De-Coding the New DNA of
Non-Qualified Deferred Compensation Plans

Pension Memo
December 2005

            Last year Congress added Section 409A to the Internal Revenue Code and thereby entirely re-wrote all the rules for non-qualified deferred compensation plans.  A lot of what we used to know about deferred compensation is now obsolete. 

            The new rules were effective on January 1, 2005.  They are expansive and important.  They apply to areas that will surprise and trap you.

            These new rules are also difficult to understand. 

            Section 409A itself is dense and abstract.  It is seven pages long.  After reading it over and over, you will most likely be confused.  It makes sense only when you understand the objectives of Congress and the statutory framework around it.  IRS Notice 2005-1 was issued immediately after the law became effective.  In late September the IRS issued proposed regulations for Section 409A.  They are 238 pages long.  The first 123 pages are the IRS's explanation of what the remaining 115 pages are supposed to mean.

            Much of the commentary about Section 409A is not helpful.  Many "experts" are hysterical, warning of huge taxes, penalties, the end of Western civilization as we know it, and the like.  Check the articles on the web from law firms, accountants, and consultants and see for yourself.  Browse through these and you will most likely be more befuddled.

            After plowing through Section 409A for almost a year, I have come to the following conclusions. 

• Section 409A and the new rules for non-qualified deferred compensation are not as earthshaking as many would have you think.  In fact, the new DNA of Section 409A codifies the basic underlying concepts of non-qualified deferred compensation that we've lived with for so long.
  
  
• Section 409A eliminates the aggressive compensatory arrangements that made headlines during the recent corporate scandals.  However, most current deferred compensation plans will not be adversely affected.
  
  
• Mere mortals are quite capable of understanding and dealing with Section 409A.
  
  
• The key to Section 409A is understanding (i) the prior concepts of deferred compensation taxation, (ii) why we actually need it (gasp!), and (iii) how Section 409A harmonizes with other parts of the tax law.
  

Stay with me on this.  It all makes a lot of sense.

            History Lesson   Deferred compensation has been a well established fringe benefit for employees.  The concept is simple:  the employee agrees to defer taking some salary now in return for the employer’s promise to pay that compensation at a future time when, presumptively, the employee is in a lower income tax bracket.

            Deferred compensation plans fall into two broad categories, “qualified” and “non-qualified” plans.  “Qualified plans” are strictly statutory, meaning they are governed entirely by complex rules in the Internal Revenue Code.  Those plans that "qualify" under the Code include pension, profit sharing, and 401(k) plans.  “Non-qualified” plans include every other kind of deferred compensation plan.

            Prior to 2005, there was no comprehensive statutory foundation for the taxation of non-qualified plans.  For more than sixty years, the only tax rules for non-qualified plans were a mixed bag of inconsistent court decisions and IRS rulings interpreting the "constructive receipt" of income or "economic benefit" concepts.  In 1978 Congress actually prevented the IRS from imposing any new rules for non-qualified deferred compensation, thereby perpetuating this unstructured area of taxation. 

            Finally, twenty-six year later, in 2004, Congress filled the void by adding Section 409A to the Code.

            How Section 409A Works    The essentials of Section 409A are: 

• Section 409A applies to any plan that defers compensation other than (i) a qualified plan, or (ii) a bona fide vacation, leave sick pay, compensatory time, disability pay, or death benefit plan.
   
  
• Section 409A applies not only to conventional employer-employee relationships, but also to partners and partnerships and service recipients and independent contractors.
  
  
• If Section 409A is violated, the deferred income is increased by 20% and that larger amount is immediately taxed.  Punitive interest is added on.  This is the "teeth" of Section 409A.  Violations are called "plan failures." 
  
  
• A deferred compensation plan can not pay out the amounts deferred until one of six events occurs:  (1) separation from service (or 6 months later for key employees), (2) disability, (3) death, (4) a time fixed at the date of the deferral, (5) a change of control, or (6) an unforeseeable emergency.  No acceleration of benefits is allowed, except as permitted by IRS regulations.
  
  
• The election to defer must be made before the start of the year the services are performed, or within 30 days of joining the plan.

            As you can see, the IRS has a lot of work to do in defining the operating parameters of Section 409A.  The proposed regulations are understandably long because of all the issues the IRS must address.  Nonetheless, the statutory DNA of Section 409A codifies much of what we had already known about non-qualified plans.            

            Timing       When Section 409A was enacted in October, 2004, screams and howls erupted from the financial services industry about not having enough time to adjust to this "new world" of deferred compensation.

            Section 409A became effective on January 1, 2005.  The initial deadline for amending plans to come into compliance was originally December 31, 2005.  However, the new proposed regulations extend that deadline by one full year to December 31, 2006.

            You should note that this deadline is only for updating documents.  Until then, nonqualified plans must operate in "good faith compliance."

            How Section 409A Fits In     Section 409A was absolutely necessary if Congress was to put an end to the high profile executive compensation shenanigans such as those uncovered with Enron.  Before Section 409A was passed, there was no solid statutory basis for the IRS to police non-qualified deferred compensation plans, and Congress had in fact prevented IRS action.

            Section 409A adds symmetry to the Code.  Now, any deferred compensation will either be qualified, and be controlled by Sections 401, 403, 408, or 457, or non-qualified, and controlled by Section 409A.  There are no statutory cracks to fall through and no place to hide.

            Section 409A supplements other reforms made with respect to executive compensation, such as revisions to the split-dollar insurance rules.  Section 409A also complements, and in some cases may subtly overlap with, Code Section 83, which deals with "property" paid as compensation for services.   That's for another time.

            Section 409A Surprises     I believe that most Section 409A problems will not be uncovered during IRS audits.  Section 409A problems will pop up in other contexts.

            I do not see the IRS as the big threat for several reasons.  First, if an employer has a non-qualified plan, the employer's advisors --- the CPA, attorney, insurance agent --- will most likely know about Section 409A and review the plan for compliance.  Second, the IRS does not have enough trained staff to audit all the existing non-qualified plans.  Those IRS agents who audit qualified plans already have a full plate, and training the general IRS field agents in Section 409A would be a huge task.  Third, how can the IRS even find non-qualified plans to audit?  These plans do not file Form 5500.

            I believe the real disasters with Section 409A --- the ones that cannot be fixed without accelerating punitive compensation --- will be uncovered by someone other than the IRS.

            For example, a business is being sold.  The buyer's CPA and attorneys do their "due diligence" and discover an employment contract, buy-sell agreement, partnership agreement, consulting agreement, joint venture agreement, independent contractor agreement, or manufacturer's rep agreement that defers compensation and violates Section 409A.  What then?  A Section 409A surprise could also pop up on a bank's review of existing or new financing.  It could arise in the context of a shareholder dispute, a divorce, an estate settlement, or a corporate reorganization.

            Conclusion    Section 409A injects statutory DNA into non-qualified deferred compensation plans.  The substantive changes are not as threatening as many believe.  These rules apply to all compensation for services, not just employer-employee relationships.  However, complying with the new rules should not create an undue burden or hardship.        

© 2008 Eugene Parrs