SC Lawyer, May 2006, #1. Formula 409A - Wiping Out Nonqualified Deferred Compensation.

• Author: By Jeff Z. Brooker III

South Carolina Lawyer

2006.

SC Lawyer, May 2006, #1.

Formula 409A - Wiping Out Nonqualified Deferred Compensation

South Carolina LawyerMay 2006Formula 409A - Wiping Out Nonqualified Deferred CompensationBy Jeff Z. Brooker IIINonqualified deferred compensation is often a tool for small businesses. It allows small businesses to offer additional benefits in the competition for quality employees that larger businesses generally can compensate at a higher rate. However, because of perceived abuses, new Section 409A to the Internal Revenue Code of 1986, as amended (the Code) will require "nonqualified deferred compensation plans" to be currently taxable, unless the Code § 409A rules are strictly followed and implemented.

Every tax planner anticipates the conversation with his or her client where the tax planner has to define "phantom income" or explain that "cash does not necessarily equal taxable income" or the like. However, many clients involved in closely held business entities that have various passive investments have had some exposure to taxable income when those clients have not yet received a distribution of cash from the entity. However, those rules have arisen in the case of investments (for the most part). The rules for taxing income earned by, but not yet paid to, the taxpayer for his/her personal services are getting an overhaul, and the target of these rules is the taxpayer, not the taxpayer's employer.

The federal government added Code Section 409A as part of the American Jobs Creation Act of 2004, and it furthers the enforcement weapons of the Internal Revenue Service (IRS) for rendering certain transactions previously believed to be "tax deferred" as now currently taxable. This new law provides that any nonqualified deferred compensation plan that does not satisfy the rules of Code Section 409A will result in the current inclusion of income of all amounts to which a "service provider" has a "legally binding right." These rules have been explained by personnel at the IRS and Treasury Department as "[rationalizing] the law of constructive receipt as it applies to compensation." Dan Hoggins, Treasury (cited in Federal Tax Weekly, Issue No. 39, October 6, 2005 (CCH)). The taxes that will be owed are very expensive for the taxpayer (the "service provider") whose nonqualified deferred compensation plan was not properly structured. These costs are as follows:

The amounts are includible in income for tax purposes of the taxpayer. Interest will be owed on the tax at the underpayment rate plus one percentage point on the underpayments "that would have occurred had the compensation been includible in income for the taxable year when first deferred or, if later, when not subject to a substantial risk of forfeiture." An additional tax of 20 percent of the amount of compensation is required to be included in income. Notice 2005-1, I.R.B. 2005-2 (emphasis added).

These new rules apply to almost all forms of nonqualified deferred compensation from forms of stock options all the way to basic deferred income associated with terminating employment. It is also worth pointing out that the IRS ruled in Notice 2005-1 that:

Taxpayers should note that although the statute makes a number of fundamental changes, §409A does not alter or affect the application of any other provision of the Code or common law tax doctrine. Accordingly, deferred...