2.7 Nonqualified Deferred Compensation
The rules for determining whether tax may be deferred under a nonqualified deferred compensation plan are governed by Code Section 409A. Section 409A applies generally to amounts deferred after 2004. Amounts deferred before 2005 are “grandfathered,” and thus generally exempt, but they become subject to Section 409A (unless excluded under IRS rules) if the plan is materially modified after October 3, 2004.
Caution
Plans subject to and excluded from Section 409A.
Unless an exception applies, Code Section 409A applies to all plans, including arrangements between an independent contractor and a service recipient, and a partner and partnership, under which the service provider has a legally binding right during a year to compensation that is not actually or constructively received, and which is payable in a later year. The law does not apply to qualified retirement plans (such as 401(k) plans), Section 403(b) tax-deferred annuities, SIMPLE accounts, simplified employee pensions, and Section 457 plans; these are excluded from the definition of “nonqualified deferred compensation plans.” Also excluded are welfare benefit plans such as vacation, sick leave, and disability programs.
The IRS has allowed exceptions for short-term deferrals, incentive stock options, employee stock purchase plan options, and certain stock appreciation rights, tax equalization payments, separation payments, reimbursement arrangements, and fringe benefits. For details, see the IRS final regulations (T.D. 9321, 2007-19 IRB 1123).
Section 409A requirements.
Plans subject to Section 409A must meet detailed requirements pertaining to the timing of deferral elections and the availability of distributions. For example, a deferral election generally must be made prior to the beginning of the year during which the services will be provided, but special rules apply to short-term deferrals and deferrals with respect to forfeitable rights. Distributions before separation from service are generally allowed only if the participant is disabled or has an unforeseeable emergency, the distribution is used to satisfy a domestic relations order, the distribution is on a specific date or under a fixed schedule specified in the plan, or there has been a change in the ownership or effective control of the corporation or in the ownership of a substantial portion of the assets.
If the Section 409A requirements are not met at any time during a taxable year, all amounts deferred under the plan for all years are currently includible in a participant’s gross income to the extent that the amounts are not subject to a substantial risk of forfeiture and were not previously included in gross income.
Reporting of Section 409A plan deferrals and earnings on your tax return.
Your employer may include 2012 plan deferrals in Box 12 of your Form W-2 using Code Y (reporting is optional). If deferrals are reported, Code Y should also be used to show earnings in 2012 on all deferrals, whether for 2012 or prior years. If any amounts are taxable because the Section 409A requirements have not been met, the taxable amount should be reported as taxable wages in Box 1 of Form W-2, and also shown in Box 12 using Code Z.
If you are not an employee, current year Section 409A deferrals of at least $600 and earnings on current and prior year deferrals may be reported in Box 15a of Form 1099-MISC. If any amounts are taxable because the Section 409A requirements have not been met, the taxable amount is reported in Box 15b and also included as non-employee compensation in Box 7 of Form 1099-MISC; this amount is generally subject to self-employment tax.
If there is a taxable amount, a penalty also must be paid equal to 20% of the includible compensation, plus interest at a rate that is 1% higher than the regular underpayment rate. The penalty and interest must be added to the line for “other taxes” on Form 1040.
Financial health triggers and offshore rabbi trusts.
Section 409A blocks the benefit of two funding arrangements that set aside assets to secure the payment of promised deferred compensation. If a nonqualified deferred compensation plan provides that assets will be restricted to payment of deferrals if the employer’s financial condition deteriorates, the setting aside of the assets will be considered a transfer of restricted property to the participants, taxable under the Section 83 rules (2.17). This is so even if the assets nominally remain available to satisfy the claims of the employer’s general creditors.
Also, a Section 83 transfer (2.17) is generally deemed to occur when assets to pay nonqualified deferred compensation are set aside in an offshore rabbi trust. Section 409A treats the funding of an offshore trust as a transfer of property to the participants, taxable under the Section 83 rules (2.17), unless substantially all of the services relating to the deferred compensation were performed in the foreign jurisdiction where the assets are held. A Section 83 transfer is deemed to occur whether or not the offshore assets are nominally available to satisfy the claims of the employer’s general creditors.
If deferrals are includible in a participant’s income because of the financial health trigger or offshore trust provisions, there is an additional 20% penalty plus interest at 1% more than the regular rate.
Rabbi trusts.
If IRS tests are met, employer contributions to a domestic “rabbi trust” are not taxed until distributions from the trust are received or made available. The trust must be irrevocable and the trust assets must be subject to the claims of the employer’s creditors in the event of insolvency or bankruptcy. Employees and their beneficiaries must have no preferred claim on the trust assets.
Offshore rabbi trusts are subject to Section 409A, as discussed above.