The Ins and Outs of Nonqualified Plans

As the U.S. Congress has drafted the Internal Revenue Code over the years, it has tried to ensure that tax-favored benefits provided by employers to employees reach as many individuals as possible and are not restricted to corporate executives and other higher-echelon employees. During the American Payroll Association Congress’ workshop, “Nonqualified Retirement Plans: Payroll and Human Resources Issues,” Karen Field, compensation & benefits director at KPMG WNT, noted that this has led to restrictions on who can participate in tax-favored retirement arrangements (such as 401(k) plans), which must meet strict nondiscrimination and contribution-limit standards to ensure that they do not unduly favor highly compensated employees. To avoid such limits in rewarding their key employees, employers often rely on “nonqualified” retirement plans, which give up some of the tax advantages of qualified plans for the sake of greater flexibility in executive compensation.

Nonqualified Plans as Incentives

As Field noted, a nonqualified deferred-compensation plan is often designed as an incentive to valued employees. Certain amounts are reserved for eventual payment to an employee, but the employee will only receive these amounts if he or she meets certain criteria. (Since the plan is nonqualified, there is no limit on how large these amounts may be.)

For example, a retention plan might promise an employee a $50,000 payment into a retirement fund payable over five years--$10,000 at the end of year one, another $10,000 at the end of year two, and so on--but only payable if the employee remains with the company. This conditional award of compensation is called the “substantial risk of forfeiture,” Field explained, and is important because deferred compensation subject to such a risk is not taxable for FICA purposes. Under the rule of constructive receipt, an outright grant of the money to the employee would render the full amount FICA taxable on grant (even if the employee did not actually receive the money); the risk of forfeiture spreads the taxation of the compensation over the period of risk--the first $10,000 taxable when it vests at the end of year one, the next $10,000 at the end of year two, and so on.

A somewhat similar situation applies to the FIT taxability of nonqualified deferred compensation. As Field explained, if the employer has only promised the employee the payment of this compensation, and not secured the monies by, for example, placing them in a trust, federal income tax need not be withheld from the funds until the employee actually receives them. As far as the Internal Revenue Service is concerned, a promise is not a payment for FITW purposes. This often leads to situations in which an employee’s deferred compensation is taxed for FICA purposes on a different schedule than for FIT, Field noted. The employee receiving the $50,000 stay bonus, for example, would be taxed for FICA in equal increments over five years (assuming he or she actually does stay), but FIT would not be withheld until the employee actually receives the funds, which could be years after the last FICA withholding.

Funded Versus Unfunded Plans

Field reminded session participants of the important difference between funded and unfunded plans. If the plan is unfunded (the employer only promises the deferred compensation to the employee), FITW is on distribution. If the plan is funded (i.e., the monies legally protected for the employee by the creation of a trust or an escrow account), amounts become taxable as any substantial risk of forfeiture lapses. So in our stay-bonus example, deferred compensation would become taxable income for FITW purposes on the same schedule as for FICA--as the employee meets his or her annual longevity tests.

As Field explained, a complicated system of taxation produces a complicated system of reporting. Deferrals under an unfunded plan are reported in boxes 3 and 5 of Form W-2 (Social Security and Medicare income) if they are not subject to substantial risk of forfeiture, but are not reported in box 1 (FIT income). If deferred funds are subject to forfeiture, they are reported in boxes 3 and 5 only as they vest (i.e., as the risk of forfeiture lapses), at which time they are also reported in box 11 (nonqualified plans). On distribution, amounts are reported as income-taxable compensation in box 1 and also in box 11. So to return to our stay-bonus example, FICA taxes could be withheld and reported over a period of five years, and FIT withheld and reported in a sixth year--possibly some considerable time after the final FICA withholding.

By Richard Vollmar, CPP