A closely-held business will often use deferred compensation arrangements to induce or reward certain behavior by its key non-shareholder executives; for example, to incentivize the executive to attain certain business performance goals or operational benchmarks.

Such an incentive arrangement will defer the payment of compensation such as a bonus until the compensation is earned, usually upon the satisfaction of the specified goal or upon the occurrence of some specified event, such as the sale of the business. wpid-thumbnail-bc8340ac3115e56fb42957431140aaeb

For the most part, these deferred compensation arrangements are contractual agreements between the employer and the executive. As such, they may be structured in whatever form achieves the goals of the parties; consequently, they may vary greatly in design.

Regardless of how the arrangement is structured, it must address two critical elements in order to successfully defer the employee’s tax liability: (A) the arrangement must comply with certain tax principles (i.e., constructive receipt, economic benefit, IRC Sec. 83), as modified by IRC Sec. 409A; and (B) this compliance must be ensured at the inception of the arrangement; otherwise – as we shall see in this post – the tax and economic results that the parties envisioned will not be attained.

IRC Sec. 409A

Under IRC Sec. 409A, all amounts deferred under a nonqualified deferred compensation plan – for all taxable years covered by the plan – are currently includible in the employee’s gross income to the extent they are not subject to a “substantial risk of forfeiture,” unless certain requirements are satisfied relating to the timing of the distribution of the deferred compensation.

A substantial risk of forfeiture exists when the employee’s rights to the compensation are conditioned upon the performance of substantial services or the occurrence of a condition related to a purpose of the compensation, such as the attainment of a prescribed level of earnings.

A deferred compensation plan is subject to the requirements of IRC Sec. 409A at all times during a taxable year.

If the plan fails to comply or to be operated in accordance with the rules under IRC Sec. 409A “at any time during a taxable year,” and there is compensation deferred under the plan that is not subject to a substantial risk of forfeiture (generally meaning the amount is vested as of the end of the taxable year), that compensation is includible in the executive’s gross income for the taxable year.

If the plan is not compliant, but the deferred amount is subject to a substantial risk of forfeiture at all times during the taxable year, it is not includible in income under Sec. 409A.

The IRS recently considered this compliance requirement in the case of an employer who attempted to correct its failure to comply with IRC Sec. 409A during a taxable year. Specifically, the IRS considered whether the correction of the plan’s failure to comply with Sec. 409A’s distribution rules would avoid income inclusion for an executive if the correction was made before the compensation vested, but during the executive’s taxable year in which it vested.

The Retention Agreement

Executive was employed by Corp. In October of Year 1, Corp. entered into a retention agreement with Executive. The retention agreement provided that, if Executive remained continuously employed until the third anniversary of the agreement (a “substantial risk of forfeiture” and the “Vesting Date,” respectively), Executive would receive a bonus.

The agreement provided for payment of the bonus in equal installments on the first two anniversaries of the vesting date (a fixed payment schedule, as permitted under IRC Sec. 409A). However, the agreement also provided that Corp., in its sole discretion, could pay the bonus as a lump sum payment on the first anniversary of the Vesting Date.

Corp. determined that the agreement failed to meet the time and form of payment requirements of Sec. 409A because it permitted Corp. to accelerate payment of the bonus. To correct the failure, Corp. amended the agreement in June of Year 3 (four months before the Vesting Date) to remove Corp.’s discretion to accelerate payment of the bonus. Executive continued providing services through October of Year 3, and the substantial risk of forfeiture thus lapsed. Corp. paid Executive the bonus in equal installments in October of Year 4 and Year 5.

Corp. asserted that the bonus should not be includible in Executive’s income under IRC Sec. 409A for any taxable year covered by the plan because the agreement was amended before the vesting date to provide for payment terms that complied with the time and form of payment requirements of Sec. 409A, even though the amounts were no longer subject to a substantial risk of forfeiture as of the end of Year 3.

The Law

The IRS explained that, with certain exceptions, a plan provides for the deferral of compensation and, so, is subject to the requirements of IRC Sec. 409A, if the employee has “a legally binding right” during a taxable year to compensation that, under the terms of the plan, is or may be payable to the employee in a later taxable year.

That the compensation deferred under the plan may be reduced or eliminated by operation of the objective terms of the plan – such as the application of a nondiscretionary, objective provision creating a substantial risk of forfeiture – does not remove the plan from the reach of IRC Sec. 409A. Stated differently, compensation that meets the general definition of deferred compensation, even if subject to a substantial risk of forfeiture (nonvested deferred compensation), is subject to the requirements of Sec. 409A regardless of the fact that it may never become vested and may never be paid.

IRC Sec. 409A provides that certain form requirements apply to a nonqualified deferred compensation plan; specifically, it provides rules for when a plan may make a distribution to an employee, and it provides that a plan may not permit the acceleration of the time or schedule of any payment to the employee except in limited circumstances.

The requirements of Sec. 409A generally are applicable from the time that the legally binding right to deferred compensation arises, regardless of whether the compensation is vested or not.

Corrections?

Deferred compensation is subject to the requirements of IRC Sec. 409A at all times during a taxable year, even though the deferred amount is not includible in income under Sec. 409A because it is subject to a substantial risk of forfeiture.

If the deferred amount is not subject to a substantial risk of forfeiture at all times during the taxable year, and the plan is not compliant with IRC Sec. 409A, the amount is includible in income, regardless of whether the failure is corrected during the taxable year, even if it is corrected before the risk of forfeiture lapses.

The IRS Rules

Executive acquired a legally binding right to the bonus on the date that Corp. and Executive executed the agreement during Year 1. To receive the bonus, Executive was required to remain continuously employed by Corp. until the vesting date, which was the third anniversary of the execution of the agreement. Executive’s legally binding right to the bonus was subject to a substantial risk of forfeiture because Executive’s right to receive the bonus was conditioned on Executive’s performance of substantial future services.

The bonus was deferred compensation, and the agreement was a nonqualified deferred compensation plan subject to the requirements of section 409A, beginning on the execution date of the agreement.

The agreement failed to meet the requirements of IRC Sec. 409A. Sec. 409A requires that a plan designate a specified time for payment of a deferred amount. The requirements of Sec. 409A are met if a plan designates that deferred amounts may be paid only at a time or pursuant to a fixed schedule specified under the plan. Such a fixed schedule may be based on a payment event that may include the lapse of a substantial risk of forfeiture. Therefore, the agreement’s provision for payment of the bonus in equal installments on the first two anniversaries of the vesting date would have complied with Sec. 409A, if the agreement had not also provided that Corp. in its sole discretion, could pay the bonus in a lump sum on the first anniversary of the vesting date.

The agreement’s provision for Corp.’s right to accelerate payment failed to meet the requirement that a plan may not permit the acceleration of the time or schedule of any payment, except as provided under regulations.

Although Corp. ultimately amended the agreement to remove its discretion to pay the bonus in a lump sum, the failure to meet the requirements of Sec. 409A began on the execution date of the agreement in Year 1and continued through Year 2, and into June of Year 3.

Notwithstanding the failure, no amount was includible in income under Sec. 409A for Year 1 and Year 2 because the entire deferred amount was subject to a substantial risk of forfeiture at the end of Year 1 and Year 2.

However, the entire deferred amount was vested (no longer subject to a risk of forfeiture) at the end of Year 3. Therefore, the entire deferred amount was includible in Executive’s income under Sec. 409A for Year 3, notwithstanding that it would be not be paid until October of Years 4 and 5.

No Time Like the Present

An employer adopts an executive incentive compensation plan with the best of intentions. However, if the plan is not implemented in compliance with applicable tax rules, including IRC Sec. 409A, the resulting tax consequences will thwart both the employer’s goals and the employee’s expectations.

Aside from the penalty imposed under IRC Sec. 409A, the situation in the ruling was not all that bad. After all, vesting occurred in Year 3 and payments were completed in Year 4 (the year in which the resulting tax was owed) and Year 5. It would have been worse if the distributions were payable at a later time, or spread out over more years. Under those circumstances, it is likely that the employer would have been “forced” to make the tax funds available to the employee, either by way of an additional bonus, or a no-to-low interest loan. But what if the funds therefor were not readily available because the employer had planned to fund the distributions through the cash value of life insurance?

The bottom line is that these consequences, and the decisions they force upon an employer, may be avoided if the employer consults with tax advisors who are familiar with the workings of deferred compensation plans prior to implementing such a plan.