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Does your company’s nonqualified deferred compensation plan comply with IRS rules?

April 20, 2022 Article 5 min read
Michael Krucker Preston Ridinger
Nonqualified deferred compensation plans offer employers great flexibility in structuring executive compensation. However, compliance with the Internal Revenue Code rules and regulations on the topic is critical to avoid significant 409A penalties. Here’s what executives need to know.

Business professional sitting at their desk reading paper documents.Nonqualified deferred compensation (NQDC) plans provide businesses with considerable flexibility to structure executive compensation in ways that are advantageous to both the employee and the employer. Despite the flexibility afforded in designing NQDC plans, the employer and the executive must comply with the requirements of Code Section 409A and regulations when drafting NQDC plan documents and operating of an NQDC plan.

A brief history

It may help to understand that the current limitations on NQDC plans arose out of some of the most significant business failures of the late 1900s and early 2000s. Executives at that time had significant influence, if not actual control, over accelerating payouts from NQDC plans. Because NQDC plans represent an unsecured promise to pay between an employer and an executive, if a business fails, then an executive’s claim for payment from an NQDC plan is lumped in with other unsecured claims.

Historically, NQDC plans retained discretion for an employer to accelerate payment, leaving open the potential for abuse where an executive plays a dual role of both decision-maker for the employer and participant in the employer’s NQDC plan. This potential for abuse was particularly heightened where the employer was in financial trouble.

A new proposal could require employers to withhold 409A plan penalties. 

Section 409A regulations and penalties

In response to the perceived potential for abuse, Congress enacted Sec. 409A to provide fairly specific rules on the timing and form of payment allowed for NQDC plans. The rules require that an NQDC plan specify, prior to or at the time of deferral:

  1. When the payment will be made (i.e., what events will trigger the payment, such as retirement, disability, death, change in ownership, etc.).
  2. What form the payment will take (e.g., annuity, lump sum, etc.).

As such, the NQDC plan documents must specify clearly how and when the participant will be paid under the plan.

The NQDC plan documents must specify clearly how and when the participant will be paid under the plan.

Because these rules were designed to curb the potential for abuse by executives, Sec. 409A imposes immediate taxation, an additional 20% tax, and in some instances interest for failures to comply. These penalties are imposed on the individual executives rather than the employer. Certain states also impose an additional state tax for failures.

Two elements of Section 409A compliance

To meet the IRS standards, an NQDC plan needs to comply with the 409A regulations, both in form and in operation.

To meet the “in form” requirement, the written plan document must lay out certain terms that meet at least the minimum thresholds set forth in the 409A regulations. For example, think about what might constitute a “termination.” That seems obvious in terms of, “The person no longer works here.” But what about the executive who returns as a consultant? What if a change in control or ownership at the employer due to acquisition leaves an executive still employed with the organization, but with a new party in control of a majority of voting shares? These kinds of nuanced situations need to be foreseen and managed during the drafting of an NQDC plan document.

Similarly, to meet the “in operation” requirement, an NQDC plan needs to be operated in accordance with the plan document and the 409A regulations. For example, if the plan says an executive will be paid 90 days following separation and the employer pays 10 days following separation, the executive will be subject to 409A penalties.

Time-sensitive opportunities to correct 409A errors

The good news for employers is that the IRS has a correcting process that reduces the impact of mistakes. Two IRS notices established programs allowing employers to correct mistakes in either form or operation of an NQDC plan. This process applies to employers who identify problems with their NQDC plans and take action to voluntarily correct them. The key is to identify and correct those mistakes in a timely manner, which may require reporting certain information to the IRS, including on Form W-2 and/or Form 1040 or employer tax returns. If the mistakes are outside the time limits, then all amounts deferred under the plan — even amounts deferred or payments made in compliance with Sec. 409A — are immediately taxable and subject to the 20% penalty with interest.

Two IRS notices established programs allowing employers to correct mistakes in either form or operation of an NQDC plan.

The not-so-good news: The correction process can be complicated, lengthy, and laborious — and compounded by the IRS-imposed timelines for qualified relief. For operational failures, the maximum window for relief provided by voluntarily correcting is two years from the year in which the error occurs and prior to the occurrence of an event triggering payment for plan document failures. For most employers, it makes sense to outsource this review process to a trusted advisor with Sec. 409A experience who can quickly identify potential problems. What’s more, an outside review every other year can help to make sure that an employer doesn’t miss out on an opportunity to correct potentially costly errors and avoid additional tax consequences and Sec. 409A penalties.

The review should include a close look at plan documents to confirm:

  • Compliance with 409A requirements from both a documentary and operational standpoint.
  • Completeness, especially with regard to amendments, updates, and enrollment documents.
  • Identification and, where possible, clarification of any ambiguous terms that could lead to confusion when an executive receives compensation under the plan.
  • A review should also examine the operations side of the plan administration, including:
  • Operational consistency between plan execution and the plan provisions and other governing documents.
  • Consistency between the actual operation of the plan and 409A regulations and guidance.
  • Consistency with participant elections.
  • Appropriate tax withholding and reporting, including Form W-2 reporting and the treatment of employment taxes as employment taxes are often due earlier than payment and income taxes.

It’s important to note that even if the employer relies on a third-party administrator to manage the operations of the NQDC plan, which often is a very prudent approach, the ultimate responsibility for plan administration falls on the plan sponsor. Any failures will impose penalties on the employer’s executives and the executives will look to the employer, not the third-party administrator, to be made whole when a violation occurs.

Looking ahead

The procedures to voluntarily correct 409A failures have been around for over a decade now, and while there’s no promise that they’ll last forever, there’s also no indication that the service plans to shut them down anytime soon. On the other hand, the IRS has recently released updated field guidance to its agents on the examination and review of nonqualified deferred compensation plans under Sec. 409A. A step like this could indicate that the IRS is moving toward placing a higher priority on reviewing these plans in the near future.

To learn more about potential pitfalls in 409A deferred compensation plan management and how a 409A compliance assessment could help your business to avoid them, please contact your Plante Moran employee benefits consulting advisor.

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