By Noah B. Rosenfarb (New York)
When nonqualified deferred compensation plans (“NQDC”) exist in a marital estate, they are often substantial components of the marital balance sheet. If your case includes an NQDC, you and your client need to consider the pros and cons of various equitable distribution options.
Background – Plan Basics
NQDC plans vary widely; as the reason for their “nonqualified” status is that they do not meet certain ERISA guidelines. In the most basic sense, all plans have a few things in common:
- Current compensation is deferred into the future. Generally, a contribution to a NQDC plan in 2008 would be compensation for the employee’s efforts in 2007.
- The method of distribution must be selected prior to the deferral. Generally plans allow for distributions options ranging from a lump sum (one payment) to payments over time (often 5, 10 or 15 years). Note that Rule 409A, created in response to Enron’s demise, eliminated the ability for an employee to access their money “early” in exchange for a penalty.
- There is no income tax paid when the deferral is made. You may not see the amount deferred on Form W-2 with other earnings. In order to determine an executive’s earnings, you must ask for an earnings statement from the employer which should list all of the entitlements of the employee.
- NQDC payments are treated as wages. When paid NQDC payments are taxed at ordinary income tax rates. Additionally, if social security and Medicare tax payments were not withheld in the year of the deferral, they will be withheld (up to the statutory limits) when paid.
- NQDC is subject to creditors. Although plan assets may be segregated and management may be prohibited from using those assets for operations, the assets are always subject to the claims of creditors.
- NQDC may be forfeited upon termination for cause. Most plans include a provision that if an employee is terminated for cause, they will not be entitled to NQCD assets.
Equitable Distribution Options
There are two distinct paths to resolve the equitable distribution of NQDC value:
- both parties receive their entitlement at the time payments are made (i.e. “as, if, and when”); or
- the non-titled party receives a present value in lieu of a future entitlement (i.e. “buy out”).
There are positive and negative consequences to examine under both scenarios before reaching an agreement with your adversary.
“As, If, and When” Option
Referred to as “as, if, and when” language, most cases settle that the non-titled spouse receives their equitable portion when it is received by the titled spouse. In these scenarios, the greatest benefit is that the risks of the plan (discussed in detail below) are shared by both parties. The challenge most frequently discussed during litigation include the application of tax rates (marginal or effective; inclusion or exclusion of social security and other withholding taxes; and the means for calculating these amounts).
Another common issue when the titled spouse anticipates continued contributions into the NQDC is the determination of the appropriate entitlement for the former spouse. In response to this concern, some plans have the ability to create a “slot” for the non-titled spouse. If their entitlement is fifty percent of the plan balance at the date of complaint (plus passive appreciation/depreciation), that amount is accounted for by the plan administrator as if it were another account. Often this accommodation includes the ability to have different investment options between the titled spouse’s account and the non-titled spouse’s “slot” account. If this option is available, there is no need to be concerned with the impact of future contributions.
However, not all plans offer this option. So, when the titled spouse will only have one account, the issues of calculating the non-titled spouse’s entitlement in the future payout is complicated and generally requires the use of actuaries at the time distributions are made.
In a recent case, an opposing expert argued the non-titled spouse should receive a fraction of the future payment equal to their entitlement percentage (assume fifty percent) times the number of years the titled spouse was in the plan while married divided by the total number of years in the plan (i.e. a “coverture fraction”). Attorneys and clients must consider the impact of using this methodology. Can the titled spouse control the amount of the deferral, thereby allowing them to manipulate the future payment stream? Will future contributions result in an unfair distribution to the non-titled spouse?
Last, there is often the issue of selecting investment options. If only one investment selection can be made for the entire portfolio, it will generally be made by the titled spouse. The portfolio they select may not be in line with the non-titled spouses’ risk tolerance or investment objectives. Consider the impact of investment selection and discuss these risks with your client. What if the titled spouse elects 100 percent investment in bonds and does not generate the anticipated growth of plan assets? Or invests 100 percent in emerging markets which decline substantial before payments begin?
Buy Out Option
Often desired by one or both parties, the buy out option includes a credit to the non-titled party equal to the present value of their future entitlement. The obvious difficulty is agreement on a present value calculation.
To account for the present value in an NQDC, you must consider the following factors, many of which are often overlooked:
- The impact of income taxes. This is generally the first item discussed in the present value calculation. There are two common applications of income tax discounts – 1) utilizing the highest current marginal tax bracket for Federal and State taxes or 2) utilizing an effective tax rate.
- The impact of social security and Medicare taxes. As described above, if social security and Medicare tax payments were not withheld in the year of the deferral, they will be withheld (up to the statutory limits) when paid. Do not forget to factor this in if these taxes have not been paid.
- The value of tax deferral.Deferring income taxes is commonly perceived as a tremendous benefit and has resulted in the popular use of tax deferred instruments such as 401k and IRA plans. If the non-titled spouse will receive their entitlement via a credit in another tax deferred instrument, then the tax deferral component is a non-issue. However, considering macroeconomic factors (like the national debt, entitlement program costs, and baby boomer demographics), most economists project increases in our Federal tax rates. Therefore, you must consider the risks that the titled spouse will pay income taxes in excess of their current rates.
- Investment options and performance inside an NQDC. Most plans offer either a fixed rate of return on deferred compensation, or the ability to invest in a limited number of mutual funds. For sophisticated investors, the returns captured inside the plan may fall well short of the returns they generate outside the plan. For example, a recent client had earned approximately 8% per year on their NQDC. Comparatively, they earned approximately 16% per year during the same period outside their plan. The disparity was due to private equity and hedge fund investments that were not available inside the NQDC plan. If this is the case for your clients, be sure to consider this when calculating the present value.
- The lack of control over the timing of payments. All plans require the payment election option be made prior to the deferral of income. Further, most plans begin payment upon termination of employment (or death, disability, or the sale of the company). Since the titled spouse has limited control over the timing of the payments, and the non-titled spouse has almost no control over the timing of the payments, this should be considered as well.
- The risk of default and forfeiture. Don’t fool yourself into believing the money inside an NQDC plan is necessarily guaranteed. A prerequisite of all plan designs is that the plan assets are subject to the claims of creditors. One way to determine this risk is to evaluate the difference between the Treasury bond rate of return (considered risk-free) and that of the paying company’s bonds, if they are marketed.
In considering the factors listed above, a determination must be made of the discount to apply to the NQDC plan balance. In my opinion, beyond the current tax impact (item #1), it is generally reasonable to discount the plan balance an additional 10 to 15 percent to account for the remaining factors.
If you have an NQDC plan balance that is a substantial marital asset, consider the benefits and detriments to various equitable distribution solutions. Common ground can often be reached once all of the variables are discussed between the parties and all of the risk factors are evaluated.
Noah B. Rosenfarb, CPA is Managing Director at Freedom Divorce Advisors where he provides sophisticated tax and financial advice to affluent divorced women. Mr. Rosenfarb integrates life planning with financial planning to ensure clients experience the maximum benefits of affluence post-divorce. His holistic approach increases the probability of leading a life that is filled with prosperity – the kind that is measured more by personal happiness than merely by currency.
Reprint with permission.