Reprinted with permission from Employee Benefit Review - October 2015
In June 2015, the Internal Revenue Service released updated audit guidelines for nonqualified deferred compensation plans. Basically, audit guidelines are used by the IRS to communicate with the agents in the field who are actually performing audits. The guidelines tell the agents what it is they should be investigating. Accordingly, employers who sponsor NQDC plans should make sure they are in compliance with the guidelines. As will be discussed in more detail below, the guidelines focus on many issues other than Section 409A of the Code.
The audit guidelines informally break NQDC plans into four or five types (depending on how you count).
- Salary Reduction Arrangements. A plan where participants can elect to have their current salary reduced, and replaced by an equivalent amount to be paid in the future. So, similar in design to 401(k) plans except that the employer does not get a current deduction and the employee’s deferral is at risk if the employer becomes insolvent.
- Bonus Deferral Plans. Similar to salary reduction arrangements, except participants choose to defer their bonus instead of their salary. Obviously, many companies combine these first two types of plans into a single program.
- Top Hat Plans. As used by the IRS, in this type of plan, the employer allocates a specific amount to the plan participants. This can be done on a defined benefit or a defined contribution basis. Under ERISA, such plans must be maintained primarily for a select group of management or highly compensated employees (known as the “top hat” group). Note that this last requirement is technically under the jurisdiction of the Department of Labor, and not the IRS.
- Excess Benefit Plans. The guidelines describe these plans as providing benefits in excess of those provided under the employer’s qualified plan, due to the limitations that apply under Section 415. Some plan sponsors occasionally lose sight of the fact that these types of plans are not limited to the top-hat group.
- Phantom Stock Plans. The guidelines point out that such plans, sometimes called restricted stock unit plans, may also be subject to the same rules that apply to the arrangements described above.
With that background, the guidelines identify the following issues:
For a NQDC plan to “work” (i.e., to obtain the benefit of the tax deferral), it is important that amounts are not “set aside” from the employer’s creditors for the benefit of the participants. Specifically, the guideline states that for NQDC purposes, it is not relevant whether the assets have been identified as belonging to the employee. What is relevant is whether the employee has a beneficial interest in the assets, such as having the amounts shielded from the employer’s creditors or whether the employee has the ability to use these amounts as collateral. Although this is not discussed in detail in the guidance, often this issue comes down to what was communicated to plan participants about to whom do the “assets” of the plan belong.
Constructive Receipt/Cash Equivalency
Under the constructive receipt doctrine, plan participants can be taxable on deferred amounts that they have not actually received, if the amounts were “constructively” received. Most constructive receipt issues have become obsolete since the enactment of Section 409A. However the guidelines do raise a few issues that plan sponsors should consider. For example, the guidelines suggest that devices tied to deferred compensation accounts, such as debit cards, credit cards and checkbooks may provide employers with sufficient control over their deferred compensation, such that they are in constructive receipt.
The cash equivalency doctrine raises issues somewhat similar to the constructive receipt issue described above. If a solvent obligor’s promise to pay is unconditional and assignable, not subject to setoff, and is of a kind that is frequently transferred to lenders or investors, such promise is the equivalent of cash, and will be subject to current taxation. This doctrine has likely been more or less superseded by Section 409A.
Timing of Deductions
As a reminder, the guidelines note that any interest or earnings credited to deferred compensation are not deductible until the deferred compensation is taxable to the participant.
For purposes of FICA (and FUTA) taxes, NQDC is taxable when the amounts vest, not when amounts are distributed. This can often be helpful to plan participants, as earnings typically exceed the Social Security taxable wage base (though there is no base for Medicare taxes), and subsequent earnings escape FICA (and FUTA) taxes completely. This assumes that earnings are tied to a reasonable rate of return – typically based on a predetermined actual investment or a reasonable rate of interest.
Rabbi Trust Funding
Funding of a “rabbi trust” is limited for plan sponsors who maintain “at risk” defined benefit plans. This provision can be overlooked, particularly in large controlled groups or following an acquisition.
Impermissible Coordination with 401(k) Plans
Another provision that is frequently overlooked by NQDC plan sponsors is the requirement that an employer may not condition any other benefit (including participation in a NQDC plan) upon an employee’s participation (or nonparticipation) in the 401(k) plan. Accordingly, the guidelines alert auditors to look for any plan provisions that limit the total amount that can be contributed to a 401(k) and NQDC plan, or any provision limiting participation in a NQDC plan to employees who elect not to participate in the 401(k) plan.
NQDC plan sponsors should perform a self-audit of their plans to make sure they are in compliance with all of the issues identified in these guidelines. In addition, sponsors should make sure they are organized and have retained (and have available) all of the documents the IRS requires as documentary substantiation under the guidelines.