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"Non Qualified" Executive Compensation

In the benefits and compensation field “non-qualified” is generally used to describe arrangements which do not receive special tax favored treatment, while “qualified arrangements” do. For example a qualified 401(k) plan produces a current year tax deferral for contributions and a tax deduction for the employer’s portion. This article reviews the differences between non-qualified and qualified executive compensation plans.

Many highly paid corporate executives and other key personnel voluntarily choose to defer the payment of compensation or benefits earned in the current year to a future year, primarily to postpone associated tax obligations.

These deferred compensation plans are governed by Section 409A of the Internal Revenue Code, and differ from elective deferrals under “qualified” plans, such as a 401(k) plan, a 403(b) or a 457(b) plan.

Stock options, severance pay, bonus payments, restricted stock, partnership payments, and other post-employment benefits are among the many forms of compensation subject to Section 409A. Severance payments resulting from an involuntary termination, however, are generally exempt.

Flexibility is a key feature of non-qualified plans. Future payments can be tied to participant-defined dates, specified trigger events, changes in corporate control, and unforeseeable emergencies.

The employer’s ability to modify the form of payment is strictly regulated, as is the funding of deferred compensation, the timing of deferral elections, and many other actions. In a down sizing, recessionary and merger environment, there is an increasing amount of litigation over non-qualified plans often regarding triggering events, “for cause” terminations, or non-compete provisions.

ERISA and “Top Hat” Executive Compensation Plans

Top hat compensation plans allow for selected highly paid employees to receive special benefits. While the qualifying level of compensation is not specified by ERISA, levels are often determined by: a) annual limits, such as those established for 401(k) discrimination testing; or b) a class of employees, such as directors and officers.

Corporate executives frequently have broad discretion in inviting top hat plan participation. Highly paid employees who are considered to be at risk of competitor poaching, for example, can be offered special benefits.

The down side to the employee is that money in a Top Hat plan remains the property of the employer, according to IRS rules. Top hat funds can be jeopardized in a bankruptcy, since the funds technically remain the property of the employer and are thus exposed to creditor claims.

Excess Benefit Plans

“Excess benefit” plans are often more broadly based. There is an annual limit as to how much of an individual’s compensation can be counted for benefits in a qualified plan environment; the maximum for 2010 is $235,000.

Benefits in excess of the plan limit can be made “pensionable.” If an executive is making a salary of $500,000, for example, the excess amount of $265,000 ($500K-$235K) becomes pensionable through the nonqualified excess benefit plan. These plans commonly mirror the benefit formula of the underlying qualified plan, with some or all of the participant’s compensation in excess of the qualified plan limit made pensionable.

The employer is not required by ERISA to set funds aside in a trust to meet future excess benefit obligations, and there is no vesting schedule. Looked at another way, this is essentially an unfunded obligation. The employer simply promises to pay benefits at an agreed upon future date. If the employer enters bankruptcy prior to the future payment date, courts may rule that creditor claims supersede payments that had been due highly paid employees.

In Summary

In a qualified benefits plan, funds are set aside in a trust to meet future obligations. These obligated funds are exclusively dedicated for providing employee benefits and are protected from creditors in the event of a corporate bankruptcy. Qualified benefit plans are also subject to fiduciary, nondiscrimination, coverage, funding, distribution, reporting and disclosure rules, while non-qualified plans are not.

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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