Many small family businesses disregard nonqualified deferred compensation because these plans don’t provide a tax deduction until disbursement. But other family businesses are large enough to worry less about such tax matters and more about retaining key employees, especially nonfamily executives. Because qualified plans are limited in scope, many of these larger businesses use nonqualified plans to compensate and retain nonfamily executives.

Nonqualified deferred compensation allows key executives to defer a portion of their salary until a later year -- much like a 401(k) plan, but without deferrable amount limits and the need to cover non-key employees. Executives can retrieve the income in later years when their tax brackets are lower or after their deferred compensation accounts have grown significantly. Sound interesting? Let’s look at the details.

Tax Rules
The IRS strictly regulates nonqualified deferred compensation. To avoid taxation, executives must elect to defer their pay before they actually earn it. The IRS also requires executives to choose the payout method before the salary is deferred. Then the executive and the company must sign a contract stipulating the terms.

Nonqualified deferred compensation plans must also include a substantial risk of forfeiture. When that risk is gone, the amounts deferred are taxable to the executive, even if he or she does not actually receive them. Usually these plans provide funds for events such as retirement, disability, termination or changes in company ownership. Some plans allow the executive to take his or her money earlier if a penalty is paid.

But nonqualified deferred compensation plans have a disadvantage. Unlike a qualified plan -- with which employees can usually roll over their money to another plan or an individual retirement account and defer taxation until at least age 70 -- executives must accept income from a nonqualified plan with payment. Some plans allow executives to push back the payment date further than originally planned, but guidelines for such exceptions vary.

Reporting Rules
Although the nonqualified deferred compensation plan described in this article is not subject to Employee Retirement Income Security Act (ERISA) rules, some reporting requirements exist. The plan administrator must file an IRS Form 5500 series annually to report the amounts held for the executive. However, because nonqualified deferred compensation plans apply to only executives, the Department of Labor (DOL)waives the reporting requirements if the company files a statement with the DOL within 120 days of implementing the compensation plan.

When the deferred compensation is paid, the company must report the income on a W-2 form or risk losing the tax deduction. The executive reports the income in the year received. Whether the amount paid is subject to FICA and Medicare tax withholding depends on when the funds became payable.

Keep Them Happy
Because your competitors may have nonqualified deferred compensation programs for their key executives, you may have to provide a similar plan to keep yours happy. After all, the typical qualified plan often has too many limitations to satisfy a key executive.

When properly structured, a nonqualified deferred compensation plan provides better compensation benefits than a qualified plan. Call us to discuss your concerns about this matter or other family business issues.