In 2004, Congress added Code Sec. 409A to the Tax Code. Code Sec. 409A makes major changes to the taxation of nonqualified deferred compensation. However, many employers have experienced delays in bringing their plans into compliance because the 409A rules are very complex. In December 2008, the IRS issued proposed regs explaining how employers, employees and independent contractors should determine the amount of deferred and taxable compensation under Code Sec. 409A. The IRS also announced an expansion of its voluntary correction program (VCP) for 409A plan failures.
Many employers and plans were hoping that the IRS would extend the deadline by which plans must be amended to comply with the 409A regulations. The IRS did not extend the deadline, which remains January 1, 2009. However, the IRS did extend transition rules for employers and payers regarding reporting and wage withholding requirements.
Nonqualified deferred comp
Deferred compensation plans allow an individual to defer an employee's receipt of taxable wages or bonuses until some future year when he or she may be in a lower tax bracket. A nonqualified deferred compensation plan is a plan that fails, either purposely or inadvertently, to meet the strict requirements imposed upon qualified plans. Although the employer and employee lose some tax advantages, nonqualified deferred compensation plans have a major advantage over qualified plans. Unlike qualified plans, they need not be offered to a broad cross-section of employees and may be offered to only a few key individuals that the employer wants to hire or retain as employees.
Since 2004, the IRS has issued many regulations on Code Sec. 409A, outlining how certain nonqualified deferred compensation plans should be handled. In a nutshell, the Code Sec. 409A regulations make nonqualified deferred compensation requirements more restrictive.
Proposed regulations
In the December 2008 proposed regulations, the IRS explained that each year is examined separately. If amounts are improperly deferred, all prior amounts deferred under the plan would become taxable, but subsequent deferrals when the plan complies with Code Sec. 409A are not taxable, even if the improperly deferred amounts are still in the plan. The total amount deferred would be determined at the end of the employee's year. The amount includes all payments made during the year. Income on deferred compensation is included in the amount deferred, even though the earnings are not FICA wages. The total amount deferred is the present value of all amounts payable under the plan, using reasonable actuarial assumptions.
Amounts deferred during the year of a violation are taxable, even if the plan is compliant at the time the amounts are deferred, the IRS explained. Amounts subject to a substantial risk of forfeiture (SRF) that vest in the same year as the violation are also taxable. For continuing failures, amounts improperly deferred from a prior year must be included in that prior year's income.
Types of plans
The December 2008 regulations also identify the amount deferred for different types of plans:
-- Account balance plan: the balance of the account at the end of the year, plus payments made.
-- Nonaccount balance plans: the general present value rule applies. Increases in present value in a subsequent year are treated like earnings (and therefore are not taxable if the plan is compliant).
-- Options and stock appreciation rights: the amount of income is the spread.
More guidance coming
The IRS also indicated that it will issue interim guidance in 2008 on calculating amounts included in income, additional taxes, and the extent taxpayers can rely on the proposed regulations. Interim guidance will address years beginning before final regulations are issued.
Correction program
Finally, the IRS announced that it is expanding its VCP for operational failures of 409A plans. While the VCP encourages self-correction, employers must take reasonable steps to prevent reoccurrence of similar failures in the future, the IRS cautioned.
Reporting
Generally, employers and payers must report all deferrals for the year under a nonqualified deferred compensation plan on Form W-2 or Form 1009-MISC, regardless of whether the deferred compensation is included in gross income under Code Sec. 409A. The IRS provided transition relief in years past.
In December 2008, the IRS announced that until further guidance is issued, an employer is not required to amounts deferred during the year under a nonqualified deferred compensation plan subject to Code Sec. 409A. Similarly, a payer is not required to report amounts deferred during the year under a nonqualified deferred compensation plan subject to Code Sec. 409A in box 15a of Form 1099-MISC.
