The American Jobs Creation Act of 2004 added Section 409A to the Internal Revenue Code. Section 409A establishes the standards that nonqualified deferred compensation arrangements must meet to achieve income tax deferral.
Click here to jump to the discussion of IRC Section 409A.
Clients should be encouraged to consult their own tax and legal advisors to assure that their nonqualified deferred compensation arrangements comply with these rules.
"Nonqualified deferred compensation" is a compensation arrangement established by employers to provide retirement income and perhaps death benefits to a select employee or a select group of highly compensated employees (or, in some cases, independent contractors). The arrangement is a contractual commitment between an employer and the participant that specifies when and under what circumstances future compensation will be paid. When properly arranged and administered, the participant (or the participant's beneficiary) can postpone federal income taxation of the deferred amounts until benefits are paid. A nonqualified deferred compensation arrangement is to be distinguished from a qualified deferred compensation plan, which refers to a pension, profit sharing, or stock bonus plan (and all the various permutations thereof) that meets the qualification requirements of Code Section 401(a) and whose assets are held in a tax-exempt trust under Code Section 501(a) or in life insurance and/or annuity contracts pursuant to Code Section 403(a).
Nonqualified deferred compensation arrangements do not have to be pre-approved by the IRS nor are they generally subject to the qualification requirements applicable to qualified retirement plans. Unlike the participation and eligibility requirements for qualified plans, employers can discriminate in favor of selected employees. Also, when properly arranged, nonqualified deferred compensation arrangements are exempt from the regulatory requirements of ERISA Title I.
A nonqualified deferred compensation arrangement may provide that an employee will receive a stipulated sum for a fixed period of time (or for life) beginning at the employee's retirement or some other specified trigger date. This is a "defined benefit" type of arrangement. The amounts deferred for the employee's benefit may also be specified in "defined contribution" terms. If an employee dies after payments have begun, the arrangement often directs that the remaining benefits be paid to a designated beneficiary or to the participant's estate.
The arrangement may provide that the employee will receive future compensation as a result of a current salary reduction or in lieu of a bonus or salary increase. This is the traditional or "true deferral" deferred compensation arrangement. In more recent times, another alternative emerged: the salary continuation arrangement. Here, the employer commits to pay future compensation in addition to current earnings, which are not reduced by participation in the arrangement. The family name, "nonqualified deferred compensation," is often used generically to describe a variety of arrangements.
Providing compensation and benefits to owner-employees, key executives and other highly skilled people is a continuing concern to businesses large and small. However, the increasingly restrictive regulatory environment imposed on qualified retirement plans, when coupled with costs of plan administration, anti-discrimination rules and caps on contributions and benefits, have made executive benefit planning through nonqualified arrangements more attractive.
Deferred compensation arrangements fill this need by providing employers with a nonqualified planning tool that rewards selected participants by helping them create financial security for retirement, death and/or disability. A nonqualified arrangement may be used as a supplement to, or as a substitute for, a qualified retirement plan.
Deferred compensation is most useful when the following positive indicators are present:
the employer is a stable profitable business with good cash flow,
the employer wishes to benefit a select group of management or highly compensated employees,
the owner-employee of a business that is structured as a C corporation wants to improve his/her own compensation and benefits package and the owner-employee is in a higher tax bracket than the corporation,
the employer has a need to attract, retain, or reward one or more key employees,
the participating employee is "maxed out" on contributions or benefits under the employer's qualified plan;
the employer has no qualified retirement plan in place and does not want to establish one.
Deferred compensation is not suitable for publicly traded employers who are bankrupt, have an "at-risk" defined benefit plan (generally less than 80% funded), or have a plan that terminated without sufficient assets to pay all benefits. In fact, the PPA prevents such employers from accumulating a reserve to fund deferred compensation benefits. If an affected employer funds a deferred compensation benefit, then the CEO and the other top four executives (if that is the group benefiting) must be treated as incurring immediate income (to the extent vested at the time of funding), interest, and a 20% penalty. If the employer grosses up the affected executives' compensation for the tax and penalty, the gross-up amounts also become subject to immediate taxation.
A nonqualified deferred compensation arrangement can provide business owners with the kind of flexibility that is unavailable with a qualified retirement plan. With nonqualified deferred compensation, the business can cover "top-hat" employees on a pick-and-choose basis without fear of running afoul of anti-discrimination rules or IRC Section 415 ceilings on contributions and benefits under qualified plans.
Employers can provide generous benefits to select, key-executive employees, including a different level of benefits for different employees. No government-imposed minimum vesting or funding standards apply, and the arrangement can be customized to suit many individual fact situations. Paperwork and administrative costs can be kept to a minimum.
A nonqualified deferred compensation arrangement is a contractual arrangement that calls for paying one or more "top-hat" employees future benefits. Since flexibility characterizes these arrangements, design can reflect the goals and objectives that the business or individual employees are trying to accomplish.
Extreme caution must be exercised when designing a plan of nonqualified deferred compensation that benefits the controlling shareholder of a corporation. First of all, it is necessary to consider the legal and tax structure of the business. If the business is structured as a partnership, limited liability company taxed as a partnership, or a corporation taxed under Subchapter S, an owner-employee or controlling shareholder may generally not benefit from a nonqualified deferred compensation arrangement because of the pass-through nature of those entities for tax purposes. If the business is a corporation taxed under Subchapter C, it is possible to structure a plan of nonqualified deferred compensation that benefits the controlling shareholder. See the discussion below on controlling shareholders.
In drafting the arrangement, attorneys will take into consideration:
the eligibility of key people, including their status as part of the select group of management or highly compensated employees;
the conditions that would trigger forfeiture of benefits;
performance and/or service incentives that benefits are based upon;
vesting of benefits; and
the limitations imposed by federal tax law.
Let's review the distinctions between unfunded and funded arrangements. We'll review the tax consequences of each later under the head, "Participant Taxation."
In unfunded arrangements, the participant has only a contractual right: an unsecured promise to receive benefits in the future. An arrangement is considered unfunded if:
either there is no reserve set aside to pay the promised benefits, or reserves are established but remain a general asset of the employer, subject to attachment by the employer's creditors; AND
the employee has no current beneficial interest in any set-aside funds.
When the employer sets aside specific assets to meet its future obligations, with the select employee as beneficiary, and these assets are out of reach of the employer's general creditors, the arrangement is considered to be funded for tax purposes. From an income perspective, a funded arrangement results in inclusion of the deferred amounts in an employee’s income as soon as there is no longer a substantial risk of forfeiture. For this reason, nonqualified deferred compensation arrangements are typically structured as unfunded arrangements, albeit with the use of a rabbi trust to enhance the security of future payments.
Participants are often concerned about the security of a nonqualified deferred compensation arrangement. They may worry that business reversals, hostile takeovers, friendly business sales, recessions, or some other change in circumstances could affect the business's ability to pay benefits when the time comes. Since a totally secure fund may trigger immediate taxation, the planner's challenge is to create a balance between financial security and tax deferral. One such device is called a rabbi trust.
A rabbi trust (named after an arrangement between a rabbi and his congregation) holds trust assets in an irrevocable trust out of the reach of the employer, or any of the employer's successors. These trusts have been given IRS approval. The IRS has even issued a model rabbi trust agreement [Rev. Proc. 92-64, 1992-2 C.B. 422]. Rabbi trusts provide participants with some measure of security and can still succeed in deferring tax.
But, while rabbi trusts generally shield funds from employer invasion, they do not protect assets from attachment by the employer's general creditors as a result of the employer's bankruptcy or insolvency. Since a general creditor can invade the rabbi trust in such a case, the IRS has held that the employee's right to benefits is forfeitable, which is important for achieving income tax deferral. As a result, a rabbi trust is considered to be an unfunded nonqualified deferred compensation arrangement, with the result that the employee will not be considered to be in receipt of taxable income until such time as amounts are actually received under the plan, provided that it satisfies all the requirements of Code Section 409A.
A secular trust (named to distinguish it from a rabbi trust) is intended to provide a participant with a greater level of security than a rabbi trust, but without tax deferral. Contributions to the trust, and earnings on those contributions, are generally includible in the employee's gross income in the year in which they become vested. Most secular trusts have been designed so they are not subject to the claims of general creditors. And, in the past, some have even provided for current distributions to cover taxes owed by the employee on the deferred amounts.
The IRS issued letter rulings that pose serious setbacks to the common provisions of many secular trusts. Under one ruling, employees were taxed on current contributions, and the employer was denied a current tax deduction, thus resulting in "double taxation." The IRS held that no deduction was available because the contribution was not made to a separate account. The IRS said that since the employer had the power to reallocate trust income from the accounts of employees not receiving benefits, the arrangement violated the separate account requirement. As such, deductions couldn't be claimed for contributions until participants began receiving benefits.
As a funded arrangement, a secular trust might also be subject to the regulatory requirements of ERISA Title I.
The secular trust would seem to be useful where the participant and employer are willing to shoulder the potential tax and ERISA burdens to provide the participant with extra protection against employer insolvency and other contingencies.
Most businesses promising deferred compensation benefits will choose to set aside funds to meet their future obligations. To avoid having contributions taxed immediately to the participant, the business should hold all property during the accumulation period, being careful not to grant vested rights in any of the assets to participants before benefits are paid.
Life insurance can be used to "informally fund" an unfunded deferred compensation arrangement without losing income tax deferral. The select employee is the insured. The employer is the policyowner, premium payer and beneficiary. As a business asset, the policy is available to creditors, and the employee has no beneficial ownership rights in the policy. Life insurance can be a cost-effective method to help employers pay the promised benefits with little or no drain on future earnings. Here are some of the benefits life insurance offers:
Recovery of plan costs/employer contributions through death benefits.
Life insurance proceeds help assure the employer that funds will be available to help pay the promised benefits regardless of when death occurs, subject to the claims-paying ability of the insurer to help meet its financial obligations (and provided all premiums are paid when due and there are no substantial withdrawals or policy loans or interest).
The cash value of a life insurance policy accumulates income-tax-deferred, unlike other vehicles which may require the employer to pay tax during the accumulation period. Withdrawals and loans will reduce policy cash values and the death benefit and may have tax consequences.
Settlement options, nonforfeiture options as well as other features in life insurance policies (which may include dividends, policy loans) provide remarkably flexible accumulation and distribution features. These features may, however, lower the death benefit.
Life insurance death benefits can be free of federal income tax if the Notice and Consent requirements of IRC Sec. 101(j) are met. There are also record keeping and reporting requirements. Click here to view the rules regarding employer-owned life insurance. The careful planner will maintain a "firewall" between the deferred compensation arrangement and the life insurance policy. The agreement between employer and participant should not mention the life insurance policy. The application for insurance should not mention the deferred compensation arrangement. Sometimes there is a deliberate "mismatch" between the policy face and the employer's obligation.
Some form of permanent life insurance—universal life, variable life, whole life, or limited pay—can be used to help build a cash value that can be used to pay the benefits. Of course, loans and withdrawals will reduce policy values and death benefits and may have tax consequences.
There are three possible disadvantages in using life insurance to accumulate funds to pay benefits:
First are the limitations that apply to corporate deductions of interest paid on policy loans when the employer elects to borrow against the cash values.
Second is the threat of the corporate alternative minimum tax. In spite of the fact that employers may receive death benefits income tax-free, a portion of the proceeds are included in a C corporation’s tax base for purposes of computing the AMT (some "small corporations" are exempt from the AMT). Employers sometimes purchase enough additional face amount to cover the potential AMT liability. Click here to view the rules regarding employer-owned life insurance and whether the death benefit is tax free or taxable.
Third are the rules governing the taxation of life insurance proceeds on an employee when the employer is the policy owner and beneficiary.
These rules apply to any employer (not only corporations). Click here for an explanation of these rules.
Notwithstanding the fact that certain death benefit proceeds might be includible in the employer’s income, the employer would be entitled to a corresponding deduction to the extent paid out as income in respect of a decedent to the employee’s beneficiaries under the terms of the nonqualified deferred compensation agreement.
Since income from annuities owned by a corporation is currently taxable (i.e., no tax-deferred inside buildup as with life insurance) the advantage of tax-deferred inside buildup would be lost if annuities were used to fund deferred compensation benefits.
For employers and employees who favor the potential rewards and attendant risks of investing in the stock and bond markets, mutual funds can offer an informal funding alternative. Mutual funds provide both professional management and diversification, but diversification cannot eliminate the risk of investment loss. If tax-exempt muni-bond funds were used, the equivalent of tax-free inside buildup would be available.
The deferred amounts in an unfunded arrangement are generally includible in the participant's gross income when actually or constructively received. See the later discussion of the constructive receipt and economic benefit doctrines.
The amounts set aside by the employer in a funded arrangement are generally includible in the participant's gross income for the first taxable year in which the participant's rights are transferable or not subject to a substantial risk of forfeiture.
Historically, a participant was generally not taxed until he or she actually received benefits as long as three conditions were met:
the income deferral was agreed upon before compensation was earned;
the deferred amounts were not unconditionally placed in trust or escrow; and
the employer's promise to pay was merely a contractual obligation and not evidenced by notes or secured in any other way.
Beginning in 2005, new tax law rules [IRC Section 409A] apply that, if violated, will accelerate the taxation of deferred amounts even if the three traditional requirements are met.
The American Jobs Creation Act of 2004 added IRC §409A, which significantly changed the law applicable to nonqualified deferred compensation arrangements.
The IRS summary of §409A is instructive:
Generally, if at any time during a taxable year a nonqualified deferred compensation plan fails to meet the requirements of §409A, or is not operated in accordance with those requirements, all amounts deferred under the plan for the taxable year and all preceding taxable years, are includible in gross income for the taxable year to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. If a deferred amount is required to be included in income under §409A, the amount also is subject to interest [charges for underpayment of tax] and an additional income [penalty] tax. [IRS Notice 2005-1, Q-2]
Bear in mind that IRC §409A is not the only tax hurdle to leap over in this area. As the IRS has cautioned, deferred compensation not required to be included in income under §409A may nevertheless be required to be included in income under §451, the constructive receipt doctrine, the cash equivalency doctrine, §83, the economic benefit doctrine, the assignment of income doctrine or any other applicable provision of the [Internal Revenue] Code or common law tax doctrine. [IRS Notice 2005-1, Purpose & Overview]
The constructive receipt doctrine and the economic benefit doctrine are described briefly following this treatment of §409A.
Section 409A generally applies with respect to amounts deferred in taxable years beginning after December 31, 2004, and with respect to amounts deferred in taxable years beginning before January 1, 2005, if the plan under which the deferral is made is materially modified after October 3, 2004. In the case of amounts deferred under a plan maintained pursuant to one or more bona fide collective bargaining agreements in effect on October 3, 2004, Section 409A does not apply for the period ending on the earlier of the date on which the last of such collective bargaining agreements terminates (determined without regard to any extension thereof after October 3, 2004) or December 31, 2009 [I.R.S. Notice 2006-79]. Certain transitional rules will be discussed in the following paragraphs.
In the past some deferred compensation arrangements have contained design features, commonly known as "haircut provisions," that permitted the participant to get distributions from the arrangement in advance of the participant's scheduled retirement, or other distribution start date under the arrangement. Effective for amounts deferred after Dec. 31, 2004, IRC §409A prescribes rules that must be met to retain the advantages of income tax deferral. Generally speaking, if the participant has early access to deferred amounts, or prohibited control over the deferred amounts, income tax deferral will be lost and the amounts included in the gross income of the participant will be subject to an additional 20% penalty tax, plus interest at the regular underpayment rate plus one percent.
Amounts deferred under a nonqualified deferred compensation arrangement are includible in the participant's gross income for all tax years in which such amounts are not subject to a substantial risk of forfeiture if the arrangement fails to meet any of three requirements:
distribution requirements;
no-acceleration-of-benefit requirements; and
deferral election requirements.
After 2004, distributions from a nonqualified deferred compensation arrangement are permitted only upon:
separation from service;
death;
disability;
a specified time (or pursuant to a fixed schedule) specified in the arrangement at the date of the deferral of the compensation;
a change in ownership or control of the employer; and
an unforeseeable emergency such as a severe financial hardship.
Distributions at any other time will result in loss of income tax deferral.
The no-acceleration-of-benefits requirement is met if the arrangement does not permit any acceleration of payments, or schedule of payments, except as the IRS provides for in its regulations. Changes in the method of distribution that result in an acceleration of payments will violate this rule. Similarly, the administrator of the arrangement may not have discretion over the timing of benefits that could result in an acceleration of payments.
To achieve income tax deferral, the participant's election to defer compensation generally must be made no later than the end of the preceding tax year (or at such other time as the IRS may prescribe in regulations). The regulations state that an election to defer compensation includes an election as to both the time and form of payment. For example, participants generally must make their 2016 deferral elections by December 31, 2015. However, a special rule applies to the participant's first year of eligibility. The initial deferral election can be made within 30 days of becoming eligible and will still apply to compensation for services subsequently performed. Thus, an employee who first becomes eligible on March 31, 2016 has until April 30, 2016 to make a deferral election with respect to 2016 compensation earned after that date. If this requirement pertaining to participant elections is not met, then the compensation that would have otherwise been deferred is included in gross income (and subject to the 20% penalty tax and interest) if it is not subject to a substantial risk of forfeiture and if it had not been previously included in gross income.
IRS Notice 2008-113 outlines procedures under which taxpayers can obtain relief from the full application of the income inclusion and the additional taxes under Sec. 409A with respect to certain failures of a nonqualified deferred compensation plan to comply with Sec. 409A(a) in operation (an "operational failure"), including:
Methods for correcting certain operational failures during the employee’s taxable year
in which the failure occurs and, for certain employees, also during the subsequent
taxable year, to avoid income inclusion under Sec. 409A(a).
Relief limiting the amount includible in income under Sec. 409A(a) for certain
operational failures during a employee’s taxable year that involve only limited amounts.
Relief limiting the amount includible in income under Sec. 409A(a) for certain
operational failures regardless of whether the failure involves only limited amounts, but
subject to further required actions to correct the failure.
Special transition relief for certain operational failures occurring before January 1,
2008.
IRC §409A allows a participant to elect to delay a scheduled payout provided:
the plan requires the election to be made at least 12 months prior to the scheduled payout date;
the election is not effective until 12 months after the date of the election; and
the delay must be for at least five years from the date the payout otherwise would have been made (except that prior distributions may be made in the case of death, disability, or unforeseeable emergency).
A deferred compensation plan may allow participants to accelerate a scheduled payment under the plan only in a few situations:
To terminate a deferral election after an unforeseeable emergency;
To comply with a domestic relations order;
To pay the income taxes due upon the occurrence of a vesting event under an IRC §457(f) plan;
To comply with any ethics agreement with the federal government or to avoid violation of an ethics law;
To pay the employment taxes on salary deferred into the plan;
To reflect inclusion in gross income under IRC §409A; and
To terminate a participant's interest in a plan.
A plan may include, or be amended to include, service recipient (i.e., the employer) discretion so as to force mandatory cashouts, provided the amount subject to the discretion does not exceed the applicable dollar amount under Code Section 402(g)(1)(B) [$18,000 for 2015];
When all arrangements of the same type are terminated,
In connection with a corporate dissolution or bankruptcy, OR
In the 12 months after a change-in-control event.
If a deferred compensation arrangement has assets set aside in an offshore trust to pay benefits under the plan, the amounts set aside will be included in the gross income of the participant for the year of the transfer to the trust, regardless of whether such assets are available to satisfy the claims of the employer's creditors. A similar rule applies in the case of plan provisions that provide for employer asset restrictions to pay benefits under the plan in the event of a change in the employer’s financial health. In addition to being included in the employee’s gross income, the amounts so included in gross income are subject to a 20% excise tax, plus an interest charge based on the underpayment interest rate plus 1%, determined on the underpayments of tax that would have occurred if the affected deferred amounts had been includible in income for the taxable year when first deferred.
The first guidance that the IRS issued on complying with IRC §409A was Notice 2005-1, in early 2005. Notice 2005-1 contains 38 questions and answers on such matters as:
the definition of nonqualified deferred compensation;
the meaning of "change of control event," under which §409A permits deferred amounts to be distributed;
circumstances in which deferred benefits may be accelerated (such as domestic relations order); and
reliance on the transition guidance in Notice 2005-1 and reasonable, good-faith interpretations of §409A until additional guidance is provided.
The IRS then issued proposed regulations [REG-158080-04] to provide comprehensive guidance under §409A. The regulations were proposed to be effective beginning on January 1, 2007; however, in general, the IRS permitted reliance on either the Proposed Regulations or Notice 2005-1.
Final regulations implementing Code Section 409A were issued April 17, 2007, and corrected July 31, 2007. These regulations were to be applicable for taxable years beginning on or after January 1, 2008. But, see Operation of a Plan below.
Extended Transition Relief. Prior to the issuance of the final regulations, Notice 2006-79 extended the effective date and transition relief from the 409A regulations from 01/01/2007 to 01/01/2008.
General. Section 409A of the Code is effective for amounts deferred after December 31, 2004 and for pre-2005 deferrals that were not vested before 2005. It is also effective for amounts deferred in taxable years beginning before January 1, 2005 if the plan under which the deferral is made is materially modified after October 3, 2004.
Collectively-Bargained Plans. Section 409A does not apply with respect to amounts deferred under a plan maintained pursuant to one or more bona fide collective bargaining agreements in effect on October 3, 2004, for the period ending on the earlier of the date on which the last of such collective bargaining agreements terminates (determined without regard to any extension thereof after October 3, 2004) or December 31, 2009.
Operation of a Plan. On October 22, 2007, the IRS issued Notice 2007-86 which generally further extended the transition relief granted by Notice 2006-79. Nonqualified deferred compensation plans did not have to comply with the final regulations under IRC Sec. 409A until January 1, 2009. Instead, employers were required to operate a nonqualified deferred compensation plan in compliance with the plan’s terms, to the extent consistent with 409A and the applicable guidance (including Notice 2005-1). Where a provision of Notice 2005-1 was inconsistent with the final regulations, taxpayers could rely upon either Notice 2005-1 or the final regulations. To the extent an issue was not addressed in Notice 2005-1 or other applicable guidance, taxpayers had to apply a reasonable, good faith interpretation of the statute. Reliance upon the final regulations was treated as applying a reasonable, good faith interpretation of the statue.
Amendment of a Plan. Under the authority of Notice 2006-79, employers generally had until December 31, 2007 to amend their plan documents to conform with §409A. However, the IRS, in Notice 2007-78, granted further limited relief from the plan document requirements of 409A until December 31, 2008. The actual amendment of the plan document could have been delayed in certain cases until December 31, 2008.
Changes in Time and Form of Payment. The deadline for making new payment elections or amendments was December 31, 2008. However, the election or amendment was not allowed to accelerate a payment into 2008 or defer a payment out of 2008.
Payments Based on Elections under Qualified Plans. Many employers provide “mirror” plans that supplement the benefits provided under qualified plans. Under a qualified plan, the participant may elect a payment option up to the time of payment. This flexibility is not allowed under 409A but such payment elections were allowed to continue in effect through December 31, 2008. Employers who offer “mirror” plans were required to modify the plans by December 31, 2008 to comply with the payment election rules.
Change in Payment Elections. As part of IRS transition guidance in 2008, plans were allowed to provide, or be amended to provide, for new payment election with respect to both the time and form of payment, provided that the plan was so amended and the elections were made on or before December 31, 2008. Elections or amendments to change a time and form of payment made during the calendar year 2008 could apply only to amounts that would not otherwise have been payable in 2008 and would not cause an amount to be paid in 2008 that would not otherwise have been payable in 2008. This rule also applied for calendar year 2007.
Employees in Pay Status. The transition relief guidance provided options for a plan that started making payments based on a reasonable, good faith interpretation of the statute and applicable guidance, but that was not in compliance with the final regulations. Such a plan was allowed to:
(i) continue such payments consistent with the plan terms at the time the payments started; or
(ii) halt such payments on or before December 31, 2008 and amend the time and form of any remaining payments to comply with the final regulations.
Service Provider. The service provider is the one performing the services that generate the compensation that would be subject to §409A and includes an individual, corporation, partnership, personal service corporation, or noncorporate entity that would be a personal service corporation if it were a corporation. In most employer-employee relationships, the service provider will be an individual who is the employee.
Service Recipient. The service recipient is the person for whom the services are performed and with respect to whom the legally binding right to the compensation arises. In other words, the service recipient is the employer in most employer-employee relationships.
Substantial Risk of Forfeiture. A substantial risk of forfeiture with respect to compensation exists if entitlement to the amount is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation and the possibility of forfeiture is substantial. A covenant not to compete cannot be a substantial risk of forfeiture for §409A purposes.
Independent Contractors. The §409A rules generally do not apply to deferred compensation arrangements between service recipients and "unrelated" service providers who are providing services to two or more unrelated service recipients. The final regulations contain several detailed conditions that must be met for the §409A rules to be inapplicable. Furthermore, the exception that provides for the inapplicability of the §409A rules if the service provider is an independent contractor with respect to the recipient does not apply to a service provider to the extent that the service provider provides management services to a service recipient.
"Specified Employee" Defined. A "specified employee" means a service provider who, as of the date of the service provider’s separation from service with the service recipient that is a corporation whose stock is publicly traded on an established securities market, is a key employee within the meaning of Code §416(i). A plan of nonqualified deferred compensation must provide that distributions to a specified employee may not be made before the date that is six months after the date of separation from service or, if earlier, the date of death.
Establishment of a Plan. A plan of nonqualified deferred compensation is established on the latest of: (i) the date on which it is adopted; (ii) the date on which it is effective; or (iii) the date on which the material terms of the plan are set forth in writing.
Nonqualified Plan Linked to a Qualified Plan. If the amount deferred under the nonqualified deferred compensation plan is determined as an amount offset by some or all of the benefits under a qualified plan or a foreign plan of deferred compensation, a decrease in amounts deferred under the nonqualified plan does not constitute an acceleration of a payment thereunder, provided that such decrease does not otherwise result in a change in the time or form of a payment under the nonqualified plan and provided further that the change does not exceed the amount of the change in the linked qualified or foreign plan of deferred compensation.
457(f) Plans. Code Section 457 governs nonqualified deferred compensation arrangements for employees of governmental and tax-exempt organizations. Subsection 457(b) is referred to as an “eligible plan” of deferred compensation, and the rules of §409A do not apply to it. Subsection 457(f) is referred to as an “ineligible plan” of deferred compensation and the rules of §409A do apply to it.
Ineligible plans of deferred compensation governed by subsection 457(f) must comply with both the §409A rules and the special rules that are applicable to ineligible plans of deferred compensation for employees of governmental and tax-exempt organizations. Under subsection 457(f), any deferred compensation is includible in a participant’s gross income in the first taxable year in which there is no substantial risk of forfeiture, notwithstanding that such plan may otherwise be in compliance with the §409A rules. For purposes of subsection 457(f), a substantial risk of forfeiture exists when the participant’s rights to compensation are conditioned upon the future performance of substantial services.
Following is an example of how the substantial risk of forfeiture rule governing taxation of amounts deferred under a plan subject to subsection 457(f) interact with the rules under §409A. Assume that a tax-exempt organization establishes a nonqualified deferred compensation plan for its key executives and that such plan contains a 10-year cliff vesting schedule (0% vesting prior to 10 years of service; 100% vesting thereafter) and that the plan provides for distributions on death, disability, separation from service with the employer, or at age 65, whichever first occurs. Under §409A, the deferred compensation would first be includible in the key executives’ income when a distributable event occurs. Under subsection 457(f) the deferred compensation would be includible in the key executives’ income as of the date that there is no longer a substantial risk of forfeiture (i.e., 10 years of service), even if that date occurred before the affected key executive was entitled to a distribution under the plan.
Separation Pay Plans. A separation pay plan that pays only upon an involuntary separation or pursuant to a window program, does not provide for a deferral of compensation subject to the §409A rules to the extent that the plan's separation pay, or portion of the separation pay, does not exceed two times the lesser of:
(1) the annual compensation based upon the annual rate of pay for services provided to the service recipient during the service provider's taxable year before the taxable year in which the separation from the recipient occurred, but adjusted for any increase during that year that was expected to continue indefinitely if the service provider had not separated from service; or
(2) the maximum amount that may be taken into account under a qualified plan pursuant to section 401(a)(17) for the year in which the service provider has a separation from service ($265,000 for 2015). In addition, the plan must provide that the separation pay must be paid no later than the last day of the second taxable year of the service provider following the taxable year of the service provider in which the separation from service occurs.
Stock Options and Stock Purchase Plans. Incentive stock options (“ISOs”) under Code §422 and employee stock purchase plans under Code §423 are not subject to the §409A rules. Nonqualified stock options (“NSOs”) are exempt from the §409A rules, provided that they are not issued at a discount.
Stock Appreciation Rights. A right to compensation based on the appreciation in value of a specified number of shares of service recipient stock occurring between the date of grant and the date of exercise of such right does not provide for the deferral of compensation subject to §409A if certain conditions are met.
Reimbursements and Other Separation Payments. The following reimbursements and payments from the service provider to the service recipient are excluded from §409A applicability:
(i) reimbursements that are not otherwise excludible from gross income for expenses that the service provider could otherwise deduct as business expenses;
(ii) reasonable outplacement expenses and reasonable moving expenses actually incurred by the service provider and related to the termination of services for the service recipient;
(iii) medical benefits provided under a separation pay arrangement; and
(iv) certain in-kind payments from the service recipient to the service provider, provided that such payments are not otherwise subject to §409A.
Split-Dollar Arrangements. Click here to jump to a discussion of IRC §409A's effect on split-dollar arrangements.
The PPA added certain restrictions on the funding of nonqualified deferred compensation plans by employers that are publicly-traded corporations maintaining underfunded or terminated single-employer defined benefit plans. These restrictions are effective for transfers or other reservations of assets after August 17, 2006 (i.e., the date of enactment of the PPA). If a publicly-traded company maintains a single-employer pension plan that is in "at risk" status for purpose of the pension funding rules (or falls within other parameters, such as employer bankruptcy), then it may not set assets aside to pay nonqualified deferred compensation to certain employees during a "restricted period." The affected employees include the chief executive officer, the four highest compensated officers (other than the CEO) for the taxable year, and individuals subject to section 16(a) of the Securities Exchange Act of 1934 [i.e., every person who is directly or indirectly the beneficial owner of more than 10 percent of any class of any equity security (other than an exempted security) which is registered pursuant to section 12, or who is a director or an officer of the issuer of such security]. The "restricted period" is: (i) any period in which a single-employer defined benefit pension plan of the employer is in "at-risk" status; (ii) any period in which the employer is in bankruptcy; and (iii) the period that begins six months before and ends six months after the date any defined benefit pension plan of the employer is terminated in an involuntary or distress termination. Any funding of a nonqualified deferred compensation plan during the restricted period results in immediate inclusion in the affected employees' income of the funding, plus interest, and plus a 20% penalty. Furthermore, if the employer grosses up the executives' compensation to cover the taxes and penalties, the gross-up amounts are also subject to immediate taxation.
Constructive receipt is a traditional tax doctrine that holds: When income is made available to an employee, it is taxed currently even if the employee does not take actual receipt of it. On the other hand, if the employee's right to income is subject to substantial restrictions, the income has not been constructively received and will not be taxed until it is received in fact. An unsecured "promise to pay," as in an unfunded deferred compensation arrangement, generally does not result in constructive receipt, or render the promised amounts subject to current income taxation.
Economic benefit is another traditional tax doctrine that holds: If funds are irrevocably transferred for the benefit of an employee, this irrevocable right to receive future benefits provides a current economic benefit and is taxed accordingly. The economic benefit doctrine generally does not apply when the property in question is subject to the rights of the employer's creditors.
If a service provider who is entitled to a benefit under a nonqualified deferred compensation plan dies, the present value of the right of his or her beneficiary to receive payments under such plan following the service provider’s death will be includible in the service provider’s gross estate for federal estate tax purposes by reason of Code §2039(a). This is the case because the service provider was either currently receiving payments under the plan or was entitled to receive payments in the future. If the plan qualifies as a death benefit only (“DBO”) plan, the present value of the survivor benefit is not includible in the gross estate of the service provider so long as the service provider is not entitled to receive any benefits under the plan. The beneficiary of the service provider who receives payments from the plan following the death of the service provider is required to include those payments in income as income in respect of a decedent under Code §691(a).
Employers can deduct benefits in the same taxable year as the benefits are reported on the participant's income tax return. Premiums for life insurance or other contributions used to "informally" fund the arrangement are not currently deductible.
IRC §409A does not affect the timing of the employer's deduction for nonqualified deferred compensation amounts; i.e., they continue to be deductible when the employee has to include them in gross income.
Nonqualified deferred compensation is generally treated as wages for FICA tax purposes at the time when the employee performs services that give rise to the accrual of the deferred compensation. However, if the deferred compensation is not vested (i.e., if it is subject to a substantial risk of forfeiture), the deferral will not be included in FICA wages until such time as it becomes vested. Under the nonduplication rule, any nonqualified deferred compensation that has been included in FICA wages as it was being accrued will not again be included in FICA wages when it is paid out. When calculating the amount of FICA tax due on the deferred compensation, such deferred compensation accruals are combined with other amounts paid to the employee that constitute wages for FICA tax purposes. Typically, the additional FICA taxes that result from inclusion of the nonqualified deferred compensation amounts equal only 2.9% (or 3.8% if the employee is subject to the Medicare tax for higher income wage earners) of the deferral amount, which is the HI portion of the tax, because employees participating in nonqualified deferred compensation plans typically receive other FICA wages in excess of the taxable wage base.
Special reporting requirements apply to both the deferral of compensation subject to §409A and the inclusion of such compensation in the service provider’s income. Amounts includible in income pursuant to §409A are also subject to income tax withholding. The rules are generally effective for amounts deferred after December 31, 2004, but special reporting and wage withholding rules under §409A have been extended until the IRS issues future guidance (Notice 2008-115).
Because of the special tax treatment of S corporations, the use of nonqualified deferred comp for S shareholders is generally not recommended. The tax deferral usually available for the arrangement would not be attainable for these persons.
There are two broad exemptions from ERISA Title I's compliance requirements. Only "unfunded" arrangements qualify for these two exemptions. The first is the "excess benefit plan" exemption where the arrangement is intended to provide benefits in excess of the caps imposed on qualified plans. The second exemption is the "top-hat" exemption where the arrangement exists only for a select group of management or highly compensated employees.
Many deferred compensation arrangements will fall within one of these exemptions. When this is the case, only minor reporting to the Department of Labor is required, in the form of a notice filed within 120 days after the plan is installed, giving cursory information about the arrangement and the reason it qualifies for exemption.
A top-hat plan is an unfunded, nonqualified deferred compensation plan maintained by an employer primarily for the purpose of providing deferred compensation or welfare benefits to a select group of management or highly compensated employees [ERISA §201(2)]. Top-hat plans are exempt from many of the requirements of ERISA Title I, which are administered by the U.S. Department of Labor.
DOL advisory opinions have tried to restrict top-hat employees to employees who "by virtue of their position or compensation level have the ability to affect or substantially influence . . . the design and operation of their deferred compensation plan." It is by no means clear that this very restrictive standard would hold up under judicial scrutiny if an employer tried to use a more expansive definition of "top-hat employees."
If the arrangement fails to qualify for an ERISA exemption, it will be subject to the participation, vesting, funding, fiduciary, reporting and disclosure requirements of ERISA Title I.
If a participant is a controlling shareholder-employee, some special considerations arise. The IRS has indicated that it will not issue a private letter ruling approving such arrangements, apparently due to a concern that a controlling shareholder could use his or her corporate control to access the deferred amounts prior to the prescribed time. The new statutory requirements of IRC §409A may persuade the IRS to relax its position.
Establishing a deferred compensation arrangement for another employee and not "overloading" benefits for the controlling shareholder-employee are precautions that may help to convince the IRS that an arrangement for a controlling shareholder-employee is bona fide.
Death benefits paid into the corporation at the shareholder-employee's death may increase the federal estate tax value of the stock the shareholder-employee owns.
Reasonable compensation may also be an issue for shareholder-employees. If a shareholder-employee's total compensation is "unreasonable," the IRS may deny a deduction for employer payments not deemed to be ordinary and necessary business expenses.
The employer can pick and choose participants from the select group of management or highly compensated employees, and who is covered remains confidential (except to the extent disclosed by accounting statements).
Recovery of plan costs/employer contributions through death benefits.
Deferred compensation is an attractive method for recruiting, retaining, rewarding and retiring valuable employees.
The arrangement can provide benefits in addition to qualified plans or it can be used in lieu of these plans.
No IRS pre-approval is required.
The cash value accumulates on a tax-deferred basis when life insurance is used.
Benefits are generally tax-deductible by the employer when paid.
The terms of the arrangement can be structured to address the specific needs of covered participants.
When properly arranged, the participant generally pays no tax on benefits until they are received.
The arrangement can supplement retirement benefits provided under qualified plans or personal savings.
Death and disability benefits can be part of the arrangement.
The arrangement can include a death benefit and post-retirement survivor benefits.
Graphic: How Deferred Compensation Arrangements Work
Reg. Sec. 409A
Notice 2006-79
Reg. Sec. 1.409A
Notice 2007-78
Notice 2007-86
Notice 2008-113
DOL Reg. Secs. 2520.104-23, 2560.503-(1)(a)
DOL Advisory Opinions 81-11A, 90-14A, 91-16A, 92-13A, 92-02A, 92-22A, 94-31A ("unfunded" plans)
DOL Advisory Opinions 75-48, 75-63, 75-64, 76-100, 76-118, 85-37A, 90-14A, 92-13A ("top-hat" exemption)
Nationwide Mutual Ins. Co. v. Darden, 503 U.S. 378 (1992)
Lackey v. Whitehall Corp., 704 F. Supp. 201 (D.C. Kan. 1988)
Peckham v. Board of Trustees, 653 F.2d 424 (10th Cir. 1981)
Schwartz v. Gordon, 761 F.2d 864 (2nd Cir. 1985)
Williams v. Wright, 927 F.2d 1540 (11th Cir. 1991)
Peterson v. American Life & Health Ins., 48 F.3d 404 (9th Cir. 1994), cert. denied 116 S. Ct. 377 (1995)
Petkus v. Chicago Rawhide Mfg. Co., 763 F. Supp. 357 (N.D. Ill. 1991)
Belsky v. First National Life Ins. Co., 818 F.2d 661 (8th Cir. 1987)
Dependahl v. Falstaff Brewing Corp., 653 F.2d 1208 (8th Cir. 1981), cert. denied 454 U.S. 968 (1981)
Belka v. Rowe Furniture Corp., 571 F. Supp. 1249 (D.C. Md. 1983)
Miller v. Heller, 915 F. Supp. 651 (S.D. N. Y. 1996)
Northwestern Mutual Life Ins. Co. v. Resolution Trust Corporation, 848 F. Supp. 1515 (N.D. Ala. 1994)
Hollingshead v. Burford Equipment Co., 747 F. Supp. 1421 (D.C. Ala. 1990)
Loffland Brothers v. Overstreet, 758 P.2d 813 (Okla. 1988)
Duggan v. Hobbs, 99 F.2d 307 (9th Cir. 1996)
Plazzo v. Nationwide Mutual Ins. Co., 697 F. Supp. 1437 (N.D. Ohio), reversed 892 F.2d 79 (6th Cir. 1989), cert. denied 498 U.S. 950 (1990)
Reg. Sec. 1.451-2(a)
Comm'r v. Oates, 207 F.2d 711 (7th Cir. 1953), affirming 18 T.C. 570 (1952), acq. 1960-1 C.B. 5
Veit v. Comm'r, 8 T.C. 809 (1947), acq. 1947-2 C.B. 4
Veit v. Comm'r, 8 T.C.M. 919 (1949)
Rev. Rul. 60-31, 1960-1 C.B. 174, as modified by Rev. Rul. 70-435, 1970-2 C.B. 100
Rev. Rul. 67-449, 1967-2 C.B. 173
Ltr. Rul. 8741078
Rev. Rul. 60-31, 1960-1 C.B. 174, as modified by Rev. Rul. 70-435, 1970-2 C.B. 100
Sproull v. Comm'r, 16 T.C. 244 (1951), affirmed per curiam, 194 F.2d 541 (6th Cir. 1952)
Minor v. U.S., 772 F.2d 1472 (9th Cir. 1985)
Goldsmith v. U.S., 586 F.2d 810 (Ct. Cl. 1978)
IRC Secs. 83, 409A
Reg. Sec. 1.83-3(c)(3)
Rev. Rul. 60-31, 1960-1 C.B. 174, as modified by Rev. Rul. 70-435, 1970-2 C.B. 100
Rev. Rul. 67-449, 1967-2 C.B. 173
Rev. Rul. 69-50, 1969-1 C.B. 140, as amplified by Rev. Rul. 77-420, 1977-2 C.B. 172
Rev. Rul. 69-474, !969-2 C.B. 105
Rev. Rul. 69-649, 1969-2 C.B. 106
Rev. Rul. 69-650, 1969-2 C.B. 106
Rev. Proc. 71-19, as amplified by Rev. Proc. 92-65, 1992-2 C.B. 428
Rev. Rul. 71-419, 1971-2 C.B. 220
Robinson v. Comm'r, 44 T.C. 20 (1965), acq. 1970-2 C.B. xxi, 1976-2 C.B. 2
Martin v. Comm'r, 96 T.C. 814 (1991)
TAM 8632002
Ltr. Rul. 9122019
Ltr. Rul. 9052016
Ltr. Rul. 8637085
Ltr. Rul. 8541043
Ltr. Rul. 8538016
Ltr. Rul. 8507040
Casale v. Comm'r, 247 F.2d 440 (2d Cir. 1957)
Frost v. Comm'r, 52 T.C. 89 (1969)
Centre v. Comm'r, 55 T.C. 16 (1970)
Rev. Rul. 59-184, 1959-1 C.B. 65
Rev. Rul. 68-99, 1968-1 C.B. 193
Rev. Rul. 72-25, 1972-1 C.B. 127
TAM 8828004
Ltr. Rul. 9517019
Ltr. Rul. 9510009
Ltr. Rul. 9505012
Ltr. Rul. 9504006
Ltr. Rul. 9427018
Ltr. Rul. 9403016
Ltr. Rul. 9347012
Ltr. Rul. 9323025
Ltr. Rul. 9309017
Ltr. Rul. 9142020
Ltr. Rul. 8607031
Ltr. Rul. 8607032
Ltr. Rul. 8103089
Ltr. Rul. 7940017
IRC 101(j)
IRC Sec. 409A
IRS REG-158080-04 (proposed regulations)
IRS Notice 2005-1
Gambling v. Comm'r, 82-1 USTC 9403 (2d Cir. 1982)
Metcalfe v. Comm'r, T.C. Memo 1982-273
Goldsmith v. Comm'r, 78-1 USTC 9312 (Ct. Cl. 1978), affirmed and adopted per curiam, 586 F.2d 810 (1978)
Minor v. U.S., 772 F.2d 1472 (9th Cir. 1985)
Centre v. Comm'r, 55 T.C. 16 (1970)
Rev. Rul. 77-25, 1977-1 C.B. 301
Rev. Rul. 82-46, 1982-1 C.B. 158
Ltr. Rul. 8119020
Ltr. Rul. 9233005
Ltr. Rul. 9122019
Ltr. Rul. 9109048
Ltr. Rul. 9036007
Notice 2008-115
IRC Sec. 2039
Reg. Sec. 20.2039-1(b)
Goodman v. Granger, 243 F.2d 264 (3rd Cir. 1957)
Estate of Barr v. Comm'r, 40 T.C. 227 (1963), acq. In result, 1978-1 C.B. 1
Neely v. U.S., 613 F.2d 802 (Ct. Cl. 1980)
Silberman v. U.S., 333 F. Supp. 1120 (W.D. Pa. 1971)
Courtney v. U.S., 84-2 USTC 13,580 (N.D. Ohio 1984)
Ltr. Rul. 8005011
Reg. Sec. 25.2511-1(h)(10)
IRC Sec. 409A
Ltr. Rul. 8113107 (the original rabbi trust)
Rev. Proc. 92-64, 1992-2 C.B. 422 (IRS model rabbi trust)
McAllister v. Resolution Trust Corporation, 201 F.3d 570 (5th Cir. 2000)
Goodman v. Resolution Trust Corporation, 7 F.3d 1123 (4th Cir. 1993)
Nagy v. Riblet Products Corp., 13 E.B.C. 1743 (N.D. Ind. 1990)
GCM 39230 (1984)
Ltr. Rul. 8906022
Ltr. Rul. 9525031
Ltr. Rul. 9214035
Ltr. Rul. 9210013
Ltr. Rul. 9144019
Ltr. Rul. 9117032
Ltr. Rul. 9115054
Ltr. Rul. 8634031
Rev. Proc. 99-3, 1999-1 C.B. 103, Sec. 3.01(31)
Rev Rul. 88-68, 1988-1 C.B. 556
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