The 411 on Section 409A: Risk and Rewards of NQDC Plans

Questions on what’s new in non-qualified deferred compensation plans? A comprehensive Meridian primer covers the legal aspects of Section 409A of the IRS code, outlines the serious consequences of non-compliance and addresses emerging trends in NQDC plans in executive compensation.

Why it matters. Offering an NQDC plan to executives can be a game-changer for attracting and retaining top talent. Be on top of the rules that govern these plans, because 409A violations come with serious penalties for the executive and the employer.

Dig deeper: NQDC plans provide an opportunity for high income earners to save beyond 401(k) plan limits, allowing them to build meaningful income replacement at retirement, accumulate wealth and defer federal income tax while working. A current trend is for executives to defer earnings from the performance plan (either shares or cash settlements). However, it should be mentioned that payroll taxes (FICA) are due from the employee when the award is vested and there is no substantial risk of forfeiture.

NQDC plans are administratively complex for employers. Be aware of the key requirements that pose the greatest risks:

• Distribution timing. Must be specified by the employee at the onset of the deferral arrangement.
  
  
• Deferral elections. Must follow strict timelines per the regulations.
  
  
• No acceleration of payments. Generally, any modification to the initial distribution timing will create a 5-year delay from the original schedule.

A major risk to the executive is substantial financial penalties if the company is found to violate Section 409A. These include:

• The immediate inclusion of income of the total deferred amount will be reportable income in the tax year of the violation.
  
  
• An additional 20% tax will be applied to the deferred amount.
  
  
• Interest penalties: a 1% interest fee is applied on the underpayments that would have occurred had the deferred compensation been included.

Takeaways. Ensure the plan administrators are in lockstep with tax and legal experts on all compliance aspects, and that documentation is up-to-date. Leading companies establish internal audits and reviews of elections, distributions, and eligibility and educate participants on the plan, taking prompt corrective actions for plan errors under the IRS correction procedures.