A non-qualified deferred compensation (NQDC) plan is a separate incentive plan, or plans, set up by an employer. They are frequently used to attract and retain company executives and key personnel.
This article describes four main types of NQDC plans, along with the key tax issues for employers as well as employees to consider as part of their implementation.
4 Main Types of Non-Qualified Deferred Compensation Plans
Non-Qualified Stock Options
Non-qualified stock options are a common type of NQDC plan. Employees are taxed when they exercise the stock option, based on the difference between the agreed-to exercise price and the fair value of the stock at the time of exercise. The difference is included in the employee’s compensation. If the shares are held for at least one year after exercise, the capital gains tax rate may apply to any appreciation in value.
Restricted Stock/Stock Awards
Another type of NQDC plan is restricted stock/stock awards. These are typically taxed when the stock award vests. The value is treated as compensation and subject to ordinary income and payroll taxes. Any further appreciation is taxed at the capital gains rate and contingent on the holding period.
Phantom Stock/Stock Appreciation Rights (SARs)
Phantom Stock and SARs plans don’t involve actual stock grants or ownership, but they offer cash payments based on the appreciation of your company’s stock compared to a value determined at plan issuance. Employees are usually taxed on the cash received as ordinary income when paid out. The payout is treated as compensation and is also subject to payroll taxes.
Long-Term Incentive Plan (LTIP)
An LTIP is a catchall that doesn’t necessarily involve a company’s stock. The design of these plans can be based on specific employee and/or employer metrics. They can also require a certain vesting period for the participant to obtain the benefits. Payments from these plans are treated as compensation to the employee and subject to ordinary income taxes. The payroll taxes on an LTIP can vary, and they depend on the plan’s design. Particular attention should be given to the timing of certain payroll taxes, especially if multiple vesting periods, during the plan’s lifespan.
Employer-Specific Considerations for Non-Qualified Deferred Compensation Plans
Tax Deductibility
Employers can generally deduct the benefits paid for NQDC plans. However, the timing of the income tax deduction depends on the type of NQDC plan. Most plans do not allow for a tax deduction until the employee has an income recognition event.
Withholding Requirements
Employers often need to withhold income and payroll taxes at various times during the lifecycle of an NQDC plan. This can be at the time of vesting, exercise, or payout of the benefits. Failing to withhold and remit the correct amount of tax can result in penalties and may also result in potential lost benefits on payroll tax timing rules.
Reporting Requirements
The administration of NQDC plans can be cumbersome. There are certain tax codes your company must continuously conform to as well as potential annual tax reporting requirements for payroll taxes. Your company should evaluate its compliance with the NQDC’s plan reporting annually.
Next Steps for Implementing the Right Non-Qualified Deferred Compensation Plan for Your Organization
Non-qualified deferred compensation plans can offer attractive and incentivizing options for retaining executives and key personnel. However, when designing or participating in an NQDC plan, both employees and employers need to carefully evaluate the tax implications. Consulting with tax professionals and potential plan administrators is important to ensure proper tax planning and compliance with relevant laws. If you have any questions or would like to continue the discussion, please contact us.