Nonqualified Deferred Compensation: You Haven’t Dropped the Ball…Yet
Sit back, relax — at least for a few more months. Around this time last year, new Internal Revenue Code Section 409A was enacted, making several major changes to deferred compensation and employee benefit tax rules. The IRS then issued Notice 2005-1, providing initial guidance with respect to the application of new Section 409A, and requiring sponsors of nonqualified deferred compensation plans (“NQDC plans”) to amend their plans to comply with Section 409A by December 31, 2005.
But breathe a little easier: the IRS is extending many, but not all, of the deadlines for complying with Section 409A. In September 2005, the IRS issued proposed regulations concerning 409A. Because final regulations are not yet in place, the IRS is extending certain aspects of the transition relief provided by Notice 2005-1 through December 31, 2006.
Prompted by corporate scandals at Enron and other companies, the new law imposes certain restrictions and limitations on the design of nonqualified deferred compensation plans. A NQDC plan is any plan or arrangement whereby a “service provider” has the legal right to compensation earned or accrued in one year, but payable in a future year. A “service provider” is normally an employee, but can also be a corporate officer or director, or an independent contractor. NQDC plans subject to the new law include, but are not limited to, the following:
Employment agreements that call for payment for services in a year after such services were performed (i.e., employee election to defer salary to a later date)
- Salary continuation agreements
- Stock appreciation rights
- “Phantom” stock option plans
- Non-qualified stock option plans
- Severance pay arrangements
- 457(f) plans (tax exempt employers)
The new law DOES NOT affect any of the following:
- 401(a) “qualified” plans (pension, profit sharing and 401(k) plans)
- 403(b) tax-deferred annuities (or “TSAs”)
- SIMPLE plans
- SEP plans
- Qualified “incentive” stock options
- 457(b) plans
- ”Welfare benefit” plans, including medical, sick leave and vacation
- Employee stock ownership plans (“ESOPs”)
- Any arrangement where the deferral of income is for less than 2 ½ months
Under Section 409A, NQDC plans must meet new distribution, acceleration of benefits, and election requirements, which are discussed in more detail below. If a plan fails to meet these requirements at any time during the year, then all compensation earned and deferred, for all tax years, must be included in the taxpayer’s income in the tax year of such failure, to the extent the amounts are not subject to a “substantial risk of forfeiture” (as now strictly defined in the Code). Interest at the underpayment rate plus one percentage point and a 20% penalty tax is also applied to the amount required to be included in income.
Restrictions on distributions. Under the new law, a NQDC plan may not permit distributions from the plan earlier than termination of employment, death, disability, a specified time (or pursuant to a fixed schedule), or the occurrence of an unforeseeable emergency.
Acceleration of benefits. Section 409A does not permit a plan to allow for the acceleration of benefits. Certain exceptions have been carved out for divisions resulting from divorce, or for changes in the control of the business.
Requirements relating to the timing of deferral elections. Under the new law, deferral elections generally must be made in the tax year preceding the year in which the services are performed, or within 30 days of becoming eligible for plan participation. If the deferred compensation award is performance-based (e.g., an incentive bonus), the election must be made not later than six months before the end of the performance period.
Delay of distributions or changes to form of distribution. Under Section 409A, any sub-sequent election to defer a distribution generally must be made at least 12 months after the deferral and must defer receipt for at least five years in the future.
Trigger upon financial health. Section 409A does not permit a plan to provide that deterioration in the financial status of the employer will trigger payment of the deferred compensation. Also, rabbi trusts that are convertible into secular trusts (protecting the assets from general creditors) are prohibited.
Now that the IRS has extended some of the deadlines for amending plan documents to comply with Section 409A, plans adopted prior to December 31, 2006, have until December 31, 2006 to conform to the new law. The IRS also extended the good-faith compliance period by one year. Thus, plans adopted on or before December 31, 2006, will not violate the distribution, acceleration of benefit, and election requirements if operated through December 31, 2006, in good-faith compliance with Section 409A, and any related guidance published and effective before January 1, 2007.
WARNING: the following transition rules under Notice 2005-1 were not extended:
- Taxpayers who wish to use the plan termination relief under Notice 2005-1 must meet the December 31, 2005 deadline in order to terminate the plan and distribute the deferred compensation without penalty.
- The December 31, 2005 deadline for terminating participation in a plan or canceling outstanding deferral elections has not been extended.
- Taxpayers wanting to take advantage of the March 15, 2005 deadline for making initial deferral elections must amend their plans by December 31, 2005.
If you would like more details about these or any other aspects of the new law or assistance in identifying or analyzing your NQDC plan, or if you simply have questions, please contact Randy Cook in our office.