Employer considerations for operating, amending and terminating
INSIGHT ARTICLE |
Authored by RSM US LLP
Nonqualified deferred compensation (NQDC) refers broadly to any plan, policy, arrangement, employment agreement, severance agreement or other document where an employer promises to make payments in a future year to employees or independent contractors (referred to here as service providers) in connection with the performance of services. NQDC is governed by section 409A of the Internal Revenue Code and, additionally, by section 457(f) if the plan sponsor is a governmental entity or tax-exempt organization.The life cycle of a NQDC plan spans four main phases: plan design and implementation, plan operations, plan amendments and plan termination. At each stage of a NQDC plan’s life cycle, employers should consider whether their plan remains compliant and aligned with the organization’s goals. This article highlights several of the main considerations for employers when they are operating, amending or terminating a NQDC plan. For more information on plan design and implementation, such as the advantages of establishing a NQDC plan, the tax consequences of a NQDC plan and design considerations, see this related insight article.
When operating, amending or terminating a NQDC plan, employers should consider the following:
How often should I review my NQDC plan(s) for compliance with section 409A?
Employers should continuously monitor NQDC plans to confirm they are compliant with section 409A and that the occurrence of an event (e.g., a transaction or a change in control of the company) does not cause the employer to experience a plan failure. Examples of common plan operational failures include:
a. Making a payment in the wrong year, such as delaying or accelerating a payment (unless an exception is provided in section 409A, as discussed below in question 5)
b. Failing to make a deferred payment when due
c. Failing to report payroll taxes when due
d. Making payments upon impermissible events
e. Accelerating the timing of payments
f. Failing to properly administer deferral elections
The occurrence of a plan failure can result in significant penalties and the loss of benefits under the plan to service providers (i.e., nontaxable, deferred income may become immediately taxable to service providers). The IRS also assesses interest and a 20% penalty tax on each service provider affected by an operational error. In light of this, it is important to prevent, detect and correct any plan failures in a timely manner to mitigate these consequences.
What happens if I discover an error in my plan that is subject to section 409A?
To mitigate the aforementioned penalties and adverse tax treatment, errors should be corrected upon discovery when possible. While there is not a formal IRS correction program for NQDC plan errors like there is for correcting qualified plan errors (i.e., the Employee Plans Compliance Resolution System), the IRS provides guidance that describes self-correction steps an employer can take for NQDC plan operational and documentation-related errors in Notices 2008-113, 2010-6 and 2010-80. Consulting with a tax advisor and having NQDC plans regularly reviewed can have a significant impact on avoiding plan failures as well as detecting and correcting plan failures in a timely manner.
How do I report deferred compensation to employees or independent contractors?
There are two separate reporting rules for deferred compensation: 1) reporting payments made from the NQDC plan to the employee and the associated federal income tax withholding, and 2) reporting payroll taxes and payroll tax withholding on those payments.
Under a special timing rule applicable to account balance plans (whether your plan is an account balance or nonaccount balance plan should be reviewed with your advisors), NQDC is subject to payroll taxes under the Federal Insurance Contributions Act (FICA) (i.e., Social Security and Medicare taxes) and is taken into account as FICA wages at the later of:
a. When the employee performs the services to earn the compensation
b. When there is no substantial risk of forfeiture of the rights to the NQDC (i.e., at vesting)
Therefore, payroll taxes and payroll tax withholding generally apply to NQDC before it is paid to an employee since many NQDC plans are designed for plan benefits to be made in a later year than vesting. As the NQDC is taken into account as FICA wages, the amount of the payment is reported on an employee’s Form W-2 (Wage and Tax Statement) in boxes 3 (Social Security wages), 4 (Social Security tax withheld), 5 (Medicare wages and tips) and 6 (Medicare tax withheld).
Upon the employee’s receipt of the payment in a later year, the NQDC is subject to federal income tax and is reportable on an employee’s Form W-2 in boxes 1 (Wages, tips, other compensation), 2 (Federal income tax withheld) and 11 (Nonqualified plans). If an employer follows the special timing rule, the related nonduplication rule provides that any subsequent payments (including additional earnings on the account balance) will not be subject to FICA taxes upon payment. Therefore, failure to follow the special timing rule may lead to both the employer and employee paying unnecessary FICA taxes.
These rules are summarized in the table below:
Reporting in year of vesting
Reporting in year of payment
Form W-2: boxes 3, 4, 5, and 6
Form W-2: boxes 1, 2, and 11
Note that NQDC may also be subject to state and local taxes when paid to the employee, and the applicable rules from each jurisdiction should be consulted to determine their applicability. Note also that special reporting rules may apply for NQDC payments made to beneficiaries of deceased employees.
Companies often sponsor NQDC plans for directors or other independent contractors. Independent contractors are not subject to FICA, but are subject to the Self Employment Contribution Act (SECA). As independent contractors are not employees, a company that sponsors a NQDC plan for its independent contractors does not have any income or employment tax withholding obligations. Unlike FICA, the self-employment tax rules do not have a special timing rule for deferred compensation amounts. Such amounts are only taxable for SECA when paid or otherwise includable in income (e.g., a 409A violation).
A NQDC plan sponsor does, however, have responsibility to report payments of deferred compensation to its independent contractors. A company will report these amounts to their independent contractors on Form 1099-NEC (Nonemployee Compensation) and 1099-MISC (Miscellaneous Income) as discussed below, and the independent contractors in turn must include these on Schedule SE (Self-Employment Tax) of Form 1040 (U.S. Individual Income Tax Return). For tax years beginning in 2020 or later, the deferrals are reported on Form 1099-MISC, box 12. At this time, the reporting of deferrals is optional. In the year paid, employers report NQDC on Form 1099-NEC, box 1.
These rules are summarized in the table below:
Reporting in years of deferral
Reporting in years of payment
Beginning in 2020 or later
Optional: Form 1099-MISC, box 12
Form 1099-NEC, box 1
When should I consider an amendment to my NQDC plan?
You should consider an amendment to your NQDC plan upon discovering an error in the way in which the documents were drafted, to correct a section 409A failure or to make changes to the terms of the plan. Before pursuing any amendments, it is important to have a discussion of the amendments with your tax advisor or legal counsel, as certain amendments may inadvertently trigger a section 409A failure.
Examples of permissible amendments include adopting a provision to require that amounts paid out under the plan do not exceed a specified amount or changing the amount of an employer’s matching contribution. Examples of impermissible amendments include adding an event upon which payments may be accelerated under the plan that was not specified in the original plan terms or allowing an employer to have discretion over the timing of the payments under the plan.
What if I need to accelerate or delay a payment from a NQDC plan to an employee? Am I able to amend my NQDC plan for payment timing, or are there any exceptions under section 409A that would allow me to either accelerate or delay a payment without incurring a plan failure?
Under section 409A, the payment terms of the NQDC plan generally cannot be modified and, therefore, any payment timing specified in the terms of the plan must be followed. However, there are exceptions where payments may be accelerated or delayed without either amending a NQDC plan or incurring a plan failure:
Deferral election timing
A service provider may elect to defer a payment of compensation until a future date under a nonqualified deferred compensation plan, provided that all of the following conditions are satisfied (Reg. section 1.409A-2(a)); such election must:
a. Be made by an employee no later than the close of the tax year before the employee wishes the election to be effective, with an exception for employees hired during the year
b. State the timing and form of payment
c. Be irrevocable
Where an employer provides for contributions under a NQDC plan, a similar rule applies, requiring the plan to be in place no later than the close of the tax year before the compensation is earned, and the timing and form of the payment to be fixed. These terms are irrevocable, subject to the rules and exceptions discussed above.
Accelerating a payment
Section 409A generally prohibits the acceleration of payments and treats accelerated payments as operational failures. However, Reg. section 1.409A-3(j)(4) provides for certain exceptions for the acceleration of payment without incurring a plan failure. Most commonly, acceleration may be permitted where the deferred payment is one of the following:
a. Necessary to fulfill a domestic-relations order or comply with ethics or conflicts of interest laws
b. Necessary to pay out amounts in the event of a section 409A violation or pay federal employment, state, local or foreign taxes
c. Distributed from a section 457(f) plan for payment of taxes on vesting
d. The result of a plan termination or liquidation (subject to certain requirements)
e. Made on account of disability
f. Made to offset a certain type of debt owed to the employer
Delaying a payment
If a NQDC plan is drafted such that it permits participants to make a deferral election postponing scheduled payments, the election is allowable if both of the following conditions are satisfied (section 409A(a)(4)(C)):
a. The deferral election must take place at least 12 months in advance of the date the election would become effective
b. The compensation must be deferred for a period of not less than five years from the originally scheduled payment date
In addition to the requirements of section 409A, a similar rule exists for section 457(f) plans of tax-exempt organizations if all of the following conditions are satisfied (Prop. Reg. section 1.457-12(e)(2)):
a. A tax-exempt organization and service provider must agree in writing to the addition or extension of a substantial risk of forfeiture (which generally controls the timing of the taxable compensation) at least 90 days in advance of when the existing substantial risk of forfeiture would have lapsed
b. The service provider must be required to perform services in the future for a minimum period of two years after the date the service provider would have originally received the compensation
c. The present value of the benefit must be materially greater (i.e., 125%) than the present value of the amount the employee would have received without the extension of the risk of forfeiture
There are limited other opportunities to delay a payment under a NQDC plan without incurring a section 409A failure, although certain circumstances such as a merger or acquisition transaction or the company being a going concern may allow for certain delays. Employers should consult with a section 409A specialist before missing a stated payment date.
Since section 409A provides an exception that allows for the acceleration of payments when a NQDC plan terminates or liquidates, would timing the termination or liquidation of my NQDC plan be an acceptable means of accelerating payments without having to amend my plan or incur a plan failure?
Yes, section 409A provides an exception that allows businesses to terminate their plans and make payments within certain timeframes without having to amend the plan or incur the harsh penalties associated with a section 409A failure. Under this rule, termination of a NQDC plan is allowable if all of the following conditions are met (Reg. section 1.409A-3(j)(4)(ix)):
a. The termination cannot be due to economic hardship experienced by the company
b. Any similar NQDC plans operated by the employer must also be terminated
c. Payments out of the plan cannot be made within 12 months of the date the employer decides to terminate the plan
d. All payments must be made within 24 months of the employer’s decision to terminate the plan
e. The employer cannot adopt a new NQDC plan within three years of terminating its NQDC plan
Plans may also be terminated and provide for the acceleration of payment when there have been certain corporate dissolutions or a change in control.
Under these types of terminations or liquidations, the service recipient would recognize income in the year the accelerated payments are received, and the employer would generally receive a corresponding deduction for amounts paid.
If I sell my business, how will this affect my NQDC plan?
When a business is sold, the sale may trigger payments if the NQDC plan designates a change in control (as defined in section 409A) as a payment trigger. Because section 409A generally prohibits the acceleration of payments, a plan failure would occur if the change in control is not a payment trigger in the plan and a payment was made. In this latter situation, a change in control may allow for a plan termination that would allow acceleration of payment if it was desired and the plan did not otherwise provide for a payment upon the change in control. This termination rule works differently than the one mentioned above (which again shows why employers must operate section 409A plans very carefully without making assumptions).
What if I sell a portion of my business and do not intend to terminate my NQDC plan? Would this cause a section 409A failure?
It depends; a company is not required to terminate its plan upon either a full or a partial sale of the business. However, a partial sale may trigger a change in control, and change in control is a common distribution-triggering event in a NQDC plan. Accordingly, in a partial sale situation, the company needs to carefully review the terms of the plan to see whether payments might be necessary.
However, a partial sale of a business may fail to satisfy section 409A’s definition of a change in control, and therefore may not be a permissible payment trigger under section 409A. A change in control for section 409A purposes generally occurs if:
a. A person or group acquires more than 50% of the total fair market value or voting power of the stock of a corporation
b. A person or group acquires at least 30% of the total voting power of the stock of the corporation over the past 12 months
c. The majority of the corporation’s board of directors is replaced over the past 12 months
d. At least 40% of the business’s assets are sold
If a transaction does not meet this threshold, the plan’s change in control provisions will not trigger required distributions. However, to the extent an employee has a separation from service, the NQDC plan’s other payment rules for former employees would apply.
It may also be possible that a change in control is not a stated payment event in the plan. In that case, in order to make payments, the employer must terminate the plan in connection with that change in control, in which case the employer has 30 days prior to the change in control event or up to 12 months following the change in control event to make payments to employees.
Being aware of the strict provisions for NQDC is integral to achieving the intended tax results of the plan. If you have not reviewed your plan recently, or if you have had changes with the external or internal service providers to the plan, it is likely time to do a thorough review of the plan’s document and operating procedures to ensure your plan is operating in the way you intended.
This article was written by Anne Bushman, Toby Ruda, Joni Andrioff, Lauren Sanchez and originally appeared on 2021-09-14.
2021 RSM US LLP. All rights reserved.
The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.
RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each is separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/about us for more information regarding RSM US LLP and RSM International. The RSM logo is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.
LaPorte is a proud member of the RSM US Alliance, a premier affiliation of independent accounting and consulting firms in the United States. RSM US Alliance provides our firm with access to resources of RSM US LLP, the leading provider of audit, tax and consulting services focused on the middle market. RSM US LLP is a licensed CPA firm and the U.S. member of RSM International, a global network of independent audit, tax and consulting firms with more than 43,000 people in over 120 countries.
Our membership in RSM US Alliance has elevated our capabilities in the marketplace, helping to differentiate our firm from the competition while allowing us to maintain our independence and entrepreneurial culture. We have access to a valuable peer network of like-sized firms as well as a broad range of tools, expertise, and technical resources.
For more information on how LaPorte can assist you, please call 713.548.2034.