A nonqualified deferred compensation (NQDC) plan is an arrangement between an employer and an employee where the employee can defer receiving a portion of the employee’s compensation, typically salary or bonuses, until a later date. Unlike qualified plans, such as a 401(k), NQDC plans do not receive favorable tax treatment under the Internal Revenue Code. Instead, the deferred compensation is subject to income tax when it is paid out to the employee. Employers should properly design and administer NQDC plans to comply with the rules of Section 409A, and employees should understand the terms of their plan and the potential tax implications of deferring their compensation.
Typical Use of Deferred Compensation Plans
NQDC plans are typically used to provide additional compensation to executives and other highly compensated employees who have reached the contribution limits of qualified plans. They can also be used to help retain key employees by providing a deferred compensation benefit that is payable in the future. The Internal Revenue Code imposes significant limitations on the benefits and contributions that can be earned under tax qualified plans such as 401(k) plans.
Some common types of NQDC plans include deferred compensation plans, supplemental executive retirement plans (SERPs), phantom stock plans, and stock appreciation rights (SARs). Each type of plan has its own specific rules and requirements for deferral, payout, and taxation.
NQDC plans are subject to the rules of Section 409A of the Internal Revenue Code
NQDC plans are subject to the rules of Section 409A of the Internal Revenue Code, which sets out the requirements for the timing and form of deferral, distribution, and acceleration of payments. Failure to comply with the rules of Section 409A can result in significant tax penalties for both the employer and the employee.
For example, deferred compensation pursuant to a NQDC plan that does not satisfy the rules of 409A would be immediately taxable as ordinary income, regardless of when that compensation is actually received by the employee! As an employee, it is important to understand the rules of Section 409A to ensure that you receive the tax benefits of deferred compensation and avoid penalties for noncompliance.
The following are some of the key rules you should be aware of:
Timing of deferrals: If you want to defer your compensation under an NQDC plan, you must make the deferral election before the year in which the compensation is earned. This means that you must make the election in advance of the year in which you would otherwise receive the compensation.
Distribution requirements: Deferred compensation must be distributed at a specified time or event. This means that you will only receive the deferred compensation at a certain date, a change in control of the company, or your death, disability, or retirement.
Restrictions on accelerating distributions: You cannot change the timing of payments once you have made the deferral election unless certain requirements are met. If you do not meet these requirements, you may be subject to penalties.
Penalties for noncompliance: If you receive deferred compensation that does not comply with the rules of Section 409A, you may be subject to additional taxes and interest on the deferred compensation that was not properly deferred. Always remember that NQDC plans are subject to audit by the IRS.
Conclusion
Internal Revenue Code Section 409A sets out the rules for nonqualified deferred compensation plans. To ensure that you comply with Section 409A, you should communicate with your employer and be familiar with the terms of your NQDC plan. You should also make your deferral election in advance of the year in which the compensation is earned and be aware of the restrictions on accelerating distributions. If you have any questions about setting up a NQDC plan or the rules of Section 409A, you should consult with a tax or financial advisor.
