United States
Hong KongNonqualified deferred compensation: the creditor risk is the point
A nonqualified plan defers compensation without contribution limits or nondiscrimination testing, and without ERISA protection. The deferred amount remains subject to the employer's creditors, which is the trade-off.
A plan for executives that trades security for capacity, and the exam tests whether you understand what has been given up.
Qualified against nonqualified
| Qualified | Nonqualified | |
|---|---|---|
| Contribution limits | Yes | None |
| Nondiscrimination testing | Yes | None - can favor executives |
| ERISA protection | Yes | Largely no |
| Assets segregated from creditors | Yes | No |
| Employer deduction | When contributed | When the employee is taxed |
| Employee taxation | On distribution | On distribution, if properly structured |
The creditor row is the whole story. A nonqualified deferral is an unsecured promise, and in bankruptcy the executive is a general creditor.
Why the assets cannot be protected
If the assets were genuinely set aside for the employee beyond the reach of creditors, the employee would be taxed immediately under constructive receipt and the economic benefit doctrine.
Deferral of tax requires acceptance of risk. That is not a design flaw, it is the mechanism.
Rabbi and secular trusts
A rabbi trust holds assets for the employee but remains subject to the employer's creditors. It protects against a change of heart or a change of control, and not against insolvency. Tax deferral is preserved.
A secular trust does place assets beyond creditors - and the employee is taxed immediately. The names are unhelpful and the distinction is straightforward: rabbi means deferral with risk, secular means security with current tax.
The deferral election must be made before the year the compensation is earned, and the distribution timing fixed at election. Failure means immediate taxation of all vested deferrals, plus a 20 per cent additional tax and interest - on the employee, not the employer.
Permitted distribution events
- A fixed date or schedule specified at election.
- Separation from service.
- Death.
- Disability.
- Change in control of the employer.
- An unforeseeable emergency, narrowly defined.
Accelerating a distribution is generally prohibited. Delaying one is possible under strict conditions, including a further five-year deferral.
When to recommend deferring
Where the executive is confident in the employer's solvency over the deferral period, is in a high bracket now and expects a lower one later, has already maxed qualified plans, and does not need the cash flow.
Where any of those fails - particularly the first - the advice is usually to take the compensation and invest it. A question describing an executive at a struggling company is testing exactly that.
Contribution and benefit limits are indexed annually and several were changed by recent legislation. Confirm the current figure against the IRS before relying on it.
Common questions
What is nonqualified deferred compensation?
An arrangement deferring compensation without contribution limits or nondiscrimination testing, and without ERISA protection. The deferred amount remains subject to the employer's creditors.
Why can the assets not be protected?
Because setting them beyond creditors would trigger immediate taxation under constructive receipt and the economic benefit doctrine. Deferral of tax requires acceptance of risk.
What is a rabbi trust?
A trust holding assets for the employee that remains subject to the employer's creditors. It protects against a change of heart or of control, not against insolvency, and preserves tax deferral.
What does section 409A require?
The deferral election before the year the compensation is earned, with distribution timing fixed at election. Failure means immediate taxation of all vested deferrals plus a 20 per cent additional tax and interest.
When should an executive defer?
Where the employer's solvency over the period is not in doubt, the current bracket is high and the later one lower, qualified plans are already maxed, and the cash flow is not needed.