Nonqualified deferred compensation.

• Author: Hernandez, Leigh

A nonqualified deferred compensation plan is any plan that provides deferred compensation to employees and does not fall under the rigorous Internal Revenue Code rules for qualified plans.

Establishing a Nonqualified Deferred Compensation Plan The key to any nonqualified arrangement is that the compensation is not taxable until constructively received by the employee. Constructive receipt is defined as the time at which the right to receive or transfer an interest in the amount by the employee is controllable by the employee. In other words, the employee must include the amount in his income when the barriers to receiving the amount (such as the performance of substantial services) are removed.

There are two major categories of nonqualified deferred compensation plans, funded and unfunded. An unfunded deferred compensation arrangement is simply an unsecured promise to pay the employee a specific amount of compensation for services prior to the performance of the services. The agreement may be part of a plan or simply part of an individual's compensation arrangement. Since the compensation is unfunded and unsecured, there is usually no difficulty in avoiding constructive receipt and therefore deferring taxation.

For deferred compensation plans, the IRS has specified certain requirements in Rev. Proc. 92-65 that it will consider in determining if an unfunded plan is valid. Under these criteria, it is possible to set aside assets to pay for an unfunded plan, despite the fact that it remains unfunded. Since careful planning is required to avoid taxation at the time the funds are set aside, these criteria are important to follow in setting up an unfunded plan:

[] The eligible employees must elect the deferral of a certain portion of their compensation before the period of service, typically a calendar year. If the election is not on the calendar year, it must be made before the period of service covered by the deferred compensation plan.

[] The plan must define the time and method for payment of deferred compensation for each event (such as termination of employment, regular retirement, disability retirement or death) that entitles a participant to receive benefits. The plan may specify the date of payment or provide that payments will begin within 30 days after the occurrence of a stated event.

[] The plan may provide for payment of benefits in the case of an "enforceable emergency." "Unforeseeable emergency" must be defined in the plan as an...