Nonprofit Variable Pay

Types of Plans

Nonqualified deferred pay plans come in many varieties. Some are individual contracts with a specific employee, and some are more generally an employer pay plan. Individual contracts can be established to meet the combined needs of the individual and the organization.

Let's take a look at some of the more common employer plans…

Excess benefit plan. Excess benefit plans are offered in addition to the organization's regular benefit plan. Companies add these on to the regular retirement plan to reward highly paid employees.

Deferred bonuses. The simplest form of deferral is postponing the receipt of a year's bonus and having it paid over several annual installments (frequently over 5 years). An unfunded plan may, upon the participant's choice to defer receipt of the entire bonus amount, defer the tax consequences of the bonus payment.

Q: When is a deferred bonus plan most useful?

A: This type of plan may be most useful when the person is retiring and will have lower income in future years to be taxed.

Vested trusts. A vested trust is an unfunded nonqualified deferred trust in which the executive is NOT paid any benefits from employer contributions until vesting occurs. Vesting is usually scheduled to occur in conjunction with a specific event such as termination or retirement.

The executive is generally NOT taxed on the benefits held in trust until vesting occurs. This assumes, of course, that the executive's rights are nontransferable and subject to a substantial risk of forfeiture (a fact which should be clearly stated in the trust's vesting provisions).

As grantor of the trust, the employer is currently taxed on all vested trust income. Therefore, the ultimate payment of benefits by the employer is includable in the executive's gross income, and the employer may generally take a corresponding deduction.

Rabbi trusts. The rabbi trust is perhaps the most talked about method of deferring compensation for executives. In a rabbi trust, assets are transferred to an irrevocable trust to be held for the benefit of executive employees (similar to a vested trust). The trust is designed to provide some assurance to the beneficiary that future benefit obligations will be satisfied.

The IRS will find a valid rabbi trust exists if the following three conditions are met:

• The trust's assets must be available to all the general creditors of the employer if the employer files for bankruptcy.
• There are no insolvency triggers that hasten payments to employees when the employer's net worth falls below a certain point, thereby bypassing creditors before insolvency is declared.
• There is a procedure to provide notice to the trustee of the bankruptcy or financial hardship of the employer.

A rabbi trust is subject to the claims of the employer's general creditors. So, the employer is considered the owner of the trust, and the executive is not subject to tax on the deferred amounts until payments are actually received. When payments are actually received, and the executive is taxed, the employer may take a corresponding deduction.

Secular trusts. The reason for the term "secular" is simply to distinguish it from a rabbi trust. A secular trust is a type of nonqualified deferred trust that's funded to compensate executives and key employees.

Q: What's the difference between secular and rabbi trusts?

A: A major distinction is that an employer's bankruptcy creditors cannot reach the money held in a secular trust.

As a result, an employer's contributions to a secular trust, and the trust's earnings, are generally considered taxable income to the executive or key employee. However, the executive can still benefit from contributions to the trust to help pay the increased tax liability.

The employer is also allowed a current tax deduction for its contributions when they are taxed to the employee, or when the contributions become vested. Once taxed, later distributions to the employee (from already taxed contributions) are tax-free.