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Nonqualified Deferred Compensation Plans and Supplemental Executive Retirement Plans

What is it?

A contractual arrangement that calls for paying an individual executive or group of executives future benefits. These plans are characterized by flexibility, and plan design can reflect the goals and objectives of the employer and individual executive. They can be used as a key tool in designing executive compensation to recruit, retain, reward and retire key executives.

The need: A Nonqualified Deferred Compensation Plan and/or Supplemental Executive retirement Plan (SERP) is indicated:

• When a company does not have or cannot afford a qualified plan but wants to provide key executives with retirement income
• The employer wants to provide additional deferred compensation benefits to executives who have already received the maximum benefits or contributions under the company’s qualified retirement plans
• When the employer wishes to pick and chose the benefits to be given and the executives who will receive those benefits
• When the executive wishes to defer additional sums of money beyond the amounts deferred into a 401(k) plan
• When the executive wishes to accumulate funds on a tax-deferred basis for one or more events that will likely occur prior to retirement (i.e. college education, marriages, down payment for homes or any desired in-service distribution date).

Advantages

Allows coverage of any group of executives or a single executive within the “top hat group,” without any nondiscrimination limitations

Can provide an unlimited benefit to any executive subject only to the “reasonable compensation” rules

Can provide different benefit amounts for different executives on different terms and conditions

Minimal IRS and ERISA regulatory requirements

Can provide deferral of taxes to the executive

Can be used as a form of “golden handcuffs” that helps to bind the executive to the company

Security to the executive can be provided through informal financing arrangements.

Disadvantages

Employer’s “CASH” tax deduction deferred until the year in which the income is taxable to the executive either because the executive has received his benefit, has the constructive right to receive the benefit or when the benefit is securitized from the company’s creditors.

No formal security for the benefit and the executive must depend on the employers’ promise to pay even if the plan is informally financed by setting up a sinking fund to provide for the timely payment of the plan benefits.

Public companies may be required to disclose compensation arrangement.

No tax advantage to tax pass-through entities.

Unfunded Plans & Financing Arrangements

To obtain the desired tax benefits (no tax to the executive until benefits are received), the plan must be considered “unfunded”. However, the company may informally “finance” its promise to pay and thereby increase the executive’s benefit security through the use of a Rabbi trust and/or corporate owned life insurance. With life insurance funding, the policy cash value accumulates on a tax-deferred basis. The policy is owned by the company and can, as a part of the plan design, provide a substantial death benefit to the executive’s beneficiaries. When life insurance funding is used, the present value of the deferred deduction to the company for the executive’s deferred compensation may be designed to be equal to the present value of the deferred benefit when it is scheduled to be paid to the executive.