Common mistakes in nonqualified deferred compensation plans.

• Author: Heroux, Mark

When navigating complex and demanding systems such as the Internal Revenue Code, it is easy to make a mistake and find yourself lost. Common sense cannot be relied on as a compass. Experience with the landscape of one or more subsections does not guarantee that you are prepared to survive others, as each may pose new, unexpected challenges. When traversing tax law landscapes without proper preparation, you can easily make a costly mistake.

Sec. 409A, which imposes requirements on nonqualified deferred compensation, presents one of these treacherous landscapes. It is a landscape where the rules are strict and the penalties for breaking them are severe. To survive, preparation is key.

Hopefully, preparation brought you to this discussion; however, it is not intended to serve as a road map. The Sec. 409A rules are more than 400 pages and cannot be adequately explained in a single article. Instead, this discussion should be viewed as like the local townsperson who warns "would-be adventurers" to take heed and avoid some dangers that lie ahead. But before taking a look at a few commonly made Sec. 409A mistakes, it is necessary to first review what Sec. 409A is, discuss the costs of failure, and touch on the risk of discovery.

Sec. 409A overview

Sec. 409A was enacted in 2004 in response to a series of financial scandals where executives "cashed out" prior to the collapse of the companies they oversaw. To curtail this abuse, Sec. 409A places restrictions on the deferral of compensation under nonqualified deferred compensation plans (including underlying agreements or any other arrangement providing nonqualified deferrals), subject to some exceptions and exclusions. A deferral of compensation generally occurs when there is a legally binding right to compensation that arises in one tax year, and the compensation is payable in a subsequent tax year. This could include, for example, bonus programs, employment agreements, severance agreements, salary deferrals, long-term cash or equity compensation plans, etc.

While it is important to understand that Sec. 409A has a broad reach, it is more important to understand how to establish and maintain compliance. Basically, four requirements must be met at initial deferral:

* The arrangement must be in writing;

* The deferred amount must be specified or based on a formula that is nondiscretionary and objectively determinable;

* The form of payment must be specified (i.e., paid as a lump sum or in a series of...