New Rules Create Hazards
for Nonqualified Deferred Compensation
Gregory A. Carnes
2006 - Nonqualified deferred-compensation (NQDC) plans have
become an essential element of executive compensation during
the last decade. Two forces drove most of these plans’
popularity in the early 1990s:
Limitations were tightened on the amount of funds that
could be deferred through qualified plans; and
Marginal tax rates for highly compensated individuals
increased significantly, which encouraged individuals
to defer income and avoid current taxation.
plans are attractive because companies can provide substantial
retirement benefits for key executives beyond what is achievable
with qualified plans. Companies can also use them to provide
performance incentives for key executives. Nevertheless,
NQDC plans create risk for executives because the deferred
funds cannot be placed out of complete reach of the company’s
the last two decades, the rules governing NQDC plans have
been generally unstructured. The foundation for the applicable
law has rested on doctrines that have been interpreted through
a series of court cases, IRS revenue rulings and private
letter rulings, and other administrative guidelines. This
resulted in a set of rules that were often complex to apply
and ambiguous in nature. Judicial decisions have often been
in conflict with IRS positions.
American Jobs Creation Act of 2004 (AJCA) addressed this
situation by adding IRC section 409A, which provides an
overall structure for the taxation of NQDC plans. The new
law focuses on elections (and reelections) to defer income,
acceleration of benefits, and distributions from NQDC plans.
Consequences of noncompliance include immediate taxation
of the deferred amounts, as well as penalties and interest.
The AJCA does not, however, override the previous authority.
Rather, it can be viewed as a structure that envelops the
existing rules, and the existing rules will still apply
to specific details not covered by the AJCA. Shortly after
these rules were enacted, the IRS issued Notice 2005-1 (2005-2
IRB 274), which provided much-needed administrative guidance.
Additionally, the IRS issued Proposed Regulations 1.409-1,
1.409-2, 1.409-3, and 1.409-6, which provide additional
information when determining these rules’ proper implementation
and their implications. Proper planning is essential in
this new environment.
Law Before the AJCA
doctrines provide the foundation for the taxation of NQDC
plans. IRC section 451(a) provides the basis for the constructive-receipt
doctrine. Under the cash method of accounting, income is
recognized when received or constructively received [i.e.,
if it has been made available to an employee and the employee’s
use of the funds is not subject to substantial limitations
or restrictions; see Treasury Regulations section 1.451-2(a)].
In the deferred-compensation arena, income inclusion hinges
on whether the executive had the opportunity to draw upon
the funds, in which case the income is immediately taxable
under the constructive-receipt doctrine. The economic-benefit
doctrine provides that if an employee has a future right
to income that is subject to current valuation, and this
right is superior to the rights of the employer’s
general creditors, then this benefit is taxable immediately.
[See Minor, Ralph v. U.S. (1985, CA9) 56 AFTR 2d
85-6037, 772 F2d 1472, affd. on remand (1986, CA9) 797 F2d
738.] The doctrine applies only if there is a clear current
economic benefit to the employee (e.g., the employee can
pledge the deferred funds as collateral).
constructive-receipt and economic-benefit doctrines are
typically avoided if the employer provides an unsecured
promise to pay the funds in the future. Most employees,
however, desire some assurance that the employer will actually
pay the funds when they become due. Therefore, deferred
compensation is often placed into a “rabbi trust”
to prevent the employer from refusing to pay the funds in
the future. The employer does not have access to funds in
a rabbi trust (Revenue Procedure 92-64, 1992-2 CB 422).
The employer’s creditors, however, do have access
to the funds, which is the mechanism that avoids taxation
under the economic-benefit doctrine.
section 83 provides that if property is received in return
for the performance of services, then the recipient will
recognize income for the taxable year in which the rights
of the individual in the property are transferable or are
not subject to a substantial risk of forfeiture. The AJCA
subjects certain transactions to IRC section 83. In those
cases, recognition of the deferred compensation for income
tax purposes will occur when there is not a substantial
risk that the interest in the property could be forfeited.
include any plan that defers compensation, if the plan is
not a qualified employer plan, or any bona fide vacation-leave,
sick-leave, compensatory-time, disability-pay, or death-benefit
plan [IRC section 409A(d)(1)]. IRC section 409A(d)(2) excludes
the following types of “qualified employer plans”:
Qualified pension, profit-sharing, and stock bonus plans;
Qualified annuity plans;
Tax-sheltered annuity plans for tax-exempt organizations;
Simplified employee pension (SEP) plans; and
retirement accounts (such as SIMPLE IRAs).
that may fall under these new requirements includes compensation
received under any deferred salary or bonus plan, stock
options, plans based on equity values (e.g., stock appreciation
rights and phantom stock), and supplemental executive retirement
plans (SERP). These rules apply to a “service provider,”
which includes individuals, C and S corporations, partnerships,
personal service corporations, and qualified personal service
corporations. IRC section 409A does not apply to service
providers that use the accrual method of accounting for
federal tax purposes [Proposed Regulation 1.409A-1(f)(2)].
Furthermore, in general, section 409A does not apply to
independent contractors, as long as the contractor provides
services to more than one service recipient and the service
recipient deferring the compensation is not related to the
contractor [Proposed Regulation 1.409A-1(f)(3)]. IRC section
409A is not limited to arrangements between an employer
and an employee. For example, it may apply to arrangements
between a partner and a partnership (Notice 2005-1, Q-7).
is deferred if a service provider has a legal right to compensation
that has not been actually or constructively received and
is payable in a later year. If a service recipient or other
person can unilaterally reduce this right in the future,
then the provider is not deemed to have a legal right to
the income, unless this power does not have substantive
significance [Proposed Regulation 1.409A-1(b)(1)].
409A will not apply to compensation that is received
within 2 Qs months after the close of the service provider’s
first tax year (known as short-term deferrals) in which
the amount is no longer subject to a substantial risk of
forfeiture [Treasury Regulations section 1.404(b)-1T, Q/A
2; Proposed Regulation 1.409-1(b)(4)].
LSU Corporation, a calendar-year taxpayer, awards a bonus
to its CEO on July 4, 2006. Because there is no substantial
risk of forfeiture with regard to the bonus, she has a legally
binding right to the income on July 4, 2006. The bonus will
not be considered to be deferred compensation as long as
it is received or made available to her by March 15, 2007.
If the compensation is received or made available after
March 15, 2007, it will be considered a deferred-compensation
may be delayed after the 15th day of the third month after
the end of the fiscal year without the plan being considered
a deferred-compensation plan if payment of the compensation
on or before this date would have jeopardized the solvency
of the service recipient, or if payment was administratively
impracticable [Proposed Regulation 1.409A-1(b)(4)(ii)].
risk of forfeiture exists if entitlement is conditioned
on the performance of substantial future services by any
person or on the occurrence of a condition that relates
to the compensation, and the possibility of forfeiture is
substantial [Proposed Regulation 1.409A-1(d)]. Caution must
be exercised if the service provider owns a significant
amount of the voting power or value of the service recipient’s
MY is director of sales for Corporation VOL and is also
a 25% shareholder. MY will receive a $100,000 bonus if he
is still employed by VOL in five years. The remaining VOL
stock is owned by TY, who is unrelated to MY. The five-year
waiting period for MY should be considered to be a substantial
restriction. If, however, instead of TY owning the remaining
stock, the stock is diversely held so that MY can exercise
substantial control of the corporation, it is unlikely that
this restriction would be considered substantial. Such could
be the result even if MY owns far less than 25% of all shares
of VOL stock.
noted above, the AJCA adds IRC section 409A, which provides
many new requirements for NQDC plans. Generally, these requirements
apply to amounts that are deferred after 2004. For areas
not addressed by the new law, pre-AJCA law continues to
of failing to comply. Failing to comply with
IRC section 409A has severe consequences. If during the
tax year the plan does not meet IRC section 409A’s
requirements regarding distributions, acceleration of benefits,
and elections, or if the plan is not operated in accordance
with any of these requirements, then the participant will
face two significant tax consequences.
a plan failure results in all compensation deferred for
the current tax year and all preceding tax years being included
in the participant’s gross income. As explained below,
in most cases income deferred before 2005 will not be subject
to these new rules. The deferred compensation will not be
included in gross income if it has previously been included
in gross income, or if it is subject to a substantial risk
of forfeiture. Only participants related to the plan failure
will have the gross income inclusion [IRC section 409A(a)(1)(A)].
“Substantial risk of forfeiture” is defined
in the same manner as in IRC section 83 and means that the
individual’s rights to the deferred compensation are
contingent on the future performance of substantial services
by the individual [IRC section 409A(a)(d)(4)]. Participants
cannot, however, use substantial risks of forfeiture to
manipulate the timing of the recognition of the income [Proposed
second consequence of a plan failure is that participants
are subject to interest and penalties on previously deferred
compensation. The penalty is equal to 20% of the compensation
taxed under IRC section 409A [see IRC section 409A(a)(1)(B)(i)].
The interest rate is the “underpayment rate”
plus one percentage point. Interest is computed on the underpayment
that would have occurred if one assumed that the deferred
compensation was taxable in the later of the taxable year
it was first deferred or the taxable year in which the deferred
compensation was not subject to a substantial risk of forfeiture
[IRC section 409A(a)(1)(B)(ii)]. While the AJCA does not
specifically define “underpayment rate,” IRC
section 6621(a)(2) defines it as the federal short-term
rate plus three percentage points. Therefore, the interest
rate for IRC section 409A purposes is the federal short-term
rate plus four percentage points.
Rebecca has been employed at NIU Corporation for the
last 10 years and has cumulative NQDC through 2004 of $100,000.
In 2006 she defers an additional $8,000 as part of her NQDC
plan. For 2006, the plan does not meet the requirements
of IRC section 409A because these amounts are not subject
to a substantial risk of forfeiture. In 2006, Rebecca must
recognize gross income of $8,000 for the deferred compensation.
She must also pay a penalty of $1,600 ($8,000 x 20%).
date. IRC section 409A applies to amounts
deferred after December 31, 2004. Proposed Regulation 1.409A-6(a)(2)
holds that the deferral is assumed to occur before 2005
if the amount is earned and vested before January 1, 2005.
IRC section 409A does not apply to earnings on amounts deferred
before 2005. For pre-2005 initial deferrals, pre-AJCA law
will also apply to later additional deferrals of these amounts.
This grandfather exception is a major benefit under the
new rules. One major exception to this grandfather rule
occurs if a material modification is made to an NQDC plan
after October 3, 2004. The addition of any benefit, right,
or feature will be considered a material modification. For
example, modifying a plan after October 3, 2004, in order
to accelerate compensation would be a material modification,
and thus IRC section 409A would also apply to pre-2005 deferrals.
The same penalties and interest described would apply to
the deferred income. The exercise of an existing benefit,
right, or feature, or the reduction of these items, will
not be considered a material modification. Under Proposed
Regulation 1.409A-6(a)(4), amendments such as changing the
plan administrator would not be a material modification
adopted before December 31, 2005, will not be treated as
violating the rules with respect to distributions, accelerations
of benefits, and elections if the plan was operated in good-faith
compliance and the plan was amended on or before December
31, 2005, to conform to the provisions of IRC section 409A
(Notice 2005-1, Q-19). Additionally, Notice 2005-1 (Q-20)
provides that a plan could have been amended before December
31, 2005, to allow a participant to terminate participation
in a plan or to cancel a previous deferral election without
triggering the section 409A penalties. For this amendment
to be valid it must have been enacted before December 31,
2005, and the amount subject to the termination must have
been included in the participant’s income in 2005
(unless earned and vested in a later year).
unaffected by IRC section 409A. IRC section
409A(c) specifically provides that if income would be recognized
earlier under another section of the Internal Revenue Code,
then section 409A will not delay the recognition. Income
will never be taxed twice as a result of section 409A. Similarly,
the House/Senate Conference Agreement on the AJCA explained
that section 409A will not affect the timing of an employer’s
deduction for compensation that is part of a nonqualified
plan. Therefore, IRC section 404(a)(5), which provides that
the general deduction rule, that a deduction is permitted
in the tax year in which the participant recognizes income,
continues to apply.
Chen defers $20,000 of income earned in 2006 to future tax
years. Due to plan defects, however, the $20,000 is taxed
to Chen in 2006 under section 409A. Chen’s employer
should receive a deduction for $20,000 in 2006, regardless
of whether the compensation is actually paid in 2006.
trusts. A common deferral technique is for
the employer to set funds aside in a rabbi trust under the
terms stipulated in Revenue Procedure 92-65 (1992-2 CB 428).
A rabbi trust prevents the employer’s access to the
funds, but constructive receipt is avoided to the employee
because the funds are subject to the claims of general creditors
and are therefore at risk. In recent years, rabbi trusts
have been created in foreign countries that make it more
difficult, and at times impossible, for general creditors
to access the funds. The AJCA provides that funds deferred
after 2004 and placed into a trust will be treated as property
transferred to the employee under IRC section 83 if the
assets or trust are located outside the United States [see
IRC section 409A(b)(1)]. This same rule applies to future
increases in value of these funds or earnings from these
funds. If the funds are initially located in the United
States and later transferred offshore, then this provision
will apply at the time of the later transfer. Importantly,
however, this rule will not apply if substantially all of
the services to which the deferred compensation is related
are performed in the foreign jurisdiction where the assets
or trust is located.
assets that have been set aside in an offshore rabbi trust
before March 22, 2006, IRC section 409A will not apply as
long as the NQDC plan is brought into conformity with section
409A(b) before January 1, 2008 (see Notice 2006-33; 2006-15
trusts. Another common NQDC planning technique
has been to provide that if a change occurs in the employer’s
financial health, an automatic trigger provision will transfer
assets to a rabbi trust. These arrangements are commonly
known as “springing trusts” because they spring
into effect when a certain condition is satisfied. Springing
trusts have caused concern because they are perceived to
bail out funds for key executives just as their company’s
health is declining. The AJCA provides that a transfer of
property will be deemed to have occurred for IRC section
83 purposes at the earlier of the date on which the plan
provides that a springing trust will be created, if certain
conditions exist, or the date that the assets are actually
transferred to the springing trust [IRC section 409A(b)(2)].
As with offshore trusts, this provision applies even if
the funds set aside are subject to the claims of creditors.
This same rule applies to future increases in the value
of these funds or earnings from these funds.
assets that have been set aside or transferred with regard
to a financial health trigger before March 22, 2006, IRC
section 409A will not apply as long as the NQDC plan is
brought into conformity with section 409A(b) before January
1, 2008 (Notice 2006-33; 2006-15 IRB 754).
section 409A provides significant restrictions on distributions
from NQDC plans. Recent corporate failures have highlighted
concerns that financially troubled companies may try to
bail out funds for key executives, so these new rules limit
the discretion that companies and plan administrators have
to time distributions. Additionally, these rules prevent
executives from taking advantage of “haircut provisions.”
These formerly common provisions allow an employee to withdraw
funds from the plan at any time as long as a fraction of
the funds remain in the plan. While the early withdrawal
was subject to a penalty, this provided executives with
the confidence of knowing that they had access to the funds.
Under IRC section 409A(a)(2)(A), distributions may not be
made earlier than one of the following events:
A time specified under the plan;
Separation from service;
A change in ownership or control;
Occurrence of an unforeseeable emergency;
Death of the employee.
time. In the past, many participants have
enjoyed flexible timing of the receipt of deferred amounts.
Under the AJCA, at the time of deferral the plan must specify
a time for future distributions, or provide a fixed schedule.
The Conference Report indicates that specifying an event,
such as when a child begins college, will not satisfy this
requirement. Requiring payments within 30 days of separation
from service is permissible, however. A participant could
also elect to receive a lump-sum distribution if disabled.
from service. Distributions cannot be made
before the employee separates from service. IRC section
409A(d)(6) sets forth employer aggregation rules. For example,
if an individual left Company A to become an employee at
Company B, and Companies A and B were members of the same
controlled group, this event would not qualify as separation
from service. This can lead to harsh consequences for employees
who are transferred within related corporations. Several
commentators have recommended revising this provision in
the final regulations to prevent section 409A from applying
to these types of transfers.
more restrictive rules [IRC section 409A(a)(2)(B(i)] apply
to “key employees,” distributions to whom cannot
be made before the earlier of six months after the separation
from service or the date of the employee’s death.
Key employees are employees of a publicly traded corporation
who meet one of the following criteria:
Officers having annual compensation greater than $135,000
(adjusted for inflation);
5% owners; or
1% owners with annual compensation greater than $150,000
[IRC section 416(i)] (not adjusted for inflation).
the Proposed Regulations, separation payments may be treated
as deferred compensation. Such payments will be excluded
from section 409A if they are due to an involuntary separation
from service, are related to participation in a “window
program,” or are reimbursement for items such as outplacement
services or moving expenses. A window program is one in
which the service recipient makes payments during a period
of time no greater than one year to service providers that
terminate their services. Payments for involuntary separation
or a window program cannot exceed two times the lesser of
the service provider’s annual compensation or net
earnings from self-employment for services provided to the
service recipient for the calendar year preceding the year
of termination, or the maximum amount ($220,000 for 2006)
that may be taken into account under a qualified plan per
IRC section 401(a)(17) [see Proposed Regulation 1.409A-1(b)(9)].
However, the Proposed Regulations as currently drafted do
not provide an exception for separation payments made in
the event of a voluntary resignation.
in ownership or control. A qualifying event
can involve a change in control or effective control based
on stock ownership or a change in the ownership of a substantial
portion of the corporation’s assets [IRC section 409A(a)(2)(A)(v)].
Proposed Regulation 1.409A-3(g)(5) provides guidance for
emergency. NQDC plans have routinely allowed
distributions for unforeseeable emergencies; the AJCA provides
more-stringent requirements. Under IRC section 409A(a)(2)(B)(ii)(I),
the term “unforeseeable emergency” means a severe
financial hardship that results from:
An illness or accident of the participant, the participant’s
spouse, or the participant’s dependent;
of the participant’s property due to a casualty;
Similar events that are extraordinary and unforeseeable,
and beyond the participant’s control.
an event qualifies as an unforeseeable emergency, the maximum
qualified distribution will be an amount necessary to satisfy
the emergency plus the taxes due on the distribution. Determining
this amount will require judgment, because one must consider
potential insurance, other reimbursements, and whether the
participant could liquidate other assets to meet the emergency
[IRC section 409A(a)(2)(B) (ii)(II)]. It appears that this
term will be interpreted in a manner similar to that used
for IRC section 457, which provides rules for deferred-compensation
plans of state and local governments and tax-exempt organizations.
(See Revenue Procedure 92-65, 1992-2 CB 428.)
A disabled participant is one who cannot engage in any substantial
gainful activity because of a physical or mental condition
that is expected to result in death or to last for at least
12 months, or who because of such a condition is receiving
income-replacement benefits for a period of at least three
months under an accident-and-health plan provided by the
employer [IRC section 409A(a)(2)(C)].
of benefits. Another major restriction of
IRC section 409A substantially restricts the acceleration
of plan benefits, limiting planning opportunities that had
been commonly used. Under the distribution rules, plans
must specify at the time of deferral the timing of future
distributions, or provide a fixed schedule for distributions.
To satisfy section 409A, an NQDC plan cannot permit the
acceleration of the time or schedule of any payment under
the plan, except as provided by IRS guidance [IRC section
Conference Agreement provides examples of changes that will
not be considered an acceleration of benefits. The choice
between cash and taxable property at the time of distribution
is permitted. Acceleration is permitted for certain distributions
necessitated by events beyond the participant’s control
if the distribution is not elective, including the following
kinds of payments:
To fulfill a domestic relations order;
To comply with a certificate of divestiture;
To pay taxes due to the vesting of an IRC section 457
payment that terminates the service provider’s interest
in the arrangement, if less than $10,000;
To pay employment taxes on deferred compensation;
arrangement that fails to meet the requirements of IRC
section 409A; and
to an unforeseeable emergency or hardship distribution
[Proposed Regulation 1.409A-3(h)(2)].
deferral election. Before the AJCA, the law
regarding deferral elections was uncertain because of differences
in IRS rulings and judicial decisions. IRC section 409A
removes this uncertainty by requiring that a plan specify
that the participant’s irrevocable election be made
no later than the close of the previous tax year, unless
an exception is provided by IRS regulations [IRC section
rules apply for the first year in which a participant becomes
eligible to participate in an NQDC plan. This could occur
because the plan is new or because of the timing of when
an employee first meets the participation requirements for
an existing plan. The election must be made within 30 days
after the date the participant becomes eligible [IRC section
409(a)(4)(B)(ii)]. This provision is consistent with IRS
policy pre-AJCA law. An election to defer income can include
choices impacting the time or the form of payment, but does
not include the payment medium (i.e., cash or property)
[Proposed Regulation 1.409A-2(a)(1)].
plans may measure employee performance over an extended
period of time. Thus, an employee may not have an opportunity
to elect to defer compensation before the current tax year
begins. If the performance plan measures performance over
a period of at least 12 months, the initial deferral election
must be made no later than six months before the end of
the performance period. To be “performance-based compensation”
the amount of compensation must not be readily ascertainable
at the time of the election and the compensation must be
contingent on preestablished criteria. Such criteria must
be determined no later than 90 days after the service period
begins [Proposed Regulation 1.409A-1(e)].
Before the AJCA, judicial decisions provided participants
with reasonable latitude in making decisions to delay the
time when deferred compensation would be paid (Howard
Veit, 8 TC 809; Howard Veit, PH TCM P 49253;
Oates, 44 AFTR 535). Under IRC section 409A, redeferrals
will be permitted only if the plan requires the following;
The redeferral will not be effective until as least 12
months after the date on which the redeferral is made:
The first payment for which the redeferral applies must
be made for a period of at least five years from the date
on which the payment would have been made without the
redeferral cannot be made less than 12 months before the
date of the first scheduled payment under the initial
election [Proposed Regulation 1.409A-2(b)(1)].
Pam has been employed for ASPD Corporation for 20 years.
She began participating in an NQDC plan in 2006. Distributions
will begin when she reaches age 60 (December 12, 2020) and
retires from ASPD. If Pam wishes to defer these distributions
beyond December 12, 2020, she must make the redeferral election
before December 12, 2019, and payment cannot commence until
after December 12, 2025. If Pam wanted to make a redeferral
for compensation deferred before 2005, pre-AJCA law applies
for those amounts.
of Section 409A on Stock Options
section 409A does not change the current treatment of incentive
stock options, options granted under employee stock-purchase
plans [Proposed Regulation 1.409A-1(b)(5)(i)(A)], or restricted
stock [Proposed Regulation 1.409A-1(b)(6)]. The rules do,
however, affect nonqualified stock options (NSO), which
are currently taxed under IRC section 83. For NSOs to not
be subject to section 409A, three conditions must be met
[Proposed Regulation 1.409A-1(b)(5)(ii)]:
On the grant date the exercise price must not be less
than the fair market value of the underlying stock (i.e.,
the option is not in the money), and the number of shares
subject to the option is fixed on the original grant date;
The only deferral feature is that the option holder has
the right to exercise the option in the future; and
The transfer of the option is subject to IRC section 83.
any of these requirements is not met, then the NSO will
be subject to IRC section 409A. Similar rules apply for
stock appreciation rights [Proposed Regulation 1.409A-1(b)(5)(i)(B)].
AJCA provides that all income that is taxable under IRC
section 409A will be subject to income tax withholding rules
[IRC section 3401(a)]. For 2005, amounts included in income
under section 409A are deemed earned on December 31, 2005,
or earlier, at the taxpayer’s election (Notice 2005-1,
Q-32). Additionally, compensation deferred after 2004 must
be reported on the individual’s W-2 or Form 1099 for
the year deferred, even if it is not taxable for that year.
A. Carnes, PhD, CPA, is the dean of the college of
business at Lipscomb University, Nashville, Tenn.