Nonqualified Deferred Compensation Plans

Corporate worksheet

Instability in the labor market and growing demand for workers are forcing companies to find new ways to retain current employees and attract prospective hires. Additionally, with many employees being at-will (or otherwise free to leave employment at any time), companies are at a higher risk now than ever before of losing experienced and capable employees to competitors offering superior benefits or alternative working arrangements. One approach companies are taking, both to persuade current employees to stay put and to attract new employees to come on board, is implementation of nonqualified deferred compensation plans.

What is a Nonqualified Deferred Compensation Plan?

A nonqualified deferred compensation (“NQDC”) plan is an arrangement in which the employer agrees to pay an employee (or group of employees) a specified amount of compensation in the future. NQDC plans allow employees to defer recognition of income (and the taxes paid on that income) until the deferred compensation is paid out (or otherwise deemed received) upon the occurrence of specified triggering event(s). Typical triggering events include a specified date in the future, termination or resignation from employment, death, disability, and a change in the ownership or effective control of the company. 

Why Are NQDC Plans Popular Among Employers?

NQDC plans are subject to various regulations, including Section 409(a) of the Internal Revenue Code. However, despite existing regulations, NQDC plans offer substantial flexibility which renders them a viable and attractive option for employers of all types and sizes. In particular, NQDC plans offer unique flexibility in terms of participation, incentive structures, and timing of compensation payments.

Participation: Employers are not required to offer participation in NQDC plans to all employees. Rather, unlike other benefit or retirement plans, employers are able to select specific employees (or groups of employees) for participation in NQDC plans. Further, NQDC plans are not subject to the same limitations as other qualified employer plans. This means employees may participate in NQDC plans while still contributing to traditional retirement or benefit plans, such as a 401(k). 

Incentive Structure: A key feature of NQDC plans is the infinite ways a company can determine what amount of money is eligible for inclusion in its NQDC plan (and therefore eligible to be paid to participating employees).  Employers often get very creative with methodologies to determine the amount of compensation participating employees are eligible to receive under an NQDC plan. Common methodologies center around company revenue targets, employee sales goals, department profit margins, growth projections, etc. Flexible incentive structures make NQDC plans an attractive and adaptable option for employers of all types.

Timing of Compensation Payments: As stated above, companies can set forth several specific events that trigger employees’ receipt of deferred compensation under an NQDC plan.

Note, although the ability of companies to use NQDC plans to “defer” compensation is attractive, employers must be sure to keep a healthy balance sheet and enough cash on hand to make the deferred compensation payments when due.  

What Should Employers Watch Out For?

As noted above, NQDC plans are subject to provisions of the Internal Revenue Code, the most important of which is Section 409(a). Employers need to ensure its NQDC plan complies with these regulations from implementation to execution. Employers must pay close attention to safeguard against inadvertently running afoul of these regulations by, for example, accelerating payments, failing to administer payment according to its plan’s specifications, and more.

Additionally, to the extent employers are looking to enact NQDC plans in connection with (or as a part of) noncompete agreements, employers should be aware of the growing trend toward aggressive limitations of noncompete agreements to ensure its NQDC plan and any accompanying noncompete agreements don’t run them into trouble. Noncompete limitations and restrictions will vary by jurisdiction, some with harsher consequences than others. For instance, Colorado recently enacted first-of-its-kind legislation that criminalizes employers’ enforcement of noncompete agreements.

The benefits, risks, and drawbacks of implementing an NQDC plan will vary for each employer. For advice and assistance with your NQDC plan, reach out to our Business Services Practice Group.  We encourage you to subscribe to our E-Briefs for the latest news, tips, and updates.