Nonqualified Plan Disadvantages

Despite its advantages, a nonqualified deferred compensation plan does have some disadvantages too. The following are the major drawbacks to consider when evaluating such plans:

• Restrictions on deferrals. Nearly all nonqualified deferred compensation plans are subject to tax rules that impose election, distribution, and funding restrictions on nonqualified plans. Individuals who defer compensation under plans that fail to comply with the rules will be subject to current taxation on all deferrals and to enhanced penalties.

Warning The tax consequences resulting from a plan's failure to comply with the applicable rules will be borne exclusively by the individual plan participant to whom the deferral relates. At the same time, the failure to comply with the governing rules will not subject either the plan or the sponsoring employer to tax and penalties. It is crucial, therefore, that any participant in a nonqualified deferred compensation plan have their situation reviewed by a tax professional to make sure that everything is in order.

• Current tax deduction unavailable to employer. An employer cannot claim a current deduction for any nonqualified deferred compensation amounts until the employee receives the amount as income. For example, employer contributions to a nonqualified deferred compensation trust established for deferrals by key employees are not considered transfers of property or gross income for plan participants until the tax year in which the amounts are transferred, paid, or otherwise made available to participants. Similarly, the mere maintenance of unfunded bookkeeping accounts under a nonqualified deferred compensation plan created for highly compensated employees is not a transfer of property or gross income to the participants until amounts from the accounts are actually transferred or paid.
• Deferred amounts may evaporate. Deferred amounts under a nonqualified deferred compensation plan are merely an employer's promise to pay the employee sometime in the future. In order to allow employees to defer income tax until the amounts are received, these amounts must remain subject to the claims of the employer's creditors in the event of insolvency (i.e., they must be unsecured). This means that an employer's promise to pay may become an empty promise if the employer becomes insolvent.

Tip With the exception of availability in the event of insolvency, there are several methods that employers can use to secure payments from nonqualified plans. One increasingly popular way is by establishing an irrevocable grantor trust, also called a rabbi trust. Other methods of securing nonqualified benefits include establishing secular trusts and using life insurance.

• Registration required for unsecured obligations. Voluntary nonqualified deferred compensation arrangements may have to be registered with the Securities and Exchange Commission (SEC) as securities since they are unsecured obligations. Employees that are offered deferred compensation could be considered investors subject to registration protections. However, if the employer does not have publicly traded securities in its company, then the SEC would not be involved and no registrations would be required.
• Shareholders may challenge executive compensation as excessive. Shareholders have this funny notion that their investment in a company should be rewarded by an adequate rate of return. If lukewarm or decreasing corporate profits are accompanied by increasing executive compensation, they are not shy about taking legal action challenging the executive compensation plan as wasteful and excessive.

Tip A nonqualified plan based on pay-for-performance usually is able to withstand the legal challenges of shareholder activism. The executive compensation should be linked to corporate financial growth and paid on the basis of solid corporate performance. As such, equity and equity-based compensation techniques, like long-term incentive stock options, are increasingly becoming more popular.