New Rules for Deferred Compensation

Simply put, deferred compensation is a promise to pay compensation in the future.  These new rules applied to nonqualified plans.

Common types of arrangements covered by §409A:

  • SERPs (supplemental executive retirement plans, or “top hat” plans)
  • §457(f) ineligible plans of governmental and tax-exempt employers
  • Discounted stock options and stock appreciation rights (SARs)
  • Severance pay plans
  • Elective salary and bonus deferral plans

Types of arrangement not covered:

These rules do not apply to qualified plans, such as profit sharing or §401(k) plans.  They also do not apply §403(b), SEP, SIMPLE, incentive stock option or §457(b) eligible plans of governmental units and tax-exempt organizations.  The proposed regulations also provide an exception for short-term deferrals.  Compensation will qualify for this exception if paid within 2 1/2 months after the year it vests to the employee.

The new rules:

The new rules are complicated and the proposed regulations are 238 pages long. This discussion is a condensed summary of the major items. Plans must be in writing by December 31, 2006.  If an existing plan does not conform to these rules, it must be amended by December 31, 2006. The material terms of the plan must include the amount deferred or some formula to get to this amount, the time the compensation will be paid, and the manner of payment, such as lump sum or installments.

The employee must make an irrevocable election to defer an amount of compensation no later than the close of the preceding tax year.  If the deferral relates to performance-based compensation, such as an increase in the company stock value, the election can occur up to six months before the end of the service period. At the time of election the employee must indicate the time and form of payment.

The new rules make it difficult to change existing elections. The time of payment may be delayed only if the following are met:

  • The election does not take place for at least 12 months.
  • If the election related to a payment at a specified time following separation from service or change in control, the first payment must be delayed at least five years.

The §409A prohibits acceleration of time except in circumstances allowed by the regulations. Before the new rules some plans had a “haircut” provision which allowed participants to accelerate payments if they reduced payments by an amount, such as 10 percent. The “haircut” provisions are no longer allowed. Early payment is allowed in the event of separation from service, death, disability, change in control of the company, or unforeseeable emergency. The change in control provisions are very specific and are not allowed for small changes.  The unforeseeable emergency provisions do not allow payment if the amount can be relieved through items such as insurance or liquidation of the participant’s assets.  Since NQDC plans are usually provided for higher paid individuals, most of them probably won’t qualify for the hardship provisions.

Amounts deferred prior to January 1, 2005 can be grandfathered unless the plan is materially modified after October 3, 2004.  Grandfathered amounts equal the earned and vested balance as of December 31, 2004.  Earnings on such amounts are also grandfathered.  An amount is earned and vested if it is not subject to a substantial risk or forfeiture or a requirement to perform future services.  A plan is materially modified if a benefit or right is enhanced or if a new benefit is added.

While I refer to “employee” or “participant” in this article, there are circumstances when these rules can apply to independent contractors, directors and partners in partnerships.

The rules are spelled out for reporting these amounts. New box 12 codes on Form W-2 have been implemented for deferrals, current year earnings, and current year taxable amounts.  Similar codes appear on the 1099-MISC for independent contractors.

At a recent seminar, a national presenter indicated that the IRS has been waiting a long time for these tools, and they are training their agents to investigate this area. He felt that they would aggressively pursue these plans, even for deferrals for the 2005 year. Employers need to examine all existing plans to see if they are subject to these new rules. There will be a lot of plans that need to be written or amended to comply.

Linda is a Principal in the Tax Department at Maner, Costerisan & Ellis, P.C.








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