Deferred compensation is compensation to employees or independent contractors that is paid after the income is earned. Examples of deferred compensation include stock options, retirement plans, agreements to defer salary or bonuses, severance agreements, and deferred payments in connection with covenants not to compete.
Qualified Deferred Compensation Plans
Under qualified deferred compensation plans, contributions by employers are not taxed to the employees at the time of the contribution. The full amount of the untaxed contribution can be invested. Employers get an immediate deduction for contributions to qualified plans, even though the employee is not taxed at that time. Eventually benefits from qualified plans are distributed, and are generally subject to taxation at this point. However, distributions can be “rolled over” to IRA’s or other qualified plans, permitting further deferral of taxation.
A deferred compensation plan is “qualified” if it meets the requirements of Section 401(a). There are three primary types of qualified compensation plans: pension plans, profit sharing plans, and stock bonus plans.
Nonqualified Deferred Compensation Plans
Nonqualifed deferred compensation plans are all deferred compensation plans that don’t meet the specific requirements of qualified deferred compensation plans. Nonqualified deferred compensation plans can be a valuable compensation tool, as these plans may be used to supplement retirement income, motivate key employees to reach certain goals, attract and retain employees, and defer compensation and tax on such compensation to a future date.
A key distinction between qualified and nonqualified plans is the timing of the deduction for the employer: in qualified plans employers get an immediate deduction, but under nonqualified plans employers are generally unable to take the deduction until the employees receive distributions from the plan.
If nonqualified plans fail to comply with the complex regulations of section 409(a) the employees (or other benefit recipients), may be subjected to relatively severe penalties.
Section 409A imposes rules on deferral elections, distributions and funding mechanisms of nonqualified plans. Section 409A provides that all benefits deferred under a nonqualified plan are currently includable in gross income to the extent that the benefits are not subject to a substantial risk of forfeiture and not previously included in gross income, unless certain requirements are satisfied.
Penalties for failure to comply with 409A include immediate taxation of benefits that may have otherwise been deferred, an additional 20% tax and interest at the IRS rate + 1%. This penalty applies to the receiver of the benefits. The company may also face some negative consequences.