3548 / What is a “short term deferral exception” under Section 409A?

The “short term deferral exception” in the regulations to Section 409A is perhaps the most important exception to coverage by Section 409A for many compensation plans.

Its name is a misnomer because this regulatory exception actually can be claimed for plan benefit distributions far in the future so long as (1) the benefit is subject to a Section 409A “substantial risk of forfeiture,” which is the most stringent definition of the seven definitions of “substantial risk of forfeiture” currently in the IRC, and (2) the plan distribution essentially is made in a lump sum on the lapse of the 409A substantial risk of forfeiture. Both of these requirements must be met to claim the Section 409A short term deferral exception.

For example, an employer-paid supplemental executive retirement plan (SERP) for a 45 year-old key employee might provide for payment upon vesting at age 62, but it might also provide for a forfeiture of the entire benefit if the executive terminates employment prior to age 62. If that promised benefit is also payable in a lump sum in that year of vesting (resulting in lapse of the substantial risk of forfeiture) or within 2½ months following that year, the plan might qualify as a so-called “vest-and-pay lump sum” plan to claim an exception from Section 409A coverage, even though the plan defers payment for 17 years. Under the short term deferral exception, no Section 409A “deferral of compensation” occurs if amounts are paid within 2½ months after the end of the tax year in which the employee obtains a legally-binding right to the amounts or any Section 409A substantial risk of forfeiture lapses. Under this rule, many multiyear bonus arrangements, including bonus life insurance or bonus annuity arrangements and “vest-and-pay lump sum” SERPs that require payments in lump sum promptly after the amounts “vest” (under Section 409A substantial risk of forfeiture requirements), as in the example, will not be subject to coverage under Section 409A.¹ Of course, in contrast, the employee loses the potential tax advantage of spreading the income across several tax years that installment payments might offer, so there are considerations other than the application (or nonapplication) of the Section 409A rules.

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Planning Point: The 2007 regulations always permitted certain delays beyond the 2½ month distribution deadline that would not cause a loss of the short term deferral exception. The exception included delays for reason of administrative impracticality so long as the delayed payments were then made as soon as administratively practical. In June 2016, the IRS released proposed 409A clarification regulations that expand these permissible delays to include payments delayed in order to comply with federal securities or other applicable laws so long as the payment is made on the first date the employer believes the payment will not violate the applicable law.² These proposed regulations, which may be relied upon now, also allow for delay of payment of covered plan death benefits until the end of the calendar year following the year of a participant’s death.

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