Funded Deferred Compensation

March 13, 2024

3543 / What requirements are there for a private nonqualified deferred compensation plan under IRC Section 409A?

<div class="Section1">Congress imposed additional documentary and operational requirements in IRC Section 409A to avoid a current constructive receipt on a “nonqualified deferred compensation plan” at inception and during the life of a covered plan. Many of these new requirements actually are those that the IRS formerly required to receive a favorable private letter ruling on income tax deferral under a plan and so are not new.<div class="Section1"> Section 409A imposes requirements on plans in four primary areas: <ol> <li>Minimum plan documentation</li> <li>Permissible Distributions</li> <li>Elections to defer</li> <li>Prohibited Accelerations</li> </ol> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3544">3544</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3547">3547</a> for a detailed discussion of each of these requirements. <hr> Planning Point: Planners should assume that any compensation plan is covered by Section 409A and plan to comply with the form and operational requirements until and unless they have satisfied themselves that the plan (which may be for only a single person) is either 1.) specifically statutorily exempted – such as a 457(b) plan – or 2.) meets (or can be designed to claim) a regulatory exception – such as the short term deferral exception. <hr> </div></div>

March 13, 2024

3555 / What rules apply to correction of errors in nonqualified deferred compensation plans excepted from Section 409A?

<div class="Section1">The IRS procedures for the voluntary correction of errors in qualified pension plans (e.g., VCP) do not apply to the correction of errors in nonqualified deferred compensation plans. Moreover, the correction of errors in connection with nonqualified deferred compensation plans was not the subject of much discussion prior to the enactment of Section 409A. However, there were legal theories for the correction of both documentation and operational administrative errors in connection with nonqualified deferred compensation plans that existed prior to Section 409A ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3553">3553</a>).<div class="Section1"> Most documentary errors, in general, were corrected under various legal theories for the reformation of contracts (such as correction of “scrivener errors”) because nonqualified deferred compensation plans are contracts. Likewise, longstanding tax bookkeeping theories and principles were applied to correct operation plan administration errors, such as the correction of incorrectly calculated participant phantom account balances ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3553">3553</a>). Where plans can claim a regulatory exception from Section 409A coverage or are grandfathered from Section 409A coverage, these pre-409A legal theories remain the appropriate methods for correcting both documentary and operational plan administration errors. Some commentators believe these pre-409A legal theories still can be used to correct errors as to 409A-covered plans not covered by Notices 2008-113 and 2010-6 (as modified by Notice 2010-80), and even as to errors specifically covered by these notices. The fact that Section 409A is additive law would seem to support this position. However, the IRS takes a strict view as to the correction of errors in 409A covered plans and is unlikely to agree with corrections made outside the notices at this stage, except as to grandfathered and 409A-excepted plans, and plans that fall under the short term deferral exception ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3548">3548</a>). </div></div>

March 13, 2024

3547 / When do prohibited (and permissible) acceleration of payment requirements apply to private nonqualified deferred compensation plans under IRC Section 409A?

<div class="Section1"> Accelerations of plan distributions outside the six primary permissible listed distributions are prohibited. Final regulations, however, define specified circumstances under which a plan may permit the acceleration of plan payments and, in effect, widen permissible plan distributions, as follows: (1) To comply with a domestic relations order (a DRO, not a QDRO since there are no “plan assets” in a promise-to-pay nonqualified deferred compensation plan to levy against). (2) To comply with a conflict-of-interest divestiture requirement, including foreign conflict of interest per 2016 409A clarifications.<a href="#_ftn1" name="_ftnref1">1</a> (3) To pay income taxes due on a vesting event under a plan subject to IRC Section 457(f). (4) To pay FICA or other employment taxes imposed on compensation deferred under the plan. (5) To pay any amount included in income under IRC Section 409A. (6) To pay only the proper amount due, based on a valid unforeseeable emergency request. (7) To terminate a participant’s entire interest in a plan: a. after a separation from service where the payment is not greater than the IRC Section 402(g)(1)(B) so-called “small amounts” ($23,500 in 2025, $23,000 in 2024, $22,500 in 2023, $20,500 in 2022, $19,500 in 2020 and 2021, and $19,000 in 2019); or b. in the calendar month prior to, or 12 months following, a Section 409A change in control event date. (8) To terminate the plan entirely at the employer’s discretion (and distribute) so long as: a. all the plans of the same Section 409A type are terminated; b. all plan termination distributions will be made no earlier than 12 months, but not later than 24 months, following the date of termination; and c. no new plan of the same Section 409A type is established for at least three years following the termination (or a retroactive violation occurs). (9) To terminate a plan pursuant to an IRC Section 331 corporate dissolution with the approval of a bankruptcy court judge.<a href="#_ftn2" name="_ftnref2">2</a> The IRS has informally advised<a href="#_ftn3" name="_ftnref3">3</a> that a “salary advance” plan that allows an employer to offset any unpaid compensation advances against an employee’s balance under a Section 409A nonqualified deferred compensation plan violates the Section 409A prohibition against acceleration of payments, and requires the amendment of the salary advance plan to prevent a violation of Section 409A for the deferred compensation plan (the terms of the two plans would be combined to determine a Section 409A violation). Offsets and substitutions of plans to achieve an earlier distribution of compensation deferred under Section 409A generally are prohibited, except for a narrow exception that allows “debt incurred in the normal course of the service relationship” to be offset in the year debt is due up to $5,000.”<a href="#_ftn4" name="_ftnref4">4</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 1043. <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.409A-3(j); Prop. Treas. Reg. REG 123854-12, June 22, 2016. <a href="#_ftnref3" name="_ftn3">3</a>. CCA 200935029, Released 8-28-2009. <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.409A-3(j)(4)(D)(xiii). </div>

March 13, 2024

3549 / What penalties can be imposed under Section 409A?

<div class="Section1">IRC Section 409A imposes substantial penalties for failing to meet either the Section 409A form (documentation) or operational (administration) requirements at inception and during the life of a covered plan. One of the peculiarities of Section 409A is that the tax falls on the participant and not the employer.<a href="#_ftn1" name="_ftnref1">1</a> In the worst-case situation, any violation of the Section 409A documentary or operational requirements results in retroactive constructive receipt, with the vested portion of the deferred compensation being taxable to the participant back to the date of the violation, which might be the date of the intended deferral.<a href="#_ftn2" name="_ftnref2">2</a></div> <div class="Section1"> However, in June 2016, the IRS released technical proposed amendments<a href="#_ftn3" name="_ftnref3">3</a> to the inclusion regulations that limit the ability of plan sponsors to use the existing exclusion of nonvested amounts from taxation to make changes in the time and form of payment in a plan document without engaging the subsequent election five-year setback. Under the proposed amendment, the nonvested amounts of a benefit cannot be excluded from the calculation of the tax in the event of a violation unless the following conditions are met: 1) the plan provisions must be noncompliant prior to the correction of the document, meaning the amendments to the document must not create the noncompliance; 2) there must be no prior history of the employer making and correcting such intentional failures; 3) there must be a consistency in how the employer makes corrections in such cases; and, 4) there must be full conformity and compliance with the IRS guidance on such plan corrections (i.e., Notice 2010-6).<a href="#_ftn4" name="_ftnref4">4</a> IRS treatment of prior instances of using the pre-June 22 exclusion of nonvested amounts in such intentional violation of 409A instances is uncertain. No specific grandfathering of such instances was provided in the June 2016 proposed amendments. This proposed amendment apparently ends a practice of some sponsors intentionally making changes in time and form of payment (probably at the request of a senior plan participant) on individualized supplemental plans in which the benefits were substantially nonvested until a late distribution date, like retirement. By not applying the subsequent election five-year set-back rule, a sponsor violates Section 409A, but avoids reporting because of the prior exclusion for nonvested benefits. In such cases now, all amounts, whether non-vested or vested, must be included in the calculation of the penalty taxes. In addition, IRS Counsel has taken the position that the correction of a form error prior to the date of vesting, but in the tax year of the vesting date, did not cure the plan sponsor’s failure to correct the error in time. Therefore, the entire amount of the plan benefits must be included in taxable income under Section 409A. The Chief Counsel’s memorandum indicated that 409A and the proposed regulations governing income inclusion require that the form correction should have been made before the end of the tax year prior to the tax year in which vesting occurred for it to have avoided application of the 409A inclusion rules for the error in form.<a href="#_ftn5" name="_ftnref5">5</a> In addition to the normal income tax on the compensation, the participant must pay an additional 20 percent tax, as well as interest at a “premium” penalty rate 1 percent higher than the normal AFR underpayment rate.<a href="#_ftn6" name="_ftnref6">6</a> Fortunately, there are now methods under Notices 2008-113 (in the case of operational errors), Notice 2010-6 (in the case of documentation error), and Notice 2010-80 (updating both prior Notices) for correcting many common documentary and operational errors that may avoid the full impact of taxation under Section 409A. <hr /> Planning Point: With regard to penalties for violations of Section 409A, at least one state – California – currently adds its own 5<a href="#_ftn7" name="_ftnref7">7</a> percent excise state income tax penalty when the federal penalty is imposed for a Section 409A error. Planners should therefore check the relevant applicable state rules at the time any voluntary deferral plan is created, to determine the additional state income tax exposure for likely eligible participants. If the sponsor and its participants are substantially all located (and likely to remain) in a state(s) that also imposes its own penalty excise tax, a discussion of other potential approaches to a 409A nonqualified deferred compensation plan may be in order if the total potential federal and state income tax for an error appears excessive. If the plan desired is an employer-paid SERP, the 409A penalty state income tax possibility may be less of an issue, but still ought to be discussed. <hr /> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. Based upon the logic in Davidson v. Henkel, No. 12-cv-14103, 2015 WL 74257 (E.D. Mich. Jan. 6, 2015), a plan sponsor can be held liable for extra FICA taxes imposed on plan participants because of an employer’s failure to withhold and pay them during their working career, and there might also be exposure to a sponsor for the extra penalty taxes imposed on plan participants because of its failure to document and operate a plan according to the requirements of 409A. There might be a risk even if the sponsor disclaims such liability in the plan documentation. <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 409A(a)(1)(A)(i); Prop. Treas. Reg. § 1.409A-4 as to valuation when worst-case taxation is required. <a href="#_ftnref3" name="_ftn3">3</a>. Per the release, the IRS provided that the proposed regulations can be immediately relied upon by taxpayers. <a href="#_ftnref4" name="_ftn4">4</a>. See generally Prop. Treas. Reg. § 1.409A-4, as amended by REG 148362-05, 73 FR 74380, Para. 6 (June 22, 2016); See also Preamble Section VII to the REG. <a href="#_ftnref5" name="_ftn5">5</a>. CCM 201518013 (May 1, 2015). <a href="#_ftnref6" name="_ftn6">6</a>. IRC § 409A(a)(1)(B); Prop. Treas. Reg. § 1.409A-4 as to valuation when worst-case taxation is required. <a href="#_ftnref7" name="_ftn7">7</a>. This penalty excise tax in California was initially 20 percent but reduced to 5 percent on October 4, 2013. On that date, California signed into law an amendment to the California Revenue and Taxation Code reducing its state excise income tax rate effective for taxable years beginning on or after January 1, 2013. </div>

March 13, 2024

3551 / What factors are important in determining whether a Section 409A substantial risk of forfeiture exists if the individual has significant voting power in the entity paying the nonqualified deferred compensation?

<div class="Section1">Where individuals have significant voting power in the entity paying the nonqualified deferred compensation, the following relevant factors must be considered to determine if there is a 409A SROF:</div> <div class="Section1"> <blockquote>The employee-shareholders’ relationship to the other shareholders and the extent of their control and potential control over the decision, and possible loss of control of the employee; The position of the employee at the employer and the extent to which the employee-shareholder is subordinate to the other employees, especially other employee shareholders; The relationship of the employee to the employer’s officers and directors (i.e., whether they are family); The person or persons who would approve the employee’s discharge; and The past actions of the employer in enforcing any restrictions on employees, especially employee-shareholders.<a href="#_ftn1" name="_ftnref1">1</a></blockquote> Of course, this means that majority or controlling shareholders in for-profit entities may find it difficult, if not impossible, to establish that there is a 409A SROF.<a href="#_ftn2" name="_ftnref2">2</a> The failure to establish a 409A SROF in such situations apparently does not mean that a nonqualified deferred compensation plan cannot be created for such an employee-shareholder, or so it has been thought to date. This is because the 409A SROF definition is used for a special purpose under Section 409A, rather than to establish whether there is current taxation. Except in the case of 457(f) plans, based on its separate definition of substantial risk of forfeiture under the proposed regulations, the 409A definition is used to determine access to the short term deferral exception that allows the plan to entirely avoid compliance with the so-called 409A “detail” requirements. If a plan has no 409A SROF and cannot claim the short term deferral exception under the final 409A regulations, it must comply with all the form and operational requirements of Section 409A. Because Section 409A is additive income tax law, the plan would then also have to comply with the other applicable pre-409A IRC income tax sections (for example, Section 61/451 substantial limitation or risk of forfeiture requirements in the case of an unfunded deferred compensation plan) in order to achieve income tax deferral for the plan. </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. See generally Treas. Reg. § 1.409A-1(d). <a href="#_ftnref2" name="_ftn2">2</a>. It is less clear how these factors would be applied to 457(f) plans for employees in tax-exempt organizations that have no shareholders. </div>

March 13, 2024

3553 / What are the correction procedures under Section 409A?

<div class="Section1">With respect to nonqualified deferred compensation plans, it is important to note that the IRS EPCS and the SCP correction procedures applying to qualified plans<a href="#_ftn1" name="_ftnref1">1</a> do not apply to nonqualified deferred compensation plans, whether subject to Section 409A or not.</div> <div class="Section1"> Fortunately, it is not always necessary to suffer worst case taxation under Section 409A for an unintentional error in either plan documentation or operation. The IRS has released three notices, one that addresses Section 409A documentation errors, Notice 2010-6,<a href="#_ftn2" name="_ftnref2">2</a> one that addresses Section 409A operational administrative errors, Notice 2008-113,<a href="#_ftn3" name="_ftnref3">3</a> and Notice 2010-80 that updates both on certain select issues.<a href="#_ftn4" name="_ftnref4">4</a> All notices require that certain preconditions be met to take advantage of the special correction processes made available. In general, the notice correction procedures allow for corrections based on the timing of the correction of the error, the party involved (whether an “insider” or another employee), and in some cases the magnitude of the error. The general remedy under the notices is to include in an employee’s income only the amount in error, in the case of operational errors, or some specified portion of the amount, such as 50 percent or 25 percent in the case of documentation errors. The 20 percent excise tax and premium penalty tax is often avoided, unless the affected participant is an “insider” (applying SEC Section 16(b) named officer standards, including by analogy those in closely-held companies). Both the employer and the employee have to report the correction of the error on tax returns to the IRS to claim the benefit of these correction procedures, unless the error is caught and corrected in the year of error. In that case, reporting is not required. Some commentators think that it also may be possible to correct some documentary and operational errors in covered plans outside the parameters of these three notices under correction concepts applicable prior to the enactment of Section 409A. However, it should be recognized that the IRS takes a strict constructionist view of errors and error correction under Section 409A, and is unlikely to agree with these alternative procedures, even though 409A is additive law and arguably historic contract and tax bookkeeping correction procedures should remain available. However, plans excepted from 409A coverage and grandfathered portions of plans would remain covered by these pre-409A correction procedures and not the formal correction procedures provided in the notices.<a href="#_ftn5" name="_ftnref5">5</a> Notices 2009-113 and 2010-6 were expanded in late 2010 under Notice 2010-80. Notice 2010-80 modified Notice 2008-113, governing operational errors, to eliminate employer and employee reporting when an operational error correction is made within the same year as the error. It also modified Notice 2010-6, governing documentation errors, to allow correction of severance/separation plans with incorrect release of claims provisions if completed by December 31, 2012, and to allow nonqualified plans “linked” to other nonqualified plans (e.g., excessive benefit plans) and stock plans to use Notice 2010-6 to make corrections for document failures prior to that date. However, this last opportunity to correct the form errors outlined in Notice 2010-80 expired on December 31, 2012. Documentary Error Correction In the case of documentation errors, there are some errors that may be corrected without an amendment or paying any tax or penalties at all. Notice 2010-6 provides an extensive digest of various (but not all possible) documentation errors and the remedies that permit the employee to report less than the amount that would be required in the worst case Section 409A taxation situation and avoid the full Section 409A 20 percent excise and premium interest penalty taxes in many cases. Notice 2010-6 highlights specific documentation errors, with corrective procedures and costs. Because it is focused on language and structures that create errors under Section 409A, it also provides a useful checklist for plan drafting to avoid common Section 409A drafting errors for various types of Section 409A-covered plans. Notice 2010-6 also gives new plans a grace period of 12 months from the effective date to correct errors found in the plan documentation. Operational Error Correction In the case of operational errors, Notice 2008-113 defines operational errors based on Section 409A requirements. It organizes them into useful categories of Section 409A operational violations, such as distributions made before the six month delay period for highly compensated employees. It outlines the Notice 2008-113 special corrective procedure required to correct that category of error without having to incur the worst case tax event. In general, full relief is available when operational errors involving any employee are discovered and corrected in the same tax year, and by the second tax year in the case of employees that are not “insiders,” as defined under Section 16(b) of the federal securities laws notwithstanding whether the employer is a public or private corporation. In other words, the “insider” rule for 409A correction purposes applies to public companies and also to private, closely-held for-profit and tax-exempt organizations by analogy. <hr /> Planning Point: Notice 2010-6 allowed a final opportunity to correct documentation errors in plans not later than December 31, 2010, and to have these corrections apply retroactively back to the January 1, 2009, effective date for actual document compliance. As of January 1, 2011, this opportunity passed, and sponsors now must use Notice 2010-6, as modified by Notice 2010-80 to make formal corrections. In addition, all errors in plans, whether of a documentary or operational nature, usually can be corrected in order to minimize the negative tax impact on an employee if the error is identified and corrected sooner rather than later, especially if caught and corrected in the same tax year. Therefore, plan sponsors should routinely audit their plans in the late fall to discover and correct any operational or documentation errors before the end of the current tax year. They should also build in a review audit in the first year of a plan in order to catch initial plan drafting errors and then correct them during the correction grace period provided for new plans that do not generally constitute an error or require formal correction under Notice 2010-6. <hr /> Planning Point: On May 9, 2014, in a subcommittee meeting at the American Bar Association annual conference, the IRS announced that it was launching a new, limited CIP 409A audit. Although the audit was to impact only 50 public companies also targeted for an audit on employment taxes, the audit was used to sharpen IRS future audit practice on 409A plans for even broader audits that will surely follow.<a href="#_ftn6" name="_ftnref6">6</a> This and prior IRS 409A audit initiatives suggest the wisdom of periodic “self-audits” of both the required documentary and operational compliance. A periodic self-audit makes sense anyway, since the special correction programs, which provide a less than worse-case results under the penalty provisions of 409A, are NOT available for companies once they are in an IRS audit. Moreover, the IRS currently applies a strict application of 409A penalties when they are discovered in audit. Therefore, it is recommended that companies routinely self-audit their 409A plans annually for operational compliance. Documents can be reviewed less frequently, but certainly should be reviewed any time they are amended or restated. However, compliant plan documentation and operation should always be in sync at all times. <hr /> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. See generally Rev. Proc. 2008-50 effective for qualified plan errors after 1-1-2009, as modified and superseded in part by Rev. Proc. 2013-12, Rev. Proc. 2016-51 and Rev. Proc. 2018-52. <a href="#_ftnref2" name="_ftn2">2</a>. Notice 2010-6, 2010-3 IRB, 1-6-2010. <a href="#_ftnref3" name="_ftn3">3</a>. 2008-51, 12-23-2008. <a href="#_ftnref4" name="_ftn4">4</a>. Notice 2010-80, 2010-51 IRB 853. <a href="#_ftnref5" name="_ftn5">5</a>. See, e.g., Olshan, Regina & Schohn, Erica, Expert Q&A on Correcting Section 409A Documentary Violations, Practicallaw.com, October, 2010; Baker, Rosina, 409A Failures: Correcting Outside of the IRS’s Formal Correction Programs, Presentation at DC Bar Luncheon Program, February 25, 2010, available at ipbtax.com; and Barker, Rosina & O’Brien, Kevin, Document Failures in the Section 409A Plan: Correcting With and Without Notice 2010-6, Pension & Benefits Daily, BNA, April 12, 2010. <a href="#_ftnref6" name="_ftn6">6</a>. However, there has been little evidence of any results from any such CIP audit. Even the IRS’s revised “Nonqualified deferred Compensation Audit Techniques Guide,” released on June 9, 2015 has little additional detail on what the Service will look for when it audits plans that might be covered by 409A as versus the information gained from its first set of 409A audits back soon after the final regulations were issued. </div>

March 13, 2024

3557 / What are Section 409A’s effective dates, compliance deadlines and grandfathering rules?

<div class="Section1">The requirements of Section 409A generally apply to amounts deferred (or prior unvested amounts) after December 31, 2004. The requirements also apply to amounts deferred prior to January 1, 2005, if the plan under which the deferral is made is “materially modified” after October 3, 2004. There is an exception for material modifications made pursuant to IRS guidance. The IRS deferred the date to comply in both form and operation with the final regulations under Section 409A until December 31, 2008, and actual compliance began as of January 1, 2009.<a href="#_ftn1" name="_ftnref1">1</a> Prior to January 1, 2009, plans were required to operate in “good faith” compliance with Section 409A documentary and operational requirements.<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> The proposed 409A technical clarification regulations that change the final 409A regulations can be relied upon until the clarifications are made final.<a href="#_ftn3" name="_ftnref3">3</a> The 457/409A integration regulations apply to compensation deferred under a plan for calendar years after the date the rules are published as final. However, they could be relied on immediately.<a href="#_ftn4" name="_ftnref4">4</a> Unfortunately, there is no grandfathering or transition language for plans impacted by any the changes, especially as to ineligible 457(f) plans, for the long period between the final regulations and the 2016 release date of proposed regulations for such plans. It should be noted that, under IRS Notice 2010-6, addressing documentation errors, sponsors were given until not later than December 31, 2010, to make corrections to documents not made compliant by December 31, 2008, and to have these corrections deemed retroactively in compliance as of the January 1, 2009 actual compliance deadline under Section 409A (see prior discussion on correction of documentation and operational plan errors in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3553">3553</a>). This deadline has passed and generally has not been extended except for certain specific corrections outlined in Notice 2010-80 that expired after December 31, 2012. Finally, plans with certain assets in offshore rabbi trusts were given only until December 31, 2007 to disconnect or terminate the trust so as to comply with the 409A(b) funding requirements. Notice 2008-33 provided temporary guidance on complying with these requirements. Currently, no regulations on Section 409A(b) have been released, so further guidance as to the structuring of assets in such rabbi trusts is not yet available. A plan is “materially modified” if a new benefit or right is added or if a benefit or right existing as of October 3, 2004 is materially enhanced and such addition or enhancement affects amounts earned and vested before January 1, 2005. The reduction of an existing benefit is not a material modification.<a href="#_ftn5" name="_ftnref5">5</a> Adding a participant right to a grandfathered plan that it did not possess, even though it was technically permissible under Section 409A, will be considered to be a material modification (for example, an “unforeseeable emergency” distribution right). <hr> Planning Point: Employers should use great care in making any modifications to existing pre-409A deferred compensation arrangements until they are paid out to avoid the application of IRC Section 409A. According to the final regulations, a “material modification” that causes loss of grandfathering may be considered to be a formal plan amendment and may occur simply by virtue of an employer’s exercise of administrative discretion in the plan participant’s favor. Any amendment effected by form or practice that adds a beneficial right to a plan, even if it was allowed prior to the enactment of Section 409A and remained permissible after enactment (for example, a financial hardship provision), can cause loss of grandfather protection. <hr> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   Notice 2007-86, 2007- 46 IRB 990; Notice 2006-79, 2006-43 IRB 763. <a href="#_ftnref2" name="_ftn2">2</a>.   Notice 2005-1. <a href="#_ftnref3" name="_ftn3">3</a>.   Prop. Treas. Regulations, REG 123854-12, June 22, 2016. <a href="#_ftnref4" name="_ftn4">4</a>.   Prop. Treas. Regulations, REG 147196-07, June 21, 2016. <a href="#_ftnref5" name="_ftn5">5</a>.   Treas. Reg. § 1.409A-6(a)(4). </div></div>

March 13, 2024

3559 / What are the deferred compensation rules applicable to foreign nonqualified entities under Section 457A?

<div class="Section1">In the Emergency Economic Stabilization Act of 2008, Congress created new IRC Section 457A to impose immediate taxation on deferred compensation where the employer is a foreign “nonqualified entity” (as defined in the law) that is not subject to U.S. taxation. This section is comparable to Section 409A, which potentially applies to nonqualified deferred compensation paid by any entity, U.S. domestic or foreign. In addition, 457A applies to both cash and accrual method taxpayers while Section 409A applies to just cash method taxpayers.</div> <div class="Section1"> Under IRC Section 457A, all compensation deferred under a nonqualified deferred compensation plan of a nonqualified entity is includable in gross income of a plan participant when there is no longer any Section 457A substantial risk of forfeiture of the rights to such compensation. IRC Section 457A has its own definition of substantial risk of forfeiture that defines a substantial risk of forfeiture as applicable “only if” a person’s rights are conditioned on the future performance of substantial services.<a href="#_ftn1" name="_ftnref1">1</a> This definition is therefore not exactly the same as that in Section 409A but is generally consistent. For instance, Section 409A includes attainment of performance goals in addition to performance of substantial services. However, the 2016 409A technical amendments make it clear that these types of plans may also be covered by both Sections 409A and 457. The 2016 proposed regulations for 457(f) and those for nonelective deferred compensation plans<a href="#_ftn2" name="_ftnref2">2</a> under Section 457(e)(12) do not substitute for or supersede 409A compliance requirements. In such cases, the plan must comply with Section 409A and 457 in addition to Section 457A, if and as necessary, which makes for complex compliance coordination indeed.<a href="#_ftn3" name="_ftnref3">3</a> IRC Section 457A defines a nonqualified entity as (1) any foreign corporation, unless substantially all of its income is “effectively connected with the conduct of a trade or business in the United States” or is “subject to a comprehensive foreign income tax,” or (2) any partnership, unless substantially all of its income is allocated to persons other than “foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax” and “organizations which are exempt from tax under this title.”<a href="#_ftn4" name="_ftnref4">4</a> (IRC Section 457A provides a limited exception for deferred compensation payable by foreign corporations that have “effectively connected income” under IRC Section 882.) A “comprehensive foreign income tax” is the income tax of a foreign country if there is an applicable comprehensive income tax treaty between that country and the United States or the Secretary of the Treasury is otherwise satisfied that it is a comprehensive foreign income tax.<a href="#_ftn5" name="_ftnref5">5</a> IRC Section 457A generally applies to nonqualified deferred compensation within the same broad scope as IRC Section 409A. IRC Section 457A explicitly applies to all stock options and stock appreciation rights, even those issued with the option price or measurement price at fair market value.<a href="#_ftn6" name="_ftnref6">6</a> IRC Section 457A also extends the 2½ month short term deferral exemption in IRC Section 409A to 12 months, meaning that IRC Section 457A does not apply to compensation received during the taxable year following that year in which the compensation is no longer subject to a substantial risk of forfeiture.<a href="#_ftn7" name="_ftnref7">7</a> If the amount of any deferred compensation taxable under IRC Section 457A is not determinable at the time it is otherwise includable under that section, it is subject to a penalty and interest when so determinable. In addition to the normal tax, the amount includable is subject to a 20 percent penalty tax and interest on the underpayment of taxes at the normal underpayment rate plus 1 percent.<a href="#_ftn8" name="_ftnref8">8</a> IRC Section 457A applies to deferred amounts attributable to services performed after December 31, 2008. Congress also directed the IRS to provide guidance within 120 days on amending plans to conform to IRC Section 457A and providing a limited period of time to do so without violating IRC Section 409A. In 2017, the Treasury Department and the IRS indicated they would issue regulations applicable as of December 8, 2017 providing the relief for plan distributions made for taxes on pre-2009 457A foreign deferred compensation. The agencies also indicated taxpayers can rely on the relief until the regulations are finalized. The coming regulations will permit the acceleration of payments under a nonqualified deferred compensation plan to pay federal, state, local, and foreign income taxes due on pre-2009 section 457A deferrals that are includible in gross income. Specifically, the Notice indicates Treasury Department and the IRS intend to issue regulations providing that a change in the time and form of payment under a nonqualified deferred compensation plan to pay federal, state, local, and foreign income taxes on pre-2009 Section 457A deferrals will not be treated as an impermissible acceleration under Sections 409A(a)(3) and 1.409A-3(j)(1). These regulations will also provide that, to the extent a deferred amount attributable to services performed before January 1, 2009, was earned and vested before December 31, 2004, and is not otherwise subject to the requirements of Section 409A due to the effective date rules under Section 1.409A-6, a change in the time and form of payment of the deferred amount to pay federal, state, local, and foreign income taxes on pre-2009 Section 457A deferrals will not be treated as a material modification of such arrangement under Section 1.409A-6(a)(4). The relief provided in these regulations will apply only to the extent that that the amount of any distribution to pay federal, state, local, and foreign income taxes on pre-2009 section 457A deferrals is not more than an amount equal to the federal, state, local, and foreign income tax withholding that would have been remitted by an employer if there had been a payment of wages equal to the income includible by the service provider under section 801(d)(2) of TEAMTRA.<a href="#_ftn9" name="_ftnref9">9</a> </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 457A(d)(1)(A). <a href="#_ftnref2" name="_ftn2">2</a>. Only a Section 457(e)(11)(A)(ii) length of service award program (LOSAP) is not considered a “nonqualified deferred compensation plan” for purposes of Section 409A. <a href="#_ftnref3" name="_ftn3">3</a>. Prop Treas. Reg., REG 123854-12 June 22, 2016. <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 457A(b). <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 457A(d)(2). <a href="#_ftnref6" name="_ftn6">6</a>. IRC § 457A(d)(3)(A). <a href="#_ftnref7" name="_ftn7">7</a>. IRC § 457A(d)(3)(B). <a href="#_ftnref8" name="_ftn8">8</a>. IRC § 457A(c). <a href="#_ftnref9" name="_ftn9">9</a>. IRS Notice 2017-75, 12-8-2017. </div>

March 13, 2024

3532 / What are the tax consequences for the employee of a Section 83 funded deferred compensation agreement?

<div class="Section1">Under IRC Section 83, as a general rule, an employee is currently taxed on a contribution to a trust or a premium paid for an annuity contract (paid after August 1, 1969), or other “transfer of property” to the extent that the interest is substantially vested when the contribution or transfer is made.<div class="Section1"> An interest is substantially vested if it is transferable or not subject to a Section 83 substantial risk of forfeiture. Under Section 83, an interest is transferable if it can be transferred free of a substantial risk of forfeiture ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3538">3538</a>).<a href="#_ftn1" name="_ftnref1">1</a> On May 29, 2012, the IRS released proposed regulations clarifying the definition of “substantial risk of forfeiture” under Section 83,<a href="#_ftn2" name="_ftnref2">2</a> and incorporating its ruling in Revenue Ruling 2005-48 as to Section 83 equity plans (for details on the changes see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3538">3538</a>). On February 25, 2014, the IRS issued final regulations that are substantially similar to the proposed regulations. These regulations will apply to all transfers of property on or after January 1, 2013, and the proposed regulations may be relied on as to transfers after May 30, 2012.<a href="#_ftn3" name="_ftnref3">3</a> A partner is immediately taxable on the partner’s distributive share of contributions made to a trust in which the partnership has a substantially vested interest even if the partner’s right is not substantially vested.<a href="#_ftn4" name="_ftnref4">4</a> If an employee’s rights change from substantially nonvested to substantially vested, the value of the employee’s interest in the trust or the value of the annuity contract on the date of change (to the extent such value is attributable to contributions made after August 1, 1969) must be included in the employee’s gross income for the taxable year in which the change occurs. The value on the date of change also probably constitutes “wages” for the purposes of withholding<a href="#_ftn5" name="_ftnref5">5</a> and for purposes of FICA and FUTA ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3576">3576</a>). The value of an annuity contract is its cash surrender value.<a href="#_ftn6" name="_ftnref6">6</a> If only part of an employee’s interest in a trust or an annuity contract changes from substantially nonvested to substantially vested during any taxable year, only that corresponding part is includable in gross income for the year.<a href="#_ftn7" name="_ftnref7">7</a> An employee is not taxed on the value of a vested interest in a trust attributable to contributions made while the trust was exempt under IRC Section 501(a).<a href="#_ftn8" name="_ftnref8">8</a> Special rules apply to trusts that lose their tax qualification because of a failure to satisfy the applicable minimum participation or minimum coverage tests.<a href="#_ftn9" name="_ftnref9">9</a> The IRS has taken the controversial position that these special rules apply to nonexempt trusts that were never intended to be tax qualified. As a result, the IRS would tax highly compensated employees (“HCEs”) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3928">3928</a>) participating in trust-funded nonqualified plans that fail the minimum participation or minimum coverage tests applicable to qualified plans ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3848">3848</a> through Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3861">3861</a>), which most nonqualified plans will fail ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3534">3534</a>). There is no tax liability when an employee’s rights in the value of a trust or annuity (attributable to contributions or premiums paid on or before August 1, 1969) change from forfeitable to nonforfeitable. Prior to August 1, 1969, an employee was not taxed when payments were made to a nonqualified trust or as premiums to a nonqualified annuity plan if the employee’s rights at the time were forfeitable.<a href="#_ftn10" name="_ftnref10">10</a> Thus, the employee did not incur tax liability when the employee’s forfeitable rights later became nonforfeitable. This old law still applies to trust and annuity values attributable to payments made on or before August 1, 1969.<a href="#_ftn11" name="_ftnref11">11</a> Where an employer amended its Section 451 “unfunded” nonqualified deferred compensation plan (one subject to the claims of the employer’s general creditors in bankruptcy) to provide those participants with a choice between a lump sum payment of the present value of their future benefits or an annuity contract securing their rights to the remaining payments under the plan (with a corresponding tax gross-up payment from the employer), any participant who chose the annuity contract would be required to include the purchase price for such participant’s benefits under the contract in gross income (as well as the tax gross-up payment) in the year paid or made available, if earlier.<a href="#_ftn12" name="_ftnref12">12</a> In July 2015, the IRS proposed new regulations that would eliminate the requirement to file a Section 83(b) election with the IRS by attaching a copy to a federal income tax return (since this requirement generally prohibits an electronic filing.)<a href="#_ftn13" name="_ftnref13">13</a> These regulations were finalized in 2016. Individuals are still required to keep records sufficient to show basis of the property and the original cost (if any). For taxation of annuity payments to an employee, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3539">3539</a>. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   IRC §§ 402(b)(1), 403(c), 83(a); Treas. Reg. §§ 1.402(b)-1(a)(1), 1.403(c)-1(a), 1.83-1(a)(1), 1.83-3(b), 1.83-3(d). <a href="#_ftnref2" name="_ftn2">2</a>.   It is important to note that there multiple definitions of “substantial risk of forfeiture” under different Internal Revenue Code Sections (there are seven definitions now since the release of the new proposed 457/409A integration regulations), and they are not exactly the same so it is important to follow the definition required for the section applicable to the tax question. For example, compare Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3538">3538</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3550">3550</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3601">3601</a>. <a href="#_ftnref3" name="_ftn3">3</a>.   Proposed Treas. Reg. § 1.83-3, 5-29-2012., made final in TD 9659, 2014-12 IRB (Mar. 17, 2014) with minor modification on Example 4. <a href="#_ftnref4" name="_ftn4">4</a>.   U.S. v. Basye, 410 U.S. 441 (1973). <a href="#_ftnref5" name="_ftn5">5</a>.   Temp. Treas. Reg. § 35.3405-1T, A-18; Let. Rul. 9417013. <a href="#_ftnref6" name="_ftn6">6</a>.   IRC §§ 402(b)(1), 403(c), 83(a); Treas. Reg. §§ 1.402(b)-1(b), 1.403(c)-1(b). <a href="#_ftnref7" name="_ftn7">7</a>.   Treas. Reg. §§ 1.402(b)-1(b)(4), 1.403(c)-1(b)(3). <a href="#_ftnref8" name="_ftn8">8</a>.   Treas. Reg. § 1.402(b)-1(b)(1). <a href="#_ftnref9" name="_ftn9">9</a>.   IRC § 402(b)(4). <a href="#_ftnref10" name="_ftn10">10</a>.   IRC §§ 402(b) and 403(b), prior to amendment by P.L. 91-172 (TRA ’69). <a href="#_ftnref11" name="_ftn11">11</a>.   Treas. Reg. §§ 1.402(b)-1(d), 1.403(c)-1(d). <a href="#_ftnref12" name="_ftn12">12</a>.   Let. Rul. 9713006. This transaction would now likely be subject to Section 409A, and the change to the plan would constitute a violation as a prohibited “substitution” by way of an alternative benefit. <a href="#_ftnref13" name="_ftn13">13</a>.   Prop. Treas. Reg. § 1.83-2(c). </div></div>

March 13, 2024

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

<div class="Section1">A properly constructed unfunded<a href="#_ftn1" name="_ftnref1">1</a> nonqualified deferred compensation agreement can postpone payment of compensation for currently rendered services until a future date, with the intended objective of postponing the taxation of such compensation until it is actually received. Since the enactment of IRC Section 409A (generally effective as to contributions/deferrals to plans as of January 1, 2005), such an agreement, at least with respect to vested compensation, likely will create a plan that is covered by the additional tax law requirements of Section 409A, unless the plan is either specifically exempted by the statute or can claim an exception under the regulations. The IRS released proposed regulations in June 2016 that made amendments to clarify the final regulations under Section 409A (TD 9321, 72 FR 19234). This document also withdraws a specific provision of the notice of proposed rulemaking (REG-148326-05) published in the Federal Register on December 8, 2008 (73 FR 74380) regarding the calculation of amounts includible in income under Section 409A(a)(1). The provision is replaced by revised proposed regulations. These proposed regulations affect participants, beneficiaries, sponsors, and administrators of nonqualified deferred compensation plans.<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> 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: <blockquote>(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</blockquote> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="3574">3574</a>). 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="3608">3608</a>). 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="3532">3532</a>). 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.” </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.   “Unfunded” does not mean that assets may not be set aside in a sponsor’s general asset reserve for a plan; just that they may not be escrowed from sponsor’s general creditors or constitute “plan assets’ under ERISA. It also means that the plan is an unsecured promise-to-pay subject to Sections 61 and 451, and not a “transfer of property” plan under Section 83. <a href="#_ftnref2" name="_ftn2">2</a>.   Reg. 123854-12, 81 FR 40569 (Jun. 22, 2016). </div></div>