Nonqualified deferred compensation and corporate-owned life insurance

A nonqualified deferred compensation (NQDC) plan is an employer's promise to pay selected employees later for services performed now, outside the tax-qualified retirement plan system. The employee generally pays tax when paid, and the employer generally deducts when the employee is taxed, provided the plan complies with IRC 409A. Employers commonly fund the promise informally with corporate-owned life insurance, corporate-owned life insurance, which they own and which remains an asset available to the employer's creditors.

Why employers use NQDC

Qualified plans such as 401(k)s cap contributions and require broad coverage and nondiscrimination testing. Highly paid executives hit those limits. An NQDC plan lets the employer pick participants and set the amount, with the executive deferring salary or bonus, receiving employer contributions, or both. It is also a retention tool, since the employer can attach vesting and forfeiture conditions.

The price of that flexibility is risk. A properly structured plan is unfunded for tax purposes. The executive holds only an unsecured promise, so if the company becomes insolvent, the executive is a general creditor. Setting aside assets in a way that protects the executive from the employer's creditors usually defeats the tax deferral.

The 409A framework

IRC 409A governs these plans. Its key requirements, as written in the statute at 26 U.S.C. 409A:

• Distributions only on permitted events. Under 409A(a)(2), compensation may be paid no earlier than separation from service, disability, death, a fixed time or schedule set at deferral, a change in ownership or control as the Treasury defines it, or an unforeseeable emergency (a severe financial hardship).
• Six-month delay for specified employees. For key employees of a company whose stock is publicly traded, payment on separation from service waits six months, or until death if earlier.
• No acceleration. 409A(a)(3) bars accelerating the time or schedule of payments except as the regulations allow.
• Subsequent deferral elections. Under 409A(a)(4)(C), an election to delay or change the form of payment takes effect no sooner than 12 months after it is made, and generally must push the payment back at least five years from the date it would otherwise have been made.
• Funding limits. Under 409A(b), assets set aside offshore for deferred compensation, and assets restricted on a decline in the employer's financial health, are treated as transferred to the employee for tax purposes.

The penalty for failing is severe and falls on the employee: the deferred amounts become includible in income when vested, plus an additional 20% tax and interest computed at the underpayment rate plus one percentage point (409A(a)(1)(B)). State penalties may add to it. Because the employer usually has withholding and reporting duties, a plan failure is a joint problem. Annual deferrals are elected before the year in which services are performed, with specific rules for new participants and performance-based pay; counsel drafts these elections.

How COLI funds the promise

The employer buys permanent life insurance on the participating executives, owns the policy, pays the premiums and is the beneficiary. The cash value grows tax-deferred inside the policy, and the death benefit is intended to repay the plan's cost when benefits come due or the executive dies. At the executive's retirement the employer can pay benefits from general assets, from policy loans and withdrawals, or from the death benefit later.

This is "informal funding." The policy is an asset of the employer. It is not held in trust for the executive. The plan and the insurance are legally separate even though the employer chooses the policy to match the plan's liabilities. Some employers use a rabbi trust, a grantor trust that holds assets for the benefit of executives but remains subject to the employer's creditors, to provide protection against a change in management while keeping tax deferral. Under 409A(b), a trust that becomes funded as the employer's financial health declines is a problem, so those provisions need review.

COLI is not the only possible funding. Employers also use mutual funds, bonds or the company's own balance sheet. Employer-owned deferred annuities are typically a poor fit, because annuities owned by a non-natural person are generally not treated as annuities for income tax purposes under IRC 72(u), subject to exceptions. See annuities for business owners: where they fit and how they are taxed.

Tax and compliance points specific to COLI

1. Premiums are not deductible. Under IRC 264(a)(1), no deduction is allowed for premiums on a life insurance policy if the taxpayer is directly or indirectly a beneficiary. The employer deducts the NQDC benefit when paid, not the premiums.
2. Death benefit. Generally income-tax-free under IRC 101(a), but IRC 101(j) limits the exclusion on employer-owned contracts unless the insured received written notice and gave written consent before issue and an exception applies. See Employer-owned life insurance: notice and consent rules under IRC 101. The employer files Form 8925 annually.
3. Interest deductions. IRC 264(a)(4) disallows interest on debt tied to employer life insurance policies, with an exception for up to $50,000 of debt per insured key person (an officer or 20% owner, subject to caps on how many people count). IRC 264(f) separately disallows a share of the employer's interest deductions allocable to unborrowed cash value, with an exception for policies covering only a 20% owner, officer, director or employee. See COLI and BOLI explained: corporate and bank-owned life insurance for the mechanics.
4. Accounting. The employer records the liability and the cash surrender value in its financial statements. Public companies need their auditors involved.
5. ERISA. Plans limited to a select group of management or highly compensated employees, often called top-hat plans, are generally exempt from most ERISA rules except reporting and enforcement provisions. Whether a plan qualifies for top-hat status is a legal question. See ERISA basics for small employers: what the law requires of your benefit plans.

Hypothetical example

Say a 150-employee manufacturer wants to retain its five senior managers. It sets up a plan where each manager may defer part of an annual bonus, with the company adding a match that vests after five years. Payments will start at separation from service on or after age 60, in ten annual installments. The company buys permanent coverage on each manager, with the company as owner and beneficiary, and asks each manager to sign a consent and notice before the policy is issued. A manager who leaves at 45 forfeits the unvested match. The deferral elections were made in the year before the pay was earned, as 409A requires. All figures here are invented.

Related executive benefits

NQDC sits alongside other executive tools. An executive bonus plan gives the executive ownership now. Split-dollar shares a policy. Death-benefit-only plans pair with key person insurance: protecting the business from a loss of talent. For owners, consider how deferred compensation interacts with business succession planning and the insurance that funds it, since unpaid promises are liabilities a buyer will price in.

Choosing and documenting a plan

• Decide the purpose: retirement supplement, retention, or make-up for qualified-plan limits.
• Document the plan, the deferral election, payment events and the timing of payment, and keep it consistent with 409A.
• Consider financial strength of the employer and the executive's risk.
• If using COLI, secure notice and consent before the policy is issued and track annual reporting.
• Review the plan annually. A plan operated differently from its terms can fail 409A.

Key takeaways

• NQDC plans give selected employees deferral beyond qualified-plan limits but expose them to the employer's credit risk.
• IRC 409A restricts when payments can be made, bars most acceleration, and imposes a 20% additional tax plus interest on noncompliant deferrals.
• COLI is a common informal funding tool; the employer owns it and its premiums are not deductible.
• IRC 101(j) notice-and-consent and Form 8925 apply to employer-owned policies.
• Plan design and operation are legal and tax matters; use qualified counsel.