What Is Deferred Compensation and Why Does It Matter?

October 19th, 2011 by JBWK

Nonqualified deferred compensation plans (as opposed to tax-favored “qualified” retirement plans) have become a popular option for employers to attract and retain management employees, often providing the so-called “golden handcuffs” to encourage key employees to stay for a certain number of years or until certain performance targets are reached. But planning for nonqualified deferred compensation has become much more complicated in recent years.

After the spectacular corporate implosions in the early 2000s, section 409A was added to the tax code. It drastically limited the flexibility of nonqualified deferred compensation plans and imposed some of the most severe penalties on employees for noncompliance. In doing so, it not only imposed regulations on standard deferred compensation plans–it also swept up a wide range of benefits and compensation arrangements that employers may not even think twice about.

Section 409A, with some specific exceptions, governs any compensation that is earned in one year but payable in a later year. It strictly regulates the details of the plan structure, acceptable times and forms of payment, and limits when, how, and under what circumstances the employee may be paid promised deferred compensation.

But while the definition is simplistic, it masks the complexity that arises in figuring out the precise details. For example, unless structured to fit into 409A’s narrow exception, severance packages could be included. Individual employment contracts are subject to 409A. Post-retirement benefits could be included. Even independent contractors may be roped in if they perform significant services for the employer. Perhaps even more dangerous is unwittingly triggering 409A–which requires a fully compliant written plan document–by casual or informal promises to employees. And to make matters worse, it’s not just limited to top executives, key employees, or publicly traded companies–everyone is subject to 409A.

And why does it all matter? Section 409A imposes, on top of the normal income and employment taxes, a 20% penalty and interest on the employee receiving the compensation, meaning the employee’s hard-earned deferred compensation could be reduced to almost zero if the employer fails to comply with 409A.

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