March 28, 2017
By Timothy A. Daum, CECP, CPC
Nonqualified deferred compensation plans are common in many industries, as well as with employee stock ownership plan (ESOP) companies, and are used to attract, retain, and motivate key employees. In addition to general plan design and fiduciary considerations (which are particularly relevant for ESOP companies), however, there are other issues for companies to consider when establishing a deferred compensation plan.
One of the main advantages of nonqualified deferred compensation plans is that many of the requirements that apply to qualified retirement plans do not apply to nonqualified plans. This difference exists because nonqualified plans, if structured properly, are exempt from many of the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). ERISA exemption typically is secured by ensuring that the plans be unfunded and cover only a select group of management or highly compensated employees (often referred to as the “top-hat” group of employees). However, even top-hat plans are subject to the ERISA annual Form 5500, “Annual Return/Report of Employee Benefit Plan,” filing requirement, unless such plans satisfy the alternative method of compliance contained in ERISA Regulation Section 2520.104-23, which entails filing a one-page statement with the Department of Labor within 120 days of establishing the plan.
Employers who either have failed to timely file the statement or failed to maintain documentation of such timely filing should consider filing as soon as possible under the Department of Labor’s Delinquent Filer Voluntary Compliance Program. The program requires a $750 penalty, which is a bargain compared to the potential penalty of $300 per day, up to $30,000 per year, that could otherwise be assessed by the Department of Labor for not filing Form 5500.
Deferred compensation plans must be structured to either comply with or be exempt from Section 409A of the IRC. Failure to comply with Section 409A (either a plan document failure or an operational failure) generally results in the following adverse tax consequences for affected individuals:
- All compensation deferred under such plans and all other plans of the same type is includible in income for the year of the failure to the extent such compensation is vested and has not been previously included in income.
- An additional 20 percent tax is assessed on such compensation.
- A third tax is assessed on any part of the compensation that vested in a previous year. The tax assessed is based on the interest that would have accrued (based on the underpayment rate, plus 1 percent) on unpaid income taxes had the deferred compensation been includible in income for the year in which it first became vested.
Employers are required to report Section 409A violations on affected employees’ W-2 forms, “Wage and Tax Statement,” by including the tainted deferred compensation in box 1 wages and in box 12 with a code Z. Employers also are required to withhold on the amount includible in income, although the penalty taxes are not subject to withholding. There are two voluntary correction programs available for Section 409A violations. IRS Notice 2008-113 contains the program for self-correction of operational failures and Notice 2010-6 contains the program for self-correction of plan document failures. If a failure occurs, the employer should consult the notices to see if the failure is eligible for self-correction. Unfortunately, however, failures often are not eligible under the narrow scope of these self-correction programs.
In addition to requiring that a deferred compensation plan be documented in writing, Section 409A imposes rigid rules regarding voluntary deferral elections and the timing of plan distributions. For example, Section 409A generally allows payment to be triggered only by the occurrence of one or more of the following permissible payment-triggering events (all of the following except death are defined in a particular manner under Section 409A):
- The employee’s separation from service with the employer
- The employee’s death
- The employee’s disability
- The occurrence of an unforeseeable emergency
- A change in control of the employer
- A predetermined time of payment
There are some exceptions to the trigger rules. For example, even if one of the above payment-triggering events has not yet occurred, it still may be possible to make a payment to the employee to avoid a Section 409(p) failure, which is discussed in the next section. It also is possible to terminate a plan and liquidate it in its entirety. However, there are certain requirements that might apply to plan terminations, such as having to wait one year after plan termination before liquidating the plan, or being precluded from establishing a similar plan for a period of three years after the plan is terminated.
ESOPs sponsored by S corporations are subject to anti-abuse testing under Section 409(p) of the IRC. Failing a Section 409(p) test is a significant concern, as the consequences of a failed test are draconian. The third-party administrator for an ESOP typically performs Section 409(p) testing for an S-corp ESOP on an annual basis. However, because deferred compensation is considered synthetic equity under the Section 409(p) rules and because an ESOP must satisfy 409(p) on every day of the year, it is important to consider the impact that a deferred compensation plan will have on Section 409(p) testing prior to establishing the plan.
It always is prudent to have the third-party administrator perform projected Section 409(p) testing (based on anticipated plan provisions and anticipated eligibility) before a plan is established. The results of the projected testing could require the employer to modify plan provisions, modify who is eligible to participate in the plan, or even scrap the plan altogether. It is important that any of these actions occur prior to the formal establishment of the plan.
It also should be noted that the number of shares of synthetic equity attributable to deferred compensation can fluctuate from year to year as a company’s stock price fluctuates. The lower the stock price, the more shares of synthetic equity that will be attributed to a particular amount of deferred compensation. Thus, in a down market, it is possible that Section 409(p) could become an issue, even if prior projected testing indicted that there should be no issue. For this reason, it might be prudent for the projected Section 409(p) testing to be performed under a conservative scenario that assumes a significant down market.
Although deferred compensation is not subject to income taxation until the compensation is paid (assuming Section 409A requirements are satisfied and no constructive receipt issues), Federal Insurance Contributions Act (FICA) taxation generally occurs earlier. The FICA rules generally require that deferred compensation be included in income upon vesting. Thus, voluntary employee deferrals that are immediately 100 percent vested are includable in FICA wages at the time of deferral. Employer deferrals that vest only upon the satisfaction of continued service requirements or achievement of performance goals are includable in FICA wages at the time such service requirements are satisfied or such performance goals are achieved. The amount includable in FICA wages is based on the value of the deferred compensation at the time of vesting (including any earnings from the time of deferral to the vesting date). Any earnings credited on an amount that has been previously included in FICA wages (post-vesting earnings) completely escape FICA taxation as long as such earnings are based either on a reasonable rate of interest or an actual predetermined investment.
There is an exception to the general FICA rules for certain deferred compensation plans. The exception generally is applicable if the present value of the benefit cannot be determined at the time of vesting. For example, assume a defined benefit plan provides for an annual payment of $20,000 per year for 10 years, with the first payment commencing within 90 days of the employee’s separation from service. Also assume that the employee becomes vested in the benefit at age 62 after satisfying the plan’s 10-year vesting requirement. The general FICA rules would require the present value of the deferred compensation to be included in FICA wages at the time the 10-year vesting requirement is satisfied. However, such present value cannot be calculated if it isn’t known when payments will commence (for instance, if it isn’t known when the employee will separate from service). In such a situation, FICA taxation may be postponed until such time as the present value can be calculated (for instance, until it is known when the employee will separate from service).
Look Before You Leap
Companies considering establishing a deferred compensation plan have many issues to consider other than normal plan design issues and fiduciary considerations. These issues include ERISA exemption, Sections 409A and 409(p), and FICA taxation. It is a best practice to become familiar with these issues and to address early on any potential concerns during the process of establishing a deferred compensation plan. Such an approach will help to avoid any unpleasant surprises down the road.