Act Now to Safely Navigate Nonqualified Deferred Compensation Minefield

Congress has established a minefield for nonqualified deferred compensation plans with the addition of Section 409A of the Internal Revenue Code. With one misstep, all compensation deferred becomes immediately taxable and is subject to an additional 20% income tax. As if that is not bad enough, Section 409A also assesses late payment interest on the taxes that may begin to run from the time the compensation was originally deferred, as if the original deferral of income had been improper.

Action to be Taken Now

Identify ALL "Nonqualified Deferred Compensation Plans", You Have More than you Think. Section 409A defines "nonqualified deferred compensation plan" broadly; so it potentially covers a myriad of agreements, ranging from traditional deferred compensation plans to equity plans to severance and employment agreements. See chart below for more details.

Defer Any Documentation or Administrative Modifications to Deferred Compensation Plans. Section 409A grandfathers vested compensation deferred prior to January 1, 2005 from the provisions of Section 409A, but only if the plan is not "materially modified" after October 3, 2004. Pending IRS guidance, it is advisable not to amend any nonqualified deferred compensation plan or to utilize plan provisions that grant discretion to the plan administrator in ways that may be found later to have materially modified the plan.

Enroll Now for Elective Deferrals of 2005 Compensation and for Bonuses Paid in 2006. Section 409A requires that deferral elections be made prior to the beginning of the taxable year during which the compensation will be earned. For performance based pay, deferral elections must be made no later than 6 months prior to the end of the performance period. Accordingly, deferral elections for regular compensation to be paid during 2005 should be made prior to December 31, 2004. Additionally, unless an employer is sure that 2006 bonus pay related to services performed in 2005 will be "performance" based, it is a good idea to have deferral elections for that bonus pay made prior to December 31, 2004. Individuals becoming newly eligible to participate in the plan have a period of 30 days after becoming eligible to elect to defer compensation.

Communicate New Nonqualified Deferred Compensation Rules to Employees. Because Section 409A will apply to compensation deferred during 2005, it is important to begin communicating with employees eligible to participate in elective deferred compensation plans, if it appears likely that compliance with Section 409A will mandate plan design changes.

Alert Payroll Department or Third Party Administrator to New Payroll Obligations. Amounts deferred under a nonqualified deferred compensation plan must now be reported on a participant’s W-2 (or Form 1099 for non-employees) for the year deferred, even if not yet includible in income. Where Section 409A requires income inclusion, federal income tax withholding will apply.

Consider Whether to Make Grants Under Certain Equity Plans. Consult counsel prior to issuing any new stock appreciation rights, restricted stock units, or discounted stock options.

Learn the Section 409A Basics. The following chart provides a general summary of Section 409A.

 

SECTION 409A AT-A-GLANCE (Please click here to download a PDF of this table)

Topic

Section 409A Provision

Legislative History of Note

Deferrals Covered
  • Amounts deferred after 12/31/04
  • Amounts deferred prior to 12/31/04 if plan under which deferral made materially modified after 10/03/04

Deferrals covered include amounts deferred prior to 12/31/04 that become vested after 12/31/04

Timing of Elective Deferral Elections
  • Must be made before the tax year in which services giving rise to the compensation are performed
  • Must be made at least 6 months before the end of the performance period for performance based compensation (applicable to performance period of at least 12 months)
  • 30 day special enrollment period applies to new participants
 

Allowable Distribution Timing
  • 6 months after separation from service for key employees of publicly traded companies
  • separation from service for non-key employees
  • death
  • disability (as defined in §409A)
  • change in control (to be defined by IRS)
  • specified time or on fixed schedule specified at time compensation deferred
  • unforeseeable financial emergency

  • Key employees include:

    • officers earning more than $130,000, as indexed for inflation (limited to 50 employees)

    • 5% or more owners of company
    • 1% or more owners of company earning more than $150,000

     

  • Amounts payable upon the occurrence of an event (for example when a child enters college) are not permissible.

Provisions Accelerating Distributions

 Prohibited, except in limited circumstances IRS provides in regulations

IRS may issue regulations allowing accelerated distributions for:

  • employment tax withholding
  • distributions of small benefits for administrative convenience
  • distributions pursuant to court approved divorce settlement

Provisions Allowing Subsequent Participant Elections to Delay Payment or Change Payment Form

Participants may make elections changing the timing of distribution or payment form the participant elected at time of deferral if:

  • new election does not become effective for 12 months
  • new election made at least 12 months before original payout date
  • payment deferred for at least 5 years
 

Types of Agreements Covered by §409A

 Common types of agreement that appear covered by §409A:
  • salary and bonus deferrals
  • supplemental executive retirement plans (SERPs)
  • stock appreciation rights and phantom stock
  • discounted stock options
  • certain severance agreements
  • restricted stock units
  • mirror plans
Types of agreements generally excluded from §409A:
  • qualified retirement plans
  • bona fide vacation leave, sick leave, compensatory time, disability pay, death benefits
  • traditional restricted stock that is not deferred after vesting
  • traditional stock options granted at fair market value that do not have any extra deferral features §403(a) annuity plans
  • §403(b) tax-deferred annuities
  • §457(b) tax-exempt and governmental plans
  • §415 governmental excess benefit plans
  • SEPs and SIMPLEs

Types of agreements legislative history provides should not be covered by §409A:

  • stock options granted at fair market value
  • incentive stock options
  • §423 employee stock purchase plans
  • restricted stock grants
  • bonuses paid no more than 2 ½ months after year in which services are performed

Reporting and Withholding

 Must report amounts deferred on participant's W-2 or 1099 for year compensation deferred, even though amount not taxable yet

When deferred amounts taxable, federal income tax withholding applies

 

Funding of Benefits

 Foreign (offshore) trusts are generally prohibited

Company financial health triggers that cause assets to flow into rabbi trusts are generally prohibited

 

Tax/Penalty Provisions

 Violation of §409A results in immediate taxation of vested deferred amounts plus:
  • an additional tax of 20% of taxable amount
  • interest at IRS underpayment rate plus 1% measured from date of deferral, or if later, date of vesting
§409A violated if:
  • plan contains provisions not allowed under §409A, or
  • plan is not operated in accordance with §409A
  

Transitional Rules

 IRS to provide regulations by 12/21/04 to allow:
  • participants to terminate plan participation or to cancel deferral elections for amount to be deferred after 12/31/04
  • plans to be amended to comply with §409A
 

For more information, please contact Nancy Brower at 704.342.5275, Hugh Davis at 919.783.2908 or the Poyner & Spruill LLP lawyer you usually consult. 

This electronic publication is published by Poyner & Spruill LLP to provide general information about significant legal developments. Because the facts in each situation vary, the legal precedents noted herein may not be applicable to individual circumstances.

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