Are you looking for a retention tool for key employees or a way to build your own tax-deferred retirement savings? You might look into adopting a nonqualified deferred compensation (NQDC) plan.
What are NQDC plans?
NQDC plans are agreements between owners and executives and their dealerships to pay out tax-deferred compensation at some future time, such as at retirement. Two key advantages: 1) They aren’t subject to the contribution limits, distribution, or funding rules that apply to qualified retirement plans, and 2) the qualified plan nondiscrimination rules do not apply.
Dealerships can tailor the amount, form and timing of when the payment is made to a participant’s specific needs. One of the most common types of NQDC plans is the salary reduction plan, which is usually in the form of a “mirror” 401(k) plan.
The mirror 401(k) plan
The key employee participating in a mirror 401(k) plan is able to elect to defer income taxation on compensation for services provided until there is “actual or constructive” receipt. However, the compensation generally will be subject to Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxation when entitlement to the compensation vests. This will usually be at the time of the deferral.
The rules governing income taxation, along with the application of the special timing rule for FICA taxation, typically result in reducing employment taxes and allow the compensation to grow income-tax-deferred. Executives participating in a mirror 401(k) plan usually must make their initial deferral election prior to the year in which they perform the services giving rise to the compensation.
So, for instance, executives who wish to defer their 2018 compensation to 2019 or beyond must have made the deferral election by the end of 2017. There are exceptions for new employees and certain elections to defer performance-based compensation.
What about restrictions?
NQDC plans are subject to IRC Sections 409A and 451, which apply to nonqualified plans. Sec. 409A imposes strict requirements on the timing, form and amount of the deferred compensation payments. This severely limits any subsequent changes. Moreover, these rules require that the deferred compensation be paid on a permissible payment date specified in the plan document.
Examples of permissible payment dates are death, disability, separation from service, change in ownership or control of the employer, and unforeseeable emergency. Penalties for noncompliance with these IRC rules are harsh: They include taxation of any benefits at the time of the deferral (which is usually the time of vesting), a 20% excise tax and a 1% increase in the applicable tax underpayment interest rate.
Other drawbacks and risks?
Unlike a qualified plan, an NQDC plan is an unfunded, unsecured promise to pay deferred compensation in the future for services performed today. All plan assets of a mirror 401(k) plan are generally held in the general assets of the employer and are subject to its creditors.
The dealership can choose to fund this arrangement by establishing a “rabbi trust” to hold and administer plan assets or invest in corporate-owned life insurance. Alternatively the deferred compensation can be accounted for and paid directly from the dealership’s general assets. As these aren’t qualified retirement plans, the participants will be unable to elect rollover contributions into an IRA or other retirement account at the time of distribution (separation from dealership service or retirement).
Finally, U.S. Department of Labor rules prohibit nonqualified plan participation by employees who aren’t members of a “select group of management or highly compensated employees,” also known as the “top hat” group. Care should be taken not to include rank-and-file employees as participants in mirror 401(k) plans to comply with this rule.