Common mistakes in nonqualified deferred compensation plans

By Devin Tenney, J.D., Milwaukee, and Christine Faris, J.D., Philadelphia

Editor: Mark Heroux, J.D.

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 periodic payments); and
  • The time of payment must be narrowly limited to one or more of six payment triggers, known as permissible payment events. The permissible payment events are when: (1) the executive has a separation from service; (2) the executive dies; (3) the executive becomes disabled; (4) a change in control of the business occurs; (5) an unforeseeable emergency occurs; or (6) a specified date is reached (or pursuant to a fixed schedule) as laid out in the plan.

In other words, all terms need to be set in stone and comply with Sec. 409A at initial deferral, leaving little room to make subsequent changes. If it is later discovered that the terms fail to comply with Sec. 409A, all vested amounts must be immediately included in the executive's income for the tax year in which the failure is discovered. And there is an additional 20% tax on that amount plus a premium interest tax. As if that were not enough, failure of one plan can result in the deemed failure of all similar plans. Basically, it is an easy way to upset the company's executive team.

While it is not unheard of for the IRS to audit a company's nonqualified deferred compensation plans for Sec. 409A compliance, failures are typically discovered upon due diligence or if an employee is being audited personally. However, the best time to discover a failure is prior to the plan's effective date. For plans already in place, the next best alternative is having the plan reviewed for Sec. 409A compliance by a tax adviser. While not the subject of this discussion, catching mistakes in a timely manner may allow for corrections to the plan that avoid Sec. 409A penalties. The following discussion includes some issues frequently encountered by this item's authors, but this is by no means an exhaustive list.

Avoid unanticipated Sec. 409A application

Although the application of Sec. 409A is broad, not every benefit is subject to its requirements. For example, capital interests, profit interests, restricted stock, incentive and nonqualified stock options, and stock appreciation rights (SARs) are all tools that can be used to award employees with future benefits while not being subject to the constraints of Sec. 409A. The problem is, for some of these benefits to avoid Sec. 409A, certain requirements must be met. Many companies find themselves running afoul of Sec. 409A because these benefit arrangements, intended to be exempt from Sec. 409A, do not satisfy the exemption requirements and are not drafted to be compliant with Sec. 409A. Failure to meet the exemption requirements results in failure of the plan.

Valuations: Take stock options (both incentive and nonqualified), as well as SARs, for example. To avoid Sec. 409A, these benefits must have an exercise price that equals or exceeds fair market value on the date of grant — meaning the employer will need to have a valuation that meets the Sec. 409A valuation requirements. It is not unlikely that the valuation was overlooked, was misplaced, or does not meet the Sec. 409A valuation requirements, and the benefits may very well be subject to Sec. 409A. Considering that both stock options and SARs generally allow the executives to exercise at their discretion, these arrangements are almost never drafted in a manner that would comply with Sec. 409A on their own, and result in a failure of the plan.

SAR versus phantom: Calling a dog a cat does not make it a cat. Nor does calling phantom stock a SAR make it a SAR. However, this is more common than one would think. SAR plans can be similar to phantom stock plans. One key difference is that SARs, like options, allow a vested executive to exercise at his or her discretion. Many SAR plans fail by restricting exercise to an event, creating an "appreciation only" phantom stock award, subject to Sec. 409A, and not a SAR. By anticipating the Sec. 409A exemption for SARs, plans may be drafted so they comply with Sec. 409A.

Get it right the first time

The Sec. 409A rules place significant roadblocks in the way of amending or modifying existing nonqualified deferred compensation plans. Understanding that it is difficult, if even possible, to make changes should be sufficient motivation to get it correct from the start. Two main areas where mistakes usually arise are using impermissible payment events and trying to change the timing of when payments will be made.

Stick with Sec. 409A definitions: Things get tricky when dealing with the six permissible payment events because the Sec. 409A rules have specific definitions for when each occurs (well, except for death, but it is easy to agree on when that occurs). If the language of the plan triggers payment outside of what is defined as permissible, then a failure has occurred.

For example, consider an executive's nonqualified deferred compensation plan that provides payment upon retirement. Some might say that retirement is a separation from service, but Sec. 409A does not. This would not be a permissible payment unless retirement is defined in a manner that falls within the Sec. 409A definition of separation from service or perhaps is set to occur upon attaining age 65 or another specified date.

Complicating things further, an executive does not have a separation from service if he or she is retained as a consultant and continues to work more than 20% of his or her past service schedule. This is easy to overlook and results in Sec. 409A failure penalties.

Disability, change in control, and unforeseeable emergency also have specific definitions under the Sec. 409A rules that need to be detailed within the plan should those permissible payment events be intended. Some employers wrongly believe that issues of incorrect or omitted definitions can be remedied by including a savings clause (i.e., a clause saying that if any plan language is found invalid the rest remains in effect). A savings clause will not fix noncompliant terms or supply a compliant one; however, it may help resolve issues where there is ambiguity in existing language. As such, it does not hurt to include one, but it should not be relied upon.

Stick with the timing: Things happen, and goals change. Sometimes executives stick around for another year or two. Executives often think it should be easy to "re-defer" the compensation for that period. However, to make a subsequent deferral, the executive must elect at least 12 months prior to the payment to defer the payment at least five years from the original payment date. This unappetizing option usually catches executives and employers off guard. Accelerating payments is not any easier to do, with the Sec. 409A rules making it nearly impossible.


Mark Heroux, J.D., is a tax principal and leader of the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.

For additional information about these items, contact Mr. Heroux at 312-729-8005 or

Unless otherwise noted, contributors are members of or associated with Baker Tilly US, LLP.

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