3541 / What requirements must be met by a private nonqualified deferred compensation plan?

(1)   a state;

(2)   a political subdivision of a state (e.g., a local government);

(3)   an agency or instrumentality of (1) or (2);¹ or

(4)   an organization exempt from tax under IRC Section 501.

Although private nonqualified deferred compensation agreements most frequently are entered into with employees of corporations, they also may be entered into with employees of other business organizations and with independent contractors.² For example, a director’s fees can be deferred through an unfunded deferred compensation agreement with the corporation.³ This remains true for plans covered by IRC Section 409A. If an employer or service recipient transfers its payment obligation to a third party, efforts to defer payments from the third party may not be effective.⁴

For rules concerning nonqualified deferred compensation plans sponsored by governmental or private tax-exempt not-for-profit employers, see Q 3581 through Q 3602.

General Taxation Rules for Unfunded Plans

IRC Section 409A is additive law that further defines the income tax doctrine of constructive receipt. Therefore, prior income tax law and theories (for example, the economic benefit theory) continue to apply, unless specifically replaced by Section 409A. This means that a plan subject to Section 409A must comply with both prior income tax law (except as specifically changed) as well as Section 409A requirements. Plans that are statutorily exempted or excepted by regulations from the Section 409A requirements (such as amounts grandfathered from 409A coverage) must continue to comply with prior income tax law only.

Pre-409A Income Tax Law Requirements

1. An employer may contractually agree to pay deferred amounts as additional compensation, or employees may voluntarily agree pursuant to contract to reduce current salary.⁵


2. The plan must provide that participants only have the status of general unsecured creditors of the employer in bankruptcy and that the plan constitutes a mere unsecured promise-to-pay benefits by the employer in the future.


3. The plan also should state that it is the intention of the parties that it is unfunded for tax (and ERISA) purposes; that is without ERISA “plan assets.”


4. The plan should prohibit and void the anticipatory assignment of the benefits by a participating employee.


5. The plan should define the time and form for paying deferred compensation for each event (e.g., retirement) that would entitle a participant to a distribution of benefits.


6. The plan should include any provisions necessary to designate and comply with controlling state law requirements.

These requirements continue after the enactment of Section 409A, and are the primary requirements for portions of plans that are grandfathered from 409A coverage or excepted from 409A coverage, such as plans that can claim the “short term deferral exception.”

If the plan refers to a trust or other informal funding mechanism, additional rules must be satisfied ( Q 3564, Q 3567).