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Tip Although nonqualified deferred compensation arrangements may not be subject to tax code restrictions, such arrangements involving contracts are subject to state contract law and, therefore, court enforcement and interpretation. |
Tax Guide |
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Nonqualified deferred pay plans are either in the form of individual contracts or employer plans. When a contract is involved, the contractual arrangements will vary to suit the parties' needs. For example, a contract may provide for installment payments of a fixed amount over a period of years or payments only after retirement. Another contractual provision may require the purchase of an annuity or an endowment policy for the executive or key employee.
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If the nonqualified compensation is provided by means of a plan, many options are available. They include:
A nonqualified deferred compensation plan may also center on the use of life insurance. The most common types of insurance arrangements used in such situations are key-employee insurance, group-term life insurance, split-dollar plans, and reverse split-dollar plans.
Funded v. unfunded nonqualified plans. A nonqualified deferred compensation plan may be funded or unfunded. A funded nonqualified plan is one where the employer maintains it by making contributions to a trust or by paying premiums on an annuity contract. The employee may or may not have to pay current tax on the contributions depending on the employee's vested rights in the contributions.
If a nonqualified plan is unfunded, the plan merely involves the employer's present promise to pay amounts to the employee in the future. The employee is taxed only when those amounts are actually or constructively received.
The distinction between funded and unfunded nonqualified plans is important to keep in mind as you look at the various types of nonqualified plans.
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