3540 / What are the tax benefits for a participant of an unfunded deferred compensation agreement with an employer?

Section 409A also creates an entirely new and greatly expanded group of compensation plan types that may be covered by Section 409A under the law’s broad definition of a “nonqualified deferred compensation plan” (see the nine plan types that follow). This definition constitutes an expansion beyond what historically was considered a deferred compensation plan and now pulls in almost all executive compensation plans and some employee benefit plans.

Under Section 409A, a nonqualified deferred compensation plan is one involving a deferral of compensation that is legally binding in the present tax year and not payable until a future tax year (beyond the current tax year plus 2½ months), and is not specifically statutorily exempted or excepted by regulation.

As noted, under the current Section 409A regulations, there are nine types or categories of nonqualified deferred compensation plans, per the so-called “aggregation rule,” as follows:

(1)   Employee account balance plans (voluntary salary, bonus, commission deferral plans)

(2)   Employer account balance plans (defined contribution, “phantom stock” plans)

(3)   Employer nonaccount balance plans (defined benefit plans)

(4)   Split dollar life insurance plans (except for the two limited formats detailed in Revenue Ruling 2008-36)

(5)   Stock equity plans

(6)   Severance/separation plans

(7)   Reimbursement or fringe benefit plans

(8)   Foreign plans

(9)   Other miscellaneous plans

This list is duplicated for directors participating in covered plans.

Under a typical “pension” type deferred compensation agreement (primarily employee and employer account balance plans and employer nonaccount balance plans using 409A language), an employer promises to pay an employee fixed or variable amounts for life or for a guaranteed number of years or to pay out an account containing pre-tax contributions plus credited gains and losses. The employer can make this promise to an employee without creating current taxation, subject to compliance with IRC Section 409A, when applicable.

When the deferred amount is received, the employee may be in a lower income tax bracket, but at least has another future income source ( Q 3574). Additionally, many employers use the employer-paid types (account or nonaccount balance) of plans to provide benefits in excess of the limitations placed on qualified plan benefits. For example, a Supplemental Executive Retirement Plan (“SERP”), in either an account balance or nonaccount balance design, for a selected group of executives generally provides extra retirement benefits. An “excess benefit plan” is a special kind of supplemental plan that addresses only the benefits lost under qualified plan limits and caps ( Q 3608).

Nonqualified deferred compensation plans have been divided into two broad categories: (1) voluntary employee deferred compensation plans and (2) employer-paid supplemental plans. Both unfunded deferred compensation plans (governed by IRC Sections 61 and 451) and funded deferred compensation plans (governed by IRC Section 83) may be divided into these categories ( Q 3532). Under prior law, taxation of these two plan categories was the same based on whether the plan was an unfunded plan (one that was merely an “unsecured promise-to-pay”) or a funded plan (one that involved the “transfer of property”).

The enactment of Section 409A, however, has added a new additional categorization: whether the plan (unfunded or unfunded) is covered or excepted from coverage from the additional Section 409A requirements. That is because Section 409A is additive tax law and only changes prior income tax law applicable to nonqualified deferred compensation to the extent specifically indicated. The term “nonqualified deferred compensation plans” should be understood to refer to both voluntary employee deferred compensation plans and employer-paid supplemental plans that are covered by Section 409A requirements, as well as all the other plan types now covered by Section 409A, unless exempted or excepted.

A “voluntary employee deferred compensation plan” involves an agreement between the employer and employee, whereby the employee defers receipt of some portion of present compensation (or a raise or bonus, or a portion thereof) in exchange for the employer’s promise to pay a deferred benefit in the future. This has been referred to as an “in lieu of” plan. As noted, under Section 409A, these plans are employee account balance plans.

An “employer-paid supplemental plan” is a compensation benefit provided by the employer to an employee in the future in addition to all other forms of compensation; the employer promises to pay a deferred benefit, but there is no corresponding reduction in the employee’s present compensation, raise, or bonus. Under Section 409A, these plans are employer account balance or nonaccount balance plans. If they are designed with a Section 409A substantial risk of forfeiture, and are paid in lump sum in the year the risk of forfeiture lapses or within 2½ months afterwards, a supplemental plan might be designed to be excepted under the Section 409A “short-term deferral exception.”