A Key Person is someone whose skills, knowledge, and/or experience make them vital to the company’s continued success. Under current income tax law, it is very difficult for employers to find benefit plans that allow them to offer benefits only to selected Key Persons. Non-qualified deferred compensation (NQDC) provides away for employers to offer special benefits to Key People. With NQDC, an employer is able to individually select employees to participate in a plan that will defer taxes and provide additional salary beyond retirement.
Unlike qualified retirement plans that have specific participation and vesting requirements, NQDC plans are not subject to the restrictive requirements imposed by ERISA. The employer can differentiate on an individual basis which of its highly compensated and management employees will receive NQDC.
Note: In order for Employer Owned Life Insurance benefits to retain an income tax free nature, certain requirements under IRC sec. 101(j) must be met. That includes: (1) the filing of IRS Form 8925 by the policyholder; and (2) the completion, signing and inclusion with the life insurance application NQDC plans are individually negotiated agreements between the employer and the employee, customized for each employee and do not require IRS approval.
A corporation can use the income-tax free death benefit from a life insurance policy to recover its after-tax benefit payment cost and premium outlay. It is possible the corporation could even have leftover proceeds from the play to use to find a replacement or some other corporate obligation or initiative.
The cash value of a life insurance policy accumulates income-tax deferred. Since the life insurance policy is an asset of the corporation, the cash value is available to the company if there is ever a need for additional funds. As long as the policy is not a MEC, the company is able to withdraw cash up to its cost basis in the contract and take policy loans without incurring any income tax liability. This additional source of borrowing may be particularly useful when the company’s line of credit has been used. However, it’s important to note that a NQDC may affect a C-corporation’s Alternative Minimum Tax, especially at the death of the employee. A C-corporation may want to gross up the death benefit amount to pay any AMT related taxes created as a result of the NQDC.
Highly compensated individuals are often limited in their ability to save for retirement through qualified plans. NQDC plans have no contribution or benefit limitations, so executives can fully prepare for retirement through a tax deferred vehicle.
Key Persons with high levels of income often find it difficult to reduce current taxes. Using a true deferral type of NQDC plan allows high-income employees to defer salary for retirement. The deferral reduces the employee’s current income, so the overall benefit is usually higher than what the employee could have generated through current receipt of after-tax dollars.
Unlike qualified retirement plans, where a trustee pays the benefit to the employee, NQDC benefits are paid to the employee by the employer. When those benefits are paid to the employer or the employee’s beneficiary, they are generally income tax deductible to the corporation. The after-tax cost of the retirement benefit can be recovered from the cash value of the policy, while the after-tax cost of the survivor benefits can be recovered through the death proceeds.
Employers find NQDC helpful in attracting and retaining quality employees. The NQDC plan can set one employer’s benefit package apart from others when competitive bidding is taking place. The NQDC also creates a strong incentive to stay with the corporation, helping maintain efficiency and ongoing initiatives without interruption, while preserving continuity of the corporation’s image and culture.
The early retirement restrictions imposed on qualified plans are not applicable to NQDC arrangements. This gives the corporation greater opportunity to design the plan to reflect the needs of the employer and the employee.
In addition to being able to implement without IRS approval and avoid the costs and hassle of most ERISA requirements, the NQDC arrangement allows an employer to take advantage of all thefeatures that are important to the corporation. Provisions like service requirements, age restrictions, encouragement of early retirement and buy-sell integration are among the variety of features an employer can implement in their NQDC arrangements to encourage specific behavior from Key Persons.
Most employers do their best to give their employees the best benefits package they can offer. There is a way to purchase life insurance for selected Key Persons that offers deferred taxes and an additional salary beyond retirement. Contact Kasmann Insurance and let our trained life insurance experts help you navigate through the myriad of concerns, companies, and questions you may have about Non-Qualified Deferred Compensation Arrangements.
Written by John K. Bangs, Agent