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Deferred Compensation
We have already discussed several forms of deferred compensation using equity-related plans. Other forms of long-term deferred compensation exist, with the most popular being those tied to retirement or severance benefits, and many are non-qualified plans for top management, meaning they are exempt from participation requirements.
Nonqualified deferred compensation plans provide executives and sometimes key management the opportunity to defer a portion of their compensation and related taxes until the deferred compensation is paid. Plans are relatively common among large, publicly held corporations, but less common among private corporations. Typically, plans are established to provide a deferral opportunity for executive compensation or benefits. They may be used to provide a retirement vehicle for executives or an opportunity to defer employee-earned compensation (typically short- and long-term incentives) and related taxes while earning interest on the deferral.
With the U.S. IRC 409A ruling, the limitations on deferred compensation plans are more restrictive and complicated.
U.S. IRC 409A covers any plan that provides for an employee or consultant to have a legally binding right in a taxable year to compensation that has not been actually or constructively received in that year, but will be paid in a later taxable year. IRC 409A affects nonqualified deferred compensation plans (NQDC), certain trusts or similar arrangements. This code covers most salary and bonus deferrals that are nonqualified plans, supplemental executive retirement plans, below market stock options, stock appreciation rights, other non-stock approaches, excess retirement plans, and excess benefit plans. We discuss these plans further in DLC Course 74: Trends in Retirement Plans and Course 42: Accumulated Earnings and Deferred Compensation.
Under IRC 409A, the participant is allowed an election, no later than the close of the preceding taxable year (or in some cases no later than six months into the performance year), during which the amount, time, and form of distribution are decided. Under IRC 409A, the IRS has the right to collect withholding taxes on income deemed earned although not paid out. Non-compliance penalties payable by the plan participant (not the employer) include interest, 20% tax penalty, and ordinary income taxes.
The allowable distributions of NQDC plan benefits include a severance payout having a mandatory 6 months wait period, the specific dates documented per schedule or fixed in the plan, and specific events like disability, death, change in control, or unforeseen emergency. Payouts may also be accelerated in the event of specific triggers like a domestic relations order, 409A violation resulting in plan termination, certain conflicts of interest, and lump sum cash out if the value of the deferral is below an amount stipulated in the plan document. The rule that allows for exceptions for unforeseeable emergencies includes the following:
- Illness or accident of the participant or beneficiary, spouse, or dependent
- Loss of the participant's or beneficiary's property due to casualty (not otherwise covered by homeowner's insurance)
- Other events beyond the control of the participant or the beneficiary such as medical expenses, imminent foreclosure or eviction from primary residence, and funeral expenses of a spouse or dependent.