Nonqualified Employer Retirement Plans: Part 1
Parent Corporation May Guarantee Unfunded Retirement Benefits. – The mere contractual guarantee of a retiree’s benefits under an unfunded retirement plan by an employer’s parent company will generally not accelerate the taxation of the benefits. (Ltr. Rul. 200450032.) See Chapter 9 of the treatise for a discussion of deferrals of compensation under unfunded retirement plans.
Early Payments Substantially Limited under Unfunded Retirement Plans. – The American Jobs Creation Act of 2004 imposed new limitations on premature payments under unfunded retirement plans (other than eligible exempt organization plans). The limitations apply to amounts deferred after 2004. The limitations also apply to amounts deferred before 2005 if an employer materially modifies a plan after October 3, 2004.
When deferred payments may begin. – Under these rules, an unfunded plan may provide for payment of benefits only after the earliest of one or more of certain dates or events. Those dates or events include (a) a date specified at deferral, (b) a participant’s separation from service, (c) a participant’s disability, (d) a participant’s death, (e) a change in ownership of the employer, or (f) an unforeseeable emergency. Nevertheless, a participant may receive earlier payments to satisfy divorce court orders, comply with federal conflict of interest rules, pay social security taxes on deferrals of compensation, and certain other unusual events.
Some additional deferrals permitted. – An unfunded plan may allow a participant to make an election to further delay payments or change their form. However, the election may not take effect for at least 12 months. The election must also delay the payments for a period of at least five additional years – unless the payments relate to the participant’s death, disability, or unforeseeable emergency. If the election involves a specified date for payment, the participant must make the election at least 12 months before the specified date.
Potentially harsh taxes, penalties, and interest. – Most employers will have modified plans to conform to the new requirements. If not, though, or if a plan actually makes payments that do not conform, a participant may become subject to substantial taxes, penalties, and interest (on the tax deferred). The participant must include in gross income all of his or her deferred compensation under the plan that is not subject to a substantial risk of forfeiture and not previously taxed. For this purpose, proposed regulations provide that deferred amounts are not subject to a substantial risk of forfeiture that lapses during the year of a failure to conform, whether lapsing before or after the failure.
The proposed regulations also narrowly define “previously taxed” amounts excludable from gross income upon a 409A failure. For example, deferred compensation is not “previously taxed” unless the participant actually reported it on a prior year tax return or amended return, or the IRS or a court required its inclusion in gross income. Thus, deferred compensation not actually included in gross income in a prior year does not escape taxation even if the statute of limitations has run on the prior year. In addition, payments of deferred amounts to a participant during the tax year of a failure to conform are not “previously taxed” amounts, whether or not paid before or after the failure.
Upon a failure to conform, the participant must also pay a 20 percent penalty tax on the taxable amounts, and must pay interest on the hypothetical taxes the participant would have incurred in prior years without the deferral. Proposed regulations provide that, for purposes of computing prior year hypothetical taxes, investment losses and payments of deferred compensation in all prior years first reduce compensation for the earliest such prior year or years.
Finally, the proposed regulations allow a participant to take a deduction for the excess of (1) unpaid deferred compensation previously included in gross income due to failures to conform over (2) the amount the retiree receives as final payment from the plan. However, the deduction is available only if the participant’s rights to any other payments under the plan are then wholly worthless.
Certain property set aside for deferred payments. – A participant may also be liable for substantial taxes, penalties, and interest if the participant’s employer owns or transfers property outside the United States that is set aside for payment of the participant’s deferred compensation – unless the property is in a foreign country where the participant earned the compensation. The taxes, penalties, and interest may also apply if the plan restricts property to payment of a participant’s benefits upon future deterioration of the employer’s financial health – or if property is actually so restricted.
For a more complete discussion of the new requirements, see Chapter 9 of the treatise. (American Jobs Creation Act of 2004, Pub. L. No. 108-537; I.R.C. § 409A; Prop. Reg. § 1.409A-4; Notice 2005-1, 2005-1 C.B. 274.)
No Private Letter Rulings on Nonqualified Plan Issues. – Unfortunately, the IRS has announced it will not issue private letter rulings on issues involving the statutory restrictions applicable to nonqualified retirement plans (i.e., on section 409A issues). (Rev. Proc. 2009-3, 2009-1 I.R.B. 107.) See Chapter 9 of the treatise for a complete discussion of section 409A.
Deferral of Recurring Part-Year Compensation. – If certain conditions are satisfied, an employee’s recurring part-year compensation will not be subject to the rules governing nonqualified deferred compensation. Most employees affected by this provision will be teachers employed for a 9 to 10 month service period, but paid over a 12-month period. To qualify, an employee must receive the compensation by the end of the 13th month following the beginning of the employee’s service period. The service period must be a period of less than 12 months and the arrangement must be likely to continue in future years.
Finally, the arrangement generally cannot defer more than a specified amount from year to year ($18,000 for 2016). However, this deferral limitation does not apply if the employee’s total compensation for the service period is less than the annual compensation limit applicable under IRC Section 401(a)(17) when the service period begins ($265,000 for a service period beginning in 2016). (I.R.C. § 457(f); Reg. § 1.409A-2(a)(14); Prop. Reg. § 1.409A-1(b)(13); Notice 2008-62, 2008-2 C.B. 130; Notice 2008-102, 2008-2 C.B. 1106.) See Chapters 9 and 10 of the treatise for discussions of nonqualified deferred compensation.
Taxes, Penalties, and Interest upon Failure to Conform to Section 409A – A participant in a nonqualified plan may suffer harsh consequences if the terms of the plan fail to satisfy the requirements of Code section 409A, or if the plan fails to operate in conformity with those requirements. The participant must include in gross income all deferred compensation under the plan not subject to a substantial risk of forfeiture and not previously taxed. For this purpose, deferred amounts are not subject to a substantial risk of forfeiture if it lapses during the year of a 409A failure, whether it lapses before or after the failure.
Further, deferred compensation is not “previously taxed” unless the participant actually reported it on a prior year return, or the IRS or a court required its inclusion in gross income. If not, the deferred compensation does not escape taxation even if the statute of limitations has run on the prior year. In addition, deferred amounts paid to a participant during the year of a 409A failure are not “previously taxed” amounts, whether or not paid before or after the failure.
Upon a 409A failure, the participant must also pay a 20 percent penalty tax on the taxable amounts, and must pay interest on the hypothetical taxes the participant would have incurred in prior years. For purposes of computing prior year hypothetical taxes, investment losses and payments of deferred compensation in all prior years first reduce compensation for the earliest such prior year or years. (I.R.C. § 409A(a)(1), (d)(5); Prop. Reg. § 1.409A-4(a), (d).) See Chapters 9 and 10 of the treatise for discussions of nonqualified deferred compensation.
Deferred Compensation Payable by Certain Foreign Entities. – Nonqualified deferred compensation payable by certain largely untaxed foreign corporations or partnerships for services performed after 2008 receives generally unfavorable treatment. Such compensation is generally taxable to the recipient when the compensation is no longer subject to a substantial risk of forfeiture. If the amount of the compensation is not determinable until a still later date, it is taxable at that later date, together with applicable interest and penalties. (I.R.C. § 457A; Notice 2009-8, 2009-4 I.R.B. 347.) See Chapters 9 and 10 of the treatise for discussions of nonqualified deferred compensation.
TARP Executive Pay Accelerations or Deferrals under Section 409A. – The Emergency Economic Stabilization Act of 2008 provided for certain adjustments to the compensation of executives of financial institutions receiving funds under the Troubled Asset Relief Program (TARP). Some such adjustments may require accelerations of the payment of deferred compensation, or require a delay in the payment of short-term deferrals beyond the usual 2½- month period. If so, the acceleration or delay generally does not constitute a violation of section 409A governing unfunded nonqualified plans. (Notice 2009-92, 2009-52 I.R.B. 964.) See Chapter 9 of the treatise for the taxation of distributions from unfunded nonqualified plans.
Relief for Section 409A Operational Failures. – The IRS has provided plan participants with some relief for operational failures to comply with section 409A. If certain conditions are satisfied, a plan and its participants may be able to obtain such relief by:
1. Correcting certain operational failures during a participant’s tax year that includes the failure
and, for some participants, during the subsequent tax year.
2. Limiting the amount includible in income for certain operational failures that involve only limited amounts.
3. Limiting the amount includible in income for certain operational failures regardless of whether the failure involves only limited amounts, but subject to further required actions to correct the failure.
4. Obtaining special transition relief for certain operational failures occurring before January 1, 2008.
The IRS has also provided relief for non-operational failures (primarily due to nonconforming documents). However, the IRS has observed that the relief provisions can be subject to manipulation and abuse and has proposed regulations to curb those potential abuses.
(Notice 2008-113, 2008-2 C.B. 1305; Notice 2010-80, 2010-51 I.R.B. 853; Notice 2010-6, 2010-3 I.R.B. 275; Prop. Reg. § 1.409A-4(a)(1)(ii)(b).) See Chapter 9 of the treatise for the taxation of distributions from unfunded nonqualified plans).
Bankruptcy Protection Extended to Participants in Former Qualified Plans. – Funds in a qualified retirement plan are generally exempt from forfeiture in bankruptcy proceedings. A bankruptcy court has now held the exemption also extends to a nonqualified plan that was formerly a qualified plan. (In re Hemmer, 2011-1 U.S.T.C. 50,153 (S.D. Ind. 2011).) See Chapter 2 of the treatise for a more complete discussion of the bankruptcy exemption.