Quick answer: A deferred compensation plan lets executives and business owners defer receipt of salary or bonus income to a future year — paying income taxes when they receive the money, not when they earn it. Nonqualified deferred compensation (NQDC) plans under IRC 409A have no contribution limits (unlike 401k plans), making them a powerful supplement for high-income owners who have maxed out qualified plan options.
Qualified vs. Nonqualified Deferred Compensation
Most small business owners think of "qualified" plans — 401(k), SEP, pension — which have IRS contribution limits, required non-discrimination testing, and ERISA protections. Nonqualified deferred compensation (NQDC) plans have none of those constraints: no contribution limits, no discrimination testing, available to select executives only. The tradeoff: NQDC assets remain on the employer's balance sheet — they're subject to creditor claims in bankruptcy. The executive holds only an unsecured promise to be paid. Additionally, once the deferral election and payment schedule are established under IRC 409A, they generally cannot be changed without triggering tax penalties. Proper planning and documentation are essential.
IRC Section 409A — The Rules That Govern Every NQDC Plan
Congress passed Section 409A in 2004 following Enron and other corporate scandals, establishing strict rules for deferred compensation: the deferral election must be made before the year the compensation is earned (not after); the payment schedule must be chosen at the time of deferral; permissible payment triggers are: separation from service, death, disability, change in control, specified date, or unforeseeable emergency. Violations of 409A result in immediate income inclusion, a 20% excise tax, and interest — a severe penalty. The plan document must comply with 409A on its face. Work with a benefits attorney to draft the plan document, and a financial professional to design the investment vehicle funding the obligation.
How Companies Fund Deferred Compensation Promises
The most common informal funding vehicle is corporate-owned life insurance (COLI). The company buys a permanent life policy; cash value growth tracks the deferred compensation liability. When the executive eventually collects, the company uses COLI cash value or death benefit to fund the payment. Some companies use rabbi trusts — an irrevocable trust that holds assets for the executive but remains subject to employer creditors (hence "rabbi" — like the rabbi it protects against the employer, but not against insolvency). Properly structured NQDC with COLI funding allows the employer to book an asset (policy cash value) against the liability, keeping the financial statement clean. Consult a benefits attorney and financial professional before establishing any NQDC plan.
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