Nonqualified deferred compensation (NQDC) arrangements can help you attract, retain, and reward your most valuable and “mission-critical” employees. They are designed by the company to help their key employees grow and flourish with the company. They can allow for flexibility and customization.
The “art” of designing company compensation arrangements is in understanding the laws of taxation, the power of tax deferral, and the power of tax-deferred investing.
NQDC arrangements enable you to take care of your mission-critical top performers. Like qualified arrangements, these are in writing and can either be structured as defined contribution (a specified amount set aside) or defined benefit arrangements (promise of a percentage of salary).
However, unlike qualified arrangements, NQDC agreements are not subject to the full Employees Retirement Income Security Act of 1974 (ERISA) participation, vesting, and funding requirements.
Only two requirements need to be met:
Employer contributions are also not deductible to the company until they are received as income by the participants.
An NQDC arrangement is a promise to pay a benefit upon a specified payout event identified in the agreement. The promised benefit cannot be accelerated without creating adverse tax consequences for your employee.
Suppose your NQDC arrangement promises to pay a select employee a benefit when they reach age 65. This employee cannot receive the promised benefit prior to age 65 without facing an additional 20% income tax penalty for violating Internal Revenue Code (IRC) 409A.