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Everywhere I go, whether it be a social or business situation, people want to talk to me about nonqualified deferred compensation plans. Why is it such a hot topic and how does it affect an associate of a law firm? If you are fortunate, you may be on the receiving end of a nonqualified plan at your firm. Even if you are not, you may wish to be conversant in the topic since many of your friends, peers in private industry and clients are enjoying their benefits. Nonqualified deferred compensation plans are a way of rewarding employees for services rendered. It may be easiest to describe what one of these plans is by telling you what it is not. A nonqualified deferred compensation plan is not a tax qualified plan. By not falling under the definition of an Internal Revenue Code qualified plan, a nonqualified plan is not subject to all of those onerous restrictions placed on qualified ones. This affords maximum flexibility in designing a nonqualified plan: no rules on who is covered and how much they benefit. Discrimination is allowed! This makes it easier for a nonqualified plan to benefit a select group of employees and to be used as a motivational tool. Qualified retirement plans represent the Holy Grail of tax planning. A tax deduction is received by the employer when a contribution is made to the plan. The employee (or beneficiary of the plan contribution) usually does not recognize income until he or she receives a distribution from the plan. As the money contributed to the plan is deposited in a tax-exempt trust, the earnings from the contributions are tax free until distributed. This is truly the best of all worlds. A nonqualified plan does not share the favorable tax attributes of a qualified plan. Instead the employer is only entitled to a deduction when the employee is taxed on the income. This is known as the matching principle. Since these plans are designed to benefit employees, and employees do not want to recognize income earlier than they have to, the employer invariably defers its income tax deduction to some future date. Note also that in certain circumstances a contribution to a nonqualified plan could be subject to employment taxes (FICA taxes) earlier than it is subject to income taxes. Thus, we can see that a nonqualified plan is not a tax-efficient vehicle. AVAILABILITY RESTRICTED To further complicate matters, an employee must be restricted in the availability of funds contributed to a nonqualified plan, otherwise taxable income can be accelerated. Generally, under the doctrine of constructive receipt, restrictions must be placed on employee’s access to funds in order to defer taxable income. Therefore, if a nonqualified plan is funded, the amounts are subject to the claims of the employer’s creditors, and the employee is only a general creditor. Often participants do not want to risk their financial future by depending upon the viability of their employers. Worse yet, what if the nonqualified deferred compensation plan is not funded? The employee bears an inherent economic risk with these plans. Where will the money come from to pay these future obligations? So why are nonqualified plans so popular? With Congress chipping away at the amount an employer can put away for employees in qualified plans, nonqualified plans are seen as a way to replace some of those benefits being taken away or restricted. Furthermore, with the flexibility in design and ability to discriminate in favor of key employees, nonqualified plans can be used by employers to motivate select employees and increase productivity. Old, boring, run-of-the-mill compensation plans can be replaced with plans that will energize personnel and help them focus on attaining specific goals. Additionally, nonqualified plans can act as golden handcuffs for key employees. A vesting schedule — with the promise to pay a generous nonqualified plan benefit upon retirement — will go a long way to retaining employees and discouraging them from leaving a company and starting a competing business. Most law firms today are structured as partnerships or limited liability partnerships (LLPs). These forms of doing business are known as pass-through entities, where the income flows through to owners who are taxed on the amounts individually. Since nonqualified plans are not tax-efficient vehicles, they are less popular in law firms and other pass-through forms of doing business. You may, however, see nonqualified plans at your firm in one of the following situations. Many of you receive a bonus, the traditional form of compensating an employee for a job well done. From the point of view of the Internal Revenue Service and the Department of Labor, a bonus is not a nonqualified deferred compensation plan unless it is paid at a date significantly later than it is earned. Bonus payments can be deferred with the stipulation that the monies will be paid at a later date, but only if the employee remains with the firm. The bonuses may be either discretionary or formula-based. The deferral period can range from several months to several years or more, and can have vesting provisions with risk of forfeiture under certain conditions. The deferred portion can be paid out in a series of installments or a lump sum. A deferred bonus is more effective than a traditional bonus as a tool for employee retention. Sometimes a law firm may wish to retain a senior associate who is not necessarily on the track of becoming a partner. To help retain that employee, the firm may offer a nonqualified profit-sharing plan that will help the individual supplement their traditional 401(k) plan and save for retirement. STOCK OPTIONS Probably the most popular form of nonqualified deferred compensation plan in recent years is the stock option. Since law firms are partnerships and not corporations, stock options in the firm are not given to employees. Some firms, however, have taken stock or options in clients, especially new media and start-up Internet ventures in exchange for services rendered. As a way of enticing associates to stay on board and not leave to work for those very clients, some firms have offered to share this stock or options with employees. Many other forms of nonqualified plans exist, including phantom stock plans, shadow stock plans and stock appreciation rights (SARs). These may be prevalent at your clients, but not necessarily at your law firm, since they are not issued for partnerships, LLCs or LLPs. Clarence G. Kehoe, CPA, is a tax partner and the director of Anchin, Block & Anchin LLP’s pension and employee benefit plans practice, as well as a member of the firm’s Law Firm Services Group

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