The Internal Revenue Code was created to provide regulations that taxpayers are legally required to follow. Section 409A of this code addresses non-qualified deferred compensation (NQDC) plans. These plans can be offered to specific individuals at the discretion of the company funding the plan.
They are put into place primarily to move earnings generated in one tax period (usually a year) to a subsequent year. Frequently, NQDC plans are used to defer income earned during a year where the taxpayer is in a high federal income tax bracket to a different year, when the taxpayer is in a lower tax bracket. When used in this manner, the taxpayer is subject to lower income taxes.
Section 409A was put into place in 2005 in an effort to reduce the ability of taxpayers to use these plans in a fraudulent manner. Rules were established to govern the NQDC and set clear guidelines for how the plans are established, funded, distributed, and maintained.
If the NQDC plan meets the regulations and follows the rules, the deferred compensation is generally not considered income or taxable until paid out to the taxpayer in the subsequent year. However, if the plan is not exempt and does not meet the Section 409A requirements, the compensation will become taxable. In addition, there is a 20% penalty due on the amount of the deferred compensation.
The recipient of the deferred compensation (usually an employee) bears the burden of paying the penalty, not the company funding the plan. The employer or company funding the deferred compensation plan would be liable for payroll taxes and related interest and penalties once the previously deferred compensation becomes taxable. To gain the tax benefits, deferred compensation must either be exempt from or comply with Section 409A regulations.
The key to complying with Section 409A regulations is timing. The law looks at when the decision is made to defer the compensation and when the deferred compensation is to be paid out. Once the timing is set, compensation cannot be provided to the taxpayer earlier than stated. Unless strict rules are met, the compensation cannot be further deferred either. Examples of allowable deferred distributions would be in the case of disability or death. Deferral can also be set to coincide with a specific date, such as when the employee turns 62 years of age.
For more information on 409A non-qualified deferral compensation plans online, visit the IRS website.