Defer with Caution
New Rules Create Hazards for Nonqualified Deferred Compensation

By Gregory A. Carnes

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• 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.

NQDC 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 creditors.

Over 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.

The 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.

NQDC Law Before the AJCA

Several 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).

The 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.

IRC 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.

Nonqualified Deferred-Compensation Plans

NQDCs 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
• Simple retirement accounts (such as SIMPLE IRAs).

Compensation 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).

Compensation 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)].

Section 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)].

Example. 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 plan.

Payments 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)].

A substantial 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 stock.

Example. 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.

New Statutory Requirements

As 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 apply.

Consequences 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.

First, 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 Regulation 1.409A-1(d)(1)].

The 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.

Example. 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%).

Effective 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 either.

A plan 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).

Items 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.

Example. 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.

Offshore 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.

For 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 IRB 754).

Springing 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.

For 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).

Distribution Rules

IRC 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;
• Disability; or
• Death of the employee.

Specified 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.

Separation 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.

Even 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).

Under 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.

Changes 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 these events.

Unforeseeable 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;
• Loss of the participant’s property due to a casualty; or
• Similar events that are extraordinary and unforeseeable, and beyond the participant’s control.

If 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.)

Disabled. 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)].

Acceleration 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 409A(a)(3)].

The 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 plan;
• A payment that terminates the service provider’s interest in the arrangement, if less than $10,000;
• To pay employment taxes on deferred compensation;
• An arrangement that fails to meet the requirements of IRC section 409A; and
• Due to an unforeseeable emergency or hardship distribution [Proposed Regulation 1.409A-3(h)(2)].

Initial 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 409(a)(4)(B)(i)]. Special 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)].

Performance 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)].

Redeferrals. 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; and
• 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)].

Example. 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.

Impact of Section 409A on Stock Options

IRC 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.

If 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)].

Reporting and Withholding

The 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.