'Informal funding' of NQDC plans

• Author: Marla J. Aspinwall - Michael G. Goldstein
• Pages: 239-246

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CHAPTER VIII

“INFORMAL FUNDING” OF NQDC PLANS

R. Lee Nunn

Senior Vice President, Aon Hewitt

I. INTRODUCTION

Many companies choose to set aside funds to finance their nonqualified benefit

obligations. Their motivations vary but commonly include a desire to communicate a sense of

benefit security to participants, to hedge accounting results,1 or to provide a source of future cash

to pay benefits. Companies that choose not to set aside funds commonly emphasize the

opportunity cost of any funds that would have been set aside.

II.

NO “FORMAL FUNDING” OF A NQDC PLAN

Companies are not required to set aside funds for a NQDC plan even when amounts have

been voluntarily deferred from an employee’s salary. In fact, tax and ERISA rules discourage

any formal funding.

A.

Tax Rules. Tax rules discourage formal funding by taxing income in the year in

which cash or property is actually or constructively received.2 An unfunded and unsecured

promise to pay money or property in the future is not property.3 Conversely, a funded or secured

promise to pay would create taxable income. For nonqualified deferred compensation

arrangements subject to IRC § 409A, even the existence of a financial trigger that will restrict

assets to the payment of benefits creates taxable income.4 To avoid current taxation to

participants, any funds set aside must be available to general creditors.

B.

ERISA. ERISA discourages formal funding by exempting “top hat” plans from

the participation, vesting, funding and fiduciary responsibilities of Title 1.5 A key requirement

of a “top hat” plan is that it be unfunded.6 The Department of Labor has indicated that IRS

1 US GAAP limits the use of the term “hedge” to certain derivatives. See Codification Paragraph 815-20-25-

45. In the context of this chapter a hedge is an asset intended to neutralize the effect of nonqualified

deferred compensation on earnings.

2 Treas. Reg. § 1.451-1(a); See Chapter III, “Income Tax Consequences of NQDC for the Employee.”

3 Treas. Reg. § 1.83-3(e).

4 IRC § 409A(b)(2).

5 See “excess benefit” and “top hat” plan exemptions under §§ 4(b)(5), 201(2), 301(a)(3) and 401(a)(1) of

Title I of the Employee Retirement Income Security Act of 1974 (ERISA) discussed in greater detail in

Chapter VI, “ERISA and NQDC.”

6 ERISA § 201(2).