Nonqualified deferred compensation agreements: tax and ERISA requirements.

• Author: Altieri, Mark P.

In the span of a few short years, the Revenue Reconciliation Act of 1990 (RRA '90) and the Revenue Reconciliation Act of 1993 (RRA '93) raised the maximum marginal individual tax rates from 28% to 39.6%. In addition, the RRA '90's phaseout of personal and dependency exemptions and reduction of itemized deductions have effectively forced high-income taxpayers to face an additional 3% to 5% of marginal taxation. In response to these significant rate increases, higher-income taxpayers and their advisers have sought relief. One of the few remaining devices for deferring tax involves the use of nonqualified deferred compensation agreements (DCAs).

Broadly defined, a nonqualified DCA is a contract under which an employee (or independent contractor) agrees to be paid in a future year for services currently rendered to an employer.(1) Deferred compensation payments generally commence on termination of employment (e.g., retirement) or preretirement death or disability. The DCA's goal is to provide cash payments to the retiree and to defer tax on the deferred compensation to a year in which the recipient may be in a lower tax bracket. Although the employer's contractual obligation to pay the DCA benefit is typically unsecured, the obligation remains a contractual promise that must be performed by the employer in the absence of the employee's breach.

Types of DCAs

There are two broad structural categories of DCAs: elective and nonelective.

Elective DCAs: Under this form of DCA, the employee opts to defer to a future tax year receipt of some salary and bonus compensation that he would otherwise currently receive. The initiative behind the deferral comes from the employee. Generally, the deferred compensation benefit is based on the amount deferred plus an interest factor. The election to defer income should be made before the income is earned--e.g., an agreement would be entered into by Dec. 31, 1995 to defer 10% of compensation that would otherwise be earned and payable in 1996. The IRS will not issue an advance ruling when the DCA is entered into after the underlying services earning such deferred compensation have been rendered.(2)

Because the employee is initiating the deferral of compensation that would otherwise shortly be earned and received, it would be inappropriate to impose a substantial risk of forfeiture on such DCA benefits. A substantial risk of forfeiture is a vesting mechanism requiring the performance of significant future services before DCA benefits become nonforfeitable. Therefore, an elective deferral would normally be fully vested and payable in the event of preretirement termination of employment for virtually any reason. Rev. Rul. 60-31(3) allows income tax deferral regardless of the existence of a substantial risk of forfeiture.

Nonelective DCAs: It is not unusual for larger employers to provide a deferred compensation benefit, in the form of a salary continuation agreement, as a fringe benefit to key employees. In this situation, the DCA benefit is a defined benefit (often based on an average of active compensation for a stated number of preretirement years) without a stated interest factor. A nonelective DCA benefit is given as an add-on component of the compensation package to the participating employee; it does not result in a reduction in salary and bonus compensation otherwise currently payable. This is the "velvet handcuff" mechanism for retaining key employees, and usually incorporates within the DCA a substantial risk of forfeiture.(4)

ERISA Coverage and Nontax Compliance Issues

ERISA, as amended, covers all employee pension plans sponsored by an employer engaged in interstate commerce. The definition of an employee pension benefit plan in ERISA Section 3(2) is broad and encompasses any type of plan or method of providing for deferral of income and a benefit payable after retirement or termination of employment, including a DCA.(5) Compliance with the reporting and disclosure, participation, vesting and benefit accrual, funding and fiduciary responsibility requirements of Title I of ERISA is extremely burdensome, time-consuming and costly. Therefore, absent an exemption from ERISA compliance, most employers would shy away from maintenance of a DCA arrangement. ERISA Section 4(b) exempts from its compliance requirements plans maintained by state and other governmental employers and church employers. Two strategies are generally employed by nongovernmental and nonchurch employers to provide the benefits of a DCA while avoiding the most onerous of the ERISA requirements: the "excess benefit plan" and the (more common) "top-hat plan."

* Excess benefit plans

ERISA Section 4(b)(5) defines an excess benefit plan as a DCA maintained by an employer to provide benefits for certain employees in excess of the Sec. 415 limitations for qualified plans. Whether or not the plan is funded, ERISA's participation and vesting standards do not apply. If funded, however, many other Title I requirements are applicable; thus, excess benefit plans are somewhat more technical and complicated. Excess benefit plans are also relatively rare compared to the top-hat plan addressed below. For example, DCAs structured to avoid both the Sec. 415 and 401(a)(17) limits on qualified plan benefits are not excess benefit plans.(6)

* Top-hat plans

The top-hat plan exception is the most commonly used method to avoid the ERISA rules. A DCA that is "unfunded and is maintained by an employer primarily ... for a select group of management or highly compensated employees" (HCEs) is exempted from most Title I requirements.(7) DOL Advisory Opinion 90-14A(8) states that the word "primarily" modifies the type of benefits being provided under the plan, not the participants; therefore, such a plan may not cover employees other than management or HCEs. However, a top-hat plan is subject to Title I's reporting and disclosure provisions. DOL Regs. Section 2520.104-23(a) allows for an abbreviated, one-time filing procedure for complying with these requirements within 120 days from the contractual implementation of the DCA. A copy of the DCA need not be included unless specifically requested. Failure to take advantage of this procedure will require the annual filing by the employer of Form 5500, Annual Return/Report of Employee Benefit Plan (with 100 or more participants).

While the concept of a top-hat plan being unfunded for ERISA purposes generally conforms to the concept of the plan being unfunded for tax purposes (discussed below), which employees constitute a "select group of management or HCEs" is much more vague. Although the idea is to distinguish key employees from the...