Employee Benefits - Topics of InterestJanuary 4, 2016
Nonqualified Deferred Compensation Arrangements
While many may know about qualified retirement plans, such as a 401(k) plan, and the rules governing such plans, it is likely that most people are not aware of the important tax rules that govern “nonqualified deferred compensation” (“NQDC”).
Broad Scope of NQDC
The first, and perhaps most important, thing to note about NQDC is its broad scope. NQDC covers generally any promise of compensation made in one taxable year for a payment of such compensation in a later taxable year. Thus, NQDC could include compensation in the form of bonuses, elective salary deferral (outside the context of a 401(k) plan), separation or severance pay, nonelective supplemental deferred compensation, stock rights (e.g., stock options; stock appreciation rights), taxable expense reimbursements, equity-based deferred compensation (e.g., restricted stock units), and many other forms of deferred compensation that may not be labeled as “deferred compensation.”
Code Section 409A
Under Section 409A of the Internal Revenue Code, and the IRS tax regulations and other guidance issued thereunder (“Section 409A” or “409A”), rules are prescribed that must be met to avoid violations that can result in the imposition of significant federal tax penalties. The essence of Section 409A is a roadmap of rules that are designed to limit the discretion of employers and employees to change the timing and form of payment of NQDC once the legally binding promise to pay such compensation is made. It is important to note that Section 409A also covers NQDC arrangements between independent contractors (e.g., consultants) and their “service recipients.”
Compliance With 409A
In practice, Section 409A requires that NQDC either (A) satisfy an exception from 409A (e.g., special exceptions from 409A apply to (i) compensation paid within a short period after the employee (or independent contractor) “vests” in the compensation, and (ii) separation pay that is payable only upon an involuntary separation from service, is limited in amount, and is paid within a prescribed time period, or (B) complies with the substantive rules of 409A (which rules require that the compensation be paid only upon certain permitted payment trigger events and that the time and form of payment of such compensation be set forth when the deferred compensation promise is made, subject to limited opportunities thereafter to change the time or form of payment).
409A Noncompliance Penalties
A failure to comply with Section 409A will often result in income inclusion for the employee (or independent contractor) in a taxable year prior to the year the amount is otherwise scheduled to be paid, and the imposition on the employee (or independent contractor) of an additional income tax penalty equal to 20% of the amount included in income, as well as, in some cases, an interest tax penalty equal to the product of the applicable interest rate on underpayments of federal income tax plus one percentage point and the additional income tax that would have been due had the deferred compensation been included in income, as applicable, in an earlier tax year when first vested. Employers (or “service recipients” with respect to independent contractors) may be subject to tax penalties for violations of 409A due to the failure to timely report and, as applicable, withhold and remit taxes with respect to amounts included in income.
Thus, the tax stakes are high for employees (and independent contractors) who are covered by NQDC plans or arrangements that fail to comply with Section 409A. Moreover, given the broad scope of what constitutes NQDC and the need to comply with Section 409A in both form of documentation and in operation, it is strongly recommended that employees (and independent contractors), and employers (and service recipients), take all steps necessary to ensure that their NQDC plans and arrangements comply with, or are otherwise exempt from, the requirements of Section 409A.