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TAX TALK: Basic Rules of Deferred Compensation under Nonqualified Plans

Posted by Hal Zemel, CPA, J.D., LL.M. on Nov 28, 2016 7:00:00 AM
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Nonqualified deferred compensation (NQDC) plans are unsecured promises by the employer to pay executives at a specific time or upon a specific event in the future for services currently performed. Unlike qualified plans, such as 401(k) s, NQDC plans:

  • Can discriminate in favor of highly compensated employees;
  • Have no limit on the amount of compensation that the executive can defer;
  • Defer the employer’s compensation deduction to the year the employee is taxed on the income; and
  • Allow the employer’s general creditors to reach any amounts set-aside to fund the future payments.

Failure to understand the complex rules applicable to NQDC plans can cause substantial tax consequences.

What you need to know

Internal Revenue Code (IRC) Sections 409A,457A and related IRS guidance have tightened and clarified the rules for NQDC plans. Some of the most important rules to be aware of affect:

Timing of initial deferral elections. Employees generally must make the initial deferral election before the year in which they perform the services for which the compensation is earned. For example, if you wish to defer part of your 2017 compensation to 2018 or beyond, you generally must make the election by the end of 2016.

Timing of distributions.  Benefits must be paid on a specified date, according to a fixed payment schedule or after the occurrence of a specified event — such as death, disability, separation from service, change in ownership or control of the employer, or an unforeseeable emergency.

Elections to change timing or form. The timing of benefits can be delayed but not accelerated. Elections to change the timing or form of a payment must be made at least 12 months in advance. Also, new payment dates must be at least five years after the date the payment would otherwise have been made.

Employment tax issues

Another important NQDC tax issue is that employment taxes for social security, Medicare, and unemployment are generally due when services are performed or when there’s no longer a substantial risk of forfeiture (becomes vested), whichever is later. This is true even though the compensation isn’t actually paid or recognized for income tax purposes until later years. So your employer may:

  • Withhold your portion of the tax from your salary;
  • Ask you to write a check for the liability; or
  • Pay your portion, in which case you’ll have additional taxable income.

No Loans. Unlike a section 401(k) plan, loans from a NQDC are not permitted.

Protecting the money. Employers can still set aside the money owed in a trust for benefit of the employee (as long as the trust is located in the US), which provides some protection to the employee. However, the employee is not protected if the employer enters into a bankruptcy or insolvency proceeding.

Employer must be subject to US tax. If the employer is not subject to US income tax (e.g., tax exempt or foreign entity), deferral is not permitted.

State taxes. In certain instances, it may be possible to eliminate or reduce the state income tax on payments from an NQDC plan. This can occur when an employee earns the income while working in a high-tax state but receives the benefits after retirement and moves to a low-tax (or no-tax) state.

Consequences of noncompliance

The penalties for noncompliance can be severe: Plan participants (that is, you, the employee) will be taxed on plan benefits at the time of vesting, and a 20% penalty and potential interest charges also will apply. So if you’re receiving NQDC, you should check with your employer to make sure it’s addressing any compliance issues. And we can help incorporate your NQDC or other compensation into your year-end tax planning and a comprehensive tax planning strategy for 2016 and beyond.

Questions? Contact me at HZemel@BerdonLLP.com or your Berdon advisor.

Hal Zemel, a Tax Principal at Berdon LLP, New York Accountants, has more than 20 years in public accounting and advises businesses in the real estate, service, and manufacturing sectors.

Topics: TAX TALK

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