3574 / How are deferred compensation account balances and nonaccount balance payments taxed when received by the employee or the beneficiary?

Section 409A is a refinement of the constructive receipt doctrine. Plans that are “nonqualified deferred compensation plans,” as defined in Section 409A, have additional requirements added to the prior tax law, unless specifically replaced by Section 409A, that are now necessary to achieve and maintain income tax deferral as to plan participants until the date of distribution under the terms of the plan. Under Section 409A, its regulations, and guidance, a participant is taxed on deferred compensation immediately upon violation of Section 409A in either form (documentation) or operation (administration). These additional 409A plan requirements (for plans not involving a trust) are primarily:

(1)   minimum required plan documentation;

(2)   limited permissible distributions;

(3)   prohibited accelerations of these distributions; and

(4)   required timing of elections to defer.

Plans Excepted or Grandfathered from Section 409A
Coverage (Residual Rules for 409A Plans)

When deferred compensation payments are actually or constructively received, they are taxed as ordinary income. Deferred compensation payments are “wages” subject to regular income tax withholding (and not the special withholding rules that apply to pensions, etc.) when actually or constructively received.¹ Section 409A greatly expands the existing definition of
constructive receipt so that violations of Section 409A requirements in either form documentation or administrative operation cause immediate taxation.

In the worst case taxation situation, deferred compensation that is subject to constructive receipt not only is immediately taxed under IRC Section 409A, but it is also subject to a 20 percent excise tax in addition to the normal tax on all vested amounts ( Q 3541, Q 3564). Interest on the underpayment of taxes is also retroactively imposed to the date of error and is also due at the normal underpayment AFR rate plus 1 percent.² The IRS has provided for certain corrections of documentation and operational errors that may entirely or substantially avoid worst-case taxation under Section 409A. The tax outcome under these correction procedures depends largely on the nature of the error, when the error occurred and is corrected, and the specific participant involved (an “insider” or not, regardless whether the company is publicly traded or privately held).

Certain Foreign Plans of “Nonqualified Entities” under IRC Section 457A

A nonqualified deferred compensation plan of a uniquely defined “nonqualified entity” (offshore fund or partnership located in a tax indifferent situs) is subject to IRC Section 457A. This is a different IRC section than Section 409A, which covers the “nonqualified deferred compensation” plans of all entities, except to the extent they are exempted or excepted from coverage. Deferred compensation provided by such 457A nonqualified entities is taxable at the time any 457A “substantial risk of forfeiture” lapses ( Q 3541). If the deferred compensation is deferred beyond the year in which the risk of forfeiture lapses, the participant is subject to a 20 percent excise tax and premium penalty interest on the underpayment of taxes at the normal underpayment AFR rate plus 1 percent on the amount.³ However, in 2016 the IRS clarified that plans subject to 457A may be covered by Section 409A and when covered must comply with it in addition to complying with 457A requirements.⁴ The 2016 proposed regulations indicate that 457A plans will have to separately and independently comply with Section 409A and 457 as well as 457A in order to postpone taxation.

Annuity Payout

Where an unfunded plan paid deferred compensation benefits in the form of a commercial single premium annuity at the termination of the participant’s employment, the IRS privately ruled that the full value of the contract would be includable in the recipient’s income at the time of distribution, in accordance with IRC Section 83.⁵ Unless the payment was due in a lump sum rather than in installments under the plan, this technique would now also violate Section 409A as an impermissible acceleration of the benefits.

Beneficiary Payments

Payments made to a beneficiary from an unfunded plan are “income in respect of a decedent” for income tax purposes and, as such, are taxed, as they would have been to the employee. It is not clear whether the same withholding rules apply. For treatment of death benefits under deferred compensation agreements, see Q 3638.