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 A. General Description Deferred compensation occurs when the payment of compensation is deferred for more than a short period after the compensation is earned (i.e., the time when the services giving rise to the compensation are performed). Payment is generally deferred until some specified event, such as the individual's retirement, death, disability, or other termination of services, or until a specified time in the future, such as five or ten years. The Internal Revenue Code (the "Code") provides tax-favored treatment for certain types of employer-sponsored deferred compensation arrangements that are designed primarily to provide employees with retirement income. These arrangements include qualified defined contribution and defined benefit pension plans (see. 401 (a)), qualified annuities (sec. 403(a)), tax-sheltered annuities (sec. 403(b)), savings incentive match plans for employees or "SIMPLE" plans (sec. 408(p)), and simplified employee pensions or "SEPS" (sec. 408(k)). For simplicity, these plans are referred to collectively here as "qualified employer plans." A nonqualified deferred compensation arrangement is any deferred compensation arrangement that is not one of these qualified employer plans.(see footnote 2) 2. Types of nonqualified deferred compensation arrangements(a) In general Nonqualified deferred compensation arrangements are contractual arrangements between the employer and the employee, or employees, covered by the arrangement. Such arrangements are structured in whatever form achieves the goals of the parties; as a result, they vary greatly in design. Considerations that may affect the structure of the arrangement are the current and future income needs of the employee, the desired tax treatment of deferred amounts, and the desire for assurance that deferred amounts will in fact be paid. In the simplest form, a nonqualified deferred compensation arrangement is merely an unsecured, unfunded promise to pay a stated dollar amount at some point in the future. However, in most cases, such a simple arrangement does not meet the needs of the parties to the arrangement; thus, the typical nonqualified defined compensation arrangement is more complicated and may involve a funding vehicle or other mechanism to provide security to the employee. (b) Possible structures Some nonqualified deferred compensation arrangements are structured as formal plans with formal governing documents. In such cases, the plan generally specifies the employees covered by the plan. In other cases, nonqualified deferred compensation may be provided for under the terms of an individual's employment contract and apply only to that particular individual (although the same type of arrangement may be included in the employment contracts of multiple individuals). A nonqualified arrangement may provide for the deferral of base compensation (i.e., salary), incentive compensation (e.g., conunissions or bonuses), or supplemental compensation. The arrangement may permit the employee to elect, such as on an annual basis, whether to defer compensation or to receive it currently, similar to a salary reduction or cash-or-deferred arrangement under a qualified employer plan. Alternatively, the arrangement may provide for compensation that is payable only on the occurrence of future events, not currently. A nonqualified deferred compensation arrangement may be structured as an account for the employee (similar to a defined contribution or individual account plan) or may provide for specified benefits to be paid to the employee (similar to a defined benefit pension plan). Under an account structure, depending on whether the arrangement is unfunded or funded, a hypothetical or actual account is maintained for the employee, to which specified contributions and earnings are credited. The employee may be permitted to direct the investments under the hypothetical or actual account. The benefits to which the employee is entitled are based on the amount in the account. Under a defined benefit structure, the terms of the nonqualified arrangement specify the amount of benefits (or formula for determining benefits) to be paid to the employee. 3. Specific types of plans(a) In general Certain types of nonqualified deferred compensation arrangements are referred to by specific terms, often based on a particular feature or purpose of the arrangement. Generally, these terms do not prescribe the structure of the arrangement other than with respect to the particular feature or purpose. In addition, because these terms often are not legally defined, they are not always used consistently. (b) Top-hat plan A "top-hat plan" is the term generally used for certain nonqualifted deferred compensation plans that are exempt from most ERISA requirements. The ERISA exemption applies to a plan that is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees. ERISA does not provide statutory definitions of "select group," "management," or "highly compensated employees," and the Department of Labor has not issued regulations defining these terms.(see footnote 4) Employees sometimes claim ERISA protection (such as vesting or funding) for benefits under a nonqualified deferred compensation plan. However, most nonqualified deferred compensation arrangements are intended to fall under the top-hat exemption. A top-hat plan is exempt from the ERISA requirements relating to participation and vesting, funding, and fiduciary responsibility. A top-hat plan is not exempt ftom the reporting and disclosure requirements or the administration and enforcement provisions under ERISA. However, under Department of Labor regulations, the reporting and disclosure requirements are satisfied by (1) a one-time filing with the Secretary of Labor of a statement that includes the name and address of the employer, the employer's tax identification number, a declaration that the employer maintains a plan or plans primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees, and a statement of the number of such plans and the number of employees in each, and (2) providing plan documents, if any, to the Secretary of Labor upon request.(see footnote 5) Another term commonly used for an unfunded plan that covers only a select group of -management or highly compensated employees is a supplemental executive retirement plan or "SERP." (c) Excess benefit plan ERISA does not apply to an "excess benefit plan" that is unfunded. As a result, an unfunded excess benefit plan is exempt from all ERISA requirements. ERISA defines an excess benefit plan as a plan maintained by an employer solely for the purpose of providing benefits for certain employees in excess of the limits on contributions and benefits under section 415 of the Code, without regard to whether the plan is funded (see footnote 6). To the extent that a separable part of a plan (as determined by the Secretary of Labor) maintained by an employer is maintained to provide benefits in excess of the Code section 415 limits, that part is treated as a separate plan that is an excess benefit plan. Coverage under an excess benefit plan need not be limited to a select group of management or highly compensated employees. Depending on the design of the plan that is subject to Code section 415, nonmangement or nonhighly compensated employees may be covered by an excess benefit plan. For example, a subsidized early retirement benefit provided to long-service employees (regardless of age) under a qualified defmed benefit plan could exceed the section 415 limit applicable to a nonhighly compensated employee, making the employee eligible for benefits under an excess benefit plan. As a practical matter, however, the limits on contributions and benefits are more likely to affect highly paid employees. In addition, the terms of the excess benefit plan may limit coverage to certain management and highly compensation employees. (d) "'Make-up", or "mirror" plan Nonqualified deferred compensation amngements are sometimes designed to provide benefits in excess of Code limits that apply to qualified retirement plans other than the limits under section 415. For example, the Code limits the amount of annual compensation that may be taken into account under a qualified retirement plan ($200,000 for 2002) and the amount of an employee's annual elective deferrals ($11,000 for 2002). In addition, the amount of elective deferrals or matching contributions for a highly compensated employee may be limited in order to satisfy special nondiscrimination requirements that apply to such contributions. A plan that provides the additional benefits that cannot be provided under a qualified retirement plan because of these limits is sometimes referred to as a "make-up" plan (or "mirror" or "tandem" plan or SERP), based on its connection to the qualified plan. A make-up plan does not meet the definition of an excess benefit plan under ERISA, which requires that the plan be maintained solely for the purpose of providing benefits in excess of the Code section 415 limits. However, a make-up plan may be a top-hat plan. (e) Phantom stock plan A "phantom stock" plan is a nonqualified deferred compensation arrangement under which deferred amounts are determined by reference to hypothetical (or "phantom") shares of employer stock. Phantom stock plans are often used to provide incentive compensation. For example, an employee may be awarded 1,000 units of phantom stock and have the right to "cash out" 200 shares a year over five years if certain performance goals are met. Depending on the terms of the arrangement, the employee may be entitled to receive only the growth in the value of the stock between the time the phantom shares are awarded and the time they are cashed out, or the employee may be entitled to receive the entire value of the stock at cash-out as well as any dividends paid since the time the phantom shares were granted. Actual shares of stock are not held for the employee under a phantom stock plan, but, depending on the terms of the plan, the employee may be entitled to be paid in actual shares or in cash at the time of the cash-out. (f) Eligible deferred compensation plan of a tax-exempt employer The Code limits the amount of nonqualified deferred compensation that can be provided by a tax-exempt employer on a tax-deferred basis (see. 457). Generally, amounts deferred under a nonqualified deferred compensation arrangement of a tax-exempt employer (other than a church) are currently included in the employee's income unless the arrangement is an eligible deferred compensation plan (a "section 457 plan"). The maximum annual deferral under such a plan generally is $11,000 (for 2002), or the employee's total includible compensation, if less. In general, amounts deferred under a section 457 plan may not be made available to a plan participant before the earlier of (1) the calendar year in which the participant attains age 70-1/2, (2) when the participant has a severance from employment with the employer, or (3) when the participant is faced with an unforeseeable emergency. Amounts deferred under an eligible deferred compensation plan of a tax-exempt employer are includible in the employee's income when paid or otherwise made available to the employee. Amounts deferred under a section 457 plan of a tax-exempt entity must remain the property of the employer, subject only to the claims of the employer's general creditors. If compensation is deferred under a plan that is not an eligible deferred compensation plan (an "ineligible plan"), deferred amounts are includible in income when the deferred compensation is not subject to a substantial risk of forfeiture, even if the deferred compensation is not funded. 4. Comparison with qualified employer plans(a) Tax treatment and general qualification requirements Qualified employer plans receive the following tax-favored treatment:
Qualified employer plans are subject to various Code requirements that must be satisfied in order for favored tax treatment to apply. The particular requirements a qualified employer plan must satisfy in order to receive tax-favored treatment depends on the type of arrangement. In general, however, among the applicable rules are limits on the amount of contributions or benefits that can be provided, minimum participation rules that restrict the age and number of years of employment an employer can require as a condition of plan participation, nondiscrimination rules that seek to ensure that qualified retirement plans benefit a broad group of employees, and, in the case of certain plans, minimum funding rules designed to ensure that employer contributions are sufficient to provide for plan benefits. For example, the maximum annual contribution that can be made to a qualified defined contribution plan is the lesser of (1) 100 percent of compensation and (2) $40,000 (for 2002). The maximum annual benefit payable at age 62 under a qualified defined benefit plan is the lesser of (1) 100 percent of compensation and (2) $160,000 (for 2002). Nonqualified deferred compensation does not receive such favorable tax treatment. For example, the employer is generally not entitled to a deduction for nonqualified deferred compensation until the compensation is includible in the gross income of the employee (see footnote 7). Such compensation is also not subject to the limits applicable to qualified employer plans. Thus, for example, there is no dollar limit on the annual aggregate nonqualified deferred compensation that may be provided. Also, nonqualified deferred compensation arrangements typically are limited to a named class of employees; in some cases, a particular arrangement may cover a single employee. (b) Eligible individuals Qualified employer plans generally may cover only employees( see footnote 8). Nonqualified deferred compensation arrangements are not subject to this restriction, and thus may cover employees and individuals who are not employees. For example, a nonqualified deferred compensation arrangement may cover the "outside" directors of a corporation (i.e., directors who are not employees of the corporation) or independent contractors who provide services.(see footnote 9) (c) Funding and security Qualified employer plans provide a high degree of security. Such plans are required to be funded i.e., assets must be set aside exclusively to provide benefits to employers. Qualified employer plans assets may not be used by employers for purposes other than providing benefits and are not subject to the claims of creditors of the employer. A nonqualified deferred compensation arrangement may be funded or unfunded, depending on the terms of the arrangement. As discussed below, whether such an arrangement is funded affects the tax treatment. Qualified defined benefit pension plan benefits are guaranteed (within limits) by the Pension Benefit Guaranty Corporation ("PBGC"). The PBGC does not guarantee benefits under other types of qualified employer plans or under nonqualified deferred compensation arrangements. (d) Appfication of ERISA Most types of qualified employer plans are subject to requirements under Title I of the Employee Retirement Income Secufity Act of 1974 ("ERISA"), as well as under the Code. ERISA requirements deal with reporting and disclosure (part I of ERISA), participation and vesting (part 2), funding (part 3), fiduciary responsibility (part 4), and administration and enforcement (part 5).(see footnote 10) As discussed more fully in Part A.3, above, ERISA contains exemptions for nonqualified deferred compensation arrangements that are top-hat plans or excess benefit plans.(see footnote 11) Most nonqualified deferred compensation arrangements are designed to fall within these ERISA exemptions. ERISA does not apply to nonqualified deferred compensation arrangements covering only nonemployees, such as outside directors.
footnote 2 An eligible deferred compensation plan (sec. 457(b)) is a nonqualified deferred compensation arrangement that is maintained by a tax-exempt or a State or local government employer and that meets certain requirements. An eligible deferred compensation plan of a State or local governmental employer generally receives tax-favored treatment under the Code similar to qualified employer plans. Eligible deferted compensation plans of tax-exempt employers are discussed more fully in Part A.3, below. (Editors note: above as per editors note) footnote 3 Such arrangements are discussed in Part B. 1, below. 3 (Editors note: Part B is not included here) footnote 4 The Code definition of "highly compensated employee" (sec. 414(q)) has not been applied for this purpose. footnote 5 29 CFR 2520.104-23. footnote 6 The limits under sec. 415 apply to qualified defined contribution and defined benefit plans, which generally must be funded. footnote 7 The tax treatment of nonqualified deferred compensation is discussed in detail in Part B, below.(Editors note: Part B is not included here) footnote 8 Self-employed individuals are generally considered employees for purposes of the rules relating to qualified employer plans. footnote 9 In general, arrangements discussed in this document may apply to individuals who are not employees as well as to employees. footnote 10 Some requirements under ERISA correspond to parallel requirements under the Code. footnote 11 Governmental plans and church plans are also exempt from ERISA. |
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Lynn R. Siewert AIMC
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