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Nonqualified Deferred Compensation and Sec. 409A Final Regulation

The final Sec. 409A regulations clarify the previously proposed regulations, establish final rules for nonqualified deferred compensation (NQDC) plans and impose strict penalties on plans that don’t comply.

October 2007
from The Tax Adviser

Prior to Sec. 409A, the regulations applicable to deferred compensation plans, particularly nonqualified deferred compensation (NQDC) plans, were somewhat murky. After a number of corporate scandals, Congress legislated restrictions for NQDC plans in 2004.

Since the enactment of Sec. 409A, interpretive guidance and proposed regulations have been issued. On April 10, 2007, the IRS released final regulations for Sec. 409A relating to NQDC plans (TD 9321). The new regulations are applicable for tax years beginning on or after January 1, 2008. If the plan was acting in “good faith” prior to the effective date of the new regulations, relief will generally be granted if the plan was not fully compliant with the guidelines issued. No extension beyond the effective date is expected. Thus, every NQDC plan should be evaluated for compliance with the new regulations and amended (if necessary) before the end of 2007.

An NQDC plan is an arrangement compensating an employee for services after the year in which they were actually performed. The purpose of many plans is to defer compensation to later years when the recipient is expected to be in a lower tax bracket or to merely defer payment of a tax (which has value in and of itself). Organizations are using NQDC plans to provide top executives with substantial retirement benefits that cannot be achieved with qualified plans, such as a Sec. 401(k) plan. Currently many of these plans are being marketed as supplemental executive retirement plans (SERPs). NQDC plans can be very flexible and set up to the employer’s custom needs to benefit a select few top executives, which is not normally allowed under a qualified plan. The most common options made available to attract and maintain key executives using NQDC plans are life insurance plans, excess-benefit plans, top-hat plans, severance plans, deferred bonuses, vested trusts, rabbi trusts, secular trusts, stock options, phantom stock, stock appreciation rights, and golden, silver, tin, and pension parachutes. Many of these arrangements are considered abusive, particularly in light of the events surrounding Enron and other corporate scandals, allowing select members of management to gain access and control of the monies while still deferring the compensation.

Before the final Sec. 409A regulations were issued, there was little statutory guidance on NQDC plans. In order to clear up confusion, the American Jobs Creation Act, P. L. 108-357, was signed into law in October 2004, with Sec. 409A effective on January 1, 2005. NQDC plans were required to act in good faith during 2005 and amend plan provisions by December 31, 2005. The sponsor was expected to amend any plan documentation in accordance with Sec. 409A in 2005. Many organizations were changing their plans to comply when the IRS introduced proposed regulations in September 2005, extending the compliance date to the end of 2007. The final Sec. 409A regulations clarify the previously proposed regulations, establish final rules for NQDC plans, and impose strict penalties on any plan that does not comply.

Penalties

The penalties for noncompliant NQDC plans are extremely steep. With a noncompliant NQDC plan, all amounts deferred are included in the individual’s gross income to the extent these deferred amounts are not subject to a substantial risk of forfeiture. For the years in which the plan was noncompliant, interest is imposed on the amount of income not included calculated using a rate of one percent greater than the interest rate on tax underpayments. Also, the amount required to be included in the participants’ income is subject to an additional 20 percent penalty tax. To avoid these harsh penalties, NQDC plans need to comply with the finalized election, distribution, and funding rules.

Elections

The timing of the initial deferral election is well defined under Sec. 409A. The initial deferral elections must be made by the participant before the beginning of the tax year during which the compensation is to be earned (Regs. Sec. 1.409A-2(a)(3)). There are two exceptions to this rule. The first applies when the participant originally becomes eligible to participate in the NQDC plan (Regs. Sec. 1.409A-2(a)(7)); the initial deferral election can be made 30 days after the participant becomes eligible to participate in the plan. The second exception applies to performance-based compensation (Regs. Sec. 1.409A-2(a)(8)). The deferral election can be made as late as six months before the end of a 12-month service period for performance-based compensation (such as non-salaried incentive pay).

Once the elections are set, Sec. 409A limits the ability to change the timing of distributions. If an NQDC plan permits a change or delay in a distribution from the plan, three conditions must be met: (1) A change to the election may not take effect until at least 12 months after the date on which it was made; (2) an election must be changed on a fixed schedule and may not be made earlier than 12 months before the date of the first scheduled payment; and (3) any payment re-deferral must be made at least five years from the original payment date.

Distribution Rules

Distributions from an NQDC plan must be made on a fixed schedule with payments made only on fixed dates. Under Regs. Sec. 1.409A-3(a), there are a few exceptions to this rule that permit early distributions in the event of separation of service, disability, death, a change in control of the employer corporation, or an unforeseeable emergency:

  1. The distribution to an employee separated from service cannot be made until six months after the separation from service.
  2. A participant is “disabled” when he or she is physically or mentally impaired for longer than 12 months.
  3. A change in ownership or control of a corporation can occur in three ways:

    • A person or group obtains more than 50 percent of the corporation’s stock.
    • 35 percent of the stock is acquired by a person or group over a 12-month period, or the majority of the board members are replaced by directors not endorsed by the prior members; both qualify as a change in effective control.
    • A change in control based on the sale of assets occurs when 40 percent or more of the gross fair market value of the assets is acquired by a person or group.
  4. Rules defining an unforeseeable emergency will be based on the definition of that term used in Sec. 457. Included in the definition is a severe financial hardship arising from illness, accident, casualty loss, or similar unforeseeable circumstances arising to the employee, spouse or any dependents. The amount distributed may not be more than what is reasonably necessary to meet the emergency needs and to pay any anticipated tax on the distribution.

The timing of payments must be set on a fixed schedule with an ascertainable beginning date (Regs. Sec. 1.409A-3(i)(1)(i)). Distributions cannot be made simply on an agreement, such as “when I retire.” Sec. 409A prohibits any acceleration of a distribution. This rule includes “haircut” provisions, under which a beneficiary may take payments at any time, subject to a reduction in amount. Also, any type of accelerated vesting is prohibited when used as a device to accelerate benefits.

Under Regs. Sec. 1.409A-1(b)(4), there is an exception for short term deferrals made two and one-half months or less before the end of the tax year, in which the amount is no longer subject to forfeiture. For example, if a calendar-year employer awards a bonus on November 15, there is no noncompliant deferral of compensation if the bonus is paid or made available to the employee by the following March 15.

Assuming the plan complies with the distribution rules, it also has to meet the funding requirements.

Funding

If an NQDC plan funds an offshore trust or places assets outside the United States, the plan will not defer the compensation. Regs. Sec. 1.409A-1(a)(3) abolishes the use of the popular offshore irrevocable trusts frequently structured as “rabbi trusts,” making them subject to the Sec. 409A penalties. Rabbi trusts were initially popular because their funding was subject to the employers’ creditors and therefore the compensation was considered deferred. To make it more difficult for creditors to access the funds, many of these trusts were set up offshore. Under Sec. 409A, contributions or any assets transferred to trusts placed outside the United States for the purpose of paying nonqualified deferred compensation are considered property transferred and are taxed in accordance with Sec. 83, regardless of whether or not the trust assets are reachable by creditors.

Under Regs. Sec. 1.409A-6, any assets transferred before March 22, 2006, are not subject to penalties if the NQDC plan is brought into compliance with Sec. 409A by January 1, 2008. Congress also enacted Sec. 409A(b)(3) in the Pension Protection Act of 2006 for at-risk status employers. If an employer or sponsor is experiencing financial difficulties such as bankruptcy, the contributions will not be deferred.

How to Comply

To comply with the new distribution, election and funding rules, organizations will likely need to make changes to their NQDC plans. Any new payment elections from plan participants that are permitted must be obtained and implemented timely. The total amounts of deferrals are required to be shown on the individual’s Form W-2, Wage and Tax Statement. If the individual is not an employee, the deferrals must be shown on a Form 1099. The plan or arrangement should be finalized and set forth in a written plan document, compliant with Sec. 409A, by December 31, 2007. Finally, the plans should be operated post-2007 in accordance with Sec. 409A and the new regulations thereunder.

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Jonathan Rose, Aidman, Piser & Company, P.A., Tampa, FL, is a contributing writer for The Tax Adviser. His views as expressed in this article do not necessarily reflect the views of the AICPA or The Tax Adviser.