Bar News - February 17, 2016
Tax Law: IRS Steps Up Audits of Deferred Compensation Plans
By: Peter Beach
Top Hat NQDC Arrangements
No article on NQDC compliance would be complete without at least a brief reference to the Employee Retirement Income Security Act (ERISA) issues relating to so-called top hat plans, which are arrangements designed to benefit only a select group of management or highly compensated employees.
Top hat plans are exempt from ERISA’s reporting and disclosure rules, if the plan administrator timely files a simple statement with the Department of Labor (DOL). Details are provided at askebsa.dol.gov.
In addition, a correction procedure exists for certain employers that have failed to file the notice in a timely manner. Top hat plans, however, are not exempt from ERISA’s general enforcement rules. This means that they must comply with the normal claims and appeals procedures that apply to qualified plans. It also means that the only remedies available to top hat plan participants are those set forth in ERISA. Although some practitioners argue that the claims and appeals procedures need not be set forth in a top hat plan, the better practice is to include them.
Now is an excellent time to review nonqualified deferred compensation arrangements with business clients, before the Internal Revenue Service shows up to audit them.
In 2014, the IRS began an audit initiative targeting nonqualified deferred compensation (NQDC) compliance under Section 409A, which imposes strict requirements relating to NQDC distributions, acceleration of benefits, and elections. Then in June 2015, presumably based at least in part on common areas of non-compliance identified through the initiative, the IRS issued Section 409A Audit Guidelines for its agents.
As a result, it is now more likely that employment tax audits will include a review of NQDC arrangements. In many cases, Section 409A documentation and operational problems can be corrected, thereby avoiding significant tax consequences, provided the problems are identified in time and corrected in accordance with IRS guidance.
More and more businesses are using NQDC arrangements to provide incentives for valued executives. But developing and managing these arrangements properly can be difficult. Seemingly minor missteps in documentation or operation can result in significant penalties. This article focuses on certain best practices and common mistakes related to NQDC arrangements. An NQDC review generally involves the three phases described below:
All employment agreements are possible NQDC arrangements, whether or not the agreement or any section of the agreement is styled as such. In addition, bonus and stock option plans and change-of-control and severance agreements can raise Section 409A issues.
Determining Which NQDC
Arrangements Are Subject to
To be subject to Section 409A, an arrangement must establish a legally binding right to compensation that is payable in a later tax year. However, certain arrangements that meet this requirement are nevertheless exempt, including: certain qualified retirement plans; some welfare benefit plans, such as bona fide vacation leave, sick leave, compensatory time, disability pay, and death benefit plans; so-called short-term deferrals (i.e., where the employee receives the compensation within 2.5 months after the end of the tax year of the employer or employee, whichever is later); and nonstatutory stock options and stock appreciation rights on employer stock, if they are not “in the money” on the date of grant, and there is no other feature for deferral of compensation.
Determining Whether an
NQDC Arrangement Complies
with Section 409A
There are four general requirements in Section 409A. They relate to: (1) the initial deferral election, (2) the timing of payments, (3) acceleration of payments, and (4) later deferral elections.
Initial deferral elections. In general, an employee must make the initial election to defer compensation before the year in which the services are performed. In an employee’s first year of eligibility, he or she may make a deferral election in the first 30 days of participation, but the election may apply only to compensation earned after the election was made. Certain elections to defer performance-based compensation can be made no later than six months before the performance period ends.
Timing of payments. Payments under an NQDC arrangement must be made at a fixed date, under a fixed schedule, or upon any of the following five events: separation from service; death; disability; change in ownership or control; or unforeseeable emergency. If the timing of payment is based on one of these types of events, the arrangement must designate an objectively determinable date or year after the event on which payment is to be made.
So-called haircut provisions, which provide that the participant may take a payment at any time so long as the payment is of a reduced amount, are prohibited under this rule. This “haircut” prohibition should not be confused with a participant’s ability to forfeit the right to a portion of a payment as long as the time and form of payment are not changed. Such confusion can lead companies, participants and their advisors to mistakenly limit downward adjustments to deferred compensation amounts that meet the forfeiture requirements under Section 409A.
Determining when a separation from service event has occurred can present some unique challenges, especially where a participant wants to work part-time for a while before retiring. The 409A regulations provide parameters under which part-time employment will or will not constitute a separation from service. Addressing this part-time issue in writing in an NQDC arrangement is a better practice that makes impermissible payouts less likely to occur.
Anti-acceleration rule. Payments of deferred compensation generally may not be accelerated. There are some exceptions to this rule, such as for payments necessary to comply with a domestic relations order or conflict-of-interest rules and for certain payments when plans are terminated. A common mistake made in connection with acceleration of payments is giving the employer the power to accelerate payment. Under Section 409A, neither the employer nor the employee can have the power to accelerate payments.
Re-deferral elections. An NQDC arrangement may allow an employee to elect to delay or change the form of a payment only if the election does not take effect until at least 12 months after the date on which it was made. In addition, if the election relates to a payment that isn’t on account of death, disability, or unforeseeable emergency, the first payment for which the election is made must be deferred for at least five years.
NQDC arrangements are not required to set forth these re-deferral requirements. As a result, it is not uncommon for employers to grant impermissible re-deferrals. Rather than assuming that employers will consult their tax advisors before granting a re-deferral, the better practice is to include the requirements in the agreement.
Correcting Section 409A Errors
Because the Section 409A rules are complex, compliance errors are likely to occur, exposing taxpayers to potentially severe consequences. Recognizing this, the IRS has provided correction procedures that allow some taxpayers to avoid the full impact of these consequences, which include a 20 percent additional tax.
Complying with the correction procedures requires paying significant attention not only to the procedures themselves, but also to the history of the NQDC arrangement’s documentation and operation.
A more detailed version of this article is available at www.sheehan.com in the publications section.
Peter Beach is head of the tax department at Sheehan Phinney Bass + Green. His practice covers a broad range of federal, international, state and local tax matters, including mergers and acquisitions, workouts, corporate and pass-through entity taxation and tax-exempt organizations.