Non-Qualified Deferred Compensation Plans (Executive Compensation)

June 1, 1996 Advisory

Although Non-Qualified Deferred Compensation Plans (NQDC Plans) have long been one of the perquisites of senior management, these plans are assuming an increasingly important role in many executive compensation packages. NQDC plans have been the subject of recent federal legislation and I.R.S. regulatory proposals making this a good time for employers to review and perhaps redesign their NQDC plans.

What are NQDC Plans?
A NQDC plan may be as simple as an unsecured promise of the employer to pay additional compensation to an executive at some later date. Other types of NQDC plans allow executives to defer bonuses or other extraordinary compensation to a subsequent year, usually after the executive has retired. One of the most popular forms of NQDC, however, is a so-called "excess benefit" or "wrap- around" plan that parallels the provisions of an employer's qualified retirement plan, but which is not subject to the qualified plan limitations (e.g., the $150,000 limit on applicable compensation or the $30,000 annual contribution limit).

State source tax legislation.
Over the past few years, several states targeted the deferred compensation of non-residents, claiming that the compensation could be taxed by the state because it was earned in the state, even though, by the time the compensation was paid, the employee was no longer living or working there. Recent federal legislation has largely neutralized this problem by prohibiting states from imposing state income taxes on "retirement income" paid to non-residents.

Under this new legislation, "retirement income" from NQDC plans is taxable if, but only if, the income is treated as "wages" for FICA purposes and

  1. the income is paid in equal installment payments for a period of not less than 10 years or the recipient's life, life expectancy or the joint lives or life expectancy of the recipient and a designated beneficiary; or
  2. the payment is received after termination of employment under an excess benefit plan designed to pay benefits in excess of the qualified plan and § 403(b) annuity limitations.

Employers who wish to shield their top executives from possible state source taxation should review the terms of their NQDC plans to ensure compliance with these requirements.