Differences in Treatment for Nonqualified Deferred Compensation

Editor: Anthony S. Bakale, CPA, M.Tax.

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 listed 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 occurs, then all compensation deferred under the plan for the tax year and all preceding tax years is includible in gross income for the tax year to the extent it is not subject to a substantial risk of forfeiture and has not previously been included in gross income. Each tax year is looked at as a separate instance, so there could be a violation in one tax year and not in another. Substantial risk of forfeiture under Sec. 409A has the same meaning as under Sec. 83(c)(1), which provides there is a substantial risk of forfeiture if the person’s right to compensation is conditioned upon the future performance of substantial services by any individual.

Individuals participating in a nonqualified deferred compensation plan issued by a not-for-profit entity do not receive the same tax-deferral benefits of those offered by for-profit entities. Sec. 457(f) states that in the case of a plan of a tax-exempt employer providing for a deferral of compensation, if that plan is not an eligible deferred compensation plan (i.e., nonqualified deferred compensation), then the compensation shall be included in the gross income of the participant or beneficiary for the first tax year in which there is no substantial risk of forfeiture of the rights to the compensation, and the tax treatment of any amount made available under the plan to a participant or beneficiary shall be determined under Sec. 72. The result of Sec. 457(f) is that an individual receiving deferred compensation from a tax-exempt entity is taxed on the deferred income upon vesting instead of when constructively received (as is the case for an individual receiving deferred compensation from a for-profit entity). The tax-deferral advantages of constructive receipt have essentially been eliminated.

Because a participant in a nonqualified deferred compensation plan subject to Sec. 457(f) is required to include in income his or her deferred compensation upon vesting in the plan, issues may arise when the participant receives distributions from the plan that ultimately are different from the actuarially calculated present value of those benefits that were previously included in income. Regs. Sec. 1.409A-1(a)(4) subjects Sec. 457(f) plans to Sec. 409A. Specifically, the regulations under Sec. 409A address what happens if a plan participant receives distributions that are greater than or less than the amount that was included in income at the time of vesting.

Regs. Sec. 1.409A-4(f) states that distributions from the plan are not included in income to the extent that they have previously been recognized in income. Once distributions exceed the amount previously reported, the participant must recognize as taxable income any further distributions from the plan.

Regs. Sec. 1.409A-4(g) states that the participant is entitled to a tax deduction in the year that he or she is not entitled to any future distributions from the plan, to the extent that the total cumulative distributions under the plan are less than the amount previously included in income.

Conclusion

The type of entity issuing the nonqualified deferred compensation plan will have a large impact upon when the participant includes the payments under the plan in taxable income. A participant receiving nonqualified deferred compensation from a qualified entity generally will not be taxed until constructive receipt of the payments has occurred, even if the participant became vested at an earlier date. A participant receiving nonqualified deferred compensation from a Sec. 457 nonqualified entity (e.g., a not-for-profit entity) is required under Sec. 457(f) to be taxed on the future payments as soon as the participant vests in the plan regardless of constructive receipt.

Situations could arise where the future payouts of nonqualified deferred compensation from a not-for-profit entity are different from the amount the participant previously included in income. In a situation where the amount will be greater, the participant will not include in income amounts distributed from the plan until the cumulative amount of distributions exceeds the amount previously included in income. Any amounts received from the plan after this point will be taxable in the year they are received. Where the payments will be less, in the year the participant is not entitled to any future payments from the plan, the participant is entitled to a deduction to the extent that cumulative distributions from the plan are less than the amount previously included in income.

EditorNotes

Anthony Bakale is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.