Nonqualified Deferred Compensation for Closely Held Businesses
This post is part three in a three-part series about noteworthy topics regarding entity choice, business succession and compensation. Part one, "Sweat Equity and Entity Choices," and part two, “Family Business Succession Planning,” review questions and factors to keep in mind when considering entity choices and business succession.
Closely held businesses should be aware of not only the perks, but also the compliance perils of nonqualified deferred compensation. Nonqualified deferred compensation plans are subject to Section 409A of the Internal Revenue Code (“Section 409A”), a tax compliance regime that can have serious consequences for employees and companies. Section 409A is intended to prevent the manipulation of the timing of income inclusion. Although many arrangements can fit within exemptions to Section 409A, care should be taken when structuring the nonqualified deferred compensation plans.
What is a nonqualified deferred compensation plan?
Nonqualified deferred compensation plans include arrangements that provide for the deferral of employee compensation. Typical arrangements that may provide for the deferral of compensation include employment agreements, deferred bonus or compensation arrangements, phantom stock plans, change in control agreements, severance agreements, long-term incentive bonus plans, and supplemental executive retirement plans. Deferred compensation includes compensation that a worker earns in one year, but is paid in a future year. Section 409A provides for certain exceptions to what is considered a “nonqualified deferred compensation plan.” For example, nonqualified deferred compensation plans do not include qualified employer plans such as a 401(k) plan and certain bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plans.
Can deferred compensation subject to Section 409A include equity-based compensation?
Yes, certain equity-based compensation such as stock appreciation rights, discounted stock options and stock options with additional deferral features could constitute deferred compensation subject to Section 409A.
What does Section 409A require?
Section 409A requires that nonqualified deferred compensation plans comply with rules governing the type, timing and formalities of deferred payments. The Section 409A rules are extensive and complicated, but below are some key rules to consider, subject to various exemptions:
- Written agreement is required: The terms of the nonqualified deferred compensation plans must be in writing.
- Time, amount and form of payment must be set: The timing, amount of payment and form of payments generally must be established in writing before the end of the calendar year in which the employee obtains a legally binding right to compensation or in the first two and a half months of the year following the year in which the legally binding right arises, provided that such compensation is not payable in the following year.
- Payment must occur upon a specified event or schedule: Payments can be specified to occur on an established date, objective schedule or on certain events such as a separation from service, disability, death, a change in control or ownership of the company, the purchase of a substantial portion of assets of the company, or an unforeseeable emergency.
- Opportunity for further deferral or acceleration is limited: Once the time and form of payment is established, it is only in limited circumstances that such payments can be further deferred or accelerated.
What are the penalties for noncompliance with Section 409A?
If a nonqualified deferred compensation plan fails to meet the requirements of Section 409A, consequences include:
- Income inclusion: All vested deferred compensation for prior years and the current year that was not already included in the employee’s income is included in the employee’s income, even if the employee has not yet received the compensation.
- 20% additional tax: The employee is subject to an additional 20% income tax on the amount of deferred compensation required to be included in income under Section 409A.
- Interest charge: The employee is subject to an interest charge based on the underpayments had the deferred compensation been includible in gross income for the tax year in which the compensation was first deferred.
- Failure of other arrangements: The failure of an arrangement with one service provider may cause similar arrangements of the business to be in noncompliance with Section 409A.
- Reporting and withholding penalties: Employers are responsible for reporting and withholding failures.