ERISA applies to a NQDC plan funded with an employee secular trust. ERISA applies only to plans established or maintained by an employer or employer organization, and employee secular trusts are deemed to be created by the participating employees for tax purposes.

Special Cases

There are several types of NQDC plans that are subject to special rules. One of these is the "excess benefit plan." This is a plan established solely to pay benefits that exceed certain qualified plan limits. ERISA does not apply to unfunded excess benefit plans. Funded excess benefit plans are exempt from ERISA's participation, funding, and vesting rules, but are subject to ERISA's reporting, disclosure, fiduciary, and enforcement provisions.

Caution: ERISA does not apply to governmental and most church retirement plans, and plans maintained solely for the benefit of non-employees (for example, company directors). NQDC plans maintained by governmental and tax-exempt employers are subject to a special set of rules, and are referred to as 457 plans.

What Tools Can Be Used to Fund or Finance a NQDC Plan?

The following are some methods of financing a NQDC plan, and providing employees with varying degrees of assurance that their NQDC benefits will in fact be paid.

Secular Trusts

A secular trust is an irrevocable trust that you establish with a third party for the purpose of holding NQDC plan assets apart from your general assets. A secular trust creates a funded plan for ERISA and tax purposes. It provides total security for employees' deferred compensation benefits because participating employees generally have a nonforfeitable and exclusive right both to the contributions made to the trust and the earnings on those contributions.

Annuities

A secular annuity may be used in lieu of a secular trust, or in conjunction with a secular trust. A secular annuity is an annuity you purchase in the name of the plan participant that secures the benefit promised under a related NQDC plan. While there are a number of variations, typically your employee owns and controls the annuity contract, and you must rely on the premature withdrawal tax and the policy surrender charges to deter the employee from surrendering the contract for its cash value. If you want more control over when your employee receives the annuity proceeds, you could consider placing the secular annuity inside a secular trust. By doing this, your employee would generally not be entitled to distributions until the time specified in the plan and trust documents.

The use of a secular annuity places the NQDC plan assets beyond the reach of your creditors and provides full security to your employees that the NQDC plan benefits will be paid (subject to the solvency of the insurer). A secular annuity creates a funded plan for tax and ERISA purposes. An employer-owned annuity contract can also be used to informally fund the employer's NQDC plan obligations. However, this is not common because the employer is generally subject to current federal income tax on the annuity contract's inside buildup.

Rabbi Trusts

A rabbi trust is a type of trust that you establish for the purpose of holding NQDC plan assets apart from your general assets. A rabbi trust does not result in a funded plan for ERISA or tax purposes, and does not provide security for your employees in the event of your bankruptcy or insolvency. A rabbi trust can be revocable or irrevocable. An irrevocable rabbi trust can, if adequately funded, largely eliminate the risk of nonpayment for all other events. A rabbi trust often includes provisions that trigger full funding or distributions in the event of a change in control of the employer. It's called a rabbi trust because a rabbi was the beneficiary of the first such trust to receive a favorable IRS ruling. The IRS has issued a model rabbi trust that employers can use in conjunction with their NQDC plans.

Rabbicular Trust (SM)

A Rabbicular Trust (SM) is a combination rabbi trust and secular trust. You contribute to the rabbi trust first. This trust is subject to the claims of your general creditors, and therefore the NQDC plan is unfunded for ERISA and tax purposes. Upon a specified trigger (for example, a change in control), assets are transferred from the rabbi trust to the secular trust. This creates a funded plan, and the assets become protected from the claims of your creditors.

Corporate-Owned Life Insurance (COLI)

Corporate-owned life insurance (COLI) refers to a life insurance policy that you take out on the life of an employee, where you are both the owner and beneficiary of the policy. COLI does not create a funded plan so long as the policy remains part of your general assets and employees have no contractual rights to the policy. COLI is commonly used as an informal funding mechanism for NQDC plans. However, informal COLI funding provides only psychological security for your employees, as the insurance policy remains part of your general assets and subject to the claims of your general creditors.

Split Dollar Life Insurance

Split dollar life insurance can take many forms. In general, it is an arrangement whereby the employer and employee share the premium cost and/or death benefits of a life insurance policy issued on the life of the employee. When used as an informal funding vehicle for NQDC plans, split dollar life insurance allows your employer to fund NQDC plan benefits with the proceeds your employer receives from the life insurance policy. While there are a number of variations, one way your employer can accomplish this is by establishing an unfunded nonqualified plan to provide you with a promised level of deferred compensation benefits.

Your employer then purchases a life insurance policy on your life. The premiums may be split between you and your employer in any way desired. Typically, you are entitled to a death benefit from the policy equal to some multiple of your compensation, for example 3 times pay. The face amount of the policy, however, is usually greater than that amount. Each year, your employer credits your nonqualified plan account with an amount specified in the NQDC plan. When distribution is scheduled to occur, your employer pays you the NQDC plan benefits from his or her general assets. Upon your death, your beneficiary receives the promised level of death benefits from the life insurance policy, and your employer receives the balance of the policy proceeds.

The life insurance benefits are tax-free. By funding a NQDC plan with split dollar life insurance, you can receive death benefit protection under the life insurance policy along with deferred compensation under the NQDC plan, and your employer can recoup all or part of the cost of providing these benefits.

Caution: The arrangement described above will not create a funded plan for ERISA or tax purposes as long as the NQDC plan provides that benefits are to be paid from the employer's general assets.

Caution: Be sure to consult your legal and financial advisors before implementing a split dollar plan. The IRS has issued regulations that have significantly changed the tax treatment of split dollar life insurance. Also, in some cases, the Sarbanes-Oxley Act may prohibit public companies from implementing certain forms of split dollar plans.

Surety Bonds and Indemnity Insurance

These are insurance contracts purchased by your employees that pay all or part of the promised NQDC benefit if you refuse or are unable to pay. While these contracts may provide security against all contingencies (except insurer insolvency), they are very rarely used because they are not readily available at reasonable cost.

Third-Party Guarantee

This is a guarantee by a third party that it will pay the benefits promised under the NQDC plan in the event of the employer's refusal or inability to pay. The third party is typically a corporation related to the employer (for example, the employer's parent corporation). A third-party guarantee can provide total security for the employee if the third-party guarantor remains solvent. The IRS has held that a third-party guarantee will not create a funded NQDC plan, so long as the third-party guarantee is itself unsecured and unfunded.

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