Construction Accounting Article -
Nonqualified Deferred Compensation Plans
- Reward and Retain Key Employees With These Arrangements

Target Audience: Construction Industry Professionals, Contractors, Construction Business Owners, Construction Accountant Interest, Construction Management, Nonqualified Deferred Compensation (NQDC) Implementation Interest

Do a few key employees play a critical role in your construction company’s success? Do you want to reward them for their hard work while increasing the likelihood that they won’t jump ship to the competition or strike out on their own? If so, a nonqualified deferred compensation (NQDC) plan may be just what you’re looking for.

Give to the Very Best

In a nutshell, NQDC plans allow you to give your very best employees an extra, tax-deferred retirement reward that you can structure in a variety of ways.

NQDC plans generally aren’t subject to the Employee Retirement Income Security Act (ERISA) or IRS regulations that govern “qualified” plans, such as 401(k)s. (To receive advantageous tax treatment, a qualified plan must cover a large percentage of employees and be subject to limits on contributions and benefits.)

NQDC plans don’t provide as many tax benefits as qualified plans do, but they’re more attractive in other ways. These arrangements are essentially contracts drawn up between your company and its select employees to pay them later for work they do today.

As such, NQDC plans allow you to play favorites. You can give one person more than you give another, and you don’t have to follow quite as many rules as you do for qualified plans. The vesting schedule can also be whatever you say it is, and contributions can be whatever you want them to be as well.

Funded vs. Unfunded

Generally, NQDC plans fall into two categories — funded and unfunded. Funded plans are those in which a third party, such as a trust or escrow account, holds assets for the NQDC.

A funded plan’s assets can’t be touched by creditors, but they’re also out of your reach — once you put money in the account, you can’t access it even in an emergency. The designated employee or group of employees is guaranteed to get it.

The downside to funded plans, and the reason they’re not commonly used, is that they provide only limited tax benefits and may be subject to ERISA requirements.

If your employees fear you’ll go bankrupt or sell your construction company, a funded plan could serve as a valuable retention tool because participants are guaranteed to get their NQDC payout as long as they remain with the company until they become fully vested. Otherwise, in most cases, everyone will be better off with an unfunded plan.

With an unfunded plan, you don’t set aside the money you’ll use to pay the benefits. Instead, you pay out of your cash flow or through property such as a corporate-owned life insurance policy. You can also set up a so-called “rabbi trust” to hold the plan assets but, if you go bankrupt or become insolvent, assets in such a trust will be subject to creditors’ claims.

The Tax Picture

If your NQDC plan is unfunded and maintained solely for the benefit of a select group of highly compensated employees, you’ll win on two fronts: You’ll be able to claim a tax deduction when participants are taxed on their benefits and you’ll avoid most ERISA regulations.

Funded plans are a little more complex. Although you’ll still be able to claim a deduction for your contributions when participants are taxed on their benefits, ERISA rules, as mentioned, may apply in some cases. (Ask your accounting consulting firm or CPA firm for details.)

In addition, as soon as employees are vested in a funded plan, they generally must include NQDC contributions in their income — and pay taxes on them. This may affect their willingness to participate in the plan.

And whether a plan is funded or unfunded, new regulations require that you still include any deferred compensation amounts on participants’ W-2 forms.

Likely Candidates

NQDC plans will most likely benefit a financially sound, closely held construction company that anticipates generating healthy profits for years to come — particularly if it’s a C corporation.

Why a C corporation? Because, if your company is an S corporation, limited liability company partnership or sole proprietorship, neither you nor anyone else with an ownership interest can defer taxes on his or her share of business income. The plan can be used as a benefit for only non-owner employees and, even in that case, the deferred income tax deduction resulting from the plan could increase the business income taxable to the owners.

Also bear in mind that, no matter what your business structure, your construction company will have to accrue an expense for the NQDC plan and the accrual will be a liability on your books. Such a liability could impair your bonding capability.

The Right Way

Done the right way, an NQDC plan can be an effective retirement funding vehicle for your key employees and an effective employee retention tool for you. Yet there are risks as well, so be sure to work with your CPA to determine whether one of these arrangements is a good fit for your construction company.

Sidebar: Deferred Comp Deadline Nears

If you already offer a nonqualified deferred compensation (NQDC) plan to any of your construction company’s key employees, you have until Dec. 31, 2008, to make sure that the plan complies with recently amended IRS regulations.

Specifically, Internal Revenue Code Section 409A applies to NQDC plans (as well as certain stock option plans, bonus plans and other longer-term deferred compensation plans) and requires that:

• Employees elect to defer compensation before the year in which they perform the services for which the compensation is earned,
• Benefit payments be made according to a fixed schedule or after a specific event (such as death, disability or separation from service), and
• Payments not be accelerated (with limited exceptions).

Penalties for noncompliance can be harsh. They may include immediate taxation of vested benefits, a 20% penalty tax and interest charges.

Find out how our expertise in construction accounting can add value to your business. Email us or call us at 1 (888) 875-9770.

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