Are your clients at risk from penalties on deferred comp plans?
One of your clients, Sally, is a 50-year-old senior
sales executive who, at your recommendation, for several years has been
putting her annual bonus into her company's nonqualified deferred
compensation (NQDC) plan.
You had advised her that since she didn't have an immediate need for her yearly bonus, and since her company offered a savings match, she should defer her bonus in the plan. That way, she will be accumulating substantial tax-deferred savings in addition to her 401(k) plan.
Sally has deferred her $30,000 bonus for the last five years. She has elected a distribution date at age 55, when she plans to take early retirement. Her NQDC plan statement shows a balance of nearly $200,000.
Sally's rising salary has made her ineligible for college financial aid for her 18-year-old daughter. Sally hadn't expected this. She decides to finance her daughter's first year's college expenses by taking an early plan withdrawal.
The CEO of Sally's company, who conveniently oversees the company's compensation committee, is happy to accommodate her. He remembers the firm's plan permits a withdrawal for "unforeseeable financial emergencies," and directs the plan's trustee to pay Sally $80,000 to cover her daughter's first year at school plus the income tax she will owe on the distribution.
When Sally telephones to tell you all this, you are first pleased that a recommendation you made several years ago has turned out so well. The funds are available. Slowly, as you recall reading an article that as best you remember had something to do with Enron, your satisfied expression turns first to uncertainty-then gradually to horror.
You take out from your desk file a folder labeled, "Section 409A," and ask Sally if you can call her back. Indeed, the article inside starts out by a reference to Enron:
"In the weeks preceding Enron's bankruptcy, executives were able to accelerate payouts of nonqualified deferred compensation to the detriment of rank and file employees, creditors and stockholders."
In response to such abuses, the article goes on to state, in 2004 Congress passed the American Jobs Creation Act, adding Section 409A to the Internal Revenue Code. While preserving the core NQDC plan benefits, Section 409A specifies new, more restrictive rules for plan implementation.
As you research these rules, you are hopeful momentarily as you see an early distribution is permitted for an "unforeseeable emergency." But Section 409A defines "unforeseeable emergency" as:
... a severe financial hardship to the participant resulting from illness or accident ... loss of the participant's property due to casualty ... or other similar extraordinary and unforeseeable circumstances ...
This won't fit Sally's case. It looks like she has inadvertently taken a disallowed distribution. What does Section 409A prescribe as the penalty for such a violation? The rules indicate all Sally's deferred compensation and plan earnings will become currently taxable retroactive to the date of deferral. Additionally, the taxable amount is increased by interest, and an extra 20% penalty is added on top.
Checking Sally's last tax return, a copy of which is in your files, you see she's in the 33% bracket. Given the current IRS penalty interest rate of 6%, plus the 20% add-on, you calculate that Sally will owe back taxes of $107,000! If there is any glimmer of good news here, it is only that Sally now has in her hands almost all the money that she will need to pay this penalty; how she will pay for her daughter's first year at college is up for grabs.
The Basic Rules Of Section 409A
To properly advise clients like Sally-hopefully before the crisis point-financial advisors need to understand how nonqualified deferred compensation plans work and, in particular, the new Section 409A rules.
Let's begin with a word of caution: The IRS is still clarifying these rules, so it's important to stay abreast of current regulations. For now, here is the basic information you need to know:
What is a nonqualified deferred compensation plan? This is any agreement including plans called NQDC plans, supplemental executive retirement plans (SERPs), 457(f) plans, and all other arrangements under which an employee (or individual contractor) earns compensation for services performed but will receive the money at a later date.
Are year-end bonuses considered deferred compensation? Section 409A exempts normal year-end bonuses, if paid within 21/2 months of year-end.
What are the advantages of NQDC plans? Employers offer these plans to attract, reward and retain key executives. Financial benefits to the more highly compensated employee include:
tax-deferred savings and investment growth,
a company match, and often,
company elective contributions based on tenure or performance.
Benefits to the employer include vesting these benefits or paying them out at retirement. This places the executive in "golden handcuffs."
Through performance provisions, the plan may also seek to align executive rewards with the attainment of long-term organizational objectives. Thus, both the executive and the employer benefit from the executive's participation in the plan and continuing commitment to the company.
Which employees can participate? A nonqualified deferred compensation plan, according to ERISA, must be for key executives only. Generally speaking, this means employees earning a salary of more than $100,000 who are at a level in the organization where they would have input into, and an understanding of, the plan.
How does a nonqualified deferred compensation plan work? An executive must elect to defer compensation before the year in which the compensation will be earned. (For bonus compensation only, the executive can currently make a deferral election as late as six months into the performance year.) For example, Sally elected to defer her first $30,000 for ten years, until she attains the age of 55. She elected to defer her second $30,000 bonus for nine years, and so forth.
Can a NQDC plan participant change his or her election? Yes, but only to extend the time period. Specifically, an election to delay or change the form of payment needs to be made at least a year in advance of when the new election is supposed to take effect. And the new distribution date must be at least five years after the old one.
Can a participating executive have any access to, or secure an indirect benefit from, his or her deferrals prior to the election date? With a few exceptions listed below, no. Until the elected or specified distribution date, the plan funds must remain the company's property. Thus, the plan is only "informally funded." The executive cannot derive any benefits from the deferrals until the election date(s) come due.
How does the employer fund the plan? The employer either pays the plan amounts out of current revenue, or more commonly, prefunds the plan out of periodic investments or corporate-owned life insurance. Obviously, an executive should only agree to participate in a plan if he or she is confident the money will be there when payments are due.
Do the Section 409A rules permit early plan distributions for any reasons? Yes, the exceptions are:
Separation from service
Change in ownership or control
Unforeseeable emergency (as defined earlier)
Miscellaneous (domestic relations order, conflict of interest divestiture requirements, de minimis cash-out payments)
In summary, a nonqualified deferred compensation plan enables key employees to benefit from tax-deferred savings growth. An executive in such a plan can elect to defer a very high percentage of his or her compensation. In return Congress, in drafting Section 409A, and the IRS in administering it, have established strict rules to prevent plan participants from accessing funds prematurely. This is to safeguard the interests of other employees, creditors and stockholders.
Lastly, as unfortunately Sally is likely to find out, the penalty for violating Section 409A is severe. And it falls on the individual, not on the company, even if it is the company that has mistakenly made the disallowed distribution.
Financial advisors need to know that all nonqualified deferred compensation plans must now operate within the new Section 409A rules. Most existing plans will need to be revised by year-end. If one of your clients is enrolled in such a plan, caution them about following the plan rules. Advise them strongly to seek legal advise from an attorney who specializes in NQDC rules before taking any action that could be judged an early distribution.
Richard Huttner is a compensation and
executive benefits consultant with Richard Huttner LLC of Waltham,
Mass. His email is firstname.lastname@example.org.