Differences in treatment for nonqualified deferred compensation.

• Author: Rice, Angeline

A business's success often depends on the talent and skills of its key employees and executives. Retaining these individuals and providing them an incentive to continue to perform at a high level is critical. Many employers use retirement benefits as a component of these key employees' compensation to meet these goals.

The Code and the Employee Retirement Income Security Act (ERISA) restrict the amount of money that can be contributed to qualified tax-deferred plans on behalf of highly compensated employees, which often leaves them with retirement savings that replace only 50% or less of their salary. One way to bridge this gap is by offering a nonqualified deferred compensation plan, which allows compensation earned in one year to be set aside and paid in a later year. The key Code section governing nonqualified deferred compensation is Sec. 409A.

Sec. 409A requires that nonqualified deferred compensation satisfy the following conditions: (1) It may only be paid upon the occurrence of a specified event (separation from service, disability, death, a specified time (or under a fixed payment schedule) specified by the plan at the time of deferral, a change in control of the business, or an unforeseeable emergency); (2) payments may not be accelerated from the payment dates fixed in the plan; and (3) the election to defer compensation must generally be made irrevocably in the year before services are performed to which the compensation relates (with similar but different rules for the first year of eligibility in the plan and performance-based compensation) and certain rules regarding changes in the time and form of a distribution in the case of a plan that permits under a subsequent election a delay in a payment or a change in the form of payment.

If the conditions fisted above are met, Sec. 409A provides that nonqualified deferred compensation does not have to be included in the key employee's gross income until constructive receipt has occurred (even if there is not a substantial risk of forfeiture). Under Regs. Sec. 1.451-2, income is considered constructively received when the amount is credited to the taxpayer's account set apart for the taxpayer or otherwise made available so that he or she may draw upon it at any time or could have drawn upon it during the tax year if notice of intention to withdraw had been given.

The penalties for violating a condition in Sec. 409A are severe. If at any time in a tax year a violation of Sec. 409A...