It’s April and your CPA just told you the check you need to send the IRS on the 15th exceeds your take-home pay for last year by more than $50,000.  Is this a ridiculous scenario?  Perhaps not.

An employee who is entitled to receive deferred compensation from his employer could find himself in this unenviable position.  He might be wise to raise the question of whether his deferred compensation arrangement complies with the requirements of Section 409A of the Internal Revenue Code.  If 409A problems are caught now, he might avoid such a call from his accountant.

Section 409A provides rules for nonqualified deferred compensation plans.  If a plan fails to comply with these rules, persons covered by the plan will be taxed upon their benefits when those benefits become vested, which may occur long before the benefits are actually paid.  If the benefits are taxable because of a failure to satisfy the requirements, they would also be subject to an additional 20% penalty tax, and possibly substantial interest charges.  The rules apply generally to compensation deferred after 2004 (or which first became or becomes vested after 2004) and earnings on that compensation.

The rules relate primarily to the timing of elections to defer compensation and the times at which benefits may be distributed.  Among other limitations, Section 409A severely restricts in-service distribution of benefits and generally prohibits the acceleration of benefit payments.  An in-service distribution will, however, be permitted with respect to deferred compensation if the distribution is made at a specified time (or pursuant to a fixed schedule) specified under the applicable plan at the date the compensation is deferred.  Once the deferral has occurred, little flexibility on the timing of payments will be available to the employer (or other recipient of services) or the employee (or other provider of services).

Despite considerable publicity regarding Section 409A, we find that many employers still have not made their plans 409A-compliant.  We continue to see such problems as the following:

  • Plan provisions permitting benefits to be paid upon termination from employment, rather than separation from service (which is the permitted payment event under Section 409A and which may not occur upon termination of employment)
  • The use of disability definitions that do not comply with the disability definition in Section 409A
  • Defining change in control in a manner not permitted by Section 409A
  • Failure to properly specify the date on which benefit payments will be made once a triggering event (such as death, separation from service, disability or a change in control) has occurred

Notwithstanding the fact that an employer might have failed to take advantage of a now-expired IRS grace period to amend its plan, it may still be able to correct certain deficiencies in its plan document.  We suggest that such an employer take a hard look at its deferred compensation arrangements and make appropriate corrections in order to protect its employees from the draconian tax consequences prescribed in Section 409A.

Deferred compensation may be payable under a variety of different types of plans and other arrangements, and may arise under agreements having a myriad of different names.  Among the types of arrangements which should be looked at are the following:

  • Nonqualified retirement or deferred compensation plans, including those referred to as supplemental executive retirement plans or top hat plans
  • Employment agreements
  • Severance plans
  • Settlement agreements with terminated employees
  • Bonus arrangements under which bonuses are paid more than 2 ½ months after the taxable year for which the bonuses are payable
  • Stock option plans
  • Stock appreciation right plans
  • 457(f) plans
  • Phantom stock plans
  • Consulting agreements

We generally think of deferred compensation plans in the employer/employee context.  Note, however, that deferred compensation plans subject to Section 409A may arise in a number of other relationships, such as (a) a partnership and its partners, (b) the recipient of services and an independent contractor providing the services, and (c) a corporation and its directors.

Article brought to you by:
Alton L. Knighton Jr.
Principal
Tax Practice Group

Neil V. Birkhoff
Principal
Chair, Tax Practice Group