Deductibility of nonqualified deferred compensation in mergers and acquisitions.

• Author: Reinbold, Melissa

Determining the tax treatment and timing of an employer corporation's deduction for amounts paid under nonqualified deferred-compensation arrangements under Sec. 404 can be a daunting task, depending on the circumstances. Even if such arrangements have not triggered any of the pitfalls in Sec. 409A, there is some ambiguity surrounding the rules governing the deductibility of nonqualified deferred compensation (NQDC) in the context of mergers and acquisitions. Proper application of these rules is complicated and at times yields surprising results.

What Is Deferred Compensation?

According to Temp. Kegs. Sec. 1.404(b)-1T, a deferred-compensation arrangement exists for purposes of Secs. 404(a), (b), and (d) when the employee receives compensation for services after the 2 1/2-month period following the end of the employer corporation's tax year in which such services were performed.

Example 1: The accrued nonqualified deferred-compensation liability of a calendar-year employer corporation on December 31, 2005, was $200,000. During 2006, the employer corporation accrued an additional $50,000 of NQDC. On February 15,2007, the employer corporation paid the entire $250,000 to the employee. Only $200,000 is deferred compensation. Because the $50,000 was paid out within 2 1/2 months of the end of 2006, the year during which the services were performed, it is not deferred compensation.

General Deductibility and Timing

An accrual-method employer may typically deduct compensation after it is earned and the liability is established, regardless of when the actual payment is made. However, under Sec. 404(a)(5), the employer's deduction of NQDC must be delayed to match the employee's recognition of income regardless of the employer's method of accounting. Sec. 404(a)(5) provides for the employer's deduction for NQDC "in the taxable year in which an amount attributable to the contribution is includible in the gross income of employees participating in the plan," as long as separate accounts are maintained for each employee (and the NQDC is otherwise deductible).

Example 2: The facts are the same as in Example 1. The employer corporation may not deduct the accrued liability amount in the years in which it was accrued (years ended on or before December 31, 2006). Rather, the deduction of the entire $250,000 may be taken by the employer corporation only in the year ended December 31, 2007, when the employee receives the cash and recognizes income.

Regs. Sec. 1.404(a)-12(b)(1) further elaborates on the timing of the deduction under Sec. 404(a) for deferred...