In our article on March 20th, we discussed Non-Qualified Deferred Compensation (NQDC) plans as a tool to compensate key employees for achieving long-term goals. One component of such plans is the fact that they are frequently unfunded and legally considered an unsecured promise to pay.
Nonetheless, both plan sponsors and recipients often want a funding mechanism to set aside assets, manage cash flow, or hedge the liability. In addition, employers typically want conditions under which they can rescind the plan for cause, including failure to achieve the objectives the plan was designed to incentivize.
Funding Mechanisms
For cash-based plans, there are four common ways to fund the plans.
- Pay as you go. Goal-based success is paid in cash as a bonus. This has the advantage of immediate expensing against profits. Amounts can still be based on progress toward longer-term goals, but there is little accumulation of a larger benefit toward a significant future payout.
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Reserve accumulation. The company sets aside funds equivalent to the amount earned toward an eventual payout. This appears as an asset on the balance sheet and has no tax deductibility until paid. Although it may give the employee some mental assurance, this asset can still be attached by creditors and has no legal segregation from the company’s other holdings.
- Rabbi Trust. This is an irrevocable trust specifically formed for the accumulation of NQDC benefits. The company cannot use the funds for another purpose, so the employee has an added level of confidence in the availability of future payment. However, the assets are not secured from creditors, and unwinding the trust in the event of the employee’s termination can be problematic.
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Company Owned Life Insurance (COLI). The accumulated benefit provides tax-deferred growth, liquidity via cash values, and reimbursement via death benefits. The asset helps to offset the accumulating liability of the NQDC on the balance sheet. The plan may define a transfer of beneficiary upon qualification or pay out the bonus in cash and keep the policy in force for a future payout.
Vesting and Forfeiture
Vesting in a plan can be structured in various ways.The most common method is based on tenure: there is an ultimate goal, and the beneficiary is entitled to a percentage of the reward each year until the full value is reached.
It may be 10% vested each year for ten years, or vesting may follow an increasing scale (e.g., 5% in the first year, 10% in the second, 15% in the third). Some plans include “cliff vesting”: the employee has no claim on the award until, and unless, the full vesting period is completed. Vesting can also be tied to the percentage of goals met each year.
Of course, “the best-laid plans of mice and men often go awry.” Sometimes the employee doesn’t work out. Life events may intervene, and the employee may terminate voluntarily—or performance may falter and they are no longer a candidate for continued participation.
That is why the legal documentation of any NQDC is critical. Most agreements read much like a buy-sell contract among shareholders. The employer and the employee are making long-term commitments to each other, and their terms of separation are best addressed at the outset.
Note: This article and the previous one on plan structuring are intended as an overview for advisors to business owners. Non-Qualified Deferred Compensation is complex and should be designed with the guidance of legal and tax advisors.
John F. Dini develops transition and succession strategies that allow business owners to exit their companies on their own schedule, with the proceeds they seek and complete control over the process. He takes a coaching approach to client engagements, focusing on helping owners of companies with $1M to $250M in revenue achieve both their desired lifestyles and legacies.