Nonqualified Deferred Compensation

Avoiding Constructive Receipt

Nonqualified deferred compensation (NQDC) plans are commonly used to provide additional benefits to selected key employees or executives. In a typical plan, an employee enters into an agreement with the employer to defer a portion of his or her compensation until a future date or event. Such plans are “nonqualified” because they do not meet the requirements of “qualified” plans under the Internal Revenue Code (IRC).1 There are two broad categories of NQDC plans:

 

Funded

The employer sets funds aside, beyond the reach of its general creditors, to guarantee payment of the amounts deferred. The money is deductible to the employer, and is included in the employee’s gross income, in the year set aside.

Unfunded

The deferred compensation is generally secured only by the employer’s promise to pay. It is deductible to the employer, and is included in the employee’s gross income, in the year that the funds are either actually or “constructively” received by the employee. Constructive receipt typically occurs when the employee has an unlimited right to the funds (received or not), with no “substantial risk of forfeiture.”

 

Avoiding current taxation on deferred amounts is highly desirable as it generally results in a larger benefit when the funds are received by the employee in the future.

Avoiding Constructive Receipt

IRC Sec. 409A

 

The American Jobs Creation Act of 2004 (AJCA) included new IRC Sec. 409A, which added to federal income tax law a number of requirements that a NQDC plan must meet to avoid having deferred amounts treated as being constructively received in the current year. If these requirements are not met, all current and past-deferred compensation, plus any earnings, are included in the employee’s gross income for the current tax year. An additional 20% tax is levied, plus an underpayment interest penalty. 

IRC Sec. 409A was effective January 1, 2005 and generally applied to amounts deferred after December 31, 2004. Certain amounts deferred before January 1, 2005 are considered “grandfathered” under the prior rules and are exempt from IRC Sec. 409A. If the plan under which these grandfathered amounts were deferred is “materially modified” on or after October 3, 2004, IRC Sec. 409A then applies to the grandfathered amounts. 

In the years following passage of the AJCA, the Internal Revenue Service (IRS) issued a series of announcements on how the new law would be applied. Taxpayers were expected to comply “in good faith” with this transitional guidance. On April 10, 2007, the IRS released TD 9321, containing most of the final IRC Sec. 409A regulations.1These regulations, which generally apply to tax years beginning on or after January 1, 2008, required plan sponsors to conform to the final regulations no later than December 31, 2007. Notice 2007-86, issued by the IRS on October 22, 2007, generally allowed employers until December 31, 2008, to bring their plans into compliance with the statute.

Key concepts

There are a number of key concepts involved in understanding NQDC plans:

  • Under the final regulations a very broad definition of “deferral of compensation” is used, “…if, under the terms of the plan and the relevant facts and circumstances, the service provider has a legally binding right during a taxable year to compensation that, pursuant to the terms of the plan, is or may be payable to (or on behalf of) the service provider in a later year.”²

    IRC Sec. 409A May Apply To:

    • Agreements covering a change in control

    • Certain incentive or bonus plans

    • Employment and separation agreements

    • Phantom or restricted stock plans

    • Split-dollar arrangements

    • Stock options/rights granted at less than Fair Market Value (FMV)

  • The person or entity who provides services. Generally, any cash basis taxpayer including: (1) an individual; (2) a corporation;¹ or (3) a partnership.²

  • Any person, organization, or entity to whom services are provided.²

  • Generally, a substantial risk of forfeiture exists when receipt of the deferred compensation depends on the employee performing “substantial future services”, or the “occurrence of a condition related to the compensation, and the risk of forfeiture is substantial.”³

1 At the same time, the government also released IRS Notice 2007-34, providing general guidance on the applicability of IRC Sec. 409A to split-dollar arrangements. 

2 Reg. Sec. 1.409A-1(b)(1)

Exceptions and Special Situations

The final regulations exempt a number of types of compensation from IRC Sec. 409A:

  • Certain deferrals paid no later than 2-1/2 months after the first tax year the amounts are no longer subject to a substantial risk of forfeiture.

  • Applicable to limited amounts of compensation, paid within a specified time period, and payable only as a result of separation from service. The final regulations carefully define the situations to which this exception applies.

  • Excepted from Section 409A are many qualified pension, profit sharing, and stock bonus plans. Bona fide plans providing welfare benefits such as medical, sick leave, vacation, or disability are also excluded.

  • The exercise price of the option or stock right can never be less than the FMV of the stock on the day the option or right is granted. A stock option or stock right plan may not include any deferral feature. Incentive stock options and options granted under employee stock purchase plans (statutory stock rights) are excluded from Section 409A.

  • Except for corporate directors and those providing management services, independent contractors are generally exempt from Section 409A.

1 Including a C corporation, an S corporation, or a personal service corporation. 

2 For the sake of simplicity, this report uses the term “employee” for “service provider” and “employer” for “service recipient.” The terms used in the final regulations are broad and intended to cover a wide range of relationships.

3 Reg. Sec. 1.409A-1(d).

Election to Defer Compensation

  • The election must be made no later than the end of the previous tax year.

  • The deferral election must be made within 30 days of an employee’s first becoming eligible to participate in the plan.

  • If an employee’s compensation is performance based, over a period of at least 12 months, the election to defer compensation must be made no later than six months before the end of the 12-month period.

Distributions

 

The timing and manner in which the deferred compensation will be paid out must be decided at the time the initial deferral election is made. Generally, distributions may be made only when one of the following events occurs: 

  • The employee separates from service.¹ 

  • Upon the employee’s death or disability. 

  • At a specific time, or according to a fixed schedule. 

  • Because of a change in ownership or effective control of the employing corporation.

  • Because of an unforeseeable emergency. 

If a plan allows an employee to later choose to delay or change the form of payment, the new election may not be effective until 12 months after it is made. If the change relates to (1) separation from service; or (2) according to a fixed schedule or at a fixed point in time; or (3) because of a change in the service recipient’s ownership, any payment made under the new election must be delayed at least five years beyond when it would have otherwise been made. Distributions made because of death, disability, or unforeseen emergency may be delayed for periods less than five years.

1 Distributions to a “specified” employee may not be made until six months after the employee separates from service (or, if earlier, the date of the employee’s death). A specified employee is a “key” employee, as that term is defined in IRC Sec. 416(i), of a corporation whose stock is publicly traded.

Acceleration of Benefits

Under the final regulations, benefit payments may be accelerated only in certain, narrow situations, and only when done either automatically (under the terms of the plan) or upon a decision by the service recipient:

  • Amounts which do not exceed specified limits.

  • Such as paying required income or employment taxes, complying with a divorce decree or domestic relations order, or meeting conflict of interest or ethics standards.

  • Specific requirements must be met.

Other Tax Issues

The Pension Protection Act of 2006 (PPA 2006) added two provisions to the federal income tax code which have a potentially heavy impact on NQDC plans:

 

Employer-owned life insurance contracts

NQDC plans are sometimes funded with life insurance. Generally, amounts received under a life insurance contract paid by reason of the death of the insured are excluded from income. Under the provisions of PPA 2006, however, death proceeds from a life insurance policy owned by an employer on the life of an employee are generally includable in income, unless certain requirements are met. This law was effective for contracts issued after August 17, 2006, except for policies acquired in an IRC Sec. 1035 exchange. See IRC Sec. 101(j).

“At-risk” qualified plans

Effective for funds transferred or set aside after August 17, 2006, PPA 2006 added restrictions on executive nonqualified deferred compensation at firms with under-funded qualified retirement plans. This law generally provides that during any period in which a qualified retirement plan is “at-risk”, any funds set aside in a NQDC plan for high-level executives will become taxable and the 20% penalty tax and special underpayment interest penalty will apply.

Seek Professional Guidance

Source: Advisys, Inc. 2022

 

Given the complexities involved, and because the tax and other penalties for not meeting the requirements of the Internal Revenue Code are significant, professional guidance is strongly recommended.