Non qualified deffered comp

ALEXANDER BUBLITZ

Non-Qualified Deferred Compensation

July 27, 2016 of 22, see disclaimer on final page

Table of ContentsNonqualified Deferred Compensation Plans: The Employee Perspective .............................................................3

Nonqualified Deferred Compensation Plans ..........................................................................................................9

Nonqualified Deferred Compensation Plan Funding Concepts ............................................................................. 18

Phantom Stock ...................................................................................................................................................... 19


Nonqualified Deferred Compensation Plans: The EmployeePerspective

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What is it?A nonqualified deferred compensation (NQDC) plan is an arrangement between an employer and employee that defers the receiptof currently earned compensation. A NQDC plan doesn't need to comply with the discrimination and administrative rules thatgovern qualified plans, such as Section 401 of the Internal Revenue Code. And if the NQDC plan is "unfunded" (most are) theplan avoids the burdensome requirements of the Employee Retirement Income Security Act of 1974 (ERISA). Since an NQDCplan doesn't have to comply with these regulatory requirements, it's a flexible form of employee compensation that allows youremployer to tailor the benefit amounts, payment terms, and conditions of the plan to your needs. In addition to its flexibility, anunfunded NQDC plan can provide you with significant tax benefits: Unlike cash compensation, which the IRS taxes currently,deferred compensation generally isn't subject to federal income taxes until you begin receiving distributions from the NQDC plan.

Funded versus unfunded plansIn generalIt is important for you to understand whether your employer's NQDC plan is "funded" or "unfunded" in order to understand how thefederal tax laws and ERISA apply to the plan. Most NQDC plans are unfunded. The reason is that employers usually adopt NQDCplans in order to provide their employees with the benefit of tax deferral while at the same time avoiding the often burdensomerequirements of ERISA.

Tip: ERISA does not apply if your employer is a church or a state or local government. If you're employed by a state or localgovernment your NQDC plan is subject to a special set of rules under IRC Section 457, and this article does not generally apply.

Unfunded plansAn unfunded plan avoids most ERISA requirements, and your benefits are usually not subject to federal income tax until youreceive them. A NQDC plan is unfunded if either assets have not been set aside by your employer to pay plan benefits (that is,your employer pays benefits from its general assets on a "pay as you go" basis), or assets have been set aside but those assetsremain subject to the claims of your employer's creditors (often referred to as an "informally funded" plan). In general, when a planis unfunded you must rely solely on your employer's unsecured promise to pay benefits at a later date. As a result, you may befearful that when it comes time for you to receive the deferred compensation, your employer may be unwilling or unable to pay thedeferred compensation or that a creditor may seize the funds through foreclosure, bankruptcy, or litigation. Unfunded plans mustgenerally be limited to a select group of management or highly compensated employees, and are often called "top-hat" plans.

Tip: Although there is no formal legal definition of "select group of management or highly compensated employees," it generallymeans a small percentage of the employee population who are key management employees or earning a salary substantiallyhigher than the average salary for all management employees. Generally, courts will look at the number of employees in the firmversus the number of employees covered under the top-hat plan, the average salaries of the select group versus the averagesalaries of other employees, and the extent to which the select group can negotiate salary and compensation packages.

Funded plansIf you fear losing your deferred compensation benefits (for example, if your employer becomes insolvent or declares bankruptcy)your employer may want to consider offering a funded NQDC plan. These are unusual, because funded NQDC plans generallymust comply with all of ERISA's requirements, and your plan benefits are subject to federal income tax as soon as they arevested. In general, a plan is considered "funded" if assets have been irrevocably set aside with a third party (for example, in atrust) by your employer for the payment of your NQDC plan benefits, and those assets are beyond the reach of your employer andyour employer's creditors. In other words, if you are guaranteed to receive your benefits under the NQDC plan, the plan isconsidered funded. This is also sometimes referred to as "formal funding." One of the most common methods of formally fundinga NQDC plan is the secular trust. But again, unfunded plans are far more common than funded plans.

Informally funded plansWhile most employers want to avoid formally funding their NQDC plans in order to avoid ERISA while providing the benefit of tax

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deferral, employers often want to accumulate assets in order to ensure they can meet their benefit obligations when they comedue. This is called 'informally funding" a NQDC plan. Even though your employer sets aside funds, the NQDC plan is notconsidered formally funded because the assets remain part of your employer's general assets, and can be reached by youremployer's creditors. Informal funding allows your employer to match assets to future benefit liabilities, and provides you withpsychological assurance (at least) that your benefits will be paid when due. The most common method of informally funding aNQDC plan is the rabbi trust, discussed more fully below. An irrevocable rabbi trust, adequately funded, can provide you with theassurance that your benefits will be paid in all events other than the insolvency or bankruptcy of your employer.

Tax treatment--unfunded planIn generalAny amount your employer promises to pay you from an unfunded NQDC plan is generally not subject to federal income tax untilyou actually receive payment of your benefits from the plan. This is true whether or not your employer chooses to informally fundthe NQDC plan (for example, through contributions to a rabbi trust). However, there are instances in which your NQDC planbenefits may be taxed prior to your actual receipt of the funds.

Constructive receiptUnder the doctrine of constructive receipt, the IRS can tax you prior to your "hands-on" receipt of funds if the funds are credited toyour account, set aside, or otherwise made available to you without substantial restriction. In other words, once the funds havebeen earned and are payable to you on demand, you must report the income even if you choose not to actually accept currentpayment of the funds. The constructive receipt doctrine has been codified in part by Internal Revenue Code (IRC) Section 409A.

Section 409A of the Internal Revenue CodeIRC Section 409A provides specific rules relating to deferral elections, distributions, and funding that apply to most NQDC plans. Ifyour employer's NQDC plan fails to follow these rules, your NQDC plan benefits for that year and all prior years may becomeimmediately taxable, and subject to penalties and interest charges. It is very important that your employer be aware of, and followthe rules in, IRC Section 409A, when establishing a NQDC plan.

Tax treatment-- funded planYour employer's contributions to a funded NQDC plan are generally taxable to you once you become vested in thecontributions--that is, when the benefits are no longer subject to a substantial risk of forfeiture. This is true even if you don't yethave a right to receive payment from the plan. If the plan is funded with a secular trust you may be entitled to a distribution fromthe trust to pay the taxes. Or your employer may decide to pay you a cash bonus that covers your tax liability. The tax treatment ofbenefits paid from a NQDC plan funded with a secular trust can be quite complex.

NQDC plan issues that concern key employeesDollar limitations on contributions to and benefits payable from qualified plansSometimes, highly compensated employees are adversely affected by the dollar limitations on contributions to and benefitspayable from qualified plans. As a result, they don't receive as high a percentage of their compensation as do lower-paidemployees under a qualified plan. A NQDC plan can help solve this problem.

Tip: The compensation limit (which is indexed for inflation) is $265,000 for 2016 (unchanged from 2015).

Example(s): Hal and Jane work at BCD Corporation. Hal earns $300,000 in 2016, while Jane earns $100,000. They bothparticipate in a defined benefit plan that provides a general benefit of 50 percent of salary. Although the plan formula dictates thatHal should get a benefit of $150,000 (50 percent of $300,000), he actually is only allowed to receive $132,500 (50 percent of$265,000) because $265,000 is the maximum compensation amount that may be used in calculating the benefit in 2016.Conversely, Jane is entitled to $50,000 (50 percent of $100,000) because her entire annual salary can be taken into account,since it is below $265,000. As a result, Hal may only receive approximately 44.2 percent of his pay, while Jane may receive the 50percent as dictated by the plan formula. Hal is adversely impacted by the $265,000 maximum, while Jane isn't.

Tax benefits


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Generally, a key employee is subject to a higher income tax rate. As a result, a key employee can benefit from deferringcompensation, since he or she is likely to be in a lower tax bracket during retirement, when the deferred compensation is finallyreceived.

Example(s): Hal works at XYZ Company. Hal is given the option of receiving as earned or deferring until retirement a $100,000bonus. His current marginal tax rate is 35 percent, and his estimated marginal tax rate at retirement will be 25 percent. Assumingno other variables, if Hal decides to receive the $100,000 bonus this year, he will be taxed $35,000 (35 percent of $100,000), but ifhe defers the income until retirement, he will only be taxed $25,000 (25 percent of $100,000).

Rabbi trustsIn generalA rabbi trust is a trust that your employer establishes in order to satisfy its obligation to provide you with benefits under an NQDCplan. It's called a rabbi trust because a rabbi was the beneficiary of the first such trust to receive a favorable IRS ruling. Theprimary reasons for establishing a rabbi trust are for your employer to provide you with assurance that assets will be available,and that payment of your deferred compensation will be made when due under the terms of the NQDC plan (except in the event ofyour employer's insolvency or bankruptcy).

Tip: Although the rabbi trust assets are held apart from your employer's other assets, the funds are still subject to the claims ofyour employer's general creditors. For this reason the NQDC plan is considered unfunded (or informally funded) for tax andERISA purposes.

Tip: A rabbi trust can be in the form of either a revocable or irrevocable trust. If a rabbi trust is irrevocable, your employer gives upthe use of the NQDC plan assets and can't get them back until all plan benefits have been paid. The assets are there to coveryou, except in the case of your employer's bankruptcy or insolvency. If bankruptcy or insolvency occurs, the assets becomeaccessible to your employer's general creditors (including you), and your NQDC plan benefits may be lost.

Why would you want your employer to establish a rabbi trust?The rabbi trust is a major step forward in providing benefit security for plan participants. An irrevocable rabbi trust, adequatelyfunded, can largely eliminate the risk of nonpayment for every reason but your employer's bankruptcy or insolvency. Foremployees who worry about nonpayment primarily by reason of a hostile takeover or a similar occurrence whereby the employerrefuses to pay, the rabbi trust is an ideal device.

IRS tax treatmentA NQDC plan informally funded with a rabbi trust is considered "unfunded" for federal income tax purposes. Even though yourNQDC plan benefits may be payable from rabbi trust assets your benefits are generally not subject to income tax until they areactually paid to you. See "Tax treatment--unfunded plan," above.

Caution: IRC Section 409A provides specific rules that govern rabbi trusts. For example if your employer funds a rabbi trust whilemaintaining an at-risk defined benefit plan, or your employer invests rabbi trust assets off-shore, you could be subject toimmediate taxation and penalties.

NQDC plans and corporate-owned life insurance (COLI)In generalCorporate-owned life insurance (COLI) is a life insurance policy that your employer takes out on your life. Your employer is boththe owner and the beneficiary of the policy. As owner of the policy, your employer is responsible for paying the premiums. Asbeneficiary of the policy, your employer retains all rights to the benefits under the policy. Other than being named as the insured,you have no interest in the policy. COLI can be used for a variety of reasons, and the use of COLI may or may not bear anyrelationship to the actual financial loss your employer may anticipate incurring upon your death. For example, COLI is commonlyused as a funding vehicle for NQDC plans. When used as a funding mechanism for an NQDC plan, your employer can borrowagainst the cash value that accumulates under the policy. Your employer can then use the borrowed funds to pay the COLIpremium payments or to fund the NQDC plan.

Tip: The Pension Protection Act of 2006 requires your employer to notify you: (a) that you may be insured under a COLI policy,


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(b) of the maximum amount of coverage your employer may take out on your life, and (c) that your employer will be the beneficiaryof the death proceeds. The Act also requires that your employer get your written consent to being insured. If your employer fails tocomply with these rules, the amount your employer can exclude from income as a tax-free death benefit will generally be limited tothe premiums your employer paid for the contract. Some state laws may also require your consent before you can be insuredunder a COLI contract.

Why would you want your employer to purchase COLI?As an informal funding mechanism for NQDC plans, the COLI policy provides you with psychological assurance that youremployer will have assets available when benefit payments are due under the plan.

Risks associated with COLIA number of risks are associated with using COLI to fund an NQDC plan. First, if the insurance company experiences severefinancial difficulties, your employer may be unable to access the policy's cash value to pay the plan benefits. In addition, thedisparity between the estimated earnings (earnings projected when the policy is issued) and the actual earnings may leave youremployer with insufficient cash value to pay plan benefits when due. Also, the COLI policy remains part of your employer's generalassets, and therefore is subject to the claims of your employer's creditors in the event of your employer's bankruptcy orinsolvency. And if the COLI policy is held directly by your employer the policy could be cashed out at any time.

NQDC plans and split dollar life insuranceAnother informal funding vehicle for NQDC plans is split dollar life insurance. In general, split dollar is an arrangement wherebyyou and your employer share the premium cost and/or death benefits of a life insurance policy issued on your life. Split dollar lifeinsurance allows your employer to fund NQDC plan benefits with the proceeds your employer receives from the life insurancepolicy. While there are a number of variations, one way your employer can accomplish this is by establishing an unfundednonqualified plan to provide you with a promised level of deferred compensation benefits. Your employer then purchases a lifeinsurance policy on your life. The premiums may be split between you and your employer in any way desired. Typically you areentitled to a death benefit from the policy equal to some multiple of your compensation, for example 3 times pay. The face amountof the policy, however, is usually greater than that amount. Each year, your employer credits your nonqualified plan account withan amount specified in the NQDC plan. When distribution is scheduled to occur, your employer pays you the NQDC plan benefitsfrom his or her general assets. Upon your death, your beneficiary receives the promised level of death benefits from the lifeinsurance policy, and your employer receives the balance of the policy proceeds. The life insurance benefits are tax-free. Byfunding an NQDC plan with split dollar life insurance, you can receive death benefit protection under the life insurance policy alongwith deferred compensation under the NQDC plan, and your employer can recoup all or part of the cost of providing thesebenefits.

Caution: Be sure to consult your legal and financial advisors before implementing a split dollar plan. The IRS has issuedregulations that have significantly changed the tax treatment of split dollar life insurance. Also, in some cases, the Sarbanes-Oxleyact may prohibit public companies from implementing certain forms of split dollar plans.

Secular trustsIn generalA secular trust is an irrevocable trust that your employer establishes with a third party to hold assets for the exclusive purpose ofpaying for your NQDC plan benefits. A significant feature of the secular trust is that participants generally have a nonforfeitableand exclusive right to the contributions made to the trust and to the earnings on those contributions. This stands in contrast to therabbi trust, where plan assets remain subject to the claims of your employer's general creditors, and your benefits may be lost inthe event of your employer's insolvency or bankruptcy.

Tip: Although your employer establishes the secular trust for your benefit, you may be treated, for tax purposes, as havingestablished the trust.

Why would you want your employer to establish a secular trust?A secular trust can provide you with the assurance that your NQDC plan benefits will not be at risk as a result of your employer'sunwillingness or financial inability to pay the benefits at a future time. Unlike assets that are within a rabbi trust, secular trust


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assets are not subject to your employer's creditors' claims. The secular trust assets must be used for the exclusive purpose ofpaying benefits due under the NQDC plan.

Disadvantages of a secular trustThe IRS taxes you each year on what could be sizable income. Unfortunately, you don't receive the cash to pay the tax on thatmoney until NQDC plan distributions are scheduled to occur. However, the plan may be designed so that you may receive adistribution from the trust to pay the taxes. Alternatively, your employer may pay you a bonus that covers your tax liability.

Types of secular trustsThere are two types of secular trusts: an employer secular trust and an employee secular trust. An employee secular trustarrangement allows you to choose to receive cash compensation or contributions to an irrevocable trust that your employerestablishes for your exclusive benefit. The trust is not subject to your employer's creditors, and your employer's role is asadministrator of the trust. An employer secular trust is similar, but you don't have the choice to receive cash instead of youremployer's contribution to the irrevocable trust. In both cases the trust assets are placed beyond the reach of your employer andyour employer's creditors.

IRS tax treatmentThe use of a secular trust creates a funded plan for tax purposes. In general, this means that your employer's contributions to asecular trust are includable in your income in the year they're made to the trust or, if later, in the year you become vested in thecontributions. The taxation of secular trusts is complex.

Secular annuitiesA secular annuity may be used in lieu of a secular trust, or in conjunction with a secular trust. A secular annuity is an annuity youremployer purchases in your name that is either a standalone benefit, or secures the benefit promised by your employer under arelated NQDC plan. While there are a number of variations, typically you own and control the annuity contract, and your employermust rely on the premature withdrawal tax and the policy surrender charges to deter you from surrendering the contract for itscash value. If your employer wants more control over when you can receive the annuity proceeds, your employer might place thesecular annuity inside a secular trust. By doing this you would generally not be entitled to distributions until the time specified inthe plan and trust documents.

A secular annuity creates a funded plan for tax and ERISA purposes. The use of a secular annuity places the NQDC plan assetsbeyond the reach of your employer's creditors and provides full security to you that your NQDC plan benefits will be paid (subjectto the solvency of the insurer). However, placing the assets beyond the reach of your employer's creditors generally causes you tobe immediately subject to federal income tax on your employer's premium payments. Any increase in the cash surrender value isgenerally tax deferred until you begin receiving payments from the annuity contract.

Caution: Distributions from a secular annuity may be subject to a 10 percent early distribution penalty if made before you reachage 59½, unless an exception applies.

Caution: Any guarantees are subject to the financial strength and claims-paying ability of the insurer.

What is a supplemental executive retirement plan (SERP) plan?A supplemental executive retirement plan (SERP) is simply an unfunded NQDC plan that provides you with benefits thatsupplement benefits you are entitled to receive under your employer's qualified retirement plan. A SERP can be either a definedbenefit plan or a defined contribution plan.

Tip: The term SERP is also sometimes used more broadly to refer to any NQDC plan that provides unfunded deferredcompensation benefits to a select group of management or highly compensated employees (i.e., a top-hat group).

What is an excess benefit plan?An excess benefit plan is a special kind of NQDC plan. An excess benefit plan is designed solely to provide you with NQDC planbenefits in excess of the limits that apply to qualified plans under IRC Section 415. Section 415 limits contributions to definedcontribution plans (like 401(k) plans and profit-sharing plans) to the lesser of $53,000 (in 2015 and 2016) or 100 percent of pay


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(plus any age-50 pre-tax catch-up contributions). Section 415 limits benefits from defined benefit plans to the lesser of $210,000(in 2015 and 2016) or 100 percent of your average compensation for your high three years. Excess benefit plans are different fromother NQDC plans because if unfunded they are entirely exempt from ERISA, and even if funded are exempt from most ERISArequirements. Also, unlike other unfunded NQDC plans, an unfunded excess benefit plans does not need to limit participation to aselect group of management or highly compensated employees even though typically only highly compensated employees will beimpacted by the Section 415 limits.


Nonqualified Deferred Compensation Plans

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What is it?A nonqualified deferred compensation (NQDC) plan is an arrangement between an employer and an employee to defer thereceipt of currently earned compensation. NQDC plans do not have the tax-favored benefits of qualified retirement plans. On theother hand, most NQDC plans do not have to comply with the participation, vesting, funding, distribution, and reportingrequirements imposed on qualified plans by Internal Revenue Code (IRC) Section 401(a) and the Employee Retirement IncomeSecurity Act (ERISA).

Since a NQDC plan doesn't generally have to comply with these IRC and ERISA requirements, it's a flexible form of employeecompensation that allows you to tailor the benefit amounts, payment terms, and conditions of the plan to both you and youremployee's needs. As a result, a NQDC plan can cover any group of employees without regard to nondiscrimination requirements,provide unlimited benefits to any employee, and can provide different benefit amounts for different employees under differentterms and conditions. In addition to its flexibility, a NQDC plan can also provide your employee with significant tax benefits. Unlikecash compensation, which the IRS taxes currently, your employees can defer taxation of their NQDC plan benefits.

Caution: In order to achieve tax deferral for employees, a NQDC plan must either be "unfunded," or if "funded" the benefits mustbe nontransferable and subject to a substantial risk of forfeiture.

Example(s): Hal and his employee Mark agree that Hal will pay Mark a salary of $100,000 a year. In addition, Hal agrees to payMark another $10,000 for each year that Mark works for Hal, payable upon Mark's retirement. Hal and Mark have established aform of nonqualified deferred compensation. At the most basic level, this is how such a plan works.

Tip: The extent to which ERISA applies to a NQDC plan depends on the type of NQDC plan and the funding status of the plan.NQDC plans are almost always designed to avoid virtually all ERISA requirements. To avoid application of most ERISArequirements, the NQDC plan must be unfunded and provide deferred compensation benefits primarily to a "select group ofmanagement or highly compensated employees," as discussed below. This is often referred to as a "top-hat" plan.

Tip: One type of NQDC plan, an "excess benefit plan," can be funded, and yet avoid most of ERISA's requirements. See thediscussion later in this article.

Caution: The SEC has sometimes taken the position that NQDC plans may be subject to registration under the Securities Act of1933. Even if this position is correct, many exceptions to registration apply. Public companies may also need to report NQDCplans to the SEC or shareholders. Consult a securities expert for more information about these requirements.

NQDC plans vs. qualified plansA qualified plan like a profit-sharing plan or a 401(k) plan can be a valuable employee benefit, generally covering all or mostemployees. A qualified plan provides an immediate tax deduction to the employer for the amount of money contributed to the planfor a particular year. As for the employee, he or she isn't required to pay income tax on amounts contributed to the plan until thoseamounts are actually distributed from the plan. However, in order to receive this beneficial tax treatment, a qualified plan mustcomply with strict and highly complex ERISA and IRS rules. In addition, qualified plans are subject to a number of limitations oncontributions and benefits. These limitations have a particularly harsh effect on highly paid executives.

In contrast, an employer will generally make NQDC plans available only to select executives and other key employees in order toavoid ERISA's requirements, and adverse tax consequences. And there are no dollar limits that apply to NQDC plan benefits(although compensation must generally be reasonable in order to be deductible). With this type of plan, an employer typicallywon't be allowed to take a tax deduction for amounts contributed to the plan until such time as funds are actually distributed fromthe plan and received as taxable income by participating employees. In effect, an employer often isn't entitled to a tax deductionuntil years after contributions are made to the plan. As with a qualified plan, employees generally don't recognize the deferredcompensation income currently (when it is earned) for income tax purposes. Rather, they recognize the income when payment isreceived from the NQDC plan.

Caution: Although most NQDC plans result in the tax structure described, actual tax consequences depend on the specific designand funding provisions of the NQDC plan.


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Caution: Unlike qualified plan benefits, unfunded NQDC plan benefits may be lost in the event of an employer's bankruptcy orinsolvency. This is one of the primary drawbacks to unfunded NQDC plans.

Funded vs. unfunded plansIn generalNonqualified deferred compensation (NQDC) plans fall into two broad categories, funded plans and unfunded plans. It is importantto understand the technical meaning of these terms in order to understand the tax and ERISA consequences that flow fromestablishing a NQDC plan. Unfunded plans are far more common than funded plans because they can provide the benefit of taxdeferral while avoiding almost all of ERISA's burdensome requirements. Funded plans, on the other hand, must generally complywith ERISA, and provide only limited deferral opportunities.

The following chart shows the general features of unfunded and funded plans.*

Plan Type Coverage Taxation of Benefits ERISA Creditor Protection

Unfunded(and informallyfunded)

Limited to select groupof management orhighly compensatedemployees

Benefits generallytaxed when paid

Very limitedapplication

Benefits subject toclaims of employer'screditors

Funded Any employee may becovered

Benefits generallytaxed when vested**

ERISA applies*** Benefits protectedfrom employer'screditors***

*Special rules apply to excess benefit plans, church plans, and plans maintained by governmental and tax-exempt employers.

**See our separate topic discussion, Secular Trusts and Annuities, for more detailed information.

*** Employee secular trusts may not be covered by ERISA. If not, then whether benefits under these plans are protected from theclaims of the employer's creditors may depend on state law.

When is a plan considered "funded?"There is no specific definition of "funding" in either ERISA or the Internal Revenue Code. But the concept has been defined bycourt cases and guidance from the Department of Labor and the Internal Revenue Service. In general, a plan is consideredfunded if assets have been irrevocably and unconditionally set aside with a third party for the payment of NQDC plan benefits (forexample, in a trust or escrow account) and those assets are beyond the reach of both you and your general creditors. In otherwords, if participants are guaranteed to receive their benefits under the NQDC plan, the plan is considered funded. This is alsosometimes referred to as "formal funding." One of the most common methods of formally funding a NQDC plan is the seculartrust.

Conversely, unfunded plans are those where either assets have not been set aside (that is, a "pay as you go" plan), or assetshave been set aside but those assets remain subject to the claims of your general creditors (often referred to as an "informallyfunded" plan--see discussion below). In general, in an unfunded plan, your employees rely solely on your unsecured promise topay benefits at a later date. In order to avoid ERISA, you must limit participation in unfunded NQDC plans to a select group ofmanagement or highly compensated employees. These plans are often referred to as "top-hat plans".

Caution: Funding may also be deemed to occur if your employees have any legal rights to specific assets you set aside to meetyour NQDC plan benefit obligations that are superior to those of your general creditors, or if employee communications leademployees to believe that their benefits are secured by specific assets. Careful drafting of all plan documents and consultationwith pension professionals is important to avoid this potential problem.

Tip: While there may be some fine distinctions between funding for tax purposes and funding for ERISA purposes, in almost allcases if a plan is considered funded for one purpose, it will be considered funded for the other.

What is an informally funded plan?While most employers want to avoid formally funding their NQDC plans in order to avoid ERISA and provide the benefit of tax


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deferral, they often want to accumulate assets in order to ensure they can meet their benefit obligations when they come due. Thisis commonly referred to as "informally funding" a NQDC plan. Even though you set aside funds, these plans are not consideredformally funded because the assets remain part of your general assets and can be reached by your creditors. Informal fundingallows you to match assets with your future benefit liabilities, and provides your employees with psychological assurance (at least)that their benefits will be paid when due. The most common methods of informally funding NQDC plans are corporate-owned lifeinsurance (COLI) and the rabbi trust, discussed below.

Example(s): Widget Corporation wishes to establish a NQDC plan for its executives. To fund the plan, it establishes a rabbi trust(a particular type of irrevocable grantor trust approved by the IRS). Although Widget Corporation has set aside these assets solelyfor the employees of its plan, the funds contained in this trust must remain subject to the claims of all of Widget's creditors. Theplan will therefore be considered unfunded from an ERISA perspective.

Why would an employer establish a funded NQDC plan?In general, you might choose to establish a funded plan, instead of an unfunded plan, if benefit security is your employees' mainconcern. In unfunded plans, any assets set aside to pay benefits must remain subject to the claims of your general creditors. Thislack of security may make employees fearful that when it comes time to receive the deferred compensation, you may be unwilling(due to a change of heart or change in control) or unable (due to a change in financial condition) to pay the deferredcompensation, or that a creditor may seize the funds through foreclosure, bankruptcy, or liquidation. Since funded plans aregenerally protected from the claims of your creditors, they provide maximum security to employees that their benefits will be paidwhen due. You may also want to establish a funded plan to provide deferred compensation benefits to an employee who does notqualify as a member of the top-hat group.

Employee tax treatment--unfunded plansIn generalGenerally, there are no income tax consequences to your employee until benefits are paid from the plan. Your employee mustthen include the full amount received in his or her gross income. However, there may be times when the IRS taxes an employeeon contributions made to an NQDC plan prior to the receipt of plan assets.

Constructive receipt doctrineUnder the doctrine of constructive receipt, the IRS can tax your employee before he or she receives funds from the plan if thefunds are credited to the employee's account, set aside, or otherwise made available to the employee without substantialrestrictions or limitations. In other words, once the funds have been earned and are available, your employee must report theincome even if the employee has chosen not to actually accept current payment of the funds.

The doctrine of constructive receipt is most relevant to NQDC plans that permit the employee to elect to defer receipt ofcompensation or would allow the employee to elect to receive previously deferred compensation. Under IRS guidelines, anemployee can avoid constructive receipt by making his or her election to defer compensation before the year he or she performsthe services that earn the compensation. Also, to avoid constructive receipt, the employee generally can't have any right to electto receive payment of his or her deferred compensation before payment is due under the terms of the NQDC plan.

Section 409A of the Internal Revenue CodeIRC Section 409A provides specific rules relating to deferral elections, distributions, and funding that apply to most NQDC plans,and in part codifies the constructive receipt rules described above. If your NQDC plan fails to follow these rules, the NQDC planbenefits of affected participants, for that year and all prior years, may become immediately taxable and subject to penalties andinterest charges. It is very important that you be aware of and follow the rules in IRC Section 409A when establishing a NQDCplan.

Employee tax treatment--funded plansIn general, your employee must include your contributions to a funded NQDC plan in gross income in the year they are made or, iflater, in the year your employee becomes vested in the contributions--that is, when the employee's benefit is no longer subject toa substantial risk of forfeiture. However, the specific tax consequences depend on the type of funding vehicle used.

Caution: Your employees may be taxed on your contributions to a funded NQDC plan, as well as investment earnings, prior to


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their actual receipt of the plan funds. If desired, you can pay your employee a cash bonus to cover his or her tax liability. Or, ifyour plan is funded with a secular trust, your employee can receive a distribution from the trust in order to pay the taxes.

Tip: A funded NQDC plan can provide the benefit of tax deferral only if the employee's benefit is subject to a substantial risk offorfeiture. In contrast, an unfunded NQDC plan can provide the benefit of tax deferral even if the employee's benefit is fully vested.

Tip: Some NQDC plans are designed so that a change in control of the employer triggers accelerated vesting or distribution ofbenefits. In these cases, the "golden parachute" rules of Internal Revenue Code Section 280G may apply.

Employer tax treatmentUnfunded planIn general, you receive a tax deduction in the taxable year an amount attributable to your contribution is included in youremployee's gross income. This means that you receive the deduction in the year your employee actually receives the planbenefits. You can deduct the total amount paid to your employee, including any earnings on your contributions.

An additional tax consideration is that if the employer sets aside funds for the purpose of paying future benefits under the NQDCplan (for example, in a rabbi trust), the employer must pay income tax on any earnings attributable to those allocated funds. Forthat reason, NQDC plans are often informally funded with corporate-owned life insurance (COLI), because policy earnings (theincrease in the cash value) are generally not subject to current income taxation (unless the alternative minimum tax (AMT) rulesapply).

Funded planIn general, you are entitled to a tax deduction in the taxable year an amount attributable to your contribution is included in youremployee's gross income. This means that you are entitled to the deduction in the year you make your contributions to the plan, orif later, when your employee becomes vested in the contributions. You are generally not entitled to a deduction for any earningson your contributions to a funded plan.

Caution: In order for you to be able to receive a deduction for contributions to a NQDC plan funded with an employer secular trustyou may need to maintain separate accounts for each employee when more than one employee participates in the plan.

Caution: Further, a deduction is permitted only to the extent that the contribution or payment is both reasonable in amount and anordinary and necessary expense incurred in carrying on a trade or business.

Caution: Publicly-held companies can't deduct total compensation in excess of one million dollars in any one year for certainexecutives.

"Top-hat" plansIn generalAs discussed earlier, most NQDC plans are unfunded in order to provide employees with the benefits of tax deferral whileavoiding ERISA's most burdensome requirements. In order to achieve these goals, unfunded NQDC plans must be maintained fora select group of management or highly compensated employees. This is the most common type of NQDC plan. When discussingunfunded NQDC plans in the balance of this article, we are referring to NQDC plans maintained for a select group of managementor highly compensated employees. Such a plan is commonly referred to as a top-hat plan.

What constitutes a "select group of management or highly compensatedemployees?"While there is no formal legal definition of a "select group of management or highly compensated employees," it generally meansa small percentage of the employee population who are key management employees or who earn a salary substantially higherthan that of other employees. Over the years, the courts and the Department of Labor (DOL) have looked at one or more of thefollowing factors: the number of employees in the firm versus the number of employees covered under the NQDC plan; theaverage salaries of the select group versus the average salaries of other employees; the average salary of the select groupversus the average salary of all management or highly compensated employees; and the range of salaries of employees in theselect group.


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The DOL has also indicated that the phrase refers only to the group of employees who, by virtue of their position or compensationlevel, have the ability to affect or influence the design or operation of the deferred compensation plan. In other words, according tothe DOL, the select group should consist of employees who would typically be in a position to negotiate their compensationpackages. Under this view, a NQDC plan could benefit only a very small percentage of the employee population. However, thecourts have typically been more liberal than the DOL.

ERISA considerationsIf a NQDC plan is unfunded (i.e., a top-hat plan) then generally only two ERISA requirements apply. First, you (or morespecifically, the plan administrator, which is typically the employer) must send a one-page notification letter to the DOL indicatingyour company's name and address, your company's employer identification number, the number of top-hat plans you maintain,the number of participants in each plan, and a declaration that the employer maintains the plan(s) primarily for the purpose ofproviding deferred compensation for a select group of management or highly compensated employees. The letter must be filedwith the DOL within 120 days of the plan's inception; otherwise the plan will be subject to all of ERISA's reporting and disclosurerequirements. Second, since top-hat plans are subject to ERISA's administrative provisions, you must inform plan participantsabout the ERISA claims procedures that apply to your plan (these will generally be described in the NQDC plan document).

If a plan is funded, it must generally comply with all of ERISA's requirements. This includes ERISA's rules governingadministration, reporting, disclosure, participation, vesting, funding, and fiduciary activities.

Caution: It is not clear if ERISA applies to a NQDC plan funded with an employee secular trust. ERISA applies only to plansestablished or maintained by an employer or employer organization, and employee secular trusts are deemed to be created by theparticipating employees for tax purposes.

Tip: ERISA doesn't apply to governmental and most church plans, plans maintained solely for the benefit of non-employees (forexample, company directors), plans that cover only partners (and their spouses), and plans that cover only a sole proprietor (andhis or her spouse).

Social Security tax (FICA and FUTA)Social Security tax actually consists of several different component taxes: the Federal Insurance Contribution Act (FICA) taxes forold age and disability benefits, the hospital insurance or Medicare tax, and the unemployment tax (FUTA). Both FICA and FUTAtaxes may be due currently on amounts deferred to a NQDC plan. However, FICA and FUTA don't have as significant an impacton NQDC plans as you might think. FUTA tax applies only to a limited amount of an employee's compensation. And mostemployees deferring compensation into a NQDC plan exceed the Social Security wage base ($118,500 in 2015 and 2016).Compensation exceeding this amount would only be subject to the 1.45 percent Medicare tax rate that applies to both theemployer and the employee.

Caution: The details regarding FICA and FUTA taxes as they apply to NQDC plans are very complicated. You should consultadditional resources that specifically address this issue for further information.

Who can adopt a NQDC plan?In generalAlthough many entities can adopt a NQDC plan, they're most suitable for entities that are financially sound and have a reasonableexpectation of continuing profitable business operations in the future. In addition, since NQDC plans are more affordable toimplement than qualified plans, it can be an attractive form of employee compensation for a new business that has potential butlimited cash resources.

Business ownersIf you're a business owner, NQDC plans are suitable only for regular or C corporations. In S corporations or unincorporatedentities (partnerships or proprietorships), business owners generally can't defer taxes on their shares of the business income.However, S corporations or unincorporated businesses can adopt NQDC plans for regular employees who have no ownershipinterest in the business.

Caution: NQDC plans covering controlling shareholders may be subject to attack by the IRS under the constructive receiptdoctrine because of the shareholder's control over the corporate employer.


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Government and tax-exempt organizationsA government or tax-exempt organization may adopt a NQDC plan. However, such organizations must follow Section 457 of theInternal Revenue Code, which limits the amount and timing of payouts or in some cases may require current taxation of theemployee with respect to the present value of his or her rights to deferred compensation.

Advantages of a NQDC planSupplements an employee's qualified benefitsQualified plans are subject to a number of limitations on contributions and benefits. These limitations have a particularly harsheffect on highly paid executives. For example, the total amount of employer and employee contributions plus forfeitures that maybe contributed to a participant's annual account in a qualified defined contribution plan is limited to the lesser of $53,000 (for 2015and 2016) or 100 percent of the participant's compensation income. Employees age 50 and older can defer up to $6,000 to a401(k) plan in excess of these dollar limits in 2015 and 2016. In addition, the maximum annual compensation that can beconsidered when making these calculations is $265,000 (for 2015 and 2016). And the maximum employee salary deferral in a401(k) plan is limited to $18,000 (for 2015 and 2016) (plus catch-up contributions). These are only a few of the restrictions oncontributions for qualified benefit plans. NQDC plans allow you to provide deferred compensation to your employees in excess ofthese qualified plan limits.

Example(s): Richard and Mary work at BCD Corporation. Richard earns $300,000 in 2016 while Mary earns $100,000. They bothparticipate in a defined benefit plan that provides a general benefit of 50 percent of their salary. Though the plan formula dictatesthat Richard should get a benefit of $150,000 (50 percent of $300,000), he actually is only allowed to receive $132,500 (50percent of $265,000) because $265,000 is the maximum compensation amount that may be used in calculating the benefit in2016. Conversely, Mary is entitled to $50,000 (50 percent of $100,000) because her entire annual salary can be taken intoaccount as it is below $265,000. As a result, Richard may only receive 44.2 percent of his pay while Mary may receive the 50percent as dictated by the plan formula. Richard is adversely impacted by the $265,000 limit while Mary is not.

Easier and less expensive than a qualified benefit planBecause qualified benefit plans must follow complex IRS and ERISA rules, they're usually more expensive (and complicated) toimplement and maintain than a NQDC plan. If you can't afford to maintain a qualified plan but wish to offer your select group ofmanagement or highly compensated employees the ability to receive tax-deferrable retirement benefits, you may want to considerimplementing a NQDC plan. This way, you will be able to provide your key employees with retirement benefits while avoiding theadministrative costs and complexities of qualified plans.

Can be offered on a discriminatory basisQualified plans are subject to specific discrimination and participation rules that require you to provide proportionate benefits tonon-highly compensated employees. A NQDC plan isn't subject to these same rules. As a result, you can decide to allow a few oreven one highly compensated employee to participate in the NQDC plan. You're not obligated to cover anyone.

Can provide unlimited benefitsSubject to the reasonable compensation requirement for deductibility, you can provide unlimited benefits to your employees.

Allows employer to control timing and receipt of benefitsBecause ERISA's vesting rules don't apply to NQDC plans that aren't formally funded, you as the employer can control the timingand receipt of employee benefits payable under the plan. You therefore have considerable flexibility in determining conditions andtimes when employees will be entitled to their benefits.

Allows employer to attract and retain key employeesFor obvious reasons, many employers strive to attract, recruit, and retain executives and other qualified key employees. A NQDCplan that provides future retirement benefits, whether in lieu of or in addition to a qualified plan, can offer an added incentive forthese key employees to come to work for and remain with an employer.


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Disadvantages of a NQDC planEmployee controls timing of employer's tax deductionThe employer generally can't deduct a contribution made to a NQDC plan until the year income is actually received from the planby the participating employee. More often than not, this will be several years away, particularly in the case of employees whochoose to defer receipt of the income until retirement. In effect, employers have no control over when they will be entitled to takethese tax deductions.

Lack of security for employeesFrom the standpoint of the participating employees, a NQDC plan isn't as secure as a qualified plan. Employees who participate ina NQDC plan generally have to rely on an employer's unsecured promise to pay benefits at a later time (except in the case of aformally funded NQDC plan). Most ERISA protections such as participation, vesting, fiduciary responsibility, and fundingstandards don't apply.

Generally not appropriate for partnerships, sole proprietorships, and S corporationsPartnerships, sole proprietorships, and S corporations can certainly establish NQDC plans to benefit key employees. However,the plan will be of little benefit to the owners themselves, since income earned by the organization is immediately taxed to thebusiness owner. In other words, the business owner can't defer taxation of amounts contributed to the NQDC plan on his or herown behalf.

Generally more costly to employer than paying compensation currentlyAn unfunded NQDC plan defers the employer's payment and the deduction for compensation that might otherwise have been paidand deducted when earned. The deferred compensation is normally increased by some amount similar to interest or investmentearnings. Until payment is actually made, the employer may realize investment income (or defer a deduction) with respect to thedeferred amount that is subject to tax. Since the employer's deduction for both the deferred amount and the investment earningsis deferred until the actual payment of benefits, the employer incurs a greater net after-tax cost for the NQDC than for a paymentof current compensation. This additional employer cost should be taken into account as the terms for any NQDC plan oragreement are considered and agreed upon by the employer.

How does a NQDC plan work?In generalIt depends on the particular type of NQDC plan, the specifics of the agreement itself, and how the plan is funded. In a typicalunfunded NQDC plan (i.e., a top-hat plan) you pay the benefits provided under the plan out of your general assets at the time thepayments become due. As a result, the executive must rely solely on your unfunded promise to pay the benefits and assumes therisk that these benefits may not be paid at all. To provide your employees with varying degrees of assurance that the promisedbenefits will be paid, you can choose to informally fund your top-hat plan with a rabbi trust or corporate-owned life insurance.However, any vehicle you use to informally fund your top-hat plan must remain subject to the claims of your general creditors.Therefore, your employees may lose their benefits in the event of your insolvency or bankruptcy. From your employee'sperspective, this is one of the major disadvantages of an unfunded NQDC plan.

Caution: Top-hat plans must be sure to comply with the rules of IRC Section 409A that govern NQDC plan deferral elections,distributions, and funding.

Employee elective salary and bonus deferralsA top-hat plan can be structured to allow participants to elect to defer a portion of their salary and/or bonus into the NQDC plan.This is often referred to as an "elective" NQDC plan, as compared to a "nonelective" plan, which provides benefits financed solelyby the employer. The election must generally be made in writing before the tax year that the compensation is actually earned. Insome cases, elections to defer bonuses can be made as late as six months prior to the end of the performance period, if theperformance period is at least 12 months. In general, an employee must also elect the timing and form of payment at the time heor she elects to defer the compensation. Unlike a qualified plan, a top-hat plan may allow a participant to defer up to 100 percentof compensation into the plan. Participants are usually fully vested in their own elective deferrals, and any related earnings.


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Discretionary employer contributionsA top-hat plan can also provide for employer contributions in addition to, or sometimes in place of, employee salary deferrals.Such employer contributions are generally discretionary. That is, most plans are set up to allow an employer to make contributionsat the employer's complete discretion. No deposits are required to be made by the employer in any given year. Employercontributions are often subject to a vesting provision. For example, a plan may require that employer contributions and relatedearnings are forfeited if an employee fails to work for the employer for a particular number of years, or terminates employmentbefore a specified age.

Accounting and investment controlThere are two main types of unfunded NQDC plans--defined contribution (or individual account) plans and defined benefit plans.Defined benefit plans pay a pension-like benefit, often based on years of service and/or final average pay. Often the plan willprovide benefits in excess of what can be provided under an employer's qualified pension plan. In an individual account plan, theemployee's benefit depends entirely on the value of his or her individual deferred compensation account. This is not a real, fundedaccount, but is a bookkeeping account that is credited with employee deferrals and employer "contributions" and investmentearnings. These are often referred to as "hypothetical" or "notational" earnings to reflect the fact that they are simply credits to theparticipant's NQDC plan bookkeeping account. Often employees can "direct" the investment of their individual account. Usually,the employer (or trustee in a NQDC plan informally funded with a rabbi trust) is not obligated to actually invest any assets in themanner selected by the participant. The participant's investment election merely controls the amount of hypothetical earnings thatthe employer agrees to credit to the participant's bookkeeping account on a periodic basis. The IRS has suggested in the past thatif the employer (or trustee) is obligated to actually invest assets as directed by the participant, this "dominion and control" by theparticipant may result in immediate taxation under the constructive receipt or economic benefit theories.

Top-hat plans that supplement qualified plan benefitsA common form of nonelective top-hat plan provides for a post-retirement pension benefit that supplements the employee'squalified plan benefits and Social Security benefits. These plans are often called supplemental executive retirement plans, orSERPs. Such SERPs may, for example, calculate a certain pension for the employee, then offset that by the benefits theemployee actually receives from the employer's qualified plans and Social Security; the resulting difference is the NQDC planretirement benefit paid by the employer to the employee after the employee's retirement. These plans often include a vestingprovision, or are tied to the vesting schedule in the employer's qualified plan.

Payment of benefitsAs the employer, you can structure a top-hat plan to pay benefits upon retirement, separation from service, disability, death,unforeseen emergency, or at a specified time. Benefits can be paid either in a lump sum or in a series of annual payments. Lifeannuities or payments for a fixed number of years (such as 5 or 10 years) are common. Since most ERISA requirements will notapply if you structure the plan correctly, you generally have some flexibility in establishing your own vesting schedule andforfeiture provisions. For example, you can stipulate that employees will forfeit their rights to benefits if they fail to work for yourcompany until retirement age. However, you must make sure the distribution provisions in your NQDC plan satisfy therequirements of IRC Section 409A.

Types of NQDC plansIn generalSince a NQDC plan is essentially a contract between employer and employee, there are almost unlimited variations of NQDCplans. In addition, the phrase "nonqualified deferred compensation" may be used to encompass various concepts. For example,stock plans can be forms of NQDC plans. Similarly, severance plans such as golden parachutes are generally considered forms ofNQDC plans.

It's also important to note that NQDC plans established by government and tax-exempt organizations are governed by InternalRevenue Code Section 457. Although these plans also classify as NQDC plans, they're more commonly referred to as Section457 Plans.

The discussion here is primarily focused on the kinds of NQDC plans that are sometimes known as compensation deferral orsupplemental plans. These plans represent non-stock-based compensation agreements between employer and employee and are


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often the result of the compensation bargaining process. While there is sometimes significant overlap, the major plans that fall intothis category are briefly described in the following sections. Except for excess benefit plans, NQDC plans are almost alwaysunfunded top-hat plans.

Deferral planDeferral plans provide employees with deferred benefits in lieu of current compensation, a raise, or a bonus. A typical example ofsuch a plan is the salary reduction plan, in which employees are able to defer dollars that could be received currently as income.

Supplemental executive retirement plan (SERP)A SERP is generally a NQDC plan that provides participants with deferred compensation benefits that supplement the employer'squalified plan benefits. A SERP can be either a defined benefit plan or a defined contribution plan. The term SERP is alsosometimes used more broadly to refer to any top-hat plan.

Wraparound 401(k) planA wraparound 401(k) plan is often referred to as a mirror 401(k) plan or executive 401(k) plan. These plans imitate the employer'squalified 401(k) plan, allowing deferrals in excess of the qualified plan limits. Under the typical plan design, an employee willdetermine how much he or she wants to defer for the year. The entire deferral will first flow into the nonqualified wraparound plan.Then, at year-end, when the 401(k) plan's discrimination testing is complete, the maximum amount the employee is eligible todefer to the 401(k) plan is transferred from the wraparound plan. This ensures the employee is able to defer exactly the amount heor she wishes, while making the maximum permitted contribution to the 401(k) plan.

Excess benefit planAn excess benefit plan is designed solely to provide benefits in excess of the limits that apply to qualified plans under InternalRevenue Code (IRC) Section 415. In general, Section 415 limits contributions to defined contribution plans to the lesser of$53,000 (for 2015 and 2016) or 100 percent of pay, and limits benefits from defined benefit plans to the lesser of $210,000 (for2015 and 2016) or 100 percent of final three year average pay. Excess benefit plans are different from other NQDC plansbecause if unfunded, they are entirely exempt from ERISA, and even if funded, they are exempt from most of ERISA'srequirements. Also, excess benefit plans need not be limited to a top-hat group of employees (although typically only highlycompensated employees will be impacted by the Section 415 limits).

Ways to "secure" the NQDC plan benefitEmployees are often concerned that the promised benefits under a NQDC plan may not be paid, either because of the employer'schange of heart, a change in control of the employer, a change in the employer's financial position, or the employer's bankruptcy.The following are some methods of providing employees with varying degrees of assurance that their NQDC benefits will in factbe paid :

• Secular trusts• Secular annuities• Rabbi trusts• Rabbicular Trusts (SM)• Corporate-owned life insurance (COLI)• Split dollar life insurance• Surety bonds, indemnity insurance• Third-party guarantees


Nonqualified Deferred Compensation Plan Funding Concepts

To understand the way that nonqualified deferred compensation (NQDC) plans work, you have to understand the differences between funded and unfunded plans. Our illustration breaks the concept of funding a NQDC plan down to its most basic components.


Phantom Stock

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What is it?Phantom stock arrangements are based on hypothetical investments in company stock. More specifically, phantom stock is theright to receive a cash or property bonus at a specified date in the future based upon the performance of phantom (rather thanreal) shares of a corporation's common stock over a specified period of time. Typically, an employee is awarded a number of unitsof phantom stock each year (at the end of the year), based on his or her contribution to the company's success.

Example(s): Anna is a long-time employee of XYZ Incorporated. She is an essential employee who knows the business and itscustomers. Anna is getting older and wants some lasting form of compensation in addition to her paycheck. XYZ Incorporated,however, has been a family-owned business for 35 years and its shareholders do not wish to issue stock to employees who arenot family members.

Example(s): So, XYZ Incorporated decides to adopt a phantom stock plan. This plan gives Anna the right to receive cash at age56, provided that she is still employed by the company. She'll receive her bonus based on phantom stock plan units equal in valueto one share of XYZ Incorporated stock. Units will be awarded at the end of each year according to Anna's contribution to thecompany's success. Both parties are happy with this arrangement.

How is the amount of the bonus calculated?The amount of the bonus is often computed as the difference between the fair market value (FMV) of the stock at the date of grantand the FMV of the stock at the later specified date. Along with this appreciation in the value of the stock, the employee is alsousually given an amount equal to the dividends paid over the same period of time.

Example(s): Michael, a key executive, enters into a phantom stock plan under which his employer awards him 10,000 phantomshares when the market value of each share is $50. The shares are credited with dividend equivalents. At the end of five years,Michael is paid an amount equal to the increase in the value of the shares over the $50 base amount, plus the dividendequivalents.

When can it be used?Corporation needs incentive to retain key employeesA principal challenge to employers is to attract, motivate, and retain key employees (and executives in particular). These goalscan be promoted by giving phantom stock to particular employees.

Current owners are unwilling to dilute their ownershipBecause the owners do not wish to dilute their ownership in the business, incentive stock options and other such methods shouldnot be considered here. Instead, phantom stock can provide an incentive to the employee without the need for a stock issuance.

Parties want compensation to be linked to company's growthPhantom stock should be used when both the employee and the employer want compensation to be linked to the company'sgrowth.

StrengthsProvides tax deferral for the employeeThe employee generally does not recognize federal income tax upon the grant of the phantom stock rights. Rather, he or she isgenerally taxed at ordinary income tax rates only upon the receipt of cash or stock at the settlement date.

Provides tax deduction for the employer


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The corporation is allowed a deduction for compensation expense when the employee recognizes the income. Thus, thecorporation deducts the amount of cash or market value of stock paid to the employee on the settlement date.

Helps business to attract, motivate, and retain key employeesA principal challenge to employers is to attract, motivate, and retain key employees (and executives in particular). These goalscan be promoted by giving phantom stock to particular employees.

Phantom stock is one example of golden handcuffs. In general, golden handcuffs refers to the combination of rewards andpenalties given to key employees that compensates them so generously for staying with the company (and penalizes them soseverely for leaving) that it would be unwise for them to leave the company. Phantom stock can serve as golden handcuffs if youestablish a vesting period or holding period for the shares of stock--if the employee leaves the company before the requisitenumber of years has expired, he or she must forfeit the value of the shares.

Avoids cumbersome Employee Retirement Income Security Act (ERISA)requirementsMany employers offer qualified retirement plans to employees. Generally, such plans are subject to cumbersome ERISA rulespertaining to funding, vesting, disclosure, and other areas. Nonqualified plans are generally not subject to most ERISA provisions.By selecting a nonqualified plan, such as phantom stock, you can sidestep the cumbersome aspects of ERISA.

Therefore, from the employer's standpoint, it is wise to structure stock plans in a way that reserves to the employer the greatestdegree of discretion with respect to the selection of participants, the size of awards, and the ability to terminate and reduce planbenefits. For practical purposes, this means that employers frequently offer phantom stock plans only to executives or other keyemployees--not to rank-and-file employees.

Keeps ownership of business from being dilutedThe owners of small or family-owned corporations often fear giving stock ownership to outsiders. With phantom stock plans, thecorporation's actual stock does not have to be given away. Thus, control of the business is not diluted.

Minimizes the use of corporate funds for payment of compensationCash flow is better than it would be with a typical deferred compensation plan, since the business does not need to pay out cashperiodically to provide employees with deferred compensation.

TradeoffsCorporation's deduction is deferredWith qualified plans, corporations are generally entitled to immediate tax deductions for money contributed to employee plans.Phantom stock plans are nonqualified. As a result, the corporation's deduction is deferred--it gets a deduction on the settlementdate.

Phantom stock does not provide all of the rights associated with stock ownershipFrom the employee's perspective, phantom stock does not provide all of the rights associated with stock ownership. In particular,voting rights are not provided. Thus, phantom stock may be less attractive to those employees who want more of an equity-basedincentive.

How to do itConsult an attorney to set up the planIt will be necessary for you to consult an employee benefits/Employee Retirement Income Security Act (ERISA) attorney to set upyour phantom stock plan. An attorney will consider the goals of your business and your financial situation and advise you of themost advantageous compensation plan to adopt. Additionally, it may be necessary to consult a certified public accountant todiscuss funding arrangements for the plan and to ensure that proper accounting methods are followed.


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Fund the planThere are a number of options for funding a phantom stock plan, including the purchase of corporate-owned life insurance.

Tax considerationsTo the employeeThe employee generally does not recognize federal income tax upon the grant of the phantom stock rights. Rather, he or she isgenerally taxed at ordinary income tax rates at the settlement date (some time in the future).

To the employerThe corporation is entitled to an income tax deduction at the settlement date; that is, at the time when the employee includes themoney in gross income.

Caution: IRC Section 409A contains complex rules that govern nonqualified deferred compensation (NQDC) plan deferralelections, distributions, funding, and reporting. If a NQDC plan fails to satisfy Section 409A's requirements, participants may besubject to current income tax, as well as an interest charge and 20 percent penalty tax. Depending on its design, a phantom stockplan may be subject to section 409A's requirements.


ALEXANDER BUBLITZ

July 27, 2016Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016

IMPORTANT DISCLOSURES

Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legaladvice. The information presented here is not specific to any individual's personal circumstances.

To the extent that this material concerns tax matters, it is not intended or written to be used, andcannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law.Each taxpayer should seek independent advice from a tax professional based on his or herindividual circumstances.

These materials are provided for general information and educational purposes based upon publiclyavailable information from sources believed to be reliable—we cannot assure the accuracy orcompleteness of these materials. The information in these materials may change at any time andwithout notice.

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