Nonqualified Deferred Compensation Plans and Section 409A

NQDC plan sponsors must understand Section 409A rules to avoid unintended tax consequences and, possibly, participant lawsuits.

The American Jobs Creation Act of 2004 was signed into law on October 22, 2004. It created a new Section 409A of the Internal Revenue Code.

According to Will Fogleman, associate at Groom Law Group in Washington, D.C., the new section was created mostly in response to the Enron scandal. “The concern was executives in nonqualified deferred compensation plans were getting tax advantages and able to move money around at will, and they weren’t treated as general creditors,” he says. A presentation from Fenwick & West LLC attorneys Marshall Mort and Ariel Gaknoki, based in Mountain View, California, explains further that Enron executives accelerated their payments under the company’s deferred compensation plan to access the money before Enron’s bankruptcy.

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Before Section 409A, nonqualified deferred compensation (NQDC) plans were more flexible, Fogleman says. Participants could elect to get their assets prior to when first agreed. Section 409A prohibited rules that would give participants the advantage of accelerating income while still receiving tax-deferred treatment.

“Basically, under 409A, a NQDC plan is defined broadly as compensation or a legally binding right to compensation that is promised to be paid to participants in a subsequent plan year,” Fogleman says. “If a plan fails to comply with 409A, the assets are subject to immediate income tax at the time of failure. All assets are accelerated at the same time, and a 20% additional penalty tax, and an interest penalty on the tax that would have been paid if the participants had claimed the compensation as income when it was originally deferred, applies.”

What is deferred compensation?

According to Mort and Gaknoki, Section 409A covers not only the types of arrangements that traditionally have been thought of as NQDC (such as supplemental executive retirements plans, or “SERPs,” and excess benefit plans), but a whole host of other typical compensation arrangements, including:

  • salary and bonus deferral arrangements;
  • annual and long-term bonus and other incentive arrangements;
  • severance pay arrangements;
  • taxable reimbursement arrangements;
  • certain in-kind benefits (such as automobiles and club memberships);
  • certain equity-based compensation (including discounted stock options and stock appreciation rights, nondiscounted stock options and stock appreciation rights with additional deferral features, restricted stock units, performance units and phantom stock);
  • change in control agreements;
  • commission arrangements; and
  • retention arrangements.

There are numerous exceptions that allow certain arrangements to avoid coverage under Section 409A, the most common of which is the short-term deferral exception, they say. This exception generally exempts from Section 409A amounts that, in all possible circumstances, will be paid by the 15th day of the third month following the end of the taxable year (of the employee or the employer) in which the right to the compensation is vested. For example, for an employer with a taxable year that ends on December 31, to fall within the short-term deferral exception, the payment would have to be made by March 15 following the end of the year in which the right to the compensation becomes vested.

There are other types of payments that may be exempt from Section 409A, but they are not within the scope of this article. Arrangements in effect prior to October 4, 2004, that are not materially modified after that date will continue to be subject to pre-existing tax rules to the extent that deferred compensation is earned and vested as of December 31, 2004.

Rules of 409A

In order to keep a plan compliant with 409A, Fogleman says, the basic rules are first, the plan has to be in writing. The plan must specify how much compensation will be deferred, when it will be paid and the form of payment.

He says there are five permissible times the deferred compensation can be paid. These are separation from service, a specified date the participant has chosen, disability, death and change of control. Fogleman adds that the first, third and fifth have specialized definitions. Amounts can also be paid in an unforeseeable emergency, which he says is like a hardship withdrawal in a qualified retirement plan, but much stricter.

Mort and Gaknoki say the time of payment generally may not be accelerated and may not be further postponed except under limited circumstances. Additional rules apply to payments to “key employees” of public companies and their affiliates if the payment event is a separation from service. In that case, payment generally must be delayed for a period of six-months from the separation from service or, if earlier, until the death of the employee. Payments may be made in lump-sums or installments.

They add that there are three situations when employers can pay out deferrals immediately:  When it ceases providing a certain category of NQDC plans altogether and the employer terminates all such plans with respect to all participants; during the 30 days preceding or 12 months following a change in control of a corporation (but only if all substantially similar arrangements of the employer are terminated); and in the case of certain corporate dissolutions or with the approval of a bankruptcy court.

“Employers should communicate with employees how the rules for NQDC plans differ from the rules that cover qualified plans,” Fogleman says. “When participants elect to defer into a nonqualified plan, they are locked into it. It’s not like a qualified defined contribution plan where they can change their election after the money starts to defer.” He adds, “It is also very difficult to get out of the plan due to payment restrictions, and if an executive needs to get his money sooner than planned, it is difficult to get it.” Fogleman says this needs to be carefully communicated to participants.

He also says the plan design should be carefully set up in advance with a professional recordkeeper that knows what it’s doing. “Most issues that come up are due to recordkeeper operational errors, such as deferrals taken out that shouldn’t be, or more money taken out that shouldn’t.”

Correcting 409A errors

“If a NQDC plan fails to comply with 409A rules, even though participants have no involvement with the design of the plan, they are the ones who pay the price,” Fogleman says.

Qualified retirement plan sponsors are able to use the IRS’ Employee Plans Compliance Resolution System (EPCRS) for corrections, but there is “no formal program like that in the nonqualified plan world,” he adds. “There are some options to correct up to two years before the correction was discovered, and the employer will have to pay money to participants and participants pay income tax.”

Fogleman says, since employees are the ones who have to pay, this causes concerns about participants suing employers for 409A failures. “It is important to have someone look at NQDC plans on an annual basis to see if errors have occurred,” he notes.

According to Mort and Gaknoki, in the event of noncompliance with Section 409A, the employee will have immediate taxation of the deferred amount in the year the right to the payment vests (even if not yet received by the employee). Interest also may apply. The 20% excise tax and immediate taxation also will apply to all vested amounts under all similar deferred compensation arrangements covering that employee. 

“Although the primary financial burden of noncompliance falls on the employee, the employer must timely report and withhold on the amounts included in income under Section 409A and has certain reporting obligations regarding the 409A compliance failure,” they add.

FICA tax

Fogleman notes that 409A relates only to income tax. “In most plans, deferrals will go in after FICA is taken out,” he says. Federal Insurance Contributions Act [FICA] tax is the money that is taken out of workers’ paychecks to pay for Social Security and Medicare benefits. It is a mandatory payroll deduction.

For example, if an employee defers his bonus, FICA is taken out before the deferral, but income tax is taken when the remainder of the bonus is paid to the employee.

A penalty for a 409A failure involves income tax and not FICA tax, he explains.

However, some participant lawsuits are filed due to the incorrect payment of FICA tax. For example, Fogleman says, with NQDC plan nonelective contributions, like employer match contributions subject to a vesting schedule, the timing of when the amount vests determines when FICA is taken out. “Many employers may not pay attention to this, and there may be payroll errors where not enough FICA is taken out or it’s not taken out at all,” he says.