Internal Revenue Service officials recently reminded taxpayers that Section 409A of the Internal Revenue Code of 1986 limits when a company can fund its non-qualified deferred compensation benefits. In addition to restricting offshore funding and funding based on a change in the company’s financial health, Section 409A provides that amounts transferred to a trust that funds the non-qualified deferred compensation benefits of covered executives (typically referred to as a “rabbi trust”) are subject to immediate taxation, and a 20% additional tax, if those amounts are transferred when the company’s qualified defined benefit pension plan is “at-risk.”
Whether a defined benefit pension plan is “at-risk” should be determined by the plan’s actuaries, but “at-risk” status can apply if the plan is sufficiently underfunded (usually less than 65%–80%, depending on the year). Such determination is made based on the preceding plan year. Given the significant downturn in the markets last year, it is possible that a large number of plans might currently be “at-risk.”
If applicable, the Section 409A funding limitations for non-qualified deferred compensation would apply to amounts transferred to fund the benefits of the company’s CEO (or the individual acting in a similar capacity). If the company is public, the limitation also would apply amounts transferred to fund the benefits of the named executive officers and the remaining Section 16 officers. The limitation also applies to amounts transferred to fund the benefits of former employees if they were the CEO or, if the company is public, a named executive officer or Section 16 officer at the time of employment termination.
Improper funding of non-qualified deferred compensation causes the employee to be subject to immediate income taxation on the amounts transferred, as well as an additional tax equal to 20% of such amounts. Interest earned on such amounts in subsequent years also is subject to accelerated taxation and the additional tax. If a funding error is discovered after the fact (on audit, for example), interest and penalties on past due amounts may also be assessed. These consequences are applied despite the fact that amounts in the non-qualified plan trust remain subject to the claims of the company’s creditors.
Companies that sponsor defined benefit plans and are concerned about triggering adverse tax treatment for their executives under non-qualified deferred compensation arrangements should review their pension plan and non-qualified plan funding policies to ensure that inadvertent violations do not occur.
Click here to read the full text of Section 409A.