Structuring Deferred Compensation: Plan Options and Key Considerations for Employee Benefits Counsel

A nonqualified deferred compensation plan allows an employer to make cash payments over a set period to:

• Motivate employees to meet long-term goals
• Retain key employees
• Enforce post-termination covenants such as noncompetition, non-solicitation, and confidentiality
• Provide key employees an opportunity to supplement tax-qualified retirement benefits

However, failure to structure written deferred compensation plans effectively may lead to a wide range of legal issues and adverse tax treatment.

Nonqualified deferred compensation can be paid only upon a permitted payment trigger under Section 409A of the Internal Revenue Code or an exemption under the related Treasury Regulations. Failure to properly define in a written plan document the relevant payment triggers or exemptions can lead to plan document failures that result in immediate taxation of the benefits and severe tax penalties. The IRS has also created strict rules relating to when and how an employee can elect to defer payment of the employee's compensation in the plan document. Once a compliant plan document is created, those adverse tax consequences can also result from failing to make deferrals or payments (i.e., "operational failures") in strict compliance with the plan document's terms.

Another essential factor in drafting a nonqualified deferred compensation plan is whether or not ERISA applies to the arrangement. Counsel must understand the factors that dictate when a plan is subject to ERISA and the pros and cons of such coverage. If the plan is subject to ERISA, counsel must know how to advise clients regarding the scope of the "top hat" group that can participate in the plan and how to evaluate the unfunded status of the plan.

Employee benefits and ERISA counsel must be knowledgeable about best practices for vesting (i.e., substantial risk of forfeiture), enforcement of post-termination covenants (e.g., noncompete), clawback practices, avoiding operational errors under 409A, and other items that may require modification of any current compensation plan.

Listen as our panel discusses current regulations, crucial considerations for 2025 and beyond, compliance strategies, and key challenges for employers and executives.