Nonqualified deferred compensation plans are used by businesses to supplement existing qualified plans. As Lawrence Bader and Yale Tauber noted in Compensation & Benefits Management, deferred compensation arrangements are proliferating in today's business and regulatory environment, and they are extending deeper into organizations. Small business owners, in particular, have made greater use of these deferred compensation plans in recent years, utilizing them to reward top executives and directors and woo top outside personnel. Another factor contributing to firms' efforts to defer compensation when possible, added Bader and Tauber, is the current limitations on deductible current compensation.

Companies have recognized other pluses associated with nonqualified deferred compensation plans as well. "One big advantage to [nonqualified] deferred compensation plans is that they escape the non-discrimination rules imposed on qualified plans," explained John B. Connor Jr. in Small Business Reports. "That means [small business owners] can offer the plan to a select group of employees, making it a more cost-effective benefit than a qualified plan. Administrative costs are lower as well because the plans are exempt from the U.S. Department of Labor's reporting requirements. All that's required is a one-time letter to the DOL stating that your plan is in place and has a given number of participants. In addition, small companies are discovering that deferred compensation plans can help them court executives from larger firms. In essence, your company can level the recruitment playing field by tailoring a benefits package comparable to that of big companies."

There are two main types of nonqualified deferred compensation plans from which small business owners may choose: supplemental executive retirement plans (SERPs) and deferred savings plans. These two options share several common characteristics, but there are also important differences between the two. For example, eligibility for both plans may be based on the executive's salary, position, or both. But whereas deferred savings plans require employees to contribute their own earnings, executives that are placed in SERPs receive their compensation from their employers.


"Executives consider SERPs to be an especially attractive plan because the company foots the bill for the benefits," wrote Connor. "SERPs generally are structured to mirror defined-benefit pension plans that promise a stated benefit from the employer at retirement." SERP benefits, which can be allocated in conjunction with other benefit plans like qualifiedplan savings and Social Security benefits, may be calculated in any number of ways. Employers may choose to pay their executives a flat dollar amount for an agreed-upon number of years; a percentage of their salary at retirement multiplied by their years with the company; or a fixed percentage of their salary at retirement for a given number of years. Companies also have the option of funding SERPs either through general assets (at the time of the employee's retirement) or via sinking funds or corporate-owned life insurance (COLI).

SINKING FUNDS Businesses that utilize the sinking fund method allocate money on an annual basis to a fund that will cover benefit payments as they come due. This money can be invested by the company as it sees fit, but it is nonetheless earmarked for retirement payments.


Under the COLI funding method, businesses buy life insurance plans on those directors and executives that they wish to compensate. Each company pays the premiums on the purchased policies, and as each executive retires, the firm pays out his or her benefits from operating assets for a previously established period of time. The key benefit for the small business owner under the COLI arrangement is that his or her business would be "designated the sole beneficiary of the insurance policy proceeds, which it would receive tax-free," explained Connor. "At the executive's death, then, your company is reimbursed for some or all of the costs of the plan, including the actual benefits paid, the insurance premiums, and the loss of the use of your company's money for other purposes." Entrepreneurs should note, however, that their firm will not receive a tax deduction for its contributions to a SERP until the director or executive actually receives the benefit payments (businesses using qualified compensation plans, on the other hand, receive deductions in the current year).


Deferred savings plans are similar to 401(k) plans in that affected employees are allowed to set aside a portion of their salary (usually up to 25 percent) and bonuses (as much as 100 percent) to put into the plan. This money is directly deducted from employee paychecks, and taxes are not levied on the money until the employee receives it. "Over the years, the executive contributions accumulate earnings in one of two ways," stated Connor. "Most commonly, the company simply guarantees a fixed rate of return on the deferrals, which would come from its general operating assets at the time of payout. A second option, which is becoming more popular, is to tie each executive's savings to the performance of a particular mutual fund; he or she would select the fund from among several offered by your plan." For those companies that set up a fixed rate of return on the deferrals, they may invest the monies in question however they wish, provided they ultimately meet their payout obligations. In addition, consultants note that some small businesses (and large ones as well) have established a policy wherein they will offer matching funds on employee deferrals or add profitsharing or incentive-based contributions.

Experts point out that executives with deferred savings plans have a variety of payout options to choose from. They may choose to set up regular post-retirement payouts for five to ten years after retirement, but they also have the option of arranging for short-term deferrals to help them pay for a new house, college education for children, and other expenses. If an executive enrolled in this type of plan dies or is fired from the company prior to retirement, he or she (or their family) receives a lump-sum payout of their benefits. It should be noted, however, that nonqualified deferred compensation plans will not be protected from creditors if the company that created them files for bankruptcy.


Nonqualified deferred compensation plans may also be utilized by tax-exempt organizations, but managers of these entities should be aware that for tax-exempt organizations, such plans are subject to considerably more stringent Internal Revenue Service (IRS) regulations. Still, Janet Den Uyl stated in Healthcare Financial Management that "alternatives are available to tax-exempt organizations seeking to set up such plans. By subjecting employer-paid, tax-deferred compensation to risk of forfeiture or by paying the required taxes, tax-exempt organizations can develop workable alternatives for funding nonqualified deferred compensation plans."

FUNDING OPTIONS Tax-exempt organizations seeking to fund employer-paid deferred compensation plans can choose from a number of options:

* Unfunded benefits that vest at retirement. Under this strategy, employers provide supplemental retirement benefit plans with assets that are not dedicated to funding the plan. If the employer runs into financial trouble before the employee or employees covered under the plan retire, it can use those assets to pay off its creditors.
* Unfunded benefits that vest during employment. Den Uyl noted that with this plan, "Vesting occurs according to plan objectives as defined by the employer and, as vesting occurs, the employer provides a cash distribution to cover taxes. The ultimate benefit at retirement is reduced to reflect the annual distribution of a portion of the benefit to pay taxes."
* Benefits funded with deferred annuities. Under this arrangement, the small business owner would acquire deferred annuities in the name of participating employees. Den Uyl pointed out that the employer that takes this tack usually provides cash distributions to cover the tax on both the contribution and the cash distribution, since contributions to the annuity are regarded by the IRS as taxable income.

Similarly, organizations looking to fund voluntary nonqualified deferred compensation plans may pursue the following funding alternatives:

* Traditional deferred compensation plans with non-compete clauses. These do not pay out money until the end of a specified period of time. If an employee who is part of the plan leaves the company to join a competing business before that specified period of time elapses, then the employee forfeits the contributions. Analysts note, however, that this choice is often not a palatable one for employers, since employees will likely resent efforts to impose such restrictions.
* Deferred annuities. Under this alternative, employees purchase deferred annuities with after-tax income, and they do not owe taxes on annuity earnings until payout.
* Deferral using after-tax dollars. Under this plan, employees are immediately vested and taxed on the deferred compensation. Aftertax compensation is subsequently placed in a mutual fund by the employer, but it is maintained for the benefit of the employee.

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