The American Jobs Creation Act of 2004 added section 409A to the Internal Revenue Code (the “Code”) to address abuses in the use of nonqualified deferred compensation plans revealed by the Enron hearings and the Joint Committee on Taxation’s concerns that many nonqualified deferred compensation plans “allowed improper deferral of income.” In general, Code section 409A requires that all amounts deferred under a nonqualified deferred compensation plan for all preceding taxable years are currently includible in gross income of the individual to the extent that these amounts are not subject to a substantial risk of forfeiture and not previously included in the individual’s gross income, unless the requirements of Code section 409A are met by the plan.
First, the business’ deferred compensation plan must be analyzed to determine whether the deferred compensation plan is a qualified or nonqualified plan. An extensive list of requirements is given in Code section 401(a) and each of these requirements must be met for a plan to be qualified. Qualification is beyond the scope of this article; however, most employers, including public, private, governmental, and tax-exempt employers, will need to analyze their individual deferred compensation plans under the new law to reassure their employees, directors, and independent contractors (collectively, the “Participants”), who participate in their respective plans, that their past and present deferred compensation will not be subject to current inclusion in the Participants’ gross income, as well as, interest charges and penalties.
Code section 409A imposes three main requirements. First, a nonqualified deferred compensation plan must provide that any compensation deferred under the plan is not distributable earlier than: (1) the Participant’s separation from service; (2) the date the Participant becomes disabled; (3) the Participant’s death; (4) a specified time (or fixed schedule) that is provided under the plan when the compensation is deferred; (5) to the extent provided by regulations, a change in the ownership of the employer, effective control of the employer, or ownership of a substantial portion of the assets of the employer; or (6) the occurrence of an unforeseeable emergency. Next, except as provided in the regulations, the plan must not allow an acceleration in the time or schedule of benefits to be paid out under the plan. Further, unless the first year of eligibility or performance-based compensation exceptions apply, the Participant may only elect to defer compensation under the plan if the election is made prior to the close of the preceding taxable year or such other time that is provided by the regulations. Finally, even if the business’ nonqualified deferred compensation plan meets the three main requirements imposed by section 409A of the Code, the plan’s operation must follow the plan’s design.
If an employer’s plan does not meet the requirements of Code section 409A as the plan is drafted or in the operation of the plan, all compensation deferred under the plan (the “plan benefits”) for the present and preceding taxable years will be included in a Participant’s gross income to the extent the plan benefits are not subject to a substantial risk of forfeiture and have not previously been included in the a Participant’s gross income. In general, there is a substantial risk of forfeiture if a Participant’s rights to the plan benefits are dependent upon the future performance of substantial services by any individual. If an employer’s plan does not meet the requirements of Code section 409A and a Participant’s plan benefits are not subject to a substantial risk of forfeiture, then not only will all of the past and present plan benefits (not previously included in the Participant’s gross income) be immediately includible in income and subject to federal income tax, but the plan benefits will also be subject to (1) a penalty equal to twenty percent of the plan benefits required to be included in the Participant’s gross income and (2) interest at the underpayment rate plus one percentage point.
Additionally, the rules relating to funding of a nonqualified deferred compensation plan were also strengthened to address the use of offshore trusts and provisions dealing with an employer’s financial health. Code section 409A rules provide that deferred compensation transferred to or held in a trust will be treated as compensation to the Participant if such assets are located or subsequently transferred outside of the United States. Notwithstanding the forgoing sentence, if substantially all of the services to which the nonqualified deferred compensation relates is performed in a jurisdiction outside of the United States, then the nonqualified deferred compensation assets may be held in a trust in the jurisdiction where substantially all of the services were performed. Code section 409A also restricts an employer’s plan from containing provisions that change the provision of benefits under the plan as a result of a change in an employer’s financial health.
Employers must be vigilant of the changes made in the tax law governing nonqualified deferred compensation plans since most employers use these types of deferred compensation plans. All employers with nonqualified deferred compensation plans should identify the changes that must be made to their respective plan, communicate the changes directly to the Participants affected, renegotiate contracts with Participants (if necessary), and adopt the necessary plan amendments in order for the plan to conform with the requirements of section 409A. Once the employer’s plan meets the requirements of section 409A, the Participants’ past and present plan benefits will not be currently includable in the Participant’s gross income; in addition, the Participants will not face the penalties and interest charges associated with forced inclusion.
If you have any questions regarding Code section 409A or how to modify your nonqualified deferred compensation plan to meet the requirements of Code section 409A, please contact Tom McLaughlinat (941) 536-2042 or firstname.lastname@example.org