Nonqualified deferred compensation (NQDC) plans pay executives or other key employees at some time in the future for services to be currently performed. If your organization offers one or is considering offering one, it’s critical to be aware of the applicable tax rules. Let’s review the basics.
How they differ
NQDC plans differ from qualified plans, such as 401(k)s, in a variety of ways. First, NQDC plans can favor highly compensated employees. And though the employee’s tax liability on the deferred income also may be deferred, the employer can’t deduct the NQDC until the employee recognizes it as income. What’s more, any NQDC plan funding isn’t protected from the employer’s creditors.
NQDC plans also differ in terms of some of the rules that apply to them. Internal Revenue Code (IRC) Section 409A and related IRS guidance affect NQDC issues such as the following:
Timing of initial deferral elections. Employees participating in an NQDC plan must make the initial deferral election before the year they perform the services for which the compensation is earned. So, for instance, for an employee to defer part of his or her 2019 compensation to 2020 or beyond, he or she generally must have made the election by the end of 2018. Deferrals of 2020 income generally must be elected by December 31, 2019.
Timing of distributions. Benefits must be paid on a specified date, according to a fixed payment schedule or after the occurrence of a specified event — such as death, disability, separation from service, change in ownership or control of the employer, or an unforeseeable emergency.
Elections to change timing or form. The timing of benefits can be delayed but not accelerated. Elections to change the timing or form of a payment must be made at least 12 months in advance. Also, new payment dates must be at least five years after the date the payment would otherwise have been made.
Employment tax issues
Another important NQDC tax issue is that FICA taxes are generally due when services are performed or when there’s no longer a substantial risk of forfeiture, whichever is later. This is true even if the compensation isn’t paid or recognized for income tax purposes until much later.
So, as the employer, you may withhold the employee’s portion of the tax from his or her salary or ask the employee to write a check for the liability. Or you may pay the employee’s portion, in which case the employee will have additional taxable income.
Consequences of noncompliance
With NQDC plans, the penalties for noncompliance can be severe. Plan participants may be taxed on plan benefits at the time of vesting, and a 20% penalty and interest charges also could apply. Our firm can help you follow the rules.
We highly recommend you confer with your Miller Kaplan advisor to understand your specific situation and how this impacts you.