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Abstract

The complex rules governing the taxation of deferred compensation are complicated. This article provides an overview of the treatment of nonqualified deferred compensation under Sections 409A and 457 of the Internal Revenue Code of 1986, as amended (the Code). It provides background information about nonqualified deferred compensation plans generally and the enactment of Code Section 409A. The related interpretive guidance issued by the Internal Revenue Service is also described. The general requirements under Section 409A for nonqualified deferred compensation plans are discussed, and the various types of arrangements that are excluded from coverage by these rules are described.The article also provides an overview of Code Section 457, and its application to 457(f) plans and 457(b) plans maintained by governmental employers and tax-exempt organizations.

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deferred compensation 409A plans 457 plans

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Payment on separation from service must be delayed at least 6 months for "specified employees." These are key employees as defined in the so-called "top-heavy" rules for qualified plans if their employer’s stock is publicly traded.

The definition of disability is strict. The employee must be unable to engage in any substantial gainful activity by reason of an impairment that can be expected to last for a continuous period of not less than 12 months or to result in death. Alternatively, the employee must be receiving disability benefits replacing lost wages for a period of not less than 3 months under the employer’s accident and health plan.

Payments made on separation from service, disability, death, change of control and so on would not violate the anti-acceleration rule if the 409A plan provided for payments on the occurrence of these events.

A "good reason" includes a material diminution in the employee’s (or his or her supervisor’s) base compensation, duties, or budget, according to the safe harbor definition in the Section 409A regulations. It also includes a material change in the employee’s geographic location or material breach of the employment agreement. In addition, the employee must provide the employer with notice of the good reason condition within 90 days of its initial existence, and the employer must have at least 30 days to remedy the good reason condition. The severance pay must be paid within 2 years following the initial existence of the good reason condition. The amount, time and form of payment for a voluntary good reason separation must be identical to the amount, time and form of payment for an involuntary separation. Finally, these good reason requirements must be incorporated into the severance plan.

Taxation of Deferred Compensation: Overview of 409A and 457

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