Non-Qualified Deferred Compensation as an Exit Planning Tool
Volume 4 • Issue 9 • November 2014
The Counselor is a monthly newsletter of Hallock & Hallock dedicated to providing useful information on estate planning, business succession planning and charitable planning issues. In this month’s issue, we will discuss the benefits of non-qualified deferred compensation plans in business succession and exit planning. If you are interested in learning more about the ideas and processes discussed in this newsletter please contact us for an initial consultation.
Non-Qualified Deferred Compensation Plans are often used to attract and keep key employees, and if you plan to sell to an insider such as a co-owner, employee or family member, they can be a powerful tool in your business succession or exit plan. This newsletter will discuss some of the basics of NQDC Plans and how they can help you in your business succession and exit planning.
What Are NQDC Plans?
Most people are familiar with deferred compensation plans such as a 401(k). Most deferred compensation plans are “qualified plans,” which mean they must meet the requirements of a federal law know as the Employee Retirement Income Security Act (ERISA). Unlike a qualified plan, NQDC Plans are plans that do not qualify under ERISA. Therefore, they are not subject to ERISA requirements such as the transfer of assets to a trustee or that most non-owner employees must be covered by the plan.While most of a company’s employees will be covered under a qualified plan, an NQDC Plan is generally only for owners and a few key employees. An NQDC Plan is simply a contractual relationship between the company and an owner or employee to defer payment of some part of the person’s compensation until a later date. Income is not recognized by the employee until a payment is made and likewise it is not deductible by the employer until that time. NQDC plan designs and funding are highly flexible, so they can be adapted to meet a variety of situations. The plan documents must address:
The formula for determining how benefits will be earned;
The time and form of payment rules, including payment options and later changes; and
Any rules that would restrict the payment of benefits to specified “key employees.”
Because the NQDC Plan must still comply with the requirements of section 409A of the Internal Revenue Code competent counsel should be sought in creating the plan.
Why Consider An NQDC Plan?
One of the important benefits of an NQDC Plan is its ability to attract and retain key employees. This can be important in ensuring those employees do not depart when the owner sells to a third party, thus increasing the value of the business. Because an insider often cannot pay cash for the business, the only way the owner can be compensated is to receive installment payments directly from the company. Therefore, it becomes important that the tax consequences to the insider be minimized in order to preserve a greater part of the company’s cash flow for payment to the departing owner. In addition, it is important to remember that every dollar paid for the business is subject to a double tax. It is taxed when earned by the company and taxed again when paid to the departing owner. By minimizing the purchase price to the lowest possible amount and paying the balance in deferred compensation, the departing owner can receive the same amount of money or more for retirement, but without the same tax consequence to the insider. This is because unlike principal payments on a long term note, payments of NQDC obligations are deductible to the business. In other words, a business must only earn $1 to pay $1 of deferred compensation, whereas it must earn that $1 plus any taxes to be paid on that $1 in order to pay $1 of a principal payment. This creates greater liquidity for the insider and therefore a greater likelihood that the departing owner can be paid.
Funding the NQDC Plan
Generally, a business cannot deduct a contribution to the NQDC plan until the year in which the employee recognizes income. As a result, nonqualified plans are often not funded immediately. Any money set aside to pay the promised benefits is still available to satisfy the company's general creditors. In this sense, the promise to pay the benefits is unsecure. An employer normally plans for the payment of this deferred obligation in one of four ways: (1) do nothing; (2) purchase investments such as mutual funds; (3) purchase corporate owned life insurance (COLI); or (4) some combination of the foregoing.
The advantage of the “do nothing” plan is its simplicity and the fact that it does not tie up any company cash. However, this also increases the risk to the participant that future company liquidity will be insufficient to pay the obligation. For key employees, this will make the plan much less attractive. Investing in mutual funds or similar investments provides an asset that can be sold to pay the obligation. However, company cash is required to make the investment and the earnings on the investment are often taxable. The benefit of using COLI is that earnings can accumulate in a tax deferred fashion, distributions from the policy in the form of loans are tax free, and the death benefits are tax free to the company. Disadvantages to using COLI can include the cost of the policy, lack of accumulated cash in the early years, and potential problems in underwriting.
As with any planning, the keys to success include understanding your goals and objectives, identifying the unique challenges and obstacles that exist and utilizing the right tools to meet those goals and objectives while overcoming the challenges and obstacles. A non-qualified deferred compensation plan is a significant planning opportunity for both company owners and key employees. Not only will an NQDC plan allow the company to better attract and keep key employees, it can make available tax efficient exit strategies for the departing owner. As with any planning strategy, it is important to start early in order to allow sufficient time for the strategy to properly mature. If you would like to discuss your exit strategy in more detail please call our office today.
This Newsletter is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. Nothing herein creates an attorney-client relationship between Hallock & Hallock and the reader.