Attracting and retaining top executive talent is essential for banks looking to build strong leadership teams. Non-Qualified Deferred Compensation (NQDC) plans offer significant benefits to executives and can enhance a bank’s overall compensation strategy. At The Bonadio Group (TBG), we help financial institutions navigate the complexities of NQDC plans while ensuring the plans meet their goals and objectives
Understanding Non-Qualified Deferred Compensation Plans
Non-qualified deferred compensation plans are arrangements where executives can defer a portion of their compensation to a future date, typically retirement. A common NQDC plan arrangement is a SERP (Supplemental Executive Retirement Plan). Unlike qualified plans, such as §401(k) plans, NQDC plans do not have to comply with the Employee Retirement Income Security Act (ERISA) requirements. This flexibility allows banks to tailor these plans to meet the specific needs of their executives.
Key Benefits for Executives
One of the primary advantages of NQDC plans is the ability for the executive to defer taxes on the compensation until it is received. This can be particularly beneficial for high-earning executives who may be in a lower tax bracket upon retirement. Additionally, executives can often choose how and when they receive their deferred compensation, providing greater control over their financial planning. NQDC plans can also serve as an additional source of retirement income, supplementing other retirement savings.
Benefits for Banks
By offering NQDC plans, banks can incentivize executives to stay with the company longer, as the benefits are often tied to continued employment. Banks also have the flexibility to design these plans to align with their strategic goals and the needs of their executives. Unlike qualified plans, NQDC plans do not require funding until the compensation is paid out, allowing banks to manage their cash flow more effectively.
Compliance with §409A
One of the most critical aspects of NQDC plans is compliance with §409A of the Internal Revenue Code. §409A governs the timing of deferrals and distributions, and failure to comply can result in significant tax penalties. Here are some key points to understand about §409A compliance:
- §409A imposes restrictions on the time at which non-qualified deferred compensation may be paid. These restrictions include limits on the types of events that can trigger payment, such as separation from service, disability, death, a specified time, change in control, or an unforeseeable emergency. The timing of deferrals must be specified in the plan documents, and any changes to the deferral election must be made at least 12 months prior to the scheduled payment date and must defer payment for at least five years.
- §409A generally prohibits accelerating payments to a time earlier than that which is specified under the plan, except under certain limited circumstances. This means that once the deferral election is made, the executive cannot receive the deferred compensation earlier than the specified date or event.
- The consequences of non-compliance with §409A can be severe. If a plan fails to comply, the deferred compensation becomes immediately taxable, and the executive must pay a 20% penalty on the amount included in income, as well as interest on any late payment of income taxes. Employers may also face penalties and interest for failing to timely report and withhold income taxes on non-compliant NQDC.
To ensure compliance with §409A, it is essential to carefully design and document NQDC plans. This includes specifying the timing of deferrals and distributions, ensuring that the plan does not allow for prohibited accelerations of payment, and regularly reviewing the plan to ensure ongoing compliance with §409A regulations.
Unfunded Requirement
To comply with §409A, NQDC plans must be unfunded. This means that the deferred compensation remains a general obligation of the employer and is subject to the claims of the employer’s creditors. The plan cannot be set aside in a trust or escrow account that is protected from the employer’s creditors. This unfunded status is crucial for the plan to maintain its tax-deferred status and avoid immediate taxation for the executive.
FICA & Income Tax Considerations
When it comes to NQDC plans, both employees and employers need to be aware of the FICA and income tax implications.
Unlike income taxes, FICA (Social Security and Medicare) taxes are due in the year the compensation is earned, not when it is paid. This means that the deferred compensation is subject to FICA taxes at the time of vesting, which is when the employee’s right to the compensation becomes non-forfeitable. Employers are responsible for withholding the employee’s share of FICA taxes and paying the employer’s share at the time of vesting.
The deferred compensation is not subject to income tax until it is actually paid to the executive. This allows the executive to defer income tax on the compensation until a later date, typically retirement, when they may be in a lower tax bracket. The deferred compensation will be reported as taxable income on the executive’s Form W-2 in the year it is paid.
Employers must ensure that they properly report and withhold FICA taxes at the time of vesting and income taxes at the time of payment. Failure to do so can result in penalties and interest.
Funding Considerations
Funding NQDC plans can be approached in various ways, and it is important for banks to carefully consider their options. Unlike qualified plans, NQDC plans do not require pre-funding, which provides flexibility in managing cash flow. However, banks may choose to set aside funds or invest in assets to ensure they can meet future obligations. One common approach is to use a “rabbi trust,” which is an irrevocable trust established to hold assets for the purpose of paying deferred compensation. While the assets in a rabbi trust remain subject to the claims of the bank’s creditors, they provide a measure of security for the executives.
Another option is to invest in bank-owned life insurance (BOLI) policies, where the bank is both the owner and beneficiary of the policy. The cash value of the policy can be used to fund the deferred compensation payments, and the death benefit can provide additional financial security. It is important for banks to work with their advisors and legal counsel to determine the most appropriate funding strategy for their specific situation.
Financial Reporting & Risk Management
Proper financial reporting of NQDC plans is essential. Deferred compensation must be accurately reflected in the bank’s financial statements, including any associated liabilities. This involves recognizing the deferred compensation as a liability on the balance sheet and ensuring that the expense is recorded in the appropriate period. Additionally, it is important to assess the financial stability of the bank to ensure it can meet its future obligations under the NQDC plans. This includes evaluating the impact on the bank’s balance sheet and cash flow, as well as considering potential risks such as changes in tax laws or economic conditions that could affect the bank’s ability to fulfill its obligations.
Other Considerations
Publicly Traded Corporations – Banks must consider the §162(m) $1 million limit on deductibility of compensation for covered employees. If a covered employee receives $1 million in cash compensation in the current year, future deferred payments earned during this year may be non-deductible. Since covered employees remain covered even after retirement, banks should work with executives to forecast deferred compensation payments to avoid exceeding the $1 million limit in future years.
Merger and Acquisition (M&A) – Given the recent increase in M&A activity, accelerated vesting and/or payment of NQDC due to a change in control could have negative consequences under the §280G golden parachute rules. Careful consideration must be given to avoiding “excess parachute payments” which could result in disallowed deductions for the employer (i.e., bank) and excise tax penalties for the recipient (i.e., executive).
Next Steps
NQDC plans are essential for banks to attract and retain top executive talent. If you need further guidance or are considering implementing NQDC plans as part of your compensation package for your executives, we are here to help, Please do not hesitate to reach out to our experts for guidance in determining the best plan and structure to meet your needs.
