A nonqualified DCP (often referred to as simply a “DCP”) is a nonqualified employer-sponsored plan, meaning that it is not subject to all of the rules, limitations and regulations of qualified plans, such as a 401(k) or an IRA. The plan is a commitment by an employer to a select group of employees that allows them to defer—pretax—an unlimited* amount of compensation and receive that compensation, plus any earnings, as a distribution at a future time.
With a DCP, key employees can elect to have a portion of their compensation (e.g., salary, bonus) withheld and paid out at a later date, such as retirement, termination of employment (also known as separation of service) or at specified future date (e.g., 2032). Because these payouts are future expenses (liabilities) for the company, DCPs are typically structured with an offsetting asset to ensure minimal or no P&L impact to the company. This asset is often held in trust to provide protection for plan participants; however, the trust does not protect again the risk of corporate insolvency. **
Companies typically invest the withheld compensation in tax-deferred accounts such as Corporate-Owned Life Insurance (COLI), and the investment of this deferred compensation grows tax-free for the participant. From the company’s perspective, these compensation deferrals are viewed as a future promise to pay.
DCPs are commonly used by employers as a form of executive compensation that can provide tax benefits to both the employer and the employee. In addition, deferred compensation plans can be designed to offer flexibility in the timing and form of payouts to employees.