Nonqualified deferred compensation (NQDC) plans can be a win-win for construction companies and their top managers. Under these contractual agreements, participants defer part of their salaries into a separate account that typically doesn’t pay out the funds until retirement, disability, or death.
Unfortunately, after the initial signing, these arrangements are often filed away and forgotten until payments come due — sometimes decades in the future. Whether your construction company has an NQDC plan in place or is considering one for the future, here are some key issues that may prompt the need for an update.
Generally, the IRS categorizes NQDC plans into four areas:
1. Salary reduction arrangements;
2. Bonus deferral plans;
3. Supplemental executive retirement plans; and
4. Excess benefit plans.
All four areas may lower a participant’s annual tax bill by deferring some of his or her pay until a later date. But it’s important to review the contract regularly to determine whether the exact language still makes sense for everyone involved.
“Funded” vs. “Unfunded”
NQDC plans come in two flavors: funded or unfunded. With a funded arrangement, the employer sets funds aside free from the claims of the company’s creditors. The money is generally taxable to the employee when funded under Internal Revenue Code Sections 83 and 402(b), so the advantage of delayed taxation isn’t available.
Many companies, however, can’t endure a funded arrangement’s immediate hit to their cash flow. This is particularly true in the “paid when paid” environment of the construction industry. So “unfunded” NQDC plans, whereby the contract is ultimately paid out from the employer’s cash flow — a trust that’s subject to the claims of the employer’s creditors or a corporate-owned life insurance policy — tend to be more popular.
When reviewing (or creating) an NQDC plan, it’s critical to understand the IRS definition of an unfunded plan as well as its latest position on these arrangements. According to IRS guidance, “An unfunded arrangement is one where the employee has only the employer’s ‘mere promise to pay’ the deferred compensation benefits in the future, and the promise is not secured in any way.”
Furthermore, IRS rules state that NQDC plan assets must be accessible by creditors during a bankruptcy in order for the participant to defer income tax payments on the money being set aside. FICA and FUTA taxes are imposed on NQDC plans under a different set of rules than income taxes are. Deferred amounts are subject to FICA and FUTA taxes at the later of when:
• The services creating the right to the underlying benefits are performed; or
• The amounts are no longer subject to a substantial risk of forfeiture.
These points hold true even if the arrangement qualifies as an “unfunded” plan.
Potential Business Sale
While unfunded NQDC plans may offer considerable long-term tax savings for participants, they often have the opposite effect on employers by limiting present-day deductions. According to IRS guidance, “In general, the [deferred salary] amounts are deductible by the employer [on tax returns] when the amount is includible in the employee’s income.” So you’ll likely be able to deduct deferred compensation only when it’s paid (well into the future) or when the plan no longer qualifies as “unfunded.”
But this year’s potential tax bill isn’t the only factor to consider. Also take into account your construction company’s overall business strategy and succession plan and how these obligations might be affected in the event of a sale.
For example, the owner of a 50-employee plumbing company recently reviewed the terms of two of his company’s unfunded NQDC plans. When the deals were originally signed, the owner planned on transferring company assets to family-member employees.
Unfortunately, personal issues forced the owner to consider a possible sale to outside investors, which would mean making substantial early payouts to the two participants in question. So the owner decided to work with the employees and the potential buyers on an updated NQDC plan that would transfer most of these future obligations to the new owners.
NQDC plans can put a substantial strain on a construction company’s finances. Then again, one of these arrangements may also help lure or retain a top-producing manager. So, whether amending an existing plan or introducing a new one, work closely with your financial advisor and attorney to get the details right while avoiding undue IRS scrutiny.
Contact us if you have questions about setting up your company’s long-term business strategy and succession plan.