True, tax-exempt organizations are altruistic in nature. But even a tax-exempt organization needs to attract and retain talent. And altruism will only go so far in landing a key executive hire. So what can charitable institutions do to give themselves a bit of an extra edge when it comes to hiring a key executive?
One option is to provide deferred compensation outside of the “typical” 403(b) or 401(k) Plan. This additional deferred compensation is often referred to as “non-qualified deferred compensation.” This post will cover the basic, non-qualified deferred compensation (“NQDC”) alternatives available to a private (i.e., non-governmental) tax-exempt organization.
Basic Rules Applicable to Tax-Exempt Organizations
Any NQDC plan sponsored by a tax-exempt entity must comply with the rules of Section 457 of the Internal Revenue Code. There are basically two (2) types of Section 457 arrangements that a tax-exempt entity can sponsor, commonly called “Section 457(b) Plans,” and “Section 457(f) Plans.”
Section 457(b) Plan. A Section 457(b) Plan can be structured as either a deferral arrangement, similar to a 401(k)-type plan, where the employee elects to deposit a portion of the employee’s compensation into the Plan; or as an employer contribution arrangement, or both. The key aspect of a Section 457(b) Plan is that the amount that can be contributed to the 457(b) Plan is subject to specific dollar limitations. These limits are currently consistent with the limits for deferrals applicable to, for example, 401(k) or 403(b) Plans. Thus, for example, the dollar limit for 2015 is $18,000.00.
A 457(b) plan must be restricted to a “select group” of management or highly compensated employees. Basically, the concept of this “select group” is that the participants must be restricted to upper-echelon management. This permissible participant group will depend on the overall level of management personnel in the organization and the total number of employees.
A participant in a Section 457(b) plan will generally not be subject to federal income taxes on the contributions in the plan until the participant is entitled to a distribution (e.g., upon termination of employment).
Section 457(f) Plans. The second primary type of NQDC plan available to tax-exempt employers is a Section 457(f) Plan. The chief advantage of a Section 457(f) Plans is that it is not subject to the same contribution limits as apply to Section 457(b) Plans. The chief disadvantage of a Section 457(f) Plan is that the sums contributed or deferred must be subject to “substantial risks of forfeiture.” The basic concept of the substantial risk of forfeiture is that the Participant’s entitlement to the plan contributions must be conditioned on the future performance of substantial services. Usually, this requirement will entail the participant working a certain number of years, such as 5 or 10 years; or until attainment of a certain age, such as an age approximating an expected retirement age (e.g. age 65). If the participant does not meet these requirements, the participant will have to forfeit the deferred compensation amounts (with only limited exceptions, such as death or disability).
As is the case with a Section 457(b) Plan, a Section 457(f) Plan must be restricted to a select group of management or other highly compensated employees.
With respect to federal income taxation issues, the amounts contributed under a Section 457(f) Plan are taxable to the participant when the substantial risks of forfeiture conditions have expired.
The End Result
For the tax-exempt employer, the key aspect to structuring a non-qualified deferred compensation arrangement for an executive-level employee is to work within the options available, but not to make the arrangement too complicated. Try to identify basic objectives, and implement those objectives in a fashion that is comprehensible to the executive and the board of the organization. Although there are plenty of variations and options available, don’t let the options over-complicate the arrangement.