Section 409A Compliance Avoids Tax Headaches


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There may be costly consequences for executives or highly-compensated employees when a nonqualified deferred compensation plan fails to meet requirements under Internal Revenue Code Section 409A, Jim Medlock, CPP, APA Education Advisor, said May 15.

Medlock spoke of the chief executive officer of a colleague's company who unintentionally made a withdrawal that did not qualify as a hardship distribution.

“He had $28 million dollars in his nonqualified deferred compensation plan. And it became taxable in that year. But he wasn't getting it in that year,” Medlock said at the annual American Payroll Association Congress at National Harbor, Md. “You do the math. I bet he wasn't too happy.”

When a plan does not comply with Section 409A, deferred amounts and earnings on the deferrals from Jan. 1, 2005, to Dec. 31 of the year that the plan failed are to be included as income for the year of the failure, and are to have income tax withheld at the supplemental wage rate.

The employee's deferrals also are to be subject to an additional 20 percent tax that the employer does not need to withhold, Medlock said.

For a nonqualified deferred compensation plan to be in compliance with Section 409A, there must be a written plan.

“It's a written agreement between the employer and the employees that are going to be involved,” Medlock said.

A plan may fail when there no longer is substantial risk of forfeiture to the participant. The risk of forfeiture rule generally requires that the agreement between the employer and a participant provide an unsecured promise to defer compensation to the participant to a future date before which distributions may not be made.

Deferral elections generally must be made by the end of the preceding taxable year, Medlock said.

Distributions may not be made earlier than what is stated in the plan's payment schedule at the time of the deferral election, he said. Employees may change the timing of distributions if the change is made at least one year before payments would start, and if the payment is delayed at least five years past the original distribution date.

Distributions also may not be made earlier than the employee's separation from the company, disability, death, or change in the employer's ownership.