Academic journal article Journal of Accountancy

Play by the Rules: IRC Section 409A Imposes New Requirements on Nonqualified Deferred Compensation

Academic journal article Journal of Accountancy

Play by the Rules: IRC Section 409A Imposes New Requirements on Nonqualified Deferred Compensation

Article excerpt


* THE AMERICAN JOBS CREATION ACT ADDED IRC section 409A and significantly changed the rules for nonqualified deferred compensation plans. For a deferral to escape current taxation, it must be subject to a substantial risk of forfeiture and must follow limited deferral and distribution rules.

* ALL NQDC ARRANGEMENTS MUST FOLLOW section 409A unless specifically exempted. Among the arrangements that must comply are IRC section 401(k) mirror, shadow and tandem plans; IRC section 457(f) plans; certain stock option and stock appreciation rights; and phantom restricted and deferred stock plans.

* THE NEW RULES DON'T COVER CERTAIN SEVERANCE plans, SARs that meet certain rules, short-term deferrals paid by the later of 2 1/2 months from the end of the employer's tax year or 2 1/2 months from the end of the participant's tax year, nonstatutory stock options, tax-qualified employer plans and certain welfare benefit plans.

* UNDER SECTION 409A, NQDC PLAN DISTRIBUTIONS are permitted only in the event of separation from service, disability, death, a change in employer control or an unforeseeable emergency. Distributions also can be made at a specified time or under a fixed schedule, as stated in the plan at the time of deferral. The law also permits plans to make accelerated distributions under certain circumstances.

* IN CALENDAR YEARS BEGINNING AFTER DECEMBER 31, 2004, new reporting rules apply to non-account-balance NQDC plans. All amounts deferred must be reported to the IRS on form W-2 or form 1099.

* SIGNIFICANT PENALTIES APPLY FOR NONCOMPLAINCE with section 409A. In addition to having compensation included in income, tax penalties equal to the IRS underpayment rate plus 1% from the time the compensation should have been included in income plus 20% of the compensation amount apply.

There's a new set of rules for players in the high-stakes nonqualified deferred compensation (NQDC) game. The American Jobs Creation Act of 2004 established I1KC section 409A, which affects existing NQDC plans for companies and executives alike. The section broadly defines a "deferral of compensation" to include all amounts employees defer under such plans. These amounts are included in gross income unless they are subject to a substantial risk of forfeiture or were previously included in income.

To avoid this draconian tax treatment, section 409A significantly restricts when plan participants may make deferral and distribution elections, and narrowly defines when they can take distributions. Section 409A also includes rules for certain trusts located outside the United States or that provide benefits only when the plan sponsor's financial health declines. In December 2004 the IRS issued notice 2005-1, which provided interim guidance on the new rules; the IRS says it will issue additional guidance later in 2005.

CPAs need to help clients and employers review existing NQDC plans to determine whether the new rules affect them, and if so, what actions to take to bring the plans into compliance. Managing partners at CPA firms also need to make sure any NQDC plans they maintain comply. This article summarizes the main points of section 409A, including a review of new reporting rules, and offers some planning tips for 2005.


The new rules apply to amounts deferred after December 31, 2004. Amounts deferred before that date, as well as future earnings, are not subject to section 409A unless the plan was "materially modified" after October 3, 2004. To avoid the penalties section 409A imposes, NQDC plans that do not comply must be amended by December 31, 2005, and must act in good-faith compliance until then.

CPAs who work with NQDCs need to be aware of some new definitions:

Deferred compensation. Deferred compensation includes payments to which participants have a legally binding right but have not received or included in their gross income, and which is payable in a later year. …

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