Potential Pitfalls in Deferred Compensation Plans

By Jordan Butler, Associate, Carlile Patchen & Murphy LLP


Deferred compensation is an arrangement in which a portion of an employee’s income is deferred and paid out at a later date. A “qualified” deferred compensation plan is one that must comply with the rules and regulations of ERISA (e.g., 401(k) plans). “Nonqualified” plans give employers more flexibility. The employer can choose which employees receive deferred compensation benefits and employers may treat those chosen differently. Furthermore, the benefit promised need not follow many of the rules applicable to qualified plans. But what happens if the employer (and/or employee) wants to change the plan after it becomes effective? For example, ABC, Inc. and employee Joe Smith enter into a non-qualified deferred compensation plan. The annual benefit is calculated based on ABC’s income each year. The benefit vests each year that Joe remains employed, and the entire amount only becomes payable at the end of year 10 if Joe is still employed by ABC. It is now the beginning of year 10 and ABC is concerned about cash flow due to recent downturns in its financial health. Joe and ABC agree that instead of the cash payment at the end of year 10, the plan will be terminated and Joe will be given stock in a year or two instead, when the financial health of ABC is expected to greatly improve. The parties are in agreement so everything is good, right? Both sides are happy because Joe gets an equity stake and ABC is unburdened from the cash payment coming due, right? Well…

Internal Revenue Code §409A allows for the termination or modification of a plan and for the forfeiture of benefits by the employee, but there are limitations. Generally, unless certain exemptions apply, the modification or termination of a plan will be a “plan failure” which results in income acceleration and penalties: total amounts deferred under the plan become includible in the employee’s gross income and are also subject to an additional 20% penalty. In order to terminate a plan without a plan failure, there are several requirements that must be met. One requirement is that termination not be due to a “downturn” of the employer’s financial health. All other similar plans must also be terminated and no new similar plan can adopted for 3 years. Any vested benefits cannot be paid within 12 months of the termination, but all payments must be made within 24 months of termination. Thus, termination of the ABC plan really hurts Joe because the cash payment still must be made and the termination will be due primarily to a downturn in ABC’s financial health.

What if Joe instead offered to forfeit the benefit? Forfeiture generally will not have any tax consequences. But, if there is a “substitution” following the forfeiture, the tax and penalty might be triggered. Generally, if a substitution accelerates or changes the time of payment in a manner that does not comply with 409A, additional taxes will be imposed. For example, Joe forfeits the right to receive unvested deferred compensation of $5,000. Then, ABC pays Joe a one- -time bonus of $5,000. However, income tax Regulations suggest that substitute payments will be okay, but such payment will still be taxable as if the original benefit is received. In such cases, payment in stock instead of cash might not trigger the penalty. The difference between this substitute payment and the improper substitution of the bonus is that Joe does not forfeit any deferred compensation.  Rather, only the form of the payment is changed. But, if Joe accepts stock in lieu of cash, he will have to pay the tax on the benefit received without receiving any cash from ABC to pay such tax!

Finally, what if ABC and Joe merely agree to defer payment of the benefit amount for a few years? To not be a plan failure, the deferral must be for at least 5 years and cannot have been made within one year before the benefit becomes payable. Since the benefits are payable to Joe at the end of the current year, any deferral triggers a plan failure. So, Joe’s and ABC’s options are limited. If Joe is willing to accept stock and pay the tax on the benefit amount without receiving cash, then such payment should be okay. But clearly there is no great option that benefits both sides.

This simple example shows that deferred compensation plans may not be as flexible as employers might think once they are put in place. It is very important to plan (no pun intended) ahead when offering an employee deferred compensation. The employer must consider whether it will have cash available to make the payments and whether it will be able to make any changes to the plan- with or without the employee’s consent.