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
Disability
Death
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 [email protected].