Because of several provisions within the recently approved federal health care reform package, employers may want to review their executive compensation program.
The new law contains a provision that introduces a 3.8-percent Medicare tax on the lesser of net investment income or the excess of modified adjusted gross income over a threshold amount. For taxpayers with high earned income and substantial investment income, this provision could increase Medicare tax payments.
One strategy to reduce this liability is to defer current earned income into future years. Employers may want to consider a nonqualified deferred compensation (NQDC) plan for this purpose.
A NQDC plan is an arrangement between an employer and an employee to defer the receipt of currently earned compensation. NQDC plans do not have the tax-favored benefits of qualified retirement plans. On the other hand, most NQDC plans do not have to comply with the participation, vesting, funding, distribution, and reporting requirements imposed on qualified plans by the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA).
As a result, NQDCs are a flexible form of employee compensation that allows an employer to tailor the benefit amounts, payment terms, and conditions of the plan to both the employer’s and the employee’s needs. The NQDC plan can cover any group of employees without regard to nondiscrimination requirements, provide unlimited benefits to any employee, and can provide different benefit amounts for different employees under different terms and conditions.
An employer will generally make NQDC plans available only to select executives and other key employees in order to avoid ERISA’s requirements and adverse tax consequences. With this type of plan, an employer typically will not take a tax deduction for amounts contributed to the plan until the plan actually distributes the funds to the employee and employees generally do not recognize the deferred compensation income currently (when they earn it) for income tax purposes. Rather, they recognize the income when they receive the payment from the NQDC plan, perhaps when the employee is in a lower tax bracket.
As with any tax or investment decision, it is critical that you work with a knowledgeable professional who can assist you with making the proper decisions.