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Distributions from Nonqualified Deferred Compensation Plans

“With respect to distributions from nonqualified deferred compensation (NQDC) plans, what are the timing requirements?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Texas is representative of a common inquiry related to distributions from Internal Revenue Code Section (IRC §) 409A NQDC plans.

Highlights of Discussion

Sponsors of NQDC plans must enforce strict distribution rules that are dictated by IRC §409A, the terms of the governing plan document and the elections made by participants (if permitted). Regarding the last variable, if a plan permits participants to elect how and when they will take distributions, they must execute their elections before deferring their compensation into the plan. The timing of withdrawals is an important tax consideration that requires advance planning. Once the form and timing of distributions are set (typically when deferral elections are made), there are complex rules that apply if participants want to make changes.

Under IRC §409A, payment events are limited to

  • Separation from service (as defined by the plan);
  • Death;
  • Disability;
  • A specified time or according to a fixed schedule;
  • An unforeseeable emergency; or
  • A change in the ownership or effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation (as defined by the plan) (see Treasury Regulation 1.409A-3).

Sponsors can elect to include all or a subset of the above listed distributable events in their plans. A person must look at the specific plan document in order to know which payment events apply to a particular plan and whether participants are allowed any discretion in selecting from among them.

A NQDC plan may allow employee elections regarding the timing and method of payment; or it can dictate the payment regime with no elections allowed. If participants have options, they record their distribution choices when they make their deferral elections. They must elect 1) when they will receive distributions from the NQDC plan, and 2) in what form the distributions will take (lump sum withdrawal or installment payments). The deadline for these elections is typically by December 31 of the year prior to the year for which salary is deferred or for which nonelective (employer) contributions are made to the plan; or within 30 days of becoming eligible to participate in the plan. If participants fail to make distribution elections when permitted, plan terms will dictate a default.

Like the timing for distributions, the methods of payment vary for each NQDC plan. The plan may allow for lump sum withdrawals, installment payments (e.g., over five or 10 years) or both, and participants may be allowed to select the payment type. The plan document will specify the available methods of payment.

With rare exception, distributions may not be accelerated. However, there is a mechanism by which participants may delay receipt of payments beyond which they initially elected [see Treas. Reg.§409A-2(b)]. In general, a participant is allowed to change the timing and method of the payment if an election is filed with the employer at least 12 months prior to the date the first payment would be due; and the payment is postponed for at least five years. Again, it is important to review the plan document to see if the plan allows for distributions to be delayed and, if so, whether distributions are treated as a series of payments or as a single payment for this purpose.

The penalties for noncompliance with these withdrawal rules are severe. The IRS will consider any compensation deferred under an errant plan as taxable income to the participant, plus it will assess a 20 percent excise tax, including accruing interest. Taxes, penalties and interest are payable by the recipient of the deferred compensation, not the employer [see IRC §409A(a)(1)(B)].

Conclusion

The form and timing of payments from IRC §409A NQDC plans is an important consideration because of the potential for income tax liability. Depending on the terms of the governing plan, participants may have flexibility in selecting when payments are due and what form they take and, therefore, have more control over when the amounts become taxable income to them. Understanding the terms of each plan and advance planning are the keys to mitigating the share Uncle Sam will take.

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Correcting IRC §409A Plan Compliance Errors

“Is there a correction program for Internal Revenue Code Section (IRC §) 409A nonqualified plans, similar to the Employee Plans Compliance Resolution System (EPCRS) for qualified retirement plans?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings plans, including nonqualified plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business. A recent call with a financial advisor from Massachusetts is representative of a common inquiry related to nonqualified deferred compensation plans.

Highlights of Discussion

While there is no one comprehensive program like EPCRS for the correction of failures for IRC § 409A nonqualified deferred compensation plans (409A plans), the IRS has issued a series of notices containing pre-approved correction methods for certain operational failures and document noncompliance issues for such plans [IRS Notices 2008-113, 2010-6, 2010-80 and 2007-100  (which employers can follow in lieu of Notice 2008-113 for pre-2009 operational errors)]. Following the correction methods can help participants reduce or delay early taxation of their deferred compensation and avoid penalties.

If a business with a 409A plan fails to operate the plan in accordance with the requirements of IRC §409A, affected participants may become subject to current income taxation of their deferred compensation, as well as have interest and penalties assessed. Generally, all amounts that are deferred under a noncompliant 409A plan for the taxable year and all preceding taxable years are includable in gross income for the taxable year, unless the amount is subject to a substantial risk of forfeiture or has previously been included in gross income. The IRS assesses interest on such amounts included in income at the IRS underpayment rate plus one percent, and applies a 20 percent penalty.  Moreover, state and local tax rules and penalties may apply. The IRS has issued proposed regulations [Treasury Regulations Section 1.409A-4(a)(1)(ii)(B)] on how to calculate the amount of income to include when a failure occurs.

IRS Notice 2008-113 covers corrections for 409A operational failures, including, but not limited to, failures to defer amounts, excess deferrals, incorrect payments, and the correction of exercise prices. The guidance of IRS Notice 2010-6 allows businesses to correct many types of 409A plan document errors, including impermissible definitions of separation of service, disability or change in control; impermissible payment events or payment schedules; impermissible payment periods following a permissible payment event; impermissible initial or subsequent deferral election procedures; and a failure to include the six-month delay of payment for specified employees of publicly traded companies.  Please note that IRS Notice 2010-80 modifies certain provisions of Notices 2008-113 and 2010-6, and should be referred to for the latest guidance.

Plan sponsors can refer to the IRS’ Nonqualified Deferred Compensation Audit Techniques Guide for issues the IRS focuses on when auditing businesses that offer 409A plans.

Conclusion

The IRS has issued a series of notices containing pre-approved correction methods for certain operational failures and document noncompliance issues for 409A plans. Following the correction methods can help participants reduce or delay early taxation of their deferred compensation and avoid penalties.

© Copyright 2018 Retirement Learning Center, all rights reserved