Back to Unfunded Deferred Compensation

Unfunded Deferred Compensation

  • 3540. What are the tax benefits for a participant of an unfunded deferred compensation agreement with an employer?

    • A properly constructed unfunded1 nonqualified deferred compensation agreement can postpone payment of compensation for currently rendered services until a future date, with the intended objective of postponing the taxation of such compensation until it is actually received. Since the enactment of IRC Section 409A (generally effective as to contributions/deferrals to plans as of January 1, 2005), such an agreement, at least with respect to vested compensation, likely will create a plan that is covered by the additional tax law requirements of Section 409A, unless the plan is either specifically exempted by the statute or can claim an exception under the regulations. The IRS released proposed regulations in June 2016 that made amendments to clarify the final regulations under section 409A (TD 9321, 72 FR 19234). This document also withdraws a specific provision of the notice of proposed rulemaking (REG-148326-05) published in the Federal Register on December 8, 2008 (73 FR 74380) regarding the calculation of amounts includible in income under Section 409A(a)(1). The provision is replaced by revised proposed regulations. These proposed regulations affect participants, beneficiaries, sponsors, and administrators of nonqualified deferred compensation plans.2

      Section 409A also creates an entirely new and greatly expanded group of compensation plan types that may be covered by Section 409A under the law’s broad definition of a “nonqualified deferred compensation plan” (see the nine plan types that follow). This definition constitutes an expansion beyond what historically was considered a deferred compensation plan and now pulls in almost all executive compensation plans and some employee benefit plans.

      Under Section 409A, a nonqualified deferred compensation plan is one involving a deferral of compensation that is legally binding in the present tax year and not payable until a future tax year (beyond the current tax year plus 2½ months), and is not specifically statutorily exempted or excepted by regulation.

      As noted, under the current Section 409A regulations, there are nine types or categories of nonqualified deferred compensation plans, per the so-called “aggregation rule,” as follows:

      (1) Employee account balance plans (voluntary salary, bonus, commission deferral plans)

      (2) Employer account balance plans (defined contribution, “phantom stock” plans)

      (3) Employer nonaccount balance plans (defined benefit plans)

      (4) Split dollar life insurance plans (except for the two limited formats detailed in Revenue Ruling 2008-36)

      (5) Stock equity plans

      (6) Severance/separation plans

      (7) Reimbursement or fringe benefit plans

      (8) Foreign plans

      (9) Other miscellaneous plans

      This list is duplicated for directors participating in covered plans.

      Under a typical “pension” type deferred compensation agreement (primarily employee and employer account balance plans and employer nonaccount balance plans using 409A language), an employer promises to pay an employee fixed or variable amounts for life or for a guaranteed number of years or to pay out an account containing pre-tax contributions plus credited gains and losses. The employer can make this promise to an employee without creating current taxation, subject to compliance with IRC Section 409A, when applicable.

      When the deferred amount is received, the employee may be in a lower income tax bracket, but at least has another future income source (Q 3574). Additionally, many employers use the employer-paid types (account or nonaccount balance) of plans to provide benefits in excess of the limitations placed on qualified plan benefits. For example, a Supplemental Executive Retirement Plan (“SERP”), in either an account balance or nonaccount balance design, for a selected group of executives generally provides extra retirement benefits. An “excess benefit plan” is a special kind of supplemental plan that addresses only the benefits lost under qualified plan limits and caps (Q 3608).

      Nonqualified deferred compensation plans have been divided into two broad categories:(1) voluntary employee deferred compensation plans and (2) employer-paid supplemental plans. Both unfunded deferred compensation plans (governed by IRC Sections 61 and 451) and funded deferred compensation plans (governed by IRC Section 83) may be divided into these categories (Q 3532). Under prior law, taxation of these two plan categories was the same based on whether the plan was an unfunded plan (one that was merely an “unsecured promise-to-pay”) or a funded plan (one that involved the “transfer of property”).

      The enactment of Section 409A, however,has added a new additional categorization: whether the plan (unfunded or unfunded) is covered or excepted from coverage from the additional Section 409A requirements. That is because Section409A is additive tax law and only changes prior income tax law applicable to nonqualified deferred compensation to the extent specifically indicated. The term “nonqualified deferred compensation plans” should be understood to refer to both voluntary employee deferred compensation plans and employer-paid supplemental plans that are covered by Section 409A requirements, as well as all the other plan types now covered by Section 409A, unless exempted or excepted.

      A “voluntary employee deferred compensation plan” involves an agreement between the employer and employee, whereby the employee defers receipt of some portion of present compensation (or a raise or bonus, or a portion thereof) in exchange for the employer’s promise to pay a deferred benefit in the future. This has been referred to as an “in lieu of” plan. As noted, under Section 409A, these plans are employee account balance plans.

      An “employer-paid supplemental plan” is a compensation benefit provided by the employer to an employee in the future in addition to all other forms of compensation; the employer promises to pay a deferred benefit, but there is no corresponding reduction in the employee’s present compensation, raise, or bonus. Under Section 409A, these plans are employer account balance or nonaccount balance plans. If they are designed with a Section 409A substantial risk of forfeiture, and are paid in lump sum in the year the risk of forfeiture lapses or within 2 ½ months afterwards, a supplemental plan might be designed to be excepted under the Section 409A “short-term deferral exception”.


      1. “Unfunded” does not mean that assets may not be set aside in a sponsor’s general asset reserve for a plan; just that they may not be escrowed from sponsor’s general creditors or constitute “plan assets’ under ERISA. It also means that the plan is an unsecured promise-to-pay subject to Sections 61 and 451, and not a “transfer of property” plan under Section 83.

      2. Reg. 123854-12, 81 FR 40569 (Jun. 22, 2016).

  • 3541. What requirements must be met by a private nonqualified deferred compensation plan?

    • An unfunded private nonqualified deferred compensation plan is a plan entered into with any employer other than:

      (1) a state;

      (2) a political subdivision of a state (e.g., a local government);

      (3) an agency or instrumentality of (1) or (2);1 or

      (4) an organization exempt from tax under IRC Section 501.

      Although private nonqualified deferred compensation agreements most frequently are entered into with employees of corporations, they also may be entered into with employees of other business organizations and with independent contractors.2 For example, a director’s fees can be deferred through an unfunded deferred compensation agreement with the corporation.3 This remains true for plans covered by IRC Section 409A. If an employer or service recipient transfers its payment obligation to a third party, efforts to defer payments from the third party may not be effective.4

      For rules concerning nonqualified deferred compensation plans sponsored by governmental or private tax-exempt not-for-profit employers, see Q 3581 through Q 3602.

      General Taxation Rules for Unfunded Plans

      IRC Section 409A is additive law that further defines the income tax doctrine of constructive receipt. Therefore, prior income tax law and theories (for example, the economic benefit theory) continue to apply, unless specifically replaced by Section 409A. This means that a plan subject to Section 409A must comply with both prior income tax law (except as specifically changed) as well as Section 409A requirements. Plans that are statutorily exempted or excepted by regulations from the Section 409A requirements (such as amounts grandfathered from 409A coverage) must continue to comply with prior income tax law only.

      Pre-409A Income Tax Law Requirements

      1.    An employer may contractually agree to pay deferred amounts as additional compensation, or employees may voluntarily agree pursuant to contract to reduce current salary.5

      2.   The plan must provide that participants only have the status of general unsecured creditors of the employer in bankruptcy and that the plan constitutes a mere unsecured promise-to-pay benefits by the employer in the future.

      3.   The plan also should state that it is the intention of the parties that it is unfunded for tax (and ERISA) purposes; that is without ERISA “plan assets.”

      4.   The plan should prohibit and void the anticipatory assignment of the benefits by a participating employee.

      5.   The plan should define the time and form for paying deferred compensation for each event (e.g., retirement) that would entitle a participant to a distribution of benefits.

      6.   The plan should include any provisions necessary to designate and comply with controlling state law requirements.

      These requirements continue after the enactment of Section 409A, and are the primary requirements for portions of plans that are grandfathered from 409A coverage or excepted from 409A coverage, such as plans that can claim the “short term deferral exception.”

      If the plan refers to a trust or other informal funding mechanism, additional rules must be satisfied (Q 3564, Q 3567).


      1. Federal credit unions, in additions to state chartered credit unions, per the IRS are considered tax-exempt organizations for purposes of 457.

      2. Rev. Rul. 60-31, 1960-1 CB 174, as modified by Rev. Rul. 70-435, 1970-2 CB 100.

      3. Rev. Rul. 71-419, 1971-2 CB 220.

      4. Rev. Rul. 69-50, 1969-1 CB 140, as amplified in Rev. Rul. 77-420, 1977-2 CB 172 (deferral of physicians’ payments from Blue Shield type organization ineffective); TAM 9336001 (deferral of plaintiffs’ attorney’s fees under structured settlement with defendants’ liability insurers ineffective); contra Childs v. Comm., 103 TC 634 (1994), aff’d, 89 F.3d 856 (11th Cir. 1996) (deferral of plaintiffs’ attorneys’ fees under structured settlement with defendant’s liability insurers effective).

      5. Rev. Rul. 69-650, 1969-2 CB 106.

  • 3542. What is the doctrine of constructive receipt and how does it apply to nonqualified deferred compensation plans?

    • Under pre-409A income tax law, tax deferment is not achieved if, prior to the actual receipt of payments, the employee is in constructive receipt of the income under the agreement. Income is constructively received if the employee can draw upon it at any time. Income is not constructively received if the employee’s control of its receipt is subject to substantial limitations or restrictions. Some agreements contain contingencies that may cause the employee to forfeit future payments. So long as the employee’s rights are forfeitable, there can be no constructive receipt.1 The IRS has ruled, however, that the employee will not be in constructive receipt of income even though rights are nonforfeitable if the agreement is entered into before the compensation is earned and the employer’s promise to pay is not secured in any way.2

      IRC Section 409A created new requirements for elections to defer compensation for covered nonqualified deferred compensation plans.3 Under pre-IRC Section 409A income tax law (which is still applicable to amounts grandfathered and plans excepted from Section 409A coverage), there was some conflict between the IRS and the courts with respect to the consequences of an election to defer compensation after the earning period commences. The IRS always has seemed to believe that a deferral election made after the earning period commences will result in constructive receipt of the deferred amounts, even if made before the deferred amounts are payable.4

      For example, in TAM 8632003, the IRS found constructive receipt where a participant in a shadow stock plan elected, just prior to surrendering his shares, to take the value of his shares in ten installment payments rather than in one lump sum. The IRS refused to permit further deferral of amounts already earned and determinable, believing that the fact that the benefits were not yet payable at the time of the election was an insufficient restriction on the availability of the money.5 A plan allowing elections to defer bonus payments on or before May 31 of the year for which the deferral was effective did not cause constructive receipt. There was no express consideration of the effect of the election provision, however.6

      In another ruling, contributions to a rabbi trust did not result in income to participants or beneficiaries until benefits would be paid or made available in the context of the plan allowing an election to further defer compensation through choice of the payout method after termination of services; there was no express consideration of the effect of the election provision.7

      Pre-Section 409A, courts looked more favorably on elections to defer compensation after the earning period commenced but before the compensation was payable. For example, the Tax Court considered the same plan addressed in TAM 8632003, above, and reaffirmed its position that an election to further defer compensation not yet due under the original deferred compensation agreement does not necessarily result in constructive receipt.8 Although the IRS did acquiesce in Oates and in the first Veit case, it tried to distinguish those cases and the second Veit case in TAM 8632003.

      The 409A general rule requires an election prior to the tax year in which the compensation is to be earned, which is the historic position of the IRS. Because the IRS was charged by Congress in the Congressional Commentary to Section 409A to pursue plans not conforming to Section 409A, it could be expected that the IRS likely will challenge plans excepted from Section 409A, and perhaps even grandfathered plans, that generally do not follow the income tax guidelines established by Section 409A, especially this one governing fundamental tax deferral.

      Planning Point: To date, the IRS has only continued to do some audits for general 409A compliance.9 Staffing problems at the IRS have forced it to forgo any broader enforcement beyond covered plans, and the focus is currently on FICA tax compliance.

      Whether Section 409A is applicable or not, special concerns are present if compensation is deferred for a controlling shareholder-employee, typically in the closely-held corporate situation. If a controlling shareholder-employee can (through control of the corporation) effectively remove any restrictions on immediate receipt of the money, the IRS can argue that he or she is in constructive receipt because nothing really stands between the shareholder-employee and the money.10 It is hard to eliminate these concerns in advance, because the IRS continues to refuse to issue advance rulings on the tax consequences of a controlling shareholder-employee’s participation in a nonqualified deferred compensation plan.11 Courts seemed to be less willing to impose constructive receipt in such situations prior to Section 409A.12

      Under Section 409A, the definition of “substantial risk of forfeiture” in the regulations embedded this IRS argument into law. The regulations to Section 409A prevent such a shareholder-employee from using the short term deferral exception to escape the coverage of Section 409A, even on a “vest and pay lump sum” Supplemental Executive Retirement Plan (“SERP”). However, they do not seem to prohibit such a nonqualified deferred compensation plan for such a shareholder-employee if the plan thereby fully complies with the documentary and operational requirements of the law. Such a plan could not claim the short term deferral exception to escape Section 409A coverage, even as to a SERP. Under the Section 409A regulations the shareholder’s control causes a loss of the substantial risk of forfeiture needed to claim the short term deferral exception. Even then, the IRS still might attempt to attack a plan for such a shareholder-employee, even if the plan is otherwise fully complying with the form and operational requirements of Section 409A. Therefore, special consideration and review must be applied to such a situation before implementing any plan, whether a voluntary deferral or employer-paid supplemental design.

      Finally, a nonqualified deferred compensation plan that is subject to registration as a security with the SEC, but that fails to register, may suffer adverse tax consequences. In such a case, a participant may be able to rescind the deferral of compensation under SEC rules. A right to rescind could cause the participant to be in constructive receipt of the deferred amounts. Currently, the IRS has not resolved either the nature or extent of any tax implications arising from a failure to register a plan with the SEC, and this is further complicated by the enactment of Section 409A. Further complicating matters, the SEC has not formally clarified in detail the nonqualified deferred compensation plans that are subject to the “security” registration requirements and has provided little useable informal guidance in this area, except to suggest that contemporary voluntary multi-account deferral designs might require registration.13


      1. Treas. Reg. §1.451-1, 1.451-2.

      2. Rev. Rul. 60-31, 1960-1 CB 174, as modified by Rev. Rul. 70-435, 1970-2 CB 100.

      3. IRC Sec. 409A(a)(4).

      4. The IRS made elections to defer prior to the tax year in which compensation is earned a requirement for a letter ruling on plans prior to enactment of Section 409A. Such IRS rulings are not available currently as to the income tax consequences of nonqualified deferred compensation plans.

      5. See also Let. Rul. 9336001 (election to defer must be made before earning compensation to avoid constructive receipt); Rev. Proc. 71-19, 1971-1 CB 698, as amplified by Rev. Proc. 92-65, 1992-2 CB 428.

      6. See Let. Rul. 9506008.

      7. See also Let. Rul. 9525031.

      8. See Martin v. Comm., 96 TC 814 (1991). See also Childs v. Comm., 103 TC 634 (1994), aff’d, 89 F.3d 856 (11th Cir. 1996); Oates v. Comm., 18 TC 570 (1952), aff’d, 207 F.2d 711 (7th Cir. 1953), acq., 1960-1 CB 5; Veit v. Comm., 8 TCM 919 (1949); Veit v. Comm., 8 TC 809 (1947), acq., 1947-2 CB 4.

      9. The IRS indicated in the spring of 2015 that it was going to do an audit of only a small number of large companies due to undergo audit for FICA tax compliance, and that the results would be used to help create guidance for its audit staff. However, if these special 409A audits occurred, none of the results seem to have shown up in the IRS’s release of its updated Nonqualified Deferred Compensation Audit Technique Guide in June, 2015. In fact, the portion covering 409A is such a small part of the new guide that there is little helpful information for practitioners as to structuring plans to avoid audit issues and the primary focus was on the FICA rules which seems to parallel the IRS’s current audit focus.

      10. See, e.g., TAM 8828004.

      11. See Rev. Proc. 2008-3, Sec. 3.01(43), 2008-1 IRB 110, Rev. Proc. 2009-3, 2009-1 IRB 107.

      12. See, e.g., Carnahan v. Comm., TC Memo 1994-163 (controlling shareholder’s power to withdraw corporate funds is not sufficient to cause constructive receipt), aff’d without opinion, 95-2 USTC ¶50,592 (D.C. Cir. 1995).

      13. For a more detailed discussion of this thorny issue, see Part V., Insurance-Related Compensation, Tax Management Portfolio, 386-4th T.M., Brody, Richey, Baier, Bloomberg, BNA (2017); and “Securities Registration Requirements and Issues,” pgs. 255-257, in Chapter 5, “SEC Considerations,” The Advisor’s Guide to Nonqualified Deferred Compensation, 2014 Edition, Richey, Baier, Phelan, National Underwriter Company.”

  • 3543. What requirements are there for a private nonqualified deferred compensation plan under IRC Section 409A?

    • Congress imposed additional documentary and operational requirements in IRC Section 409A to avoid a current constructive receipt on a “nonqualified deferred compensation plan” at inception and during the life of a covered plan. Many of these new requirements actually are those that the IRS formerly required to receive a favorable private letter ruling on income tax deferral under a plan and so are not new.

      Section 409A imposes requirements on plans in four primary areas:

      1. Minimum plan documentation

      2. Permissible Distributions

      3. Elections to defer

      4. Prohibited Accelerations

      See Q 3544 to Q 3547 for a detailed discussion of each of these requirements.

      Planning Point: Planners should assume that any compensation plan is covered by Section 409A and plan to comply until and unless they have satisfied themselves that the plan (which may be for only a single person) is either specifically statutorily exempted – such as a 457(b) plan – or meets (or can be designed to claim) a regulatory exception – such as the short term deferral exception.

  • 3544. What are the minimum plan documentation requirements for a private nonqualified deferred compensation plan under IRC Section 409A?

    • Under Section 409A, a covered plan must be compliant both in form (documentation) and operation (administration). Therefore, there are certain minimum requirements for plan documentation to comply with Section 409A at the outset. In general, any plan subject to Section 409A must meet the following minimum requirements.

      As to Section 409A:

      1.   The plan must be in writing, but there are no IRS prototype plans available as is the case for qualified plans. In effect, a plan is in violation of Section 409A if it is a covered arrangement but not in writing. However, the plan may be in more than one document, such as a plan and joinder agreement. The IRS will currently not issue letter rulings in regard to 409A.1

            This also suggests that plans claiming exception from 409A ought to be in writing to make the exception from coverage clear if audited. There are indications that the IRS auditors are asking for an identification of those plans that are covered and those claiming a 409A coverage exception to include the relevant exception and justification in pre-audit requests.2

      2.  The plan must state either the amount of the deferred compensation or the method for calculating the amount and the plan also must state the time and form of payment distribution, which would include:

      a.   all of the Section 409A rules for elections (and appropriate timing) to defer on salary, commissions, performance-based compensation bonuses, and nonperformance-based compensation bonuses, and newly eligible participants as applicable (see Q 3545 and Q 3546); and

      b.   all of the Section 409A permissible distributions, “earlier of” sequencing, and a prohibition against all other non-Section 409A distributions and accelerations (see Q 3547).

      3.  The plan must contain all the unique definitions (e.g., “separation from service”) and key terminology (e.g., “leave of absence”) from Section 409A that apply to the plan, including the special plan termination rules.

      4.  The plan should contain a “Section 409A interpretation clause” defining undefined, ambiguous, or missing plan definitions and other language consistent with Section 409A.

      5.  The plan should include the Section 409A compliant timing for distribution following a permissible distribution event.

      6.  The plan should state the inclusion or prohibition of permitted Section 409A acceleration events (e.g., domestic relations orders).

      7.  The plan should state the requirements for a voluntary plan termination by the employer.

      8.  The plan should include an indemnification provision that either accepts or refuses the responsibility of the employer for any Section 409A violations and the adverse tax consequences that may result.

      9.  The plan should state whether it will allow subsequent elections and whether a series of installment payments shall be treated as a single distribution or a series of individual distributions for purposes of the plan, and subsequent elections to extend deferral.

      10. The plan should include a provision for a delay of the payment start date for six calendar months when there is a separation from service of “specified employees,” including the desired optional “catch-up” treatment (the provision is required if the plan is sponsored by a publicly-traded company; the provision is conditional (or unnecessary) if the sponsor is a closely-held company or tax-exempt organization).

      11. The plan should include a prohibition provision against crediting interest on any participant accounts during any period that the plan sponsor is not in compliance with the minimum funding requirements for any qualified defined benefit pension plan.

      12. The plan optionally may include a provision for:

      a.   the very limited Section 409A right of the employer to offset participant liabilities to the employer against a participant’s account, unless extended in the normal course of business as outlined in Section 409A, which should be clearly documented if this very narrow exception to the rule will be relied upon;

      b.   accelerated cash-outs for certain allowed small amounts (those amounts less than the annual 402(g)(1)(b) amount) upon a separation from service; and

      c.   automatic cancellation of a participant’s deferral election for the balance of the plan year upon a request for an “unforeseeable emergency” request.

      As to continuing prior law:

      1.   The plan should contain a provision in which the employer contractually agrees to pay deferred amounts at a future date as additional compensation, or employees contractually voluntarily agree with the employer to reduce current salary.3

      2.  The plan must provide that participants only have the status of general unsecured creditors of the employer in bankruptcy and that the plan constitutes mere promise-to-pay benefits by the employer in the future.

      3.  The plan also should state that it is the intention of the parties that it be unfunded for tax (and ERISA) purposes.

      4.  The plan should prohibit and void the anticipatory assignment of the benefits by a participating employee.

      5.  The plan should include any provisions necessary to designate and comply with controlling state law requirements.


      1. Rev. Proc. 2019-3.

      2. During early audits, several counsel shared pre-audit IRS written requests online at various tax blogs in the past several years, and generally suggested the wisdom of a written plans, even if claiming an exception to 409A coverage. This remains good advice to document the claimed exception for the sponsor and for the IRS in case of an audit of all its various plans.

      3. Rev. Rul. 69-650, 1969-2 CB 106.

  • 3545. When can a participant in a private nonqualified deferred compensation plan receive a distribution of previously deferred compensation under IRC Section 409A?

    • Under Section 409A, a participant may only receive a distribution of previously deferred compensation upon the occurrence of one of six primary events.

      •     Separation from service (which has a detailed definition with only limited flexibility to modify)

      •     Date the participant becomes disabled (requires the Social Security definition of a disability)

      •     Death

      •     A fixed date or time (or pursuant to a fixed scheduled) specified in the plan at the date of the deferral

      •     A change in the ownership or effective control of the corporation or assets of the corporation, to the extent provided in regulations (but an equity investment by the federal government under the Troubled Asset Relief Program (TARP) is not considered a change in ownership or control)1

      •     The occurrence of an unforeseeable emergency2

      Most of these events have definitions unique to Section 409A and must be used in covered plans. Generally speaking, the definitions are narrower than one might suppose, and have special rules. There are also a limited number of other regulatory permissible accelerated distribution events covering plan termination; domestic relations orders (DRO); payment to avoid conflict of interest statutes; payment of applicable employment (FICA) taxes and distribution withholdings; payment of amounts because of 409A violations; payment of “small amounts” under Section 402(g)(i)(B); payment of applicable local, state and foreign taxes; payment to avoid a “nonallocation year” under Section 409A(p) with respect to an ESOP sponsored by an S corpoartion; and payment of applicable employment and income tax withholding because of taxable vesting under Section 457(f) plan of a tax exempt entity (see Q 3547).3

      Under 409A, “specified employees” (“key employees” as defined under IRC Section 416(i)) of publicly-traded corporations may not take distributions until six calendar months after a 409A separation from service (or the date of death of the employee, if earlier).4 In general, plan distribution in other situations and at earlier times, except as permitted under “combination elections”, is prohibited under Section 409A (see below).

      Under final regulations, a change in ownership occurs when an individual or persons acting as a group acquires more than 50 percent of the total fair market value or total voting power of the corporation. Ownership under these rules is subject to attribution under IRC Section 318(a). A change in effective control occurs when (1) an individual or persons acting as a group acquires 35 percent or more of the total voting power of the stock of the corporation within a twelve month period or (2) where there is an adversarial change in a majority of the membership of the board of directors within a twelve month period. A change in the ownership of a substantial portion of the assets of the corporation occurs when an individual or persons acting as a group acquire assets equal to or greater than 40 percent of the total gross fair market value of the corporation.5

      An “unforeseeable emergency” under Section 409A means “a severe financial hardship to the participant resulting from an illness or accident” of the participant, the participant’s spouse, or a dependent (as defined in IRC Section 152(a)) of the participant, loss of the participant’s property due to casualty, or other similar “extraordinary and unforeseeable circumstances” arising as a result of events beyond the control of the participant.6 A nonqualified deferred compensation plan financial hardship withdrawal under this provision may be taken without taking a financial hardship distribution from any qualified 401(k) plan balance of the employee, and the plan may require that the balance of remaining voluntary employee deferral elections for the plan year be cancelled if a financial hardship distribution is taken from an employee’s 401(k) plan balance (to comply with 401(k) plan financial hardship requirements).7


      Planning Point: The IRS confirmed that a coronavirus-related distribution is a distribution that can be treated as a hardship distribution for nonqualified deferred compensation plan purposes.  This allows nonqualified deferred compensation plans to amend their terms to allow either (1) automatic suspension of the individual’s deferral elections throughout 2020 or (2) the right for qualified individuals to elect to suspend their deferral elections during 2020.8


      Under the technical 409A Proposed Amendments in June 2016, the IRS clarified the definition of a “payment”, which is important for meeting distribution and subsequent election requirements. A “payment” is made under Section 409A when any taxable benefit is actually or constructively received.9


      1. Notice 2009-49, 2009-25 IRB 1093.

      2. IRC Sec. 409A(a)(2)(A); Treas. Reg. § 1.409A-3.

      3. See specific subsections, Treas. Reg. §§ 1.409A-1 and 409A-3 for permissible regulatory accelerations.

      4. IRC Sec. 409A(a)(2)(B)(i).

      5. Treas. Reg. § 1.409A-3(i)(5).

      6. Treas. Reg. § 1.409A-3(i)(3).

      7. Treas. Reg. §1.409A-3(j)(4)(viii); Preamble Section VII.D., Section 409A Proposed Treasury Regulations, 9-23-2005.

      8. Notice 2020-50.

      9See generally, Prop. Treas. Reg. § 1.409A-2 and 3, as amended by REG. 123854-12, 81 FR 40569, Para. 4 and 5 (June 22, 2016). See also, Preamble Section IV. To the REG.

  • 3546. When must a participant in a private nonqualified deferred compensation plan elect to defer compensation under IRC Section 409A?

    • IRC Section 409A imposes timing requirements for participants electing to defer compensation. The general rule is that participants now generally must make deferral elections prior to the end of the preceding taxable year (December 31 in most cases) in which the income is earned.1 There are two major exceptions to the general rule, as follows:

      1.    In the first year of a plan, a participant can make a pro rata election on compensation, based upon the number of days remaining in the year.

      2.   In the case of any “performance-based compensation,” (PBC) as defined in the regulations to Section 409A, a participant must make an election to defer not later than six months before the end of the covered period (June 30 for a calendar year performance period) and performance period in the case of a fiscal year. The compensation must meet this unique Section 409A definition, which includes (among other important requirements) a twelve month performance period.2 This rule also allows an election on fiscal year performance-based compensation to be made six months prior to the end of the fiscal year if that is the end of the performance period.3 This rule changes the common practice on bonus compensation under prior law, especially as to new plans, to make elections late in the performance period. Now it is essential to start and enroll a deferral plan prior to the six month deadline to maximize the deferral opportunity.

            In the case of existing plans, participants need not make a final election on PBC until the six-month prior deadline, even if they make a preliminary election on it in the prior tax year.

      Newly eligible participants must make an election within thirty days after the date of eligibility, but only with respect to services to be performed subsequent to the election. In addition, elections to defer on plans of the same Section 409A plan type (for example, all employee account balance plans) under the “aggregation rule,” if there is more than one, must occur at the same time.

      Planning Point: Employers with more than one plan of the same Section 409A type (e.g., employee account balance plans) only should allow enrollment in plans, including for newly eligible employees, during perhaps a mid-year and end-of calendar year enrollment window to comply with the requirement of a common enrollment period for similar Section 409A plans.

      Section 409A also requires a plan to specify whether any elected series of installment payments shall be treated as a single distribution or a series of individual distributions.

      Subsequent Elections: Using this rule, Section 409A allows participants to elect to make a “subsequent election” to delay the timing of an existing elected distribution or change the form of that distribution from a plan so long as the plan provides for such subsequent election right. To make such a subsequent election, the plan document and the administration must require the subsequent election to be made at least twelve months in advance of the original distribution date, and the subsequent election must delay the timing of the distribution at least five years from the date of the original distribution (unless made on account of disability, death, or an unforeseeable emergency).

      In addition, there is a twelve month waiting period requirement after the subsequent election during which the old election must be applied for an event-based separation from service. An election related to a scheduled series of installment payments made pursuant to a fixed schedule and treated as a single distribution must be made at least twelve months in advance of the first such scheduled installment payment.4 In general, it is usually preferable to create more flexibility for a participant in a plan by designating that a series of installment payments be treated as a series of individual distributions. However, it is necessary to have a plan administrator who can manage this complex flexibility and thereby comply with Section 409A to include it in a plan.

      Current regulations generally also provide that a separately identified amount of an installment (either by percentage or fixed dollar amounts) that an employee is entitled to receive on a determinable date may be deferred subject to the subsequent election rules.5 In effect, a portion of an installment, if a series of installment payments are treated as a series of individual distributions, may be subsequently deferred.


      1. IRC Sec. 409A(a)(4)(B)(i).

      2. IRC Sec. 409A(a)(4)(B); Treas. Reg. §1.409A-2.

      3. However, this rule only covers fiscal year performance-based compensation and not salary or other types of compensation. The IRS requires the election on these types of compensation to be made before the end of the taxable calendar year in advance of the beginning of the specific fiscal year. In effect, these other types of compensation cannot be deferred based upon a fiscal year.

      4. IRC Sec. 409A(a)(4)(C); Treas. Reg. §1.409A-2(b).

      5. Treas. Reg. §1.409A-2(b)(2).

  • 3547. When do prohibited (and permissible) acceleration of payment requirements apply to private nonqualified deferred compensation plans under IRC Section 409A?

    • Accelerations of plan distributions outside the six primary permissible listed distributions are prohibited. Final regulations, however, define specified circumstances under which a plan may permit the acceleration of plan payments and, in effect, widen permissible plan distributions, as follows:

      (1) To comply with a domestic relations order (a DRO, not a QDRO since there are no “plan assets” in a promise-to-pay nonqualified deferred compensation plan to levy against).

      (2) To comply with a conflict-of-interest divestiture requirement, including foreign conflict of interest per 2016 409A clarifications.1

      (3) To pay income taxes due on a vesting event under a plan subject to IRC Section 457(f).

      (4) To pay FICA or other employment taxes imposed on compensation deferred under the plan.

      (5) To pay any amount included in income under IRC Section 409A.

      (6) To pay only the proper amount due, based on a valid unforeseeable emergency request.

      (7) To terminate a participant’s entire interest in a plan:

      a.   after a separation from service where the payment is not greater than the IRC Section 402(g)(1)(B) so-called “small amounts” ($20,500 in 2022, $19,500 in 2020 and 2021, $19,000 for 2019); or

      b.   in the calendar month prior to, or twelve months following, a Section 409A change in control event date.

      (8) To terminate the plan entirely at the employer’s discretion (and distribute) so long as:

      a.   all the plans of the same Section 409A type are terminated;

      b.   all plan termination distributions will be made no earlier than twelve months, but not later than twenty-four months, following the date of termination; and

      c.   no new plan of the same Section 409A type is established for at least three years following the termination (or a retroactive violation occurs).

      (9) To terminate a plan pursuant to an IRC Section 331 corporate dissolution with the approval of a bankruptcy court judge.2

      The IRS has informally advised3 that a “salary advance” plan that allows an employer to offset any unpaid compensation advances against an employee’s balance under a Section 409A nonqualified deferred compensation plan violates the Section 409A prohibition against acceleration of payments, and requires the amendment of the salary advance plan to prevent a violation of Section 409A for the deferred compensation plan (the terms of the two plans would be combined to determine a Section 409A violation).

      Offsets and substitutions of plans to achieve an earlier distribution of compensation deferred under Section 409A generally are prohibited, except for a narrow exception that allows “debt incurred in the normal course of the service relationship” to be offset in the year debt is due up to $5,000.”4


      1. IRC Sec. 1043.

      2. Treas. Reg. §1.409A-3(j); Prop. Treas. Reg. REG 123854-12, June 22, 2016.

      3. CCA 200935029, Released 8-28-2009.

      4. Treas. Reg. §1.409A-3(j)(4)(D)(xiii).

  • 3548. What is a “short term deferral exception” under Section 409A?

    • The “short term deferral exception” in the regulations to Section 409A is perhaps the most important exception to coverage by Section 409A for many compensation plans.

      Its name is a misnomer because this regulatory exception actually can be claimed for plan benefit distributions far in the future so long as (1) the benefit is subject to a Section 409A “substantial risk of forfeiture,” which is the most stringent definition of the seven definitions of “substantial risk of forfeiture” currently in the IRC, and (2) the plan distribution essentially is made in a lump sum on the lapse of the 409A substantial risk of forfeiture. Both of these requirements must be met to claim the Section 409A short term deferral exception.

      For example, an employer-paid supplemental executive retirement plan (SERP) for a forty-five year-old key employee might provide for payment upon vesting at age sixty-two, but it might also provide for a forfeiture of the entire benefit if the executive terminates employment prior to age sixty-two. If that promised benefit is also payable in a lump sum in that year of vesting (resulting in lapse of the substantial risk of forfeiture) or within 2½ months following that year, the plan might qualify as a so-called “vest-and-pay lump sum” plan to claim an exception from Section 409A coverage, even though the plan defers payment for seventeen years. Under the short term deferral exception, no Section 409A “deferral of compensation” occurs if amounts are paid within 2½ months after the end of the tax year in which the employee obtains a legally-binding right to the amounts or any Section 409A substantial risk of forfeiture lapses. Under this rule, many multiyear bonus arrangements, including bonus life insurance or bonus annuity arrangements and “vest-and-pay lump sum” SERPs that require payments in lump sum promptly after the amounts “vest” (under Section 409A substantial risk of forfeiture requirements), as in the example, will not be subject to coverage under Section 409A.1 Of course, in contrast, the employee loses the potential tax advantage of spreading the income across several tax years that installment payments might offer, so there are considerations other than the application (or nonapplication) of the Section 409A rules.

      Planning Point: The 2007 regulations always permitted certain delays beyond the 2½ month distribution deadline that would not cause a loss of the short term deferral exception. The exception included delays for reason of administrative impracticality so long as the delayed payments were then made as soon as administratively practical. In June 2016, the IRS released proposed 409A clarification regulations that expand these permissible delays to include payments delayed in order to comply with federal securities or other applicable laws so long as the payment is made on the first date the employer believes the payment will not violate the applicable law.2 These proposed regulations, which may be relied upon now, also allow for delay of payment of covered plan death benefits until the end of the calendar year following the year of a participant’s death.


      1. Treas. Reg. §1.409A-1(b)(4).

      2. Prop Treas. Regulation, REG 123854-12, June 22, 2016.

  • 3549. What penalties can be imposed under Section 409A?

    • IRC Section 409A imposes substantial penalties for failing to meet either the Section 409A form (documentation) or operational (administration) requirements at inception and during the life of a covered plan. One of the peculiarities of Section 409A is that the tax falls on the participant and not the employer.1 In the worst-case situation, any violation of the Section 409A documentary or operational requirements results in retroactive constructive receipt, with the vested portion of the deferred compensation being taxable to the participant back to the date of the violation, which might be the date of the intended deferral.2

      However, in June 2016, the IRS released technical proposed amendments to the inclusion regulations that limit the ability of plan sponsors to use the existing exclusion of nonvested amounts from taxation to make changes in the time and form of payment in a plan document without engaging the subsequent election five-year setback. Under the proposed amendment, the nonvested amounts of a benefit cannot be excluded from the calculation of the tax in the event of a violation unless the following conditions are met: 1) the plan provisions must be noncompliant prior to the correction of the document, meaning the amendments to the document must not create the noncompliance; 2) there must be no prior history of the employer making and correcting such intentional failures; 3) there must be a consistency in how the employer makes corrections in such cases; and, 4) there must be full conformity and compliance with the IRS guidance on such plan corrections (i.e., Notice 2010-6).3 IRS treatment of prior instances of using the pre-June twenty-two exclusion of nonvested amounts in such intentional violation of 409A instances is uncertain. No specific grandfathering of such instances was provided in the June 2016 proposed amendments.

      This proposed amendment apparently ends a practice of some sponsors intentionally making changes in time and form of payment (probably at the request of a senior plan participant) on individualized supplemental plans in which the benefits were substantially nonvested until a late distribution date, like retirement. By not applying the subsequent election five-year set-back rule a sponsor violates Section 409A, but avoids reporting because of the prior exclusion for nonvested benefits. In such cases now, all amounts whether non-vested or vested, must be included in the calculation of the penalty taxes.

      In addition, IRS Counsel has taken the position that the correction of a form error prior to the date of vesting, but in the tax year of the vesting date, did not cure the plan sponsor’s failure to correct the error in time. Therefore, the entire amount of the plan benefits must be included in taxable income under Section 409A. The Chief Counsel’s memorandum indicated that 409A and the proposed regulations governing income inclusion require that the form correction should have been made before the end of the tax year prior to the tax year in which vesting occurred for it to have avoided application of the 409A inclusion rules for the error in form.4

      In addition to the normal income tax on the compensation, the participant must pay an additional 20 percent tax, as well as interest at a “premium” penalty rate 1 percent higher than the normal AFR underpayment rate.5 Fortunately, there are now methods under Notices 2008-113 (in the case of operational errors), Notice 2010-6 (in the case of documentation error), and Notice 2010-80 (updating both prior Notices) for correcting many common documentary and operational errors that may avoid the full impact of taxation under Section 409A.

      Planning Point: With regard to penalties for violations of Section 409A, at least one state – California – currently adds its own 56 percent excise state income tax penalty when the federal penalty is imposed for a Section 409A error. Planners should therefore check the relevant applicable state rules at the time any voluntary deferral plan is created, to determine the additional state income tax exposure for likely eligible participants. If the sponsor and its participants are substantially all located (and likely to remain) in a state(s) that also imposes its own penalty excise tax, a discussion of other potential approaches to a 409A nonqualified deferred compensation plan may be in order if the total potential federal and state income tax for an error appears excessive. If the plan desired is an employer-paid SERP, the 409A penalty state income tax possibility may be less of an issue, but still ought to be discussed.


      1. Based upon the logic in Davidson v. Henkel, No. 12-cv-14103, 2015 WL 74257 (E.D. Mich. Jan. 6, 2015), a plan sponsor can be held liable for extra FICA taxes imposed on plan participants because of an employer’s failure to withhold and pay them during their working career, and there might also be exposure to a sponsor for the extra penalty taxes imposed on plan participants because of its failure to document and operate a plan according to the requirements of 409A. There might be a risk even if the sponsor disclaims such liability in the plan documentation.

      2. IRC Sec. 409A(a)(1)(A)(i); Prop. Treas. Reg. §1.409A-4 as to valuation when worst-case taxation is required.

      3See generally, Prop. Treas. Reg. § 1.409A-4, as amended by REG 148362-05, 73 FR 74380, Para. 6 (June 22, 2016); See also, Preamble Section VII to the REG.

      4. CCM 201518013 (May 1, 2015).

      5. IRC Sec. 409A(a)(1)(B); Prop. Treas. Reg. §1.409A-4 as to valuation when worst-case taxation is required.

      6. This penalty excise tax in California was initially 20 percent but reduced to 5 percent on October 4, 2013. On that date, California signed into law an amendment to the California Revenue and Taxation Code reducing its state excise income tax rate effective for taxable years beginning on or after January 1, 2013.

  • 3550. What is a “substantial risk of forfeiture” for Section 409A purposes?

    • The definition of “substantial risk of forfeiture” under Section 409A (409A SROF) further defines the constructive receipt doctrine and is more stringent than any of the other definitions under the IRC (Q 3538, footnote 1), especially as to closely-held companies and tax-exempt organizations. The 409A definition starts with the language from the Section 83 definition that there is substantial risk of forfeiture only if compensation is conditioned on the performance of substantial future services, the occurrence of a condition related to the purpose of the compensation, and the possibility of forfeiture is substantial. Whether there is a 409A SROF is based on the likelihood of enforcement, given all the facts and circumstances according to the IRS. This regulatory position presents the most problems as to participants who are majority or controlling shareholder and family members of such participants.

      On May 29, 2012, the IRS released proposed Section 83 regulations clarifying “substantial risk of forfeiture” as to funded Section 83 “transfer of property plans” and it has drawn some language from Section 409A in doing so (Q 3538). On February 25, 2014, the IRS released final Section 83 regulations that are substantially similar to the proposed regulations. It appears that the IRS may be trying to better integrate Section 83 with 409A by dropping 409A concepts into these Section 83 regulations. However, in doing so, it may be making substantive changes to “substantial risk of forfeiture” requirements for Section 83 plans by adopting the more stringent 409A requirements, although the IRS has always claimed that its interpretation of regulations under Section 83 have never changed. Of course these changes to Section 83 impact only funded “transfer of property” plans and not unfunded promise-to-pay plans that are specifically exempt from Section 83 coverage.

      For example, the final Section 409A regulations note the following as to certain specific circumstances that do not constitute a 409A SROF:

      •    Voluntary salary deferrals (because the deferrals are fully vested and so such a plan is covered and therefore must comply with Section 409A requirements as to form and operation);

      •    A covenant not to compete, even if the compensation is forfeitable in the event of on a breach;

      •    Compensation following an extension or modification of an existing 409A SROF (hence rolling vesting dates do not create a 409A SROF and, unless there is new consideration for the extension or modification, the amount will be treated as vested and subject to 409A compliance requirements);

      •    Compensation beyond the time at which the employee could have otherwise received it, unless the present value of the amount subject to the 409A SROF is materially greater than the present value of the amount the employee could have elected to receive in the absence of the 409A SROF;

      Planning Point: These 2007 rules primarily created a problem for “ineligible” 457(f) voluntary deferral plans operating under the then-applicable guidance of IRS Notice 2007-62. This was because in the Notice the IRS proposed to substitute the 409A SROF definition for the definition found in 457(f). In addition, the IRS indicated that it did not believe any risks of forfeiture are real in a Section 457(f) voluntary deferral design unless there is a significant employer match that would provide a materially greater benefit on a present value basis to the employee for deferring and placing otherwise vested compensation back at risk. However, the IRS failed to provide guidance on a minimum safe harbor employer amount.

      Then, in June 2016 the IRS released the long-delayed proposed 457/409A integration regulations. In these proposed regulations, the IRS created a unique definition of substantial risk of forfeiture for Section 457, and did not adopt the current 409A definition directly into Section 457. These proposed regulations still seem to drive planners toward Section 457(b) “eligible” plans as the preferred alternative for voluntary deferral plans under Section 457, especially if the employer does not and cannot make the substantial employer match as proposed. 

      However, if a match can be contemplated, the minimum safe harbor for a “materially greater” safe harbor match has been defined as more than 125 percent on a present value basis as required for a 457(f) “ineligible” voluntary deferral plan covering vested compensation (for example, salary, bonus deferral) to establish a substantial risk of forfeiture for purposes of a plan covered by Section 457. However, there is no guidance in the 2016 proposed regulations as to treatment or correction for a 457(f) plan that may have used a lesser employer matching percentage during the long interim in which there was no substantive guidance defining a “materially greater” match. Practitioners should check for guidance when the propped regulations are finalized.

      •    Payments based on attainment of a prescribed level of earnings, unless there is a substantial risk that this level may not be achieved;

      •    Payments based on an initial IPO unless the risk there will be no initial IPO is substantial from the beginning; and

      •    Stock options immediately exercisable in exchange for substantially vested stock, even if the ability to exercise the option would terminate on a separation from service.

      In the first reported Section 409A case (where the facts occurred during the transition period in 2005 when there were no regulations and only the bare statute and IRS Notice 2005-1 to review), the Tax Court held in a summary opinion (meaning it is not legal precedent) that a surrender charge on an annuity was not a substantial risk of forfeiture. The case is confusing at best because the taxpayer was arguing that the situation was covered by Section 409A and a deferral existed, while the IRS argued only that there was a constructive receipt of income under Section 61 and made no 409A violation arguments at all.1

      In 2016, IRS Chief Counsel advised an audit team in a memo that the use of a 25 percent matching formula on a continuation of a voluntary deferral of current salary until a future fixed date, but forfeitable (along with the match) was sufficient to create a materially greater present value amount to qualify as a 409A SROF.2


      1Slater v. Comm., T.C. Summary Opinion 2010-1, 1-11-2010.

      2. CCM 201645012, Nov. 27, 2016. This CCM predated and anticipated the 125 percent PV increase (25 percent employer DC match) safe harbor incorporated into the June 2016 proposed 457/409A integration regulations.

  • 3551. What factors are important in determining whether a Section 409A substantial risk of forfeiture exists if the individual has significant voting power in the entity paying the nonqualified deferred compensation?

    • Where individuals have significant voting power in the entity paying the nonqualified deferred compensation, the following relevant factors must be considered to determine if there is a 409A SROF:

      •    The employee-shareholders’ relationship to the other shareholders and the extent of their control and potential control over the decision, and possible loss of control of the employee;

      •    The position of the employee at the employer and the extent to which the employee-shareholder is subordinate to the other employees, especially other employee shareholders;

      •    The relationship of the employee to the employer’s officers and directors (i.e., whether they are family);

      •    The person or persons who would approve the employee’s discharge; and

      •    The past actions of the employer in enforcing any restrictions on employees, especially employee-shareholders.1

      Of course, this means that majority or controlling shareholders in for-profit entities may find it difficult, if not impossible, to establish that there is a 409A SROF.4 The failure to establish a 409A SROF in such situations apparently does not mean that a nonqualified deferred compensation plan cannot be created for such an employee-shareholder, or so it has been thought to date. This is because the 409A SROF definition is used for a special purpose under Section 409A, rather than to establish whether there is current taxation. Except in the case of 457(f) plans, based on its separate definition of substantial risk of forfeiture under the proposed regulations, the 409A definition is used to determine access to the short term deferral exception that allows the plan to entirely avoid compliance with the so-called 409A “detail” requirements. If a plan has no 409A SROF and cannot claim the short term deferral exception under the final 409A regulations, it must comply with all the form and operational requirements of Section 409A.
      Because Section 409A is additive income tax law, the plan would then also have to comply with the other applicable pre-409A IRC income tax sections (for example, Section 61/451 substantial limitation or risk of forfeiture requirements in the case of an unfunded deferred compensation plan) in order to achieve income tax deferral for the plan.


      1See generally, Treas. Reg. §1.409A-1(d).

      2. It is less clear how these factors would be applied to 457(f) plans for employees in tax-exempt organizations that have no shareholders.

  • 3552. What are the reporting and withholding requirements under Section 409A?

    • Section 409A requires both informational annual tax reporting and tax reporting of amounts in violation of Section 409A (to determine the special taxes). Under IRC Section 409A, employers are required to make an informational tax report on all employee deferrals for a year on a Form W-2 or a Form 1099-MISC, regardless of whether such deferred compensation currently is includable in gross income. These amounts are reportable for informational purposes, whether or not they are treated as wages under IRC Section 3401(a).1 The IRS temporarily waived the informational reporting obligations of employers for 2005-2010.2 The IRS has since indicated that no informational reporting will be required until the proposed regulations on income taxation under Section 409A are made final.3 Employers should annually check with their administrator to determine if informational reporting will be required for the coming tax year.

      Employers also must annually report amounts includable in gross taxable income under IRC Section 409A on a Form W-2 or a Form 1099-MISC for any documentary or operational violations of Section 409A. This includes violations that require “worst case” tax reporting for a violation, or amounts includible under the documentary and operational correction procedures allowed under current IRS Notices 2008-113, 2010-6, and 2010-80.

      Amounts reportable for violations of Section 409A should be reported as wages on line 2 in Form 941 and then in Box 12 of Form W-2 using a “Z” code. No code is added on Box 12 if the compensation is taxable but not subject to the penalties of Section 409A. The amounts for an independent contractor should be reported as nonemployee compensation in Box 7 and Box 15b of Form 1099-MISC. This includible income is treated as supplemental wages subject to withholding, but there is no requirement for an employer to withhold on the 20 percent excise penalty and late interest tax penalty amounts.4


      1. IRC Secs. 6041, 6051.

      2. Notices 2005-1; 2005-94; 2006-100; 2007-89, 2008-115 and 2010-80.

      3. Prop. Treas. Reg. §1.409A-4. As of September 2020 these proposed income inclusion regulations have not yet been made final and annual reporting has not yet been made mandatory.

      4. Notice 2008-115.

  • 3553. What are the correction procedures under Section 409A?

    • With respect to nonqualified deferred compensation plans, it is important to note that the IRS EPCS and the SCP correction procedures applying to qualified plans1 do not apply to nonqualified deferred compensation plans, whether subject to Section 409A or not.

      Fortunately, it is not always necessary to suffer worst case taxation under Section 409A for an unintentional error in either plan documentation or operation. The IRS has released three notices, one that addresses Section 409A documentation errors, Notice 2010-6,2 one that addresses Section 409A operational administrative errors, Notice 2008-113,3 and Notice 2010-80 that updates both on certain select issues.4 All notices require that certain preconditions be met to take advantage of the special correction processes made available. In general, the notice correction procedures allow for corrections based on the timing of the correction of the error, the party involved (whether an “insider” or another employee), and in some cases the magnitude of the error.

      The general remedy under the notices is to include in an employee’s income only the amount in error, in the case of operational errors, or some specified portion of the amount, such as 50 percent or 25 percent in the case of documentation errors. The 20 percent excise tax and premium penalty tax is often avoided, unless the affected participant is an “insider” (applying SEC Section 16(b) named officer standards, including by analogy those in closely-held companies). Both the employer and the employee have to report the correction of the error on tax returns to the IRS to claim the benefit of these correction procedures, unless the error is caught and corrected in the year of error. In that case, reporting is not required.

      Some commentators think that it also may be possible to correct some documentary and operational errors in covered plans outside the parameters of these three notices under correction concepts applicable prior to the enactment of Section 409A. However, it should be recognized that the IRS takes a strict constructionist view of errors and error correction under Section 409A, and is unlikely to agree with these alternative procedures, even though 409A is additive law and arguably historic contract and tax bookkeeping correction procedures should remain available. However, plans excepted from 409A coverage and grandfathered portions of plans would remain covered by these pre-409A correction procedures and not the formal correction procedures provided in the notices.5

      Notices 2009-113 and 2010-6 were expanded in late 2010 under Notice 2010-80. Notice 2010-80 modified Notice 2008-113, governing operational errors, to eliminate employer and employee reporting when an operational error correction is made within the same year as the error. It also modified Notice 2010-6, governing documentation errors, to allow correction of severance/separation plans with incorrect release of claims provisions if completed by December 31, 2012, and to allow nonqualified plans “linked” to other nonqualified plans (e.g., excessive benefit plans) and stock plans to use Notice 2010-6 to make corrections for document failures prior to that date. However, this last opportunity to correct the form errors outlined in Notice 2010-80 expired on December 31, 2012.

      Documentary Error Correction

      In the case of documentation errors, there are some errors that may be corrected without an amendment or paying any tax or penalties at all. Notice 2010-6 provides an extensive digest of various (but not all possible) documentation errors and the remedies that permit the employee to report less than the amount that would be required in the worst case Section 409A taxation situation and avoid the full Section 409A 20 percent excise and premium interest penalty taxes in many cases. Notice 2010-6 highlights specific documentation errors, with corrective procedures and costs.

      Because it is focused on language and structures that create errors under Section 409A, it also provides a useful checklist for plan drafting to avoid common Section 409A drafting errors for various types of Section 409A-covered plans. Notice 2010-6 also gives new plans a grace period of twelve months from the effective date to correct errors found in the plan documentation.

      Operational Error Correction

      In the case of operational errors, Notice 2008-113 defines operational errors based on Section 409A requirements. It organizes them into useful categories of Section 409A operational violations, such as distributions made before the six month delay period for highly compensated employees. It outlines the Notice 2008-113 special corrective procedure required to correct that category of error without having to incur the worst case tax event. In general, full relief is available when operational errors involving any employee are discovered and corrected in the same tax year, and by the second tax year in the case of employees that are not “insiders,” as defined under Section 16(b) of the federal securities laws notwithstanding whether the employer is a public or private corporation. In other words, the “insider” rule for 409A correction purposes applies to public companies and also to private, closely-held for-profit and tax-exempt organizations by analogy.

      Planning Point: Notice 2010-6 allowed a final opportunity to correct documentation errors in plans not later than December 31, 2010, and to have these corrections apply retroactively back to the January 1, 2009, effective date for actual document compliance. As of January 1, 2011, this opportunity passed, and sponsors now must use Notice 2010-6, as modified by Notice 2010-80 to make formal corrections. In addition, all errors in plans, whether of a documentary or operational nature, usually can be corrected in order to minimize the negative tax impact on an employee if the error is identified and corrected sooner rather than later, especially if caught and corrected in the same tax year. Therefore, plan sponsors should routinely audit their plans in the late fall to discover and correct any operational or documentation errors before the end of the current tax year. They should also build in a review audit in the first year of a plan in order to catch initial plan drafting errors and then correct them during the correction grace period provided for new plans that do not generally constitute an error or require formal correction under Notice 2010-6.

      Planning Point: On May 9, 2014, in a subcommittee meeting at the American Bar Association annual conference, the IRS announced that it was launching a new, limited CIP 409A audit. Although the audit was to impact only fifty public companies also targeted for an audit on employment taxes, the audit was used to sharpen IRS future audit practice on 409A plans for even broader audits that will surely follow.6 

      This and prior IRS 409A audit initiatives suggest the wisdom of periodic “self-audits” of both the required documentary and operational compliance. A periodic self-audit makes sense anyway, since the special correction programs, which provide a less than worse-case results under the penalty provisions of 409A, are NOT available for companies once they are in an IRS audit. Moreover, the IRS currently applies a strict application of 409A penalties when they are discovered in audit. Therefore, it is recommended that companies routinely self-audit their 409A plans annually for operational compliance. Documents can be reviewed less frequently, but certainly should be reviewed any time they are amended or restated. However, compliant plan documentation and operation should always be in sync at all times.


      1. See generally, Rev. Proc. 2008-50 effective for qualified plan errors after 1-1-2009, as modified and superseded in part by Rev. Proc. 2013-12, Rev. Proc. 2016-51 and Rev. Proc. 2018-52.

      2. Notice 2010-6, 2010-3 IRB, 1-6-2010.

      3. 2008-51, 12-23-2008.

      4. Notice 2010-80, 2010-51 IRB 853.

      5. See for example, Olshan, Regina & Schohn, Erica, Expert Q&A on Correcting Section 409A Documentary Violations, Practicallaw.com, October, 2010; Baker, Rosina, 409A Failures: Correcting Outside of the IRS’s Formal Correction Programs, Presentation at DC Bar Luncheon Program, February 25, 2010, available at ipbtax.com; and Barker, Rosina & O’Brien, Kevin, Document Failures in the Section 409A Plan: Correcting With and Without Notice 2010-6, Pension & Benefits Daily, BNA, April 12, 2010.

      6. However, there has been little evidence of any results from any such CIP audit. Even the IRS’s revised “Nonqualified deferred Compensation Audit Techniques Guide,” released on June 9, 2015 has little additional detail on what the Service will look for when it audits plans that might be covered by 409A as versus the information gained from its first set of 409A audits back soon after the final regulations were issued.

  • 3554. How is the penalty tax under Section 409A calculated?

    • If it is necessary to compute the worst case scenario, the directions for completing the calculations, including the calculation of the late premium penalty interest, as applicable, can be found in Proposed Treasury Regulation Section 1.409A-4. This proposed regulation for calculation of the tax under Section 409A was issued in December 2008 and was subject to a proposed amendment in 2016 as to the inclusion or exclusion of nonvested amounts under the anti-abuse rule. Both the 2008 and 2016 proposed amendments are still not yet final as of the date of this publication.

      One of the positive elements in the calculations under the 2008 proposed regulations was that the calculation applied only to vested benefit amounts unless there was an indication that vesting was being used as a subterfuge to avoid the application of Section 409A. In general, this anti-abuse rule provided that amounts would not be treated as unvested (hence would require inclusion) to the extent there is an indication of a pattern or practice of permitting changes of the time and form of payment on unvested amounts contrary to the rules providing for such changes (primarily the so-called “subsequent election” rule).

      The anit-abuse rule has since been made more stringent)by proposed 409A technical clarifications regulations released in June, 2016 to address the apparent issue of abusive changes in timing or form of payment being made to plans, especially with long vesting periods. The antiabuse rule now provides that any unvested amounts will be treated as vested for purposes of income inclusion if there is a change in a plan provision otherwise not permitted by 409A as to time and form of payment and has otherwise to comply with the applicable 409A change rules. To remain unvested, there must be a reasonable good faith basis to conclude: 1) the original provision did not meet 409A requirements, and 2) the change is necessary to bring the plan into compliance with the form requirements. The proposed technical regulations actually provide examples of patterns of permitting impermissible change in time and form of payment, and dictate the appropriate, 409A correction procedure to be applied.1

      Planning Point: Under this revised anti-abuse portion of the unvested amounts noninclusion exception rule, corrections cannot now made on a SERP design with vesting delayed until nearly retirement (as many SERPs for key employees in closely-held companies are structured), and still be able to make corrections to the plan for errors during nearly the entire period of the plan, if the form correction were made in a tax year prior to the tax year in which separation from service occurred,2 without worrying about imposition of a tax under Section 409A. This is because the benefits will be treated as vested, and therefore includible in any calculations for an error, unless the error is discovered at that late date and the change made is necessary to assure compliance. Even then, if the time and form of payment would be changed, the 409A rules for changes in the timing and form of payment would need to be followed, and the appropriate correction procedure must be followed as part of the error correction.

      Of course, such plans might be better designed as a plan excepted from 409A coverage entirely, so as to avoid IRS questions on whether the exclusion of unvested amounts will be recognized. Presumably, the IRS would ignore this rule if the plan is drafted outside the requirements of Section 409A, or if there appears to be a pattern of ignoring Section 409A with regard to the plan, or making periodic changes to plan provisions that are not necessary to bring a plan into compliance, or change a provision that is already compliant.


      1. Prop Treas. Regulation, REG 123854-12, June 22, 2016.

      2See, CCA 201518013 (April 14, 2015) in which the IRS Chief Counsel’s Office took the position that a correction of a plan error prior to the vesting date, but not prior to the tax year in which the vesting date occurred, was made too late to prevent an inclusion of all the plan benefit amounts to participants for the failure of form compliance under Section 409A.

  • 3555. What rules apply to correction of errors in nonqualified deferred compensation plans excepted from Section 409A?

    • The IRS procedures for the voluntary correction of errors in qualified pension plans (e.g., VCP) do not apply to the correction of errors in nonqualified deferred compensation plans. Moreover, the correction of errors in connection with nonqualified deferred compensation plans was not the subject of much discussion prior to the enactment of Section 409A. However, there were legal theories for the correction of both documentation and operational administrative errors in connection with nonqualified deferred compensation plans that existed prior to Section 409A (Q 3553).

      Most documentary errors, in general, were corrected under various legal theories for the reformation of contracts (such as correction of “scrivener errors”) because nonqualified deferred compensation plans are contracts. Likewise, longstanding tax bookkeeping theories and principles were applied to correct operation plan administration errors (Q 3553).

      Where plans can claim a regulatory exception from Section 409A coverage or are grandfathered from Section 409A coverage, these pre-409A legal theories remain the appropriate methods for correcting both documentary and operational plan administration errors. Some commentators believe these pre-409A legal theories still can be used to correct errors as to 409A-covered plans not covered by Notices 2008-113 and 2010-6 (as modified by Notice 2010-80), and even as to errors specifically covered by these notices. The fact that Section 409A is additive law would seem to support this position. However, the IRS takes a strict view as to the correction of errors in 409A covered plans and is unlikely to agree with corrections made outside the notices at this stage, except as to grandfathered and 409A-excepted plans, and plans that fall under the short term deferral exception (Q 3548).

  • 3556. Does Section 409A apply to independent contractors?

    • IRC Section 409A generally does not apply to amounts deferred under an arrangement between an employer and either an accrual-based independent contractor or an unrelated independent contractor. If both the employer and the independent contractor are accrual-based taxpayers, the agreement is not a nonqualified deferred compensation plan covered by Section 409A. However, the IRS has clarified that a “service recipient” may be an entity and not just a natural person.1

      In addition, if, during a contractor’s taxable year in which an amount is deferred, the contractor provides significant services to each of two or more service recipients that are unrelated, both to each other and to the independent contractor, the arrangement does not involve a deferral of compensation under Section 409A; the plan is not covered by Section 409A. For this exception, a safe harbor rule provides that an independent contractor will be treated as providing significant services to more than one service recipient where not more than 70 percent of the total revenue of the trade or business is derived from any particular service recipient or group of related service recipients. Unfortunately, there is no three-of-five or similar multiyear feature in this safe harbor rule.2

      Practice Point: The IRS has clarified that when an employee changes status to an independent contractor the former employee will be treated as having separated from service for purposes of 409A if at the time of separation the level of services to be reasonably expected would result in a separation of services under the employee rules (generally less than 20-50 percent of the prior level of services).3


      1. Prop Treas. Regulation, REG 123854-12, June 22, 2016.

      2. Treas. Reg. §1.409A-1(f)(2)(C)(iii).

      3. Op. Cite., F. 1.

  • 3557. What are Section 409A’s effective dates, compliance deadlines and grandfathering rules?

    • The requirements of Section 409A generally apply to amounts deferred (or prior unvested amounts) after December 31, 2004. The requirements also apply to amounts deferred prior to January 1, 2005, if the plan under which the deferral is made is “materially modified” after October 3, 2004. There is an exception for material modifications made pursuant to IRS guidance. The IRS deferred the date to comply in both form and operation with the final regulations under Section 409A until December 31, 2008, and actual compliance began as of January 1, 2009.1 Prior to January 1, 2009, plans were required to operate in “good faith” compliance with Section 409A documentary and operational requirements.2

      The proposed 409A technical clarification regulations that change the final 409A regulations can be relied upon until the clarifications are made final.3 The 457/409A integration regulations apply to compensation deferred under a plan for calendar years after the date the rules are published as final. However, they may be relied on immediately.4 Unfortunately, there is no grandfathering or transition language for plans impacted by any the changes, especially as to ineligible 457(f) plans, for the long period between the final regulations and the 2016 release date of proposed regulations for such plans.

      It should be noted that, under IRS Notice 2010-6, addressing documentation errors, sponsors were given until not later than December 31, 2010, to make corrections to documents not made compliant by December 31, 2008, and to have these corrections deemed retroactively in compliance as of the January 1, 2009 actual compliance deadline under Section 409A (see prior discussion on correction of documentation and operational plan errors in Q 3553). This deadline has passed and generally has not been extended except for certain specific corrections outlined in Notice 2010-80 that expired after December 31, 2012.

      Finally, plans with certain assets in offshore rabbi trusts were given only until December 31, 2007 to disconnect or terminate the trust so as to comply with the 409A(b) funding requirements. Notice 2008-33 provided temporary guidance on complying with these requirements. Currently, no regulations on Section 409A(b) have been released, so further guidance as to the structuring of assets in such rabbi trusts is not yet available. A plan is materially modified if a new benefit or right is added or if a benefit or right existing as of October 3, 2004 is materially enhanced and such addition or enhancement affects amounts earned and vested before January 1, 2005. The reduction of an existing benefit is not a material modification.5 Adding a participant right to a grandfathered plan that it did not possess, even though it was technically permissible under Section 409A, will be considered to be a material modification (for example, an “unforeseeable emergency” distribution right).

      Planning Point: Employers should use great care in making any modifications to existing pre-409A deferred compensation arrangements until they are paid out to avoid the application of IRC Section 409A. According to the final regulations, a “material modification” that causes loss of grandfathering may be considered to be a formal plan amendment and may occur simply by virtue of an employer’s exercise of administrative discretion in the plan participant’s favor. Any amendment effected by form or practice that adds a beneficial right to a plan, even if it was allowed prior to the enactment of Section 409A and remained permissible after enactment (for example, a financial hardship provision), can cause loss of grandfather protection.


      1. Notice 2007-86, 2007- 46 IRB 990; Notice 2006-79, 2006-43 IRB 763.

      2. Notice 2005-1.

      3. Prop. Treas. Regulations, REG 123854-12, June 22, 2016.

      4. Prop. Treas. Regulations, REG 147196-07, June 21, 2016.

      5. Treas. Reg. §1.409A-6(a)(4).

  • 3558. What elements of an unfunded arrangement met regulatory requirements before the enactment of Section 409A?

    • Prior to the enactment of Section 409A, the IRS generally would issue advance determination rulings concerning the tax consequences of an unfunded arrangement if the arrangement met the requirements outlined below. Some of the requirements parallel those now required in IRC Section 409A.1 Currently, the IRS generally will not issue a letter ruling to a plan sponsor on the income tax consequences of a plan under Section 409A and does not plan to issue any prototype documents under Section 409A (there were no prototype documents prior to the enactment of Section 409A either).2

      Any initial election to defer compensation generally had to be made before the beginning of the period of service for which the compensation was payable, regardless of the existence of forfeiture provisions. If any election other than the initial election to defer compensation could be made after the beginning of the period of service, the plan had to set forth substantial forfeiture provisions that had to remain in effect throughout the entire period of the deferral. The plan had to define the time and method for paying deferred compensation for each event (such as retirement) entitling a participant to benefits. The plan could specify the date of payment or provide that payments would begin within thirty days after a triggering event.

      If the plan provided for the early payment of benefits in the case of an “unforeseeable emergency,” that term was defined as an unanticipated emergency caused by an event beyond the control of the participant or beneficiary that would cause severe financial hardship if early withdrawal were not permitted. The plan also had to provide that any early withdrawal would be limited to the amount necessary to meet the emergency. Language similar to that in Treasury Regulations Sections 1.457-2(h)(4) and 1.457-2(h)(5) could be used. The plan had to provide that participants had the status of general unsecured creditors of the employer and that the plan constituted a mere promise by the employer to pay benefits in the future. The plan also had to state that it was the intention of the parties that it be unfunded both for tax and ERISA purposes. The plan had to provide that a participant’s rights to benefits could not be anticipated, alienated, sold, transferred, assigned, pledged, encumbered, attached, or garnished by the participant’s or the participant’s beneficiary’s creditors.3


      1. Rev. Proc. 2009-3, 2009-1 IRB 107, 2008-1 IRB 110. It should be noted that many plans operated without a letter ruling pre-409A anyway because of the IRS’s rigid positions on some features and provisions as versus favorable court decisions.

      2. Rev. Proc. 2008-61, 2008-30 IRB 180 (superseded by Rev. Proc. 2018-3), amplifying Rev. Proc. 2008-3, 2008-1 IRB 110. Also see Section 3.01(67), Rev. Proc. 2020-3.

      3. Rev. Proc. 2009-3, Sec. 3.01(42), 2009-1 IRB 107; Rev. Proc. 71-19, 1971-1 CB 698, as amplified by Rev. Proc. 92-65, 1992-2 CB 428.

  • 3559. What are the deferred compensation rules applicable to foreign nonqualified entities under Section 457A?

    • In the Emergency Economic Stabilization Act of 2008, Congress created new IRC Section 457A to impose immediate taxation on deferred compensation where the employer is a foreign “nonqualified entity” (as defined in the law) that is not subject to U.S. taxation. This section is comparable to Section 409A, which potentially applies to nonqualified deferred compensation paid by any entity, U.S. domestic or foreign. In addition, 457A applies to both cash and accrual method taxpayers while Section 409A applies to just cash method taxpayers.

      Under IRC Section 457A, all compensation deferred under a nonqualified deferred compensation plan of a nonqualified entity is includable in gross income of a plan participant when there is no longer any Section 457A substantial risk of forfeiture of the rights to such compensation. IRC Section 457A has its own definition of substantial risk of forfeiture that defines a substantial risk of forfeiture as applicable “only if” a person’s rights are conditioned on the future performance of substantial services.1 This definition is therefore not exactly the same as that in Section 409A but is generally consistent. For instance, Section 409A includes attainment of performance goals in addition to performance of substantial services. However, the 2016 409A technical amendments make it clear that these types of plans may also be covered by both Sections 409A and 457. The 2016 proposed regulations for 457(f) and those for nonelective deferred compensation plans2 under Section 457(e)(12) do not substitute for or supersede 409A compliance requirements. In such cases, the plan must comply with Section 409A and 457 in addition to Section 457A, if and as necessary, which makes for complex compliance coordination indeed.3

      IRC Section 457A defines a nonqualified entity as (1) any foreign corporation, unless substantially all of its income is “effectively connected with the conduct of a trade or business in the United States” or is “subject to a comprehensive foreign income tax,or (2) any partnership, unless substantially all of its income is allocated to persons other than “foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax” and “organizations which are exempt from tax under this title.4(IRC Section 457A provides a limited exception for deferred compensation payable by foreign corporations that have “effectively connected income” under IRC Section 882.)

      A “comprehensive foreign income tax” is the income tax of a foreign country if there is an applicable comprehensive income tax treaty between that country and the United States or the Secretary of the Treasury is otherwise satisfied that it is a comprehensive foreign income tax.5

      IRC Section 457A generally applies to nonqualified deferred compensation within the same broad scope as IRC Section 409A. IRC Section 457A explicitly applies to all stock options and stock appreciation rights, even those issued with the option price or measurement price at fair market value.6 IRC Section 457A also extends the 2½ month short term deferral exemption in IRC Section 409A to twelve months, meaning that IRC Section 457A does not apply to compensation received during the taxable year following that year in which the compensation is no longer subject to a substantial risk of forfeiture.7

      If the amount of any deferred compensation taxable under IRC Section 457A is not determinable at the time it is otherwise includable under that section, it is subject to a penalty and interest when so determinable. In addition to the normal tax, the amount includable is subject to a 20 percent penalty tax and interest on the underpayment of taxes at the normal underpayment rate plus 1 percent.8

      IRC Section 457A applies to deferred amounts attributable to services performed after December 31, 2008. Congress also directed the IRS to provide guidance within 120 days on amending plans to conform to IRC Section 457A and providing a limited period of time to do so without violating IRC Section 409A.

      In 2017, the Treasury Department and the IRS indicated they would issue regulations applicable as of December 8, 2017 providing the relief for plan distributions made for taxes on pre-2009 457A foreign deferred compensation. The agencies also indicated taxpayers can rely on the relief until the regulations are finalized. The coming regulations will permit the acceleration of payments under a nonqualified deferred compensation plan to pay federal, state, local, and foreign income taxes due on pre-2009 section 457A deferrals that are includible in gross income.

      Specifically, the Notice indicates Treasury Department and the IRS intend to issue regulations providing that a change in the time and form of payment under a nonqualified deferred compensation plan to pay federal, state, local, and foreign income taxes on pre-2009 section 457A deferrals will not be treated as an impermissible acceleration under sections 409A(a)(3) and 1.409A-3(j)(1). These regulations will also provide that, to the extent a deferred amount attributable to services performed before January 1, 2009, was earned and vested before December 31, 2004, and is not otherwise subject to the requirements of section 409A due to the effective date rules under section 1.409A-6, a change in the time and form of payment of the deferred amount to pay federal, state, local, and foreign income taxes on pre-2009 section 457A deferrals will not be treated as a material modification of such arrangement under section 1.409A-6(a)(4). The relief provided in these regulations will apply only to the extent that that the amount of any distribution to pay federal, state, local, and foreign income taxes on pre-2009 section 457A deferrals is not more than an amount equal to the federal, state, local, and foreign income tax withholding that would have been remitted by an employer if there had been a payment of wages equal to the income includible by the service provider under section 801(d)(2) of TEAMTRA.9


      1. IRC Sec. 457A(d)(1)(A).

      2. Only a Section 457(e)(11)(A)(ii) length of service award program (LOSAP) is not considered a “nonqualified deferred compensation plan” for purposes of Section 409A.

      3. Prop Treas. Reg., REG 123854-12 June 22, 2016.

      4. IRC Sec. 457A(b).

      5. IRC Sec. 457A(d)(2).

      6. IRC Sec. 457A(d)(3)(A).

      7. IRC Sec. 457A(d)(3)(B).

      8. IRC Sec. 457A(c).

      9. IRS Notice 2017-75, 12-8-2017.

  • 3560. What are the tax consequences to a qualified plan of a transfer of interests in a nonqualified deferred compensation plan?

    • Under Section 409A, “substitutions” of another benefit involving a nonqualified deferred compensation plan results in a prohibited acceleration of the nonqualified benefit that is immediately taxable.1 In a pre-409A private letter ruling, the IRS determined that employees electing to cancel their interests in an unfunded nonqualified deferred compensation plan in exchange for substitute interests in a qualified plan would be taxable on the present value of their accrued benefits in the qualified plan upon the funding of those new interests. They would have to include the value of future benefits attributable to future compensation when the cash, which otherwise would have been received under the nonqualified plan, would have been includable.2 Under Section 409A, such a transaction should also constitute a violation of 409A that attracts immediate inclusion and penalties.

      Planning Point:This IRS letter ruling was released prior to, but is largely consistent with Section 409A, which broadly prohibits “substitutions” of benefits, and deems them a prohibited acceleration that results in immediate taxation and the application of penalty taxes. Therefore, such a substitution should be taxable under Section 409A. However, this prohibition does not apply to an annual transfer from a nonqualified plan to a qualified 401(k) plan that occurs within the framework of a “wrap-around” nonqualified plan, which remains potentially possible under Section 409A, so long as the IRS guidance on the technique is followed.3 Nor does Section 409A apply to the process of using alternative qualified nondiscrimination testing rules to determine and then allocate the largest possible benefit into the qualified plan as between the excess benefit nonqualified plan and the qualified plan.


      1. Treas. Reg. § 1.409A-3(f).

      2. Let. Rul. 9436051.

      3. The approved wrap plan format is contained in IRS Let. Rul. 9436051, as modified by Section 409A. However, note that the ERISA rules that require a very limited amount of sponsor delay to deposit qualified plan contributions may apply to further limit the use of the nonqualified wrap-around 401(k) mirror plan technique.

  • 3561. What ERISA requirements are imposed on deferred compensation employee benefit pension plans?

    • Deferred compensation employee pension benefit plans may be required to meet various requirements under ERISA, including reporting, funding, vesting and fiduciary requirements, unless they can find an exemption from coverage and meet those ERISA exemption requirements.1

      Certain pension type plans, including “top hat” plans for an unfunded “select group,” of management or “excess benefit plans” (Q 3608), and plans that provide payments to a retired partner or a deceased partner’s successor in interest under IRC Section 736, are exempt from some or all of these more onerous ERISA requirements.2 For exempt plans, there is currently only a one-time short-form filing report at the inception of an ERISA-exempt plan, no funding or vesting requirements, and only a written plan document (which is necessary for purposes of Section 409A anyway) and a claims procedure (recently revised as to disability claims) as nominal partial fiduciary responsibility. As of January 1, 2017, the one-time filing must now be made online at the DOL website (See Q 3562). For comparison, “employee welfare benefit plans”, like split dollar insurance plans, also have certain available ERISA exemptions that parallel those for ERISA pension benefit plans, but they are not the same. Section 162 bonus life insurance programs, when properly designed and operated, are not ERISA “employee benefit plans,” pension or welfare, at all and would be expected to escape all ERISA requirements.3

      In a 2017 case involving a nonqualified deferred compensation plan, a U.S. Appellate Court has affirmed a lower district court holding that a company can change its phantom crediting rates on employee deferrals into the plan prospectively without violating its fiduciary duties under ERISA. The court said in a de novo review that the changes appeared proper on the facts and were an expected normal exercise of the plan’s authority and judgment of discretion concerning crediting exercises crediting indices, and were uniformly applied to all plan participant. In effect, the court said that participants have no contractual right to a specific expectation of specific crediting indices over the life of a plan.4

      In a 2018 case involving a nonqualified deferred compensation plan, another U.S. Appellate Court held a plan participant had no standing to make a claim against the plan sponsor for violating its fiduciary duty or engaging in a prohibited transaction in order to recover benefits or obtain a declaratory judgment
      against the plan sponsor as to the participant’s qualified as well as nonqualified plans. In this case, the Siemen’s Corporation transferred the employee participant’s specific nonqualified deferred compensation plan benefit liabilities as a part of a sale of a division of the sponsor’s business Sivantos, Inc., the buying company. The buying company agreed to assume all the plan liabilities, including those of the participant, as part of the purchase. The participant was upset because the buying company was much smaller and financially less significant than Siemens. The Appellate Court affirmed the district court dismissal of the case for slightly different reasons saying the plaintiff’s claim did not shown an “injury in fact’ of an invasion of a legally protected interest” that is “concrete and particularized” and there is a casual relationship between the injury and the conduct complained of ” and a “likelihood” that the injury will be redressed by a favorable decision. The Appellate court said the claims were too speculative in the absence of a real showing of actual loss, or failure to pay or some similar injury, even
      though the participant alleged that the informal COLI funding behind the plan in a Rabbi Trust was eliminated thereby reducing the security of the participant’s benefits.5

      In considering this decision, it should be noted that nonqualified deferred compensation plans are not mandated and cannot escrow or trustee assets for a plan without causing current income taxation to plan participants. Moreover, plan sponsors are not even required to informally create a general asset reserve (as in this case of COLI in Rabbi Trust) to help support a plans liabilities, unless the plan requires it, which it apparently did not. Hence there was fiduciary duty violated in the plan sponsor’s actions under the facts.


      1. See, generally, ERISA, Titles I and IV. ERISA covers “employee pension benefit” plans and “employee welfare benefit” plans. The exemptions are different for pension type plans (ex. SERP) versus welfare benefit (e.g., split dollar) plans.

      2. ERISA Secs. 4(b), 201, 301, 401, 4021.

      3. See Mozingo v. Trend Personnel, No. 15-11263 (5th Cir. App. Ct. Aug. 13, 2016).

      4. Plotnick v. Computer Sciences Corporation, No. 1q6-1606 (4th Cir Ct App. Dec. 8, 2017, aff ’g 182 F. Supp.3d 573 (2016)).
      5. Krauter v. Siemens Corporation, No. 2-16-CV-02015 (3rd Cir. Ct, App. Feb. 16, 2018).

  • 3562. What rules govern “top hat” employee pension benefit plans?

    • Under ERISA, a “top hat” pension benefit plan is an unfunded plan maintained “primarily” to provide deferred compensation for a “select group of management or highly compensated employees”.1 The determination of whether a plan is offered to a “select group” is a facts and circumstance determination.2 The factors that are to be applied and the weight to be given each to determine whether any specific group qualifies as an ERISA select group remains in much dispute.3 The DOL inserted itself into the ongoing debate among the federal circuits by filing an amicus brief in the Bond case in 2015 to support its interpretations of the exemption, including its own so-called “qualitative” requirement.4 However, one federal district court has expressly rejected this as a requirement to claim the exemption.5 In one strange case, where all management employees were eligible for a plan, the plan did not meet the select group requirement because the group was apparently not select enough.6 The maximum amount a court has approved is 15.4 percent of the workforce,7 but less is desirable. The inclusion of even one nonhighly compensated employee might cause loss of the exemption under the DOL’s position as described in its amicus brief.

      The second requirement to claim the select group exemption is that the plan be “unfunded” for ERISA purposes. Generally speaking, this requirement means that there should not be any ERISA “plan assets” in connection with the plan, but only general assets supporting the plan’s liabilities. In a 2015 case, a court reaffirmed that the question to ask is whether an employer has set aside funds, separate from its general assets, for payment of plan benefits and whether plan beneficiaries have a legal right greater than that of a general, unsecured creditor to the corporation’s assets. Applying this question, the court held that the use of employer-owned COLI contracts did not cause a plan to be funded for ERISA purposes.8

      Top hat plans are subject to a different standard of review from other ERISA plans, because they are exempt from most of ERISA’s substantive rules. They are subject to a de novo review unless the plan documents expressly grant deference to the plan administrator, rather than to the “arbitrary and capricious”9 standard of Firestone v. Bruch.10

      There is another ERISA exemption available for “excess benefit plans” that make up the difference between what the qualified plan pays and what it would have paid but for the caps on qualified plan benefits to the highly compensated. This type of plan is also commonly referred to as a “top hat” plan since by its definitional terms it applies only to highly compensated employees.11

      Planning Point: Plans claiming either the “top hat” or “excess benefit” ERISA exemption must file a one-time letter statement with the DOL for a new pension benefit plan. This statement relieves the sponsor from having to file the more complex and detailed Form 5500 annually on the plan and all other pension reporting and disclosure requirements. This one-time statement must be filed within 120 days of the inception of a plan.12 Historically, the filing involved a letter statement mailed to the DOL. However, as of January 1, 2017, this filing must be made electronically on the DOL’s website.13

      As to income taxation, top hat plans will generally be Section 409A “nonqualified deferred compensation plans” and thereby be covered by 409A additive requirements sections (as well as prior income tax law), unless an exception to Section 409A coverage can be claimed (example, short term deferral exception for SERPs).


      1. ERISA Sec. 201(2), 301(a)(3), 4021(b)(6); also see DOL Reg. Section 2520.104-23 providing an alternative, one-time short-form of reporting.

      2. See, e.g., Demery v. Extebank, 216 F.3d 283 (2d Cir. 2000) (“select group” requirement was met where plan was offered to 15.34 percent of employees, since they were all either management or highly compensated employees).

      3.Consider, Tolbert v. RBC Capital Markets Corporation, 758 F.3d 619 (5th Cir. App. Ct. 2014), Bond v. Marriott International, Inc., 971 F.Supp.2d 480 (Dist. Ct. Md. Dist. 2013.

      4. DOL amicus brief filed July, 2015, Bond v. Marriott International, Inc., 971 F.Supp.2d 480 (Dist. Ct., Md. Dist. 2013. Also see specifically, DOL Adv. Opin. 90-14A. The US Chamber of Commerce, ERIC and ABC also filed its own amicus brief in opposition to the DOL position brief on July 2, 2015. SIFMA filed an amicus brief in Tolbert Case. The three amicus briefs make for comprehensive reading of the issues and positions.

      5Sikora v. UPMC, 153 F.Supp. 3d 820 (2015).

      6Carrabba v. Randalls Food Mkts, Inc., 252 F.3d 721 (5th Cir. 2001), cert. denied, 26 EBC 2920 (US Sup. Ct. 2001).

      7. See, Footnote 2, the Demery Case.

      8Huber v. Lightforce USA, 367 P.2d 228 (2015).

      9Goldstein v. Johnson & Johnson, 251 F.3d 433 (3d Cir. 2001).

      10. 489 U.S. 101 (1989).

      11. ERISA Sections 4(b)(5), 201(7), 301(a)(9), 4021(b)(6).

      12See DOL. Reg. Section 2520.104-23(b).

      13. To access the DOL’s electronic statement filing site go to www.dol.gov/efiletophatfilinginstructions.html. The site provides instructions as well as the electronic form to file. Of interest, the new statement is slightly different than the prior letter filing format (e.g., requires name and address, including email, of plan administrator). However, the DOL has indicated in the Preamble to the Proposed Regulations changing the filing procedures that no substantive change in content is contemplated by the new statement.

  • 3563. What is the “economic benefit” theory and how does it apply to nonqualified deferred compensation plans?

    • Under the economic benefit income tax theory, an employee is taxed when the employee receives something other than cash that has a determinable, present economic value. The danger, in the nonqualified deferred compensation context, is that an arrangement for providing future benefits will be considered to provide the employee with a current economic benefit capable of valuation. Current taxation arises when assets are unconditionally and irrevocably paid into a fund or trust to be used for the employee’s sole benefit.1

      An employer can establish a reserve for satisfying its future deferred compensation obligations while preserving the “unfunded and unsecured” nature of its promise, provided that the reserve is wholly owned by the employer and remains subject to the claims of its general creditors. A mere promise to pay, not represented by notes or secured in any way, is not regarded as a receipt of income.2 Unfunded plans do not confer a present, taxable economic benefit.3 An unfunded and unsecured promise of future payment is specifically excluded from coverage under IRC Section 83, which codifies the economic benefit theory.4

      It generally has been accepted that deferred compensation benefits can be backed by life insurance or annuities (or any other assets) in a general asset reserve of the employer without creating a currently taxable economic benefit to a participant.5

      In the old Goldsmith case,6 the court found that the promises of preretirement death and disability benefits provided the employee with a current economic benefit – current life insurance and disability insurance protection – even though the corporation was the owner and beneficiary of the policy, which was subject to the claims of its general creditors. The court did not find constructive receipt of the promised future deferred compensation payments, but ruled that the portion of the premium attributable to life, accidental death, and disability benefits was taxable as a current economic benefit to the employee. The Goldsmith case appears to be anomalous. Since it was decided, the IRS has not treated pre-retirement death or disability benefits paid out as ordinary income under a nonqualified deferred compensation plan as creating a currently taxable economic benefit.7 This income tax treatment can be compared with that intended by Congress for deferred compensation plans under IRC Section 457 (Q 3600).

      It should be noted that the economic benefit tax theory has not been eliminated by the enactment of Section 409A, because Section 409A is additive law and actually further defines constructive receipt. Therefore, the IRS still can apply this theory and all other pre-409A income taxation theories (e.g., assignment of benefit) to impose taxation on deferred compensation when supported by the facts of any nonqualified deferred compensation arrangement situation, regardless of whether it is covered by, grandfathered, or excepted from Section 409A coverage. Therefore, the nonassignability and unfunded plan provisions commonly placed in nonqualified deferred compensation, whether covered by or excepted from 409A coverage, remain a necessity to reduce the chance of the IRS applying the economic benefit as well as assignment of benefit tax theories to impose premature income taxation on plan participants.

      It should be noted that the economic benefit tax theory has not been eliminated by the enactment of Section 409A, because Section 409A is additive law and actually further defines constructive receipt. Therefore, the IRS still can apply this theory and all other pre-409A income taxation theories (e.g., assignment of benefit) to impose taxation on deferred compensation when supported by the facts of any nonqualified deferred compensation arrangement situation regardless of whether it is covered by, grandfathered, or excepted from Section 409A coverage. Therefore, the nonassignability and unfunded plan provisions commonly placed in nonqualified deferred compensation, whether covered by or excepted from 409A coverage, remain a necessity to reduce the chance of the IRS applying the economic benefit as well as assignment of benefit tax theories to impose premature income taxation on plan participants.


      1Sproull v. Comm., 16 TC 244 (1951), aff’d per curiam, 194 F.2d 541 (6th Cir. 1952); Rev. Rul. 60-31, sit. 4, 1960-1 CB 174.

      2. Rev. Rul. 60-31, 1960-1 CB 174, 177; Rev. Rul. 70-435, 1970-2 CB 100.

      3Minor v. U.S., 772 F.2d 1472, 85-2 USTC ¶9717 (9th Cir. 1985).

      4. Cf. Treas. Reg. §1.83-3(e).

      5. See, e.g., Casale v. Comm., 247 F.2d 440 (2d Cir. 1957) (the IRS has said it will follow this decision, Rev. Rul. 59-184, 1959-1 CB 65); Rev. Rul. 72-25, 1972-1 CB 127; Rev. Rul. 68-99, 1968-1 CB 193; TAM 8828004; Rev. Rul. 60-31, 1960-1 CB 174.

      6Goldsmith v. U.S., 586 F.2d 810, 78-2 USTC ¶9804 (Ct. Cl. 1978).

      7See, e.g., Let. Ruls. 9517019, 9510009, 9505012, 9504006, 9427018, 9403016, 9347012, 9323025, 9309017, 9142020.

  • 3564. How does an informal funding affect a private IRC Section 451 unfunded nonqualified deferred compensation account balance or nonaccount balance plan?

    • An IRC Section 451 unfunded deferred compensation account balance or nonaccount balance arrangement cannot be formally funded. That is, the employee cannot be given any secured interest in any trust or escrowed fund or in any asset, such as an annuity or life insurance contract, without adverse tax consequences to a participant. If a secured interest is given, the arrangement is treated as a funded arrangement under IRC Section 83 and must be handled according to its specific tax deferral requirements (Q 3532 to Q 3539).

      A nonqualified deferred compensation account balance or nonaccount balance arrangement can be informally funded without jeopardizing tax deferral, even after enactment of Section 409A.  Under 409A(b), an employer can specifically set aside assets as a general reserve in a rabbi trust (Q 3567) to provide funds for payment of deferred compensation obligations, as long as the following requirements are met:

      (1) the plan participants have no interest in those assets and they remain the employer’s property, subject to the claims of the employer’s general creditors in bankruptcy;

      (2) the trust or assets supporting the plan are not placed offshore (in light of IRC Section 409A(d));

      (3) the trust does not receive assets or pay out deferred compensation to participants during the period of an employer’s declining economic circumstances [as detailed in IRC Section 409A(b)(2)]; and

      (4) there is no transfer of assets to a trust during a period the sponsor’s qualified defined benefit pension plan, if any, is “at risk” or underfunded.1

      Rabbi trusts remain very popular devices for reserving assets acquired to support the liabilities of a nonqualified deferred compensation account balance or nonaccount balance arrangement. Currently, however, there are no proposed regulations for the so-called “funding” rules under Section 409A; there is only the bare language of the law under 409A(b). Practitioners should watch for these regulations, which are likely to further clarify these “funding” prohibition requirements in connection with the use of such a trust.

      Even before Section 409A(b), the IRS historically has not considered a plan that sets aside assets in an escrow account to be “formally funded” if the assets are subject to the claims of the employer’s general creditors.2 Of course, the Section 409A prohibition on the use of offshore trusts to hold assets intended to hold general company assets adds a new requirement as do the others listed above to the use of such a trust.

      It has been accepted for some time that an employer may informally fund its obligation by setting aside an employer-owned fund composed of life insurance contracts, annuities, mutual funds, securities, etc., without adverse tax consequences to the employee so long as the fund remains the unrestricted asset of the employer and the employee has no interest in it.3 Thus, a deferred compensation plan should not be regarded as “funded” for income tax purposes (although there is another issue of funding for ERISA purposes) merely because the employer purchases a life insurance policy or an annuity contract to ensure that funds will be available when needed. The Tax Court stretched these rules a bit in ruling that payment obligations to attorneys under a structured settlement were unfunded even though the attorneys were annuitants under the annuities financing the obligations; it is not clear if this decision can be extended to more traditional nonqualified deferred account balance and nonaccount balance plans.4 In general, the sponsoring company must be the owner and recipient of all benefits from any insurance contracts in the general reserve for the arrangement to be treated as unsecured and thereby unfunded for income tax purposes, although the use of a split dollar endorsement of portions of the death benefit proceeds to a participant on an EOLI/COLI supporting a plan does not seem to be a problem for the IRS.

      Since the enactment of Section 409A, securing or distributing deferred compensation on the employer’s falling net worth or other financial events unacceptably secures the payment of the promised benefits.5 This now includes hybrid rabbi/secular trust arrangements that distribute assets from nominal rabbi trusts to secular trusts on the occurrence of triggering events based on the employer’s financial difficulty. Under any such arrangement, compensation otherwise successfully deferred is immediately taxable as a violation of Section 409A, and is subject to its 20 percent excise tax, plus premium penalty interest on the underpayment of taxes (the normal underpayment AFR rate plus 1 percent).6

      As noted, setting aside assets in an offshore trust to directly or indirectly fund deferred compensation now also unacceptably secures the payment of the promised benefits under the funding provisions of Section 409A.7 Under any such arrangement, the compensation otherwise successfully deferred is immediately taxable and subject to a 20 percent excise tax, and premium penalty interest is due at the normal underpayment AFR rate plus 1 percent.8

      Both the Section 409A prohibition on financial triggers and on offshore trusts apply even to deferrals of compensation earned and vested on or before December 31, 2004 (and thus not generally subject to the requirements of Section 409A). The IRS provided transition relief through December 31, 2007, for amounts otherwise subject to Section 409A(b), if those assets relate to compensation deferred on or before December 31, 2004, and if those assets were set aside, transferred, or restricted on or before March 21, 2006.9 This relief was not extended to coincide with the extension of compliance relief under Section 409A to December 31, 2008. Compliance with the Section 409A funding requirements needed to be completed by December 31, 2007.

      In addition, the Section 409A funding requirements also prohibit top executives – individuals described in IRC Section 162(m)(3) or subject to Section 16(a) of the Securities Exchange Act of 1934 – from setting aside assets in a rabbi trust or other informal funding device during a “restricted period.” The restricted period is any period during which the employer is in bankruptcy, during which a company’s qualified defined benefit plan is in “at-risk” status (underfunded per the statutory requirements), or during the six months before or after an insufficient plan termination. The restrictions apply to any transfers or reservations after August 17, 2006. If any Section 409A prohibited transfer occurs, compensation otherwise successfully deferred is immediately taxable and subject to a 20 percent excise tax and premium penalty interest on the underpayment of taxes is due at the normal underpayment AFR rate plus 1 percent.10

      Pre-409A, one court had ruled that a “death benefit only” plan backed by corporate-owned life insurance was “funded” for ERISA purposes.11 The decision has been criticized and largely limited to its unusual facts by other courts. However, the result, if ever accepted by other courts, could have far reaching tax implications.

      If a plan is “funded” for ERISA purposes (meaning that assets are ERISA “plan assets”), it generally is required to satisfy ERISA’s exclusive purpose rule and to meet certain minimum vesting and funding standards. Once these requirements are met, the plan may no longer be considered “informally funded” for tax purposes as well, and adverse income tax consequences may follow. In 1987, the same court that decided Dependahl distinguished it from a second case, concluding that a nonqualified deferred compensation plan informally funded with life insurance contracts was not funded for ERISA purposes and thus was not subject to minimum vesting and funding standards.12 The court distinguished this case from Dependahl, in part, by noting that the Belsky agreement stated specifically that the employee’s only right against the employer was that of an unsecured creditor.13

      Over the years, the Department of Labor (“DOL”) has issued various advisory opinions permitting the use of an employer-owned asset to finance different types of plans while the plans maintained their “unfunded” status under ERISA.14 The DOL has stated that plan assets include any property, tangible or intangible, in which the plan has a beneficial ownership interest.15 According to footnote three in Advisory Opinion 94-31A, the “beneficial ownership interest” analysis is not relevant in the context of excess benefit and top hat plans.16 The DOL reasoned that its position was supported by the special nature of these plans, the participating employees’ ability to affect or substantially influence the design and operation of the plan, and the rulings of the IRS surrounding the tax consequences of using rabbi trusts with these plans. The kind of plan asset analysis relevant in that context is not clear, although the DOL does have a working premise that rabbi trusts meeting with IRS approval will not cause excess benefit or top hat plans to be funded for ERISA purposes.17 The impact on the ERISA treatment of assets after application of the Section 409A funding rules is yet to be determined. The basic concept of the prior DOL position that a plan is “unfunded” for ERISA purposes if it is “unfunded” for income tax purposes still would seem to work.

      Pre-409A, a key associate insurance policy used to informally fund a plan should be held by the employer (as owner) and not distributed to the employee at any time; otherwise, the employee would be taxed on the value of the contract when received.18 This result would not change under Section 409A since a key associate policy, as an informal funding device, generally would not be subject to Section 409A when set up correctly (Q 297). The employer cannot deduct its premium payments, but the employer receives the death proceeds tax-free.19 Prior to the repeal of the corporate AMT, proceeds paid to a corporation may have been includable, at least in part, in the corporation’s income for alternative minimum tax purposes (Q 316).20 For tax results on the surrender of a policy, see Q 51, Q 52. For a discussion of accumulated earnings tax, see Q 308.

      Even after Section 409A, an employee generally is not taxable on the premiums paid by the employer or on any portion of the value of the policy or annuity, provided that the employer applies for, owns, is beneficiary of, and pays for the policy or annuity contract and uses it merely as a general reserve asset for the employer’s obligations under the deferred compensation agreement.21 Properly structured funding arrangements should not be treated asnonqualified deferred compensation subject to Section 409A.

      With respect to contributions made after February 28, 1986 to annuity contracts held by a corporation, partnership, or trust (i.e., a nonnatural person), “the income on the contract” for the tax year of the policyholder generally is treated as ordinary income received or accrued by the contract owner during such taxable year (Q ).22 Prior to 2018, corporate ownership of life insurance may result in exposure to the corporate alternative minimum tax (Q 316). However, the corporate AMT was repealed for tax years beginning after 2017.


      1Minor v. U.S., 772 F.2d 1472, 85-2 USTC ¶9717 (9th Cir. 1985); see also McAllister v. Resolution Trust Corp., 201 F.3d 570 (5th Cir. 2000); Goodman v. Resolution Trust Corp., 7 F.3d 1123 (4th Cir. 1993).

      2. Let. Ruls. 8901041, 8509023.

      3. Rev. Rul. 72-25, 1972-1 CB 127 (annuity contract); Rev. Rul. 68-99, 1968-1 CB 193 (life insurance).

      4Childs v. Comm., 103 TC 634 (1994), aff’d, 89 F.3d 856 (11th Cir. 1996).

      5. IRC Sec. 409A(b)(2); Notice 2006-33, 2006-15 IRB 754.

      6. IRC Sec. 409A(b)(5).

      7. IRC Sec. 409A(b)(1); Notice 2006-33, 2006-15 IRB 754.

      8. IRC Sec. 409A(b)(5).

      9. Notice 2006-33, 2006-15 IRB 754.

      10 .IRC Secs. 409A(b)(3), 409A(b)(5).

      11. See Dependahl v. Falstaff Brewing Corp., 491 F. Supp. 1188 (E.D. Mo. 1980), aff’d in part, 653 F.2d 1208 (8th Cir. 1981), cert. denied, 454 U.S. 968 (1981) and 454 U.S. 1084 (1981).

      12Belsky v. First Nat’l Life Ins. Co., 818 F.2d 661 (8th Cir. 1987).

      13. For courts finding plans backed by life insurance or annuities to be unfunded, see Reliable Home Health Care Inc. v. Union Central Ins. Co., 295 F.3d 505 (5th Cir. 2002); Miller v. Heller, 915 F. Supp. 651 (S.D.N.Y. 1996); The Northwestern Mut. Ins. Co. v. Resolution Trust Corp., 848 F. Supp. 1515 (N.D. Ala. 1994); Darden v. Nationwide Mut. Life Ins. Co., 717 F. Supp. 388 (E.D.N.C. 1989), aff’d, 922 F.2d 203 (4th Cir.), cert. denied, 502 U.S. 906 (1991); Belka v. Rowe Furniture Corp., 571 F. Supp. 1249 (D. Md. 1983).

      14See DOL Adv. 92-22A (cash value element of split dollar life insurance policy under death benefit plan is not a plan asset); DOL Adv. Op. 92-02A (stop-loss insurance policy backing medical expense plan obligations is not plan asset of death benefit plan); DOL Adv. Op. 81-11A (corporate-owned life insurance is not plan asset of death benefit plan).

      15. DOL Adv. Op. 94-31A.

      16. But see Miller v. Heller, 915 F. Supp. 651 (S.D.N.Y. 1996) (in holding that a deferred compensation plan is an unfunded top hat plan, the court interpreted footnote three in Advisory Opinion 94-31A to mean that the DOL’s entire analysis for determining whether assets are plan assets is not relevant to the issue of whether the plan is funded).

      17See, e.g., DOL Adv. Op. 92-13A. See also DOL Adv. Op. 90-14A (great deference is given to the position of the IRS regarding deferred compensation plans when determining, for ERISA purposes, whether a top hat plan is funded).

      18Centre v. Comm., 55 TC 16 (1970); Morse v. Comm., 17 TC 1244 (1952), aff’d, 202 F.2d 69 (2nd Cir. 1953). See Treas. Reg. §1.83-3(e).

      19. IRC Sec. 264(a)(1).

      20. IRC Secs. 56-59.

      21Casale v. Comm., 247 F.2d 440 (2nd Cir. 1957) (the IRS has said it will follow this decision, Rev. Rul. 59-184, 1959-1 CB 65); Rev. Rul. 72-25, 1972-1 CB 127; Rev. Rul. 68-99, 1968-1 CB 193; Let. Ruls. 8607032, 8607031; TAM 8828004. See also Let. Rul. 9122019. But see Goldsmith v. U.S., 586 F.2d 810, 78-2 USTC ¶9804 (Ct. Cl. 1978) discussed in Q 3563.

      22. IRC Sec. 72(u).

  • 3565. Can a split dollar arrangement be subject to the Section 409A rules?

    • Where an employee receives a basic vested right in cash values of a policy, or basic life insurance protection and a vested right in the cash surrender values of a policy, the policy becomes a split dollar life insurance arrangement. A split dollar arrangement is also subject to Section 409A, unless it is structured as one of the two excepted variations under IRS Notice 2007-34.1

      Premiums for a split dollar policy should be taxable to the employee under both split dollar and Section 409A rules (making it subject to the Section 409A penalty taxes and interest if the arrangement does not comply with Section 409A requirements in both form and operation). The Tax Court has held that employer-paid life insurance premiums on an employee’s life, where the annual increase in the cash surrender value benefits the employee and the employee also receives annual insurance protection for both the employee and family, will be includable in the employee’s gross income.2 Only an endorsement split dollar (where the participant receives only an interest in a portion of the policy death benefits and pays only an economic benefit tax cost) seems to escape additional taxation under both split dollar and Section 409A tax rules.


      1. IRS Notice 2007-34 was issued as the same time as the final Section 409A regulations in April of 2007 and were intended to specifically discuss the application of Section 409A to split dollar life insurance plans in more detail.

      2Frost v. Comm., 52 TC 89 (1969).

  • 3566. How does a surety bond, indemnification insurance or a third party guarantee affect a private IRC Section 451 unfunded nonqualified deferred compensation account balance or nonaccount balance plan?

    • The IRS has privately ruled that an employee’s purchase of a surety bond (with no reimbursement from the employer) as protection against nonpayment of unfunded deferred compensation benefits would not, by itself, cause deferred amounts to be includable in income prior to receipt.1 The IRS also warned, however, that an employer-paid surety bond would cause current taxation. A later letter ruling has blurred the line between employee-provided and employer-provided surety bonds; the IRS hinted, without clearly distinguishing between employee-paid and employer-paid surety bonds, that the use of a surety bond to protect deferred compensation could cause the promise to be secured, resulting in taxation under IRC Section 83 when the deferred compensation is substantially vested (that is, either not subject to a substantial risk of forfeiture or transferable to a third party free of such a risk).2 Whether the IRS meant to question both employer-provided and employee-provided surety bonds is not clear.

      The IRS has also ruled privately that an employee can buy indemnification insurance to protect deferred benefits without causing immediate taxation. This result holds even if the employer reimburses the employee for the premium payments as long as the employer has no other involvement in the arrangement (the employee’s premium payments must be treated as nondeductible personal expenses, and any premium reimbursements must be included in the employee’s income).3 The ERISA consequences of such an arrangement are not clear.

      On occasion, third party guarantees of benefit promises have received favorable treatment. For example, a parent corporation’s guarantee of its subsidiary’s deferred compensation obligations did not accelerate the taxation of the benefits.4 The conclusion that the plaintiffs’ promise to pay their attorney was funded and secured (and subject to IRC Section 83) where they irrevocably ordered the defendants’ insurers to pay the plaintiffs’ attorney his fees out of the plaintiffs’ recovery and the defendants’ insurers paid the attorney by purchasing annuities for him was “strengthened” by the fact that a defendant and the defendants’ insurers guaranteed to make the annuity payments should the annuity issuer default.5

      The current value of protection provided by an employer-paid surety bond or other guarantee arrangement constitutes a taxable economic benefit;6 protecting deferred compensation benefits by giving employees certificates of participation secured by irrevocable standby letters of credit secured the promise and triggered application of IRC Section 83.7 Further, an employer’s purchase of irrevocable standby letters of credit that were beyond the reach of its general creditors to back its promise to pay accrued vacation benefits secured the promise and triggered taxation under IRC Section 83.8

      There is some controversy between the IRS and the Tax Court over whether a promise to pay will be “funded” for tax purposes if the benefit obligation is transferred to a third party. The IRS is likely to think that the employer’s promise is funded, even if the third party pays the transferred obligations out of general revenues or sets aside a fund that remains its general asset and to which the employee has no special claim.9 The Tax Court does not seem to think that the transfer will automatically result in funding; rather, the Tax Court is more likely to examine whether any property is specially set aside (secured) by the new obligor for the employee.10

      A US firm has recently released a proprietary technique to protect nonqualified plan benefits that pools small groups of executives from publicly-traded companies with similar debt credit ratings (e.g.; AAA) in trusts that pay a participant’s benefits up to the limits of a participant’s agreed benefit coverage in the event that his or her employer plan sponsor should go bankrupt during a fixed time frame (apparently either 5 or 10 year periods). Based upon this editor’s most current information, this technique relies on the 1993 IRS letter ruling on indemnity insurance purchased by the employee for the lack of any tax impact to the employee as their plan benefits. This technique is not indemnity insurance (or a surety bond), although there are surface parallels to indemnity insurance. Time will tell if this technique can pass IRS scrutiny, especially in light of enactment of Section 409A and the expansion of the constructive
      receipt doctrine.11


      1. Let. Rul. 8406012.

      2. Let. Rul. 9241006.

      3. Let. Rul. 9344038. The age (1993) and the nonprecedental nature of this private letter ruling makes reliance uncertain, especially in light of the passage of Section 409A that expands the constructive receipt doctrine. Unfortunately, letter rulings are not currently available on the income tax issues of deferred compensation plans under Section 409A. Presumably this means letter rulings would also not be available on the economic benefit doctrine that can still be applied to transactions by the IRS, since 409A is additive income tax law.

      4. Let. Ruls. 8906022, 8741078. See also Berry v. U.S., 593 F. Supp. 80 (M.D.N.C. 1984), aff’d per curiam, 760 F.2d 85 (4th Cir. 1985) (a guarantee does not make a promise secured, because the guarantee is itself a mere promise to pay); Childs v. Comm., 103 TC 634 (1994) (same), aff’d, 89 F.3d 856 (11th Cir. 1996).

      5. TAM 9336001.

      6. Let. Rul. 8406012.

      7. Let. Rul. 9331006.

      8. Let. Rul. 9443006.

      9. Rev. Rul. 69-50, 1969-1 CB 140, as amplified in Rev. Rul. 77-420, 1977-2 CB 172; TAM 9336001.

      10Childs v. Comm., 103 TC 634 (1994), aff’d, 89 F.3d 856 (11th Cir. 1996).

      11. The editor continues to watch for developments and to evaluate updates on this proposed benefit security technique, which continues to be presented to the marketplace as of the date of this publication.

  • 3567. What is a “rabbi” trust?

    • A rabbi trust is a trust vehicle for accumulating assets to support an employer’s unfunded deferred compensation plan obligations. Under the IRC, this trust is considered an IRC Section 671 “grantor” trust. Established by the employer with an independent trustee, a rabbi trust is designed to provide employees with some assurance that their promised benefits will be paid while preserving the tax deferral that is at the heart of unfunded deferred compensation plans. To accomplish these ends, a rabbi trust is generally irrevocable.

      The use of such trusts with nonqualified deferred compensation plans has been affirmed under Section 409A(b). However, plans must meet the funding rules contained in 409A(b) that include prohibitions against funding or distribution while in declining financial circumstances, placing them offshore,1 and placing assets into one during the “restricted period” when a sponsor is underfunded on any qualified defined benefit plan.2 There are currently no regulations covering these 409A(b) funding rules but they are expected to be released at some point in the future.

      Planning Point: Planners need to watch for the proposed regulations covering these funding rules under Section 409A(b). Although Section 409A(b) now statutorily confirms use of rabbi trusts in connection with nonqualified plans, these regulations are likely to make substantive changes in the requirements for a 409A(b) compliant rabbi trust. They will likely revoke or replace the current rabbi trust model trust in Revenue Procedure 92-643 (Q 3569).

      In addition to the new funding requirements of Section 409A(b),the key characteristic of a rabbi trust is that it must provide that its assets remain subject to the claims of the employer’s general creditors in the event of the employer’s insolvency or bankruptcy.4 This result has been affirmed even when there was a delay in making a distribution of account, based on a legitimate participant request under the plan, until a bankruptcy filing prevented any distribution.5

      These trusts are called “rabbi” trusts because the first such trust approved by the IRS was set up by a synagogue for a rabbi.6 Historically, the combination of security (albeit imperfect; a rabbi trust can protect an employee against the employer’s future unwillingness to pay promised benefits, but it cannot protect an employee against the employer’s future inability to pay) and the tax deferral offered to participants in a nonqualified deferred compensation plan supported by a rabbi trust has made such trusts very popular, even though the new Section 409A(b) funding rules have reduced the ability to use the trust device to provide security for the payment of benefits (for example, placing it offshore).


      1. 26 USC Section 409A(b)(2) as amended by the Gulf Opportunity Zone Act of 2005 (“GOZA”).

      2. 27 USC Section 409A(b)(3) in the Pension Protection Act of 2006.

      3 .1992-2 C.B. 422.

      4. See McAllister v. Resolution Trust Corp. 201 F.3d 570 (5th Cir. 2000); Goodman v. Resolution Trust Corp. 7 F.3d 1123 (4th Cir. 1993) (both underscoring that beneficiaries of rabbi trusts take the risk of trust assets being subject to the claims of the employer’s general creditors for the benefit of favorable tax treatment).

      5In re Washington Mutual Inc., 450 B.R. 490 (June 1, 2011) (denying motion for “constructive trust” for payments).

      6. Let. Rul. 8113017.

  • 3568. What is the impact of Section 409A(b) on a “rabbi” trust?

    • IRC Section 409A has statutorily codified the use of rabbi trusts subject to certain limitations on their use. Since enactment of the Section 409A(b) funding rules, there have been three funding prohibitions on the use of a rabbi trust.

      (1) The securing or distribution of deferred compensation during a period when the employer’s net worth is falling or during other financial events that unacceptably secure the payment of the promised benefits is treated as a violation of Section 409A.1 This includes hybrid rabbi/secular trust arrangements that distribute assets from nominal rabbi trusts to secular trusts on the occurrence of triggering events indicating the employer’s financial difficulty. Under any such arrangement, otherwise deferred compensation is immediately taxable and subject to the 20 percent additional tax, plus premium interest on the underpayment of taxes (at the normal underpayment AFR rate plus 1 percent).2

      (2) Also, under the Section 409A(b) funding rules, setting aside assets in an offshore trust (one outside the United States) to directly or indirectly fund deferred compensation also unacceptably secures the payment of the promised benefits.3 Under any such arrangement, the otherwise deferred compensation is immediately taxable and subject to the 20 percent additional tax, plus premium interest on the underpayment of taxes (at the normal underpayment AFR rate plus 1 percent).4

      The Section 409A funding rules on both (a) prohibition on financial triggers and (b) offshore trusts apply even to deferrals of compensation earned and vested on or before December 31, 2004 (and thus not generally subject to the requirements of IRC Section 409A). The IRS provided transition relief through December 31, 2007, for amounts otherwise subject to IRC Section 409A(b), if those assets relate to compensation deferred on or before December 31, 2004, and if those assets were set aside, transferred, or restricted on or before March 21, 2006.5 Note: the IRS did not further extend the deadline for compliance on the funding rules to December 31, 2008, as it did for other documentary and operational compliance with Section 409A. December 31, 2007, was the deadline for compliance with the Section 409A(b) funding requirements. All existing trusts out of compliance with the Section 409A funding requirements should have been terminated and assets distributed or the trust amended as of December 31, 2007. A trust that has not done so is in violation of Section 409A.

      (3) Finally, a trust is in violation of the funding requirements of Section 409A if it makes contributions or transfers assets to a trust during the period that any qualified defined benefit pension plan is “at risk” (below the required percentage statutory funding levels) under the qualified pension funding rules enacted in the Pension Reform Act of 2006, or during the period of any reorganizational bankruptcy.

      Planning Point: IRC Section 409A has called into question many prior decisions and rulings in the deferred compensation arena, and there are no detailed regulations on the new funding rules of Section 409A(b), even though the law has been in effect for more than a decade. Moreover, during this time, there has been no IRS update on the model trust in light of the enactment of Section 409A. Employers and employees therefore should rely on their own legal counsel in structuring deferred compensation when using rabbi trusts and any other informal funding mechanisms. There currently are not even proposed regulations for Section 409A(b) requirements, so much detail for guidance in trust construction, especially in the absence of a revised model trust, is lacking. Using the model trust document modified to add the current three funding prohibitions of Section 409A(b) should be acceptable. The planner needs to continue to watch for the release of Section 409A proposed regulations, even though there seems to be no IRS priority for it. These regulations will likely make substantive changes in the requirements under these new rules governing rabbi trusts that will impact documentation and operation. The fate of Revenue Procedure 92-64 governing the model rabbi trust document should also be part of this proposed regulation release. Ideally, a new prototype rabbi trust document will be part of the release. However, as of the date of this publication, no such revised revenue procedure or prototype grantor rabbi trust document exists.


      1. IRC Sec. 409A(b)(2); Notice 2006-33, 2006-15 IRB 754. As of the date of this publication, there are still no regulations covering the funding rules of Section 409A.

      2. IRC Sec. 409A(b)(4).

      3. IRC Sec. 409A(b)(1); Notice 2006-33, 2006-15 IRB 754.

      4. IRC Sec. 409A(b)(4).

      5. Notice 2006-33, 2006-15 IRB 754.

  • 3569. What pre-409A issues were raised by the IRS model rabbi trust?

    • The rabbi trust has been so popular historically that the IRS released a model rabbi trust instrument in 1992 to aid taxpayers and to relieve the processing of requests on the IRS for advance rulings on these arrangements.1 The IRS model trust was intended to serve as a safe harbor document for employers. Used properly, pre-409A, the model trust assured employers that plan participants either were not in constructive receipt of income or that they incurred no economic benefit because of the trust. Of course, whether an unfunded deferred compensation plan using the model rabbi trust effectively deferred taxation depended on whether the underlying plan effectively deferred compensation.

      Pre-Section 409A, the IRS would issue advance rulings on the tax treatment of unfunded deferred compensation plans that did not use a trust and unfunded deferred compensation plans that used the model trust in Revenue Procedure 92-64. The IRS announced at that time that it would not issue advance rulings on unfunded nonqualified deferred compensation arrangements that use a trust other than the model trust.2 With the enactment of Section 409A, the IRS announced that it would not issue any advance letter rulings on the income tax consequences of nonqualified deferred compensation plans, but would continue to advise on peripheral tax issues, such as gift tax issues. It also declined to issue prototype plans, although it did not indicate that this pronouncement also includes a revision of its model rabbi trust under the existing revenue procedure. The status of the model trust as provided in the revenue procedure has remained in limbo pending Section 409A regulations, and the funding portion of the law that include rules on trusts.3

      The current model trust language contains all the pre-409A provisions necessary for operation of a trust separate from the underlying plan except provisions describing the trustee’s investment powers. The parties involved are still required to provide language describing the investment powers of the trustee, and those powers must include some investment discretion. Proper use of the model trust requires that its language be adopted verbatim, except where substitute language is expressly permitted. Although it is somewhat puzzling in light of the claim by the IRS that it will not rule on plans that do not use the model trust, the employer may add additional text to the model trust language, as long as such text is “not inconsistent with” the model trust language.4 The enactment of Section 409A, and specifically the new funding rules (see Q 3568) that impact trusts used in connection with such plans, places the use of the model rabbi trust requirements at issue, even if the grantor adds language incorporating the essential language contained in Section 409A(b), including all the amendments since the enactment of Section 409A.

      Under the pre-409A model trust, the rights of plan participants to trust assets had to be merely the rights of unsecured creditors. Participants’ rights could not be alienable or assignable. The assets of the trust were required to remain subject to the claims of the employer’s general creditors in the event of insolvency or bankruptcy.5

      In at least one older pre-409A letter ruling, the IRS held that the use of a third party guarantee as an additional security measure did not undermine the tax-effectiveness of a rabbi trust.6

      Under the pre-409A process, the board of directors and the highest ranking officer of the employer were required to notify the trustee of the employer’s insolvency or bankruptcy, and the trustee must be required to cease benefit payments on the company’s insolvency or bankruptcy.7

      Under pre-409A process, if the model trust was used properly, it should not cause a plan to lose its status as “unfunded.” In other words, contributions to a rabbi trust should not cause immediate taxation to employees; employees should not have income until the deferred benefits are received or otherwise made available.8 Contributions to a rabbi trust for the benefit of a corporation’s directors have been treated similarly.9 Likewise, contributions to a rabbi trust should not be considered “wages” subject to income tax withholding until benefits are actually or constructively received.10

      Pre-409A, a proper rabbi trust would not be considered an IRC Section 402(b) nonexempt employees’ trust. Contributions to a proper rabbi trust would not be subject to IRC Section 83.11

      Pre-409A, the employer would receive no deduction for amounts contributed to the trust, but would receive a deduction when benefit payments were includable in the employee’s income (Q 3573). In pre-409A and premodel trust days, the employer generally was considered the owner of the trust under IRC Section 677 and was required to include the income, deductions, and credits generated by the trust in computing the employer’s taxable income.12 This is normal grantor trust tax treatment.

      Pre-409A, the IRS generally would issue advance rulings on the grantor trust status of trusts following the model trust.13 Those pre-409A model trust rulings seem entirely consistent with earlier rulings.14 In pre-409A and premodel trust rulings, the IRS generally conditioned favorable tax treatment upon the satisfaction of two additional requirements: that creation of the trust did not cause the plan to be other than unfunded for ERISA purposes, and that trust provisions requiring that the trust’s assets be available to satisfy the claims of general creditors in the event of insolvency or bankruptcy were enforceable under state and federal law.15 The same conditions were imposed in earlier model trust rulings.16

      Pre-409A, the concern of the IRS with respect to ERISA seems to have been that if the DOL took the position that the use of a rabbi trust causes the underlying plan to be other than unfunded for ERISA purposes, then this would cause the plan to be funded for tax purposes and require the accelerated taxation of contributions to the rabbi trust. The DOL’s position has been that rabbi trusts maintained in connection with excess benefit or top hat plans will not cause the underlying plans to be funded for ERISA purposes so long as the IRS maintains they are not taxable because they are unsecured (hence not funded for tax purposes).17

      Also, at least one court prior to the enactment of Section 409A noted that the use of a rabbi trust will not cause a top hat plan to lose its ERISA exemption as long as the trust assets remain subject to the claims of the employer’s creditors in the event of insolvency, and the participants’ interests are inalienable and unassignable.18 Nonetheless, pre-Section 409A rulings on plans using the model trust are supposed to state that the IRS expresses no opinion on the ERISA consequences of using a rabbi trust.19

      In earlier pre-409A private letter rulings, the IRS had allowed the use of a rabbi trust in conjunction with a deferred compensation plan that permitted hardship withdrawals, ruling that the hardship withdrawal provision did not cause amounts deferred to be taxable before they are paid or made available. In these letter rulings, “hardship” generally was defined as an unforeseeable financial emergency caused by events beyond the participant’s control. The amount that could be withdrawn generally was limited to the amount needed to satisfy the emergency need.20

      Pre-409A IRS guidelines for giving advanced rulings on unfunded deferred compensation plans expressly permitted the use of certain hardship withdrawal provisions (Q 3541).21 Therefore, pre-409A, it seemed that a rabbi trust conforming to the model trust could be used in conjunction with a deferred compensation plan permitting an acceptable hardship withdrawal.22 Pre-409A, an appropriate hardship withdrawal provision was not expected to trigger taxation before deferred amounts are paid or made available. Such a provision might have triggered constructive receipt; however, at the time a qualifying emergency arose.23

      Pre-409A, the trustee could be given the power to invest in the employer’s securities. If the trustee was given that power, the trust had to be revocable or include a provision that the employer could substitute assets of equal value for any assets held by the trust.24

      Where presumably model trusts separately serving a parent and affiliates could invest in the parent’s stock, it was ruled that:

      (1) dividends paid on the parent’s stock held by the parent’s trusts would not be includable in the parent’s income in the year paid;

      (2) no gain or loss would be recognized by the parent on transfer of its stock from its trusts to its participants or their beneficiaries; and

      (3) no gain or loss would be recognized by the affiliates on the direct transfer of the parent’s stock to the affiliates’ participants or their beneficiaries if that stock was transferred directly by the parent to the participants or beneficiaries and neither the affiliates nor their trusts were the legal or beneficial owners of parent’s stock.25

      Regulations under IRC Section 1032 (Q 307) generally permit nonrecognition treatment for transfers of stock from an issuing corporation to an acquiring corporation if the acquiring corporation immediately disposes of such stock. A transfer of a parent corporation’s stock to a rabbi trust for the benefit of a subsidiary’s employee would not qualify for this nonrecognition treatment because the stock is not immediately distributed to the participant. The IRS has announced that nonrecognition treatment is available for such transfers, albeit under a different theory. The IRS treated the parent corporation, rather than the subsidiary corporation, as the grantor and owner of the rabbi trust, so long as the trust provided that stock not transferred to the subsidiary’s employees reverts to the parent and the parent’s creditors can reach the stock.26 Pre-409A, the IRS had indicated that it would rule on model rabbi trusts that have been modified to comply with this notice.

      Pre-409A, the trust had to provide that, if life insurance would be held by the trust, the trustee would have no power to name any entity other than the trust as beneficiary, assign the policy to any entity other than a successor trustee, or loan to any entity the proceeds of any borrowing against the policy (but an optional provision permits the loan of such borrowings to the employer).27

      Pre-409A, the IRS issued several private letter rulings addressing the deductibility of interest paid on life insurance policy loans after the policies were transferred to a rabbi trust (Q 30).

      Planning Point: Until proposed regulations under Section 409A(b) are released, the model trust will need to be amended to comply with all the new Section 409A(b) funding requirements if it is to be used with a Section 409A plan and remain 409A compliant under Section 409A(b). These forthcoming regulations under Section 409A(b) will be important in determining what will happen to Revenue Procedure 94-64 and the model trust contained in it, as well as the details that may be required to draft such trust provisions and guide trust operations. Planners and sponsors need to continue to watch for these proposed regulations or action on Rev. Proc. 92-64. In the meantime, they need to rely on legal counsel’s expert guidance to integrate the 409A(b) requirements with those in the revenue procedure, especially in light of more than a decade of inaction by the IRS.


      1. 1992-2 C.B. 422.

      2. See Rev. Proc. 92-64, 1992-2 CB 422, 423.

      3. See Rev. Proc. 2008-61, 2008-42 IRB, 934 and Rev. Proc. 2009-3, 2009-1 IRB 107, Section 3.01(42).

      4. Rev. Proc. 92-64, 1992-2 CB 422, 423, Secs. 4.01 and 5.01.

      5. Sections 1(d) and 13(b) of the model trust, at 1992-2 CB 424 and 427; but see Goodman v. Resolution Trust Corp., 7 F.3d 1123 (4th Cir. 1993) (assets in a rabbi trust must be subject to the claims of creditors at all times).

      6. See Let. Rul. 8906022 (employer established a rabbi trust and its corporate parent also guaranteed the obligations).

      7. See section 3(b)(1) of the model trust, at 1992-2 CB 425.

      8. Rev. Proc. 92-64, Sec. 3, 1992-2 CB 422, 423; Let. Ruls. 9732008, 9723013, 9601036.

      9. Let. Ruls. 9525031, 9505012, 9452035.

      10. Let. Rul. 9525031.

      11. Let. Ruls. 9732006, 9548015, 9542032, 9536027.

      12. Let. Ruls. 9314005, 9242007, 9214035.

      13. Rev. Proc. 92-64, Sec. 3, 1992-2 CB 422, 423.

      14. Let. Ruls. 9542032, 9536027, 9443016.

      15. Let. Ruls. 9314005, 9242007, 9214035, 8634031.

      16. See, e.g., Let. Ruls. 9548015, 9517019, 9504006; see also Rev. Proc. 92-64, Sec. 4.02, 1992-2 CB 422, 423; sections 1(d), 1(e) and 3(b) of the model trust, at 1992-2 CB 424, 425.

      17. See DOL Adv. Op. 94-31A, fn.3; DOL Adv. Op. 92-13A.

      18. See Nagy v. Riblet Prod. Corp., 13 EBC 1743 (N.D. Ind. 1990), amended on other grounds and reconsideration denied, 1991 U.S. Dist. Lexis 11739 (N.D. Ind. 1991).

      19. See Rev. Proc. 92-64, Sec. 3, 1992-2 CB 422, 423.

      20. See Let. Ruls. 9242007, 9121069. Section 409A allows hardship distributions from covered plans but uses the 457 definition of “unforeseeable emergency” rather than the hardship definition under 401(k).

      21. Rev. Proc. 92-65, Sec. 3.01(c), 1992-2 CB 428.

      22. Let. Rul. 9505012.

      23. Let. Rul. 9501032.

      24. See IRS Model Trust, section 5(a), Rev. Proc. 92-64, 1992-2 CB 425.

      25. Let. Rul. 9505012.

      26. Notice 2000-56, 2000-43 IRB 393.

      27. See IRS Model Trust, sections 8(e) and 8(f), Rev. Proc. 92-64, 1992-2 CB 426.

  • 3570. Pre-409A, if a taxpayer wanted to adopt the model trust and wished to obtain an advance ruling from the IRS on the underlying deferred compensation plan, what additional guidelines was it required to follow?

    • Pre-409A, taxpayers that wanted to adopt the model trust and wished to obtain an advance ruling on the underlying deferred compensation plan had to follow not only the standard guidelines for obtaining a ruling on an unfunded deferred compensation plan (Q 3541) but had to also follow other guidelines unique to plans using a trust.

      First, the plan had to provide that the trust and any assets would be held to conform to the terms of the model trust.

      Second, taxpayers had to generally include a representation that the plan was not inconsistent with the terms of the trust with the letter ruling request.

      Third, the language of the trust had to conform generally with the model text, and taxpayers generally had to include a representation that the trust conformed to the model trust language (including the order in which the provisions appear) and that the trust did not contain any inconsistent language (in substituted portions or elsewhere) that conflicted with the model trust language. Provisions were permitted to be renumbered if appropriate, any bracketed model trust language could be omitted, and blanks could be filled in.

      Fourth, the request for a letter ruling generally had to include a copy of the trust document on which all substituted or added language was clearly marked and on which the required investment authority text was indicated.

      Fifth, the request for a ruling generally had to contain a representation that the trust was a valid trust under state law, and that all of the material terms and provisions of the trust, including the creditors’ rights clause, were enforceable under the appropriate state laws.

      Finally, the trustee generally had to be an independent third party that could be granted corporate trustee powers under state law, such as a bank trust department or a similar party.1

      In summary, as of the date of this publication, a plan sponsor can neither obtain an advance ruling on the income taxation consequences for plan participants in a 409A covered unfunded nonqualified deferred compensation plan or an associated rabbi trust designed to follow the trust revenue procedure updated for 409A requirements.


      1. Rev. Proc. 2003-3, Secs. 3.01(35), 4.01(33), 2003-1 IRB 113; Rev. Proc. 92-64, Secs. 3 and 4, 1992-2 CB 422, 423.

  • 3571. Can a private IRC Section 451 unfunded nonqualified deferred compensation employee account balance plan be used in connection with a qualified 401(k) elective deferral plan to maximize the annual deferrals into the qualified 401(k) and also to receive employee contributions that cannot go into the qualified plan because of nondiscrimination testing issues?

    • Yes. However, 409A income tax and ERISA developments governing participant deposits have raised questions about the so-called 401(k) “wrap-around” technique.

      A 1995 private letter ruling approved a particular nonqualified/401(k) “wrap-around” “spill-over” or “pour-over” plan.1 Since then, more rulings approving the use of wrap-around plans have been issued.2 Wrap-around plans have been primarily used to maximize elective deferrals under both an IRC Section 401(k) plan and a nonqualified voluntary employee account balance plan, which generally is subject to IRS Section 409A. These plans are referred to as “linked” plans by the IRS for purposes of Section 409A, as are “excess benefit” plans. Such a nonqualified arrangement may be unnecessary due to the method by which the actual deferral percentage test for 401(k) plans now is administered (Q 3802).

      For employers that continue to elect to use the current year testing method on their qualified plans, use of a wrap-around nonqualified employee account balance plan will continue to provide planning opportunities and any employer, regardless of method, may desire a nonqualified employee account balance plan to permit highly compensated employees to voluntarily defer more than that permitted under a qualified plan.

      Section 409A Impact

      Under final regulations to IRC Section 409A, the IRS advised that such a wrap-around nonqualified plan is still possible under IRC Section 409A if it meets certain requirements:

      (1) The plan must follow the structure provided in the favorable IRS letter rulings (contributions must all go first into the nonqualified employee account balance plan and then spill into the qualified 401(k) as it becomes clear the qualified plan may receive them, based on discrimination testing).

      (2) Such a linkage may not result in a decrease in deferrals in the nonqualified arrangement in excess of the deferral limits under IRC Section 402(g)(1)(b) ($20,00 in 2022, $19,500 in 2020 and 2021, $19,000 in 2019).3 For existing nonqualified wrap-around arrangements, the IRS offered transition relief through December 31, 2008. For these plans, elections as to the timing and form of payment under the nonqualified plan that are controlled by the qualified plan were permitted through December 31, 2008. Elections had to be made in accordance with the terms of the nonqualified plan as of October 3, 2004.4 In Notice 2010-80, the IRS modified Notice 2010-6 governing plan documentation correction to allow “linked” plan documentation under the notice’s guidance so long as certain prerequisites are met.


      DOL Guidance Potentially Impacting Wrap Plans

      Although Section 409A does not seem to preclude a nonqualified wrap-around plan based upon income tax considerations after Section 409A, the DOL’s released guidance and ongoing focus5 on the timeliness of qualified plan deposits and the required deadlines raises ERISA issues for wrap-around plans that need to be discussed with legal counsel, if a wrap design is to be used. This discussion is necessary because the currently approved wrap plan structure does not conform to these more recent timely deposit rules.


      1. See Let. Rul. 9530038.

      2. Let. Ruls. 200116046, 200012083, 199924067, 9752018, 9752017.

      3. Treas. Reg. §§1.409A-2(a)(9), 1.409A-3(j)(5), Notice 2018-83, Notice 2019-59, Notice 2020-79.

      4. Notice 2006-79, 2006-43 IRB 763.

      5. The DOL continues to make timely deposit of employee contributions a priority focus of its audits. It is unclear if the DOL has addressed a situation where the employer has a wrap plan for HCEs and is not necessarily making deposits to the 401(k) plan on the timing normally expected. As of the date of this publication, there is no special guidance from the DOL on thus unique situation.

  • 3572. What approved wrap plan structure exists to allow employees to maximize 401(k) plan deferrals using a nonqualified deferred compensation account balance plan to temporarily hold elective deferrals?

    • An employer seeking to maximize highly compensated employees’ (“HCEs”) elective deferrals to its 401(k) plan established in an unfunded, nonqualified salary reduction plan (employee account balance plan) to temporarily hold elective deferrals until the maximum amount of 401(k) elective deferrals could be determined for the tax year. Employees could defer compensation into the proposed nonqualified plan by entering into salary reduction agreements by December 31 of the prior year. These employees then would receive “matching” contributions under the nonqualified plan equal to their matching contributions under the 401(k) plan. The employer would determine the maximum amount of elective contributions that the HCEs could make to the 401(k) plan for the current year as soon as practicable each year, but no later than January 31 of the next year.

      Then, the lesser of the maximum allowable amount or the amount actually deferred under the nonqualified plan would be distributed in cash to the HCEs by March 15 of the following year unless they irrevocably elected to have such amounts contributed as elective deferrals to the 401(k) plan at the same time they elected to defer compensation into the nonqualified plan. Where such election is made, the “elective deferrals” and the appropriate “matching” contributions under the nonqualified plan would be contributed directly to the 401(k) plan. Earnings under the nonqualified plan would not be contributed to the 401(k) plan. Presumably, any balance in the nonqualified plan would remain in the nonqualified plan.

      In a pre-409A ruling, the IRS determined that amounts initially held in the nonqualified employee account balance plan would be treated as made to the 401(k) plan in the year of deferral under the nonqualified plan, and would be excluded from income under IRC Section 402(e)(3). Amounts distributed to an employee that the employee did not elect to contribute to the 401(k) plan would be taxable in the year the compensation was earned. This is the linked plan design structure for a nonqualified wrap-around plan approved under Section 409A.

      Apparently, the key to the success of this wrap-around arrangement was the requirement that the election to transfer amounts to the 401(k) plan had to be made at the same time as the election to initially defer compensation into the nonqualified plan, before the beginning of the year in which the compensation was earned. The IRS earlier had approved, and then revoked in 1995, its approval of a similar arrangement where the election to transfer excess amounts flowed from a 401(k) plan into a nonqualified plan, even after the close of the year in which the amounts were earned.1 Apparently, the IRS was concerned that this arrangement raised the specter of constructive receipt and violated qualified 401(k) plan law (Q 3541).

      Another pre-409A private letter ruling approved a similar arrangement utilizing a rabbi trust (Q 3567) in connection with the nonqualified plan.2 One ruling (involving a top hat plan, Q 3541) specifically indicated that amounts must be transferred from the nonqualified plan to the 401(k) plan no later than March 15th.3

      A 401(k) plan will be disqualified if any employer-provided benefit (other than matching contributions) is contingent on the employee’s elective deferrals under the 401(k) plan (Q 3753). The 401(k) regulations provide that participation in a nonqualified deferred compensation plan is treated as contingent only to the extent that the employee may receive additional deferred compensation under the nonqualified deferred compensation plan based on whether he or she makes elective deferrals under the 401(k) plan. These regulations explicitly state that a provision under a nonqualified deferred compensation plan requiring an employee to have made the maximum permissible elective deferral under the 401(k) plan is not treated as contingent (deferrals under a nonqualified plan permitting deferral of up to 15 percent of compensation if participants have made maximum allowable 401(k) elective deferrals were not impermissibly conditioned on elective deferrals).4

      In determining how this structure compares to the final regulations published by the DOL (as finalized on January 14, 2010), it should be noted that the written rule provides that employers have a fiduciary duty to remit employee contributions to the qualified plan as soon as they can be reasonably segregated from the employer’s general assets, but not later than the fifteenth business day of the month following the month in which the participant contributions are withheld or received.5 Unfortunately, the DOL has taken the position that the “reasonable segregation” language takes precedence over the “no later than the fifteenth day of the month following the month” language.

      The 2010 regulations provided a safe harbor for retirement and health and welfare plans with fewer than 100 participants (often referred to as “small plans”). The DOL has said that “…employee contributions are deemed to be timely if the amounts are deposited with the plan no later than the 7th business day following the date the contributions (including loan repayments) are received by the employer.”

      The DOL has declined to extend the same or similar safe harbor to large plans. The rule for large plans is a facts-and-circumstances determination, which is no rule at all. But, in either case, the rule for timely deposits to the qualified plan, and many versions of the wrap-around design, especially those that need to wait until the following year to determine and move deposits to the qualified plan, do NOT meet these DOL timely deposit rule requirements. There are some qualified plan systems that may facilitate the approved wrap-around plan design by functionally being able to move the money virtually in real time from the nonqualified plan to the qualified plan almost instantly as it comes in on a timely deposit basis until the qualified plan caps out and thereafter leaves the balance of the deposits in the nonqualified plan. If the qualified plan system cannot do this, then the timely deposit rules are an issue for use of a wrap-around design.

      Planning Point: Of interest is the fact that the DOL timely deposit rules have always been an issue since the wrap design first appeared in the mid-1990s. What has changed is the DOL’s heavy continuing focus on timely deposit compliance, and the emphasis on the shortest period possible for remission of employee contributions to the qualified plan. The IRS, for its part, has apparently given the wrap-around design basic approval, even under Section 409A, so long as certain nominal requirements discussed heretofore are met.

      It is important, however, not to overlook the ERISA issue concerning the timeliness of contributions to the qualified 401(k) plan under such a wrap-around plan linked to the employer’s qualified 401(k) plan, and to determine the measure of the risk. Obtaining clearance from the DOL for the design may be in order, based upon the ability of the qualified plan recordkeeping and nondiscrimination testing capabilities system to move deposits from the nonqualified plan to the qualified plan on a timely basis. If it cannot meet or approach the timely deposit requirements, counsel must help the sponsor understand the measure of the risk involved if this 401(k) wraparound design is to be implemented.


      1. See Let. Ruls. 9423034 and 9414051, revoking Let. Rul. 9317037.

      2. See Let. Rul. 9752018.

      3. Let. Rul. 200116046.

      4. See, e.g., Let. Rul. 199902002.

      5. DOL Reg. 2510.3-102(b).

  • 3573. When are deferred amounts under an unfunded nonqualified account and nonaccount balance plan deductible by the employer?

    • An employer can take an income tax expense deduction for nonqualified deferred compensation only when it is includable in the employee’s income, regardless of whether the employer is on a cash or accrual basis of accounting.1 Likewise, deduction of amounts deferred for an independent contractor can be taken only when they are includable in the independent contractor’s gross income.2 Section 409A has not changed the income tax deduction timing for the employer; only the potential timing of income tax inclusion by a participant. Nor does the enactment of the 2017 Tax Reform Act seem to change the timing of this deferred tax deduction of nonqualified deferred compensation for the sponsoring business entity, although it may impact the amount of the deduction if the aggregate compensation, including nongrandfathered nonqualified deferred compensation, for a participant exceeds $1M.

      The IRS has confirmed that payments made under an executive compensation plan within 2½ months of the end of the year in which employees vest do not constitute deferred compensation and thus may be deducted in the year in which employees vest, rather than the year in which the employees actually receive the payments.3 Previously, there was some controversy over the proper timing of an accrual basis employer’s deduction for amounts credited as “interest” to employee accounts under a nonqualified deferred compensation plan. The weight of authority currently holds that IRC Section 404(a)(5) governs the deduction for such amounts, which must be postponed until such amounts are includable in employee income. Amounts representing “interest” cannot be currently deducted by an accrual basis employer under IRC Section 163.4

      To be deductible, deferred compensation payments must represent reasonable compensation for the employee’s services when added to current compensation. The question of what is reasonable is question of fact in each case. One factor considered in determining the reasonableness of compensation is whether amounts paid are intended to compensate for past, under-compensated services (Q 3519). Thus, deferred compensation for past services may be deductible, even if the total of such compensation and other compensation for the current year is in excess of reasonable compensation for services performed in the current year, as long as that total, plus all compensation paid to the employee in prior years, is reasonable for all of the services performed through the current year.5

      Planning Point: Substantiating the rationale behind the deferred compensation can be particularly important in a plan that is implemented for the benefit of an owner-operator nearing retirement in a closely-held company, because this substantiation can make the difference between whether the post-retirement payments are considered tax deductible compensation, rather than a nondeductible dividend. This is especially true in light of the increases in dividend tax rates for clients in the highest income tax bracket, which took effect beginning January 1, 2013. Proposed reductions in income tax rates may change this.

      Historically, best practice dictates documenting that the deferred compensation is partial compensation to make up for past “under compensation” in board resolutions and supporting materials, as well as the plan document itself (if written as a separate individual agreement) in order to support it as reasonable compensation. This also suggests the wisdom of creating such a plan for an owner-operator as far in advance of retirement as possible, so as to make the deferred compensation part of compensation for as many tax years as possible, thereby helping establish its long-term reasonableness, even if resources to initially fund it are not readily available.

      However, if the desired plan design is 409A covered, under the current regulations the IRS may be expected to take the position that the deferral of taxation is not effective because of the unlikelihood that the 409A plan operational requirements will be followed by a majority or controlling shareholder with respect to his or her own benefit.

      Reasonableness of compensation is usually not an issue as to non-shareholder or minority shareholder employees. A finding of unreasonableness in the case of a controlling shareholder is more likely. In one case, benefits paid to a surviving spouse of a controlling shareholder of a closely-held corporation were held not reasonable compensation where:

      (1) the controlling shareholder had not been under-compensated in previous years;

      (2) the controlling shareholder’s compensation exceeded the amounts paid by comparable companies;

      (3) the payments were not part of a pattern of benefits provided to employees; and

      (4) there was an absence of dividends.6

      In a second case, deferred compensation payments were held to be reasonable where the controlling shareholder was inadequately paid during the controlling shareholder’s life and the surviving spouse, to whom payments were made, did not inherit a controlling stock ownership.7 Proper documentation (e.g., board of directors’ minutes) is important to help substantiate the reasonableness of the compensation.

      Publicly-traded corporations generally do not run into the reasonable compensation issue. This is because public companies are not permitted to deduct compensation in excess of $1 million per tax year to certain top-level employees (note that the exception for  performance-based incentive compensation was eliminated for tax years beginning after 2017 (Q 3519)).8

      Golden parachute rules may limit the amount of the deduction for deferred compensation payments that are contingent upon a change in ownership or control of a corporation or made under an agreement that violates a generally enforced securities law or regulation (Q 3530).9


      1. IRC Sec. 404(a)(5); Treas. Reg. §§1.404(a)-1(c), 1.404(a)-12(b)(2). See also Lundy Packing Co. v. U.S., 302 F. Supp. 182 (E.D.N.C. 1969), aff’d per curiam, 421 F.2d 850 (4th Cir. 1970); Springfield Prod., Inc. v. Comm., TC Memo 1979-23.

      2. IRC Sec. 404(d).

      3. Let. Rul. 199923045.

      4Albertson’s, Inc. v. Comm., 42 F.3d 537 (9th Cir. 1994), vacating in part 12 F.3d 1529 (9th Cir. 1993), aff’g in part 95 TC 415 (1990) (divided court), en banc reh’g denied, (9th Cir. 1995), cert. denied, 516 U.S. 807 (1995); Notice 94-38, 1994-1 CB 350; Let. Rul. 9201019; TAM 8619006.

      5. Treas. Reg. §1.404(a)-1(b).

      6. See, e.g., Nelson Bros., Inc. v. Comm. TC Memo 1992-726.

      7Andrews Distrib. Co., Inc. v. Comm., TC Memo 1972-146.

      8. IRC Sec. 162(m).

      9. IRC Sec. 280G.

  • 3574. How are deferred compensation account balances and nonaccount balance payments taxed when received by the employee or the beneficiary?

    • Plans Subject to Section 409A

      Section 409A is a refinement of the constructive receipt doctrine. Plans that are “nonqualified deferred compensation plans,” as defined in Section 409A, have additional requirements added to the prior tax law, unless specifically replaced by Section 409A, that are now necessary to achieve and maintain income tax deferral as to plan participants until the date of distribution under the terms of the plan. Under Section 409A, its regulations, and guidance, a participant is taxed on deferred compensation immediately upon violation of Section 409A in either form (documentation) or operation (administration). These additional 409A plan requirements (for plans not involving a trust) are primarily:

      (1) minimum required plan documentation;

      (2) limited permissible distributions;

      (3) prohibited accelerations of these distributions; and

      (4) required timing of elections to defer.


      Plans Excepted or Grandfathered from Section 409A Coverage (Residual Rules for 409A Plans)

      When deferred compensation payments are actually or constructively received, they are taxed as ordinary income. Deferred compensation payments are “wages” subject to regular income tax withholding (and not the special withholding rules that apply to pensions, etc.) when actually or constructively received.1 Section 409A greatly expands the existing definition of constructive receipt so that violations of Section 409A requirements in either form documentation or administrative operation cause immediate taxation.

      In the worst case taxation situation, deferred compensation that is subject to constructive receipt not only is immediately taxed under IRC Section 409A, but it is also subject to a 20 percent excise tax in addition to the normal tax on all vested amounts (Q 3541, Q 3564). Interest on the underpayment of taxes is also retroactively imposed to the date of error and is also due at the normal underpayment AFR rate plus 1 percent.2 The IRS has provided for certain corrections of documentation and operational errors that may entirely or substantially avoid worst-case taxation under Section 409A. The tax outcome under these correction procedures depends largely on the nature of the error, when the error occurred and is corrected, and the specific participant involved (an “insider” or not, regardless whether the company is publicly traded or privately held).

      Certain Foreign Plans of “Nonqualified Entities” under IRC Section 457A

      A nonqualified deferred compensation plan of a uniquely defined “nonqualified entity” (offshore fund or partnership located in a tax indifferent situs) is subject to IRC Section 457A. This is a different IRC section than Section 409A, which covers the “nonqualified deferred compensation” plans of all entities, except to the extent they are exempted or excepted from coverage. Deferred compensation provided by such 457A nonqualified entities is taxable at the time any 457A “substantial risk of forfeiture” lapses (Q 3541). If the deferred compensation is deferred beyond the year in which the risk of forfeiture lapses, the participant is subject to a 20 percent excise tax and premium penalty interest on the underpayment of taxes at the normal underpayment AFR rate plus 1 percent on the amount.3 However, in 2016 the IRS clarified that plans subject to 457A may be covered by Section 409A and when covered must comply with it in addition to complying with 457A requirements.4 The 2016 proposed regulations indicate that 457A plans will have to separately and independently comply with Section 409A and 457 as well as 457A in order to postpone taxation.

      Annuity Payout

      Where an unfunded plan paid deferred compensation benefits in the form of a commercial single premium annuity at the termination of the participant’s employment, the IRS privately ruled that the full value of the contract would be includable in the recipient’s income at the time of distribution, in accordance with IRC Section 83.5 Unless the payment was due in a lump sum rather than in installments under the plan, this technique would now also violate Section 409A as an impermissible acceleration of the benefits.

      Beneficiary Payments

      Payments made to a beneficiary from an unfunded plan are “income in respect of a decedent” for income tax purposes and, as such, are taxed, as they would have been to the employee. It is not clear whether the same withholding rules apply. For treatment of death benefits under deferred compensation agreements, see Q 3638.


      1. See IRC Sec. 3401(a); Rev. Rul. 82-176, 1982-2 CB 223; Rev. Rul. 77-25, 1977-1 CB 301; Temp. Treas. Reg. §35.3405-1T, A-18; cf. Let. Rul. 9525031 (contributions to rabbi trust were not subject to income tax withholding because they were not the actual or constructive payment of wages).

      2. IRC Sec. 409A(b)(4).

      3. IRC Sec. 457A(c).

      4. Prop. Treas. Regs., REG 123854-12, June 22, 2016.

      5. Let. Rul. 9521029.

  • 3575. How are deferred compensation account balances and nonaccount balance payments taxed when they are received by an ex-spouse pursuant to divorce?

    • Prior to Section 409A (but continuing for excepted and grandfathered plans), benefits assigned by an employee to an ex-spouse in a divorce agreement can be split and, if so, are income taxed to the employee and the ex-spouse according to their split. However, the employee retains the tax liability for FICA/FUTA purposes. Pre-409A, generally speaking, there was no specific framework for the assignment of nonqualified deferred compensation for any reason, other than for eligible Section 457 plans (Q 3584), which is similar to the framework for the assignment of qualified plan benefits through a qualified domestic relations order (“QDRO”).1 In fact, plans frequently prohibited such assignments (as well as all others) to avoid a constructive receipt, economic benefit and assignment of income issues for plan participants since it was required under Rev. Proc. 1992-652 in order to get a positive letter ruling prior to the enactment of Section 409A. They sometimes did allow splitting of the vested nonqualified account, but prohibited accelerated distribution of the ex-spouse’s portion granted in a divorce until it was due.

      Section 409A final regulations now specifically permit the accelerated distribution of a nonqualified account balance or nonaccount balance benefit to an ex-spouse under a domestic relations order (“DRO”). Note that this is not a QDRO, and the DRO form, which generally should parallel a QDRO, cannot actually do so in all respects because a nonqualified plan has no “plan assets” (to which the standard QDRO attaches). Under Section 409A, this right is optional and a plan still does not have to provide for this divorce participant right if the employer does not want to include it in the plan. Moreover, it is not clear if the prior rulings (involving the responsible party for income tax and FICA purposes) continue to apply in the case of a 409A plan DRO divorce distribution to an ex-spouse.

      Finally, even if the plan does not provide for a participant to split their account/benefit under a DRO, does a plan sponsor have the right, by virtue of the ERISA preemption of state law to ERISA plans, to refuse a properly presented DRO from a state family law court under ERISA even though Section 409A allows it “optionally”? In general, this area remains a mess for all parties involved, especially the employer who is caught in the middle and may not even have general account reserves set aside to address a requested payout of a spouse’s vested portion of a nonqualified benefit or account, especially in the case of a supplemental plan.


      1. See Let. Rul. 9340032.

      2. 1992 C.B 428.

  • 3576. Are contributions to, and postretirement payments from, a deferred compensation account balance or nonaccount balance plan subject to FICA and FUTA taxes?

    • Yes.

      There are two timing rules for the treatment of deferred compensation amounts under the Federal Insurance Contributions Act (“FICA”) and the Federal Unemployment Tax Act (“FUTA”): (1) the “general timing rule,” and (2) the “special timing rule.”

      The general timing rule provides that amounts taxable as wages generally are taxed when paid or “constructively received” (Q 3541).

      The special timing rule applies to amounts deferred by an employee under any deferred compensation plan of an employer covered by FICA. The special timing rule applies to voluntary salary, commission and bonus reduction plans, employer-paid supplemental plans, funded and unfunded plans, private plans, and eligible or ineligible Section 457 plans. It does not apply to excess (golden) parachute payments.

      In a 2016 case, the 11th Circuit affirmed this application of FICA taxation to an employer-paid SERP in a case where the taxpayer sought to argue that the subject plan was not a supplementary deferred compensation plan that constituted FICA taxable “wages”.1

      Section 409A has not changed the application or calculation of employment taxes. Under these rules, vested nonqualified plan contributions (and the earnings on them) generally are taxable for employment tax purposes (compared with income tax purposes) when they are contributed (as in the case of most voluntary salary/bonus deferral plans) or when they are vested (as in the case of an employer-paid supplemental plan with risks of forfeiture on the benefits).

      General Timing Rule

      Under the general timing rule, an employee’s “amount deferred” is considered to be “wages” for FICA purposes at the later of the date when the services are performed or the employee’s rights to such amount are no longer subject to a Section 3121 “substantial risk of forfeiture” governing the timing of the imposition of FICA taxes on compensation.2 This definition of substantial risk of forfeiture or limitation should not be confused with the seven others discussed in Q 3538 and Q 3541; it is similar but not the same as the others and should be reviewed separately for FICA inclusion questions.

      Similar rules apply for FUTA (federal unemployment tax) purposes, although the taxable wage base for FUTA purposes is substantially smaller ($7,000).3

      Where an amount deferred cannot be readily calculated by the last day of the year, employers may choose between two alternative methods: the estimated method and the lag method.

      Under the estimated method, the employer treats a reasonably estimated amount as wages paid on the last day of the calendar year. If the employer underestimates, it may treat the shortfall as wages in the first year (or in the first quarter of the second year). If the employer overestimates, it may claim a refund or credit.

      Under the lag method, the employer may calculate the end-of-year amount deferred on any date in the first quarter of the next calendar year. The amount deferred will be treated as wages paid and received on that date, and the amount deferred that otherwise would have been taken into account on the last day of the year must be increased by income through the date on which the amount is taken into account.4

      Special Timing (Nonduplication) Rule

      The “special timing” (nonduplication) rule is designed to prevent double taxation once an amount is treated as wages. Under this rule, any amount (and any income attributable to it) will not again be treated as wages for FICA or FUTA purposes in any later year.5 A deferred amount is treated as taken into account for FICA and FUTA purposes when it is included in computing the amount of wages, but only to the extent that any additional tax for the year resulting from the inclusion actually is paid before the expiration of the period of limitation for the year. A failure to take a deferred amount into account subjects it (and any income attributable thereto) to inclusion when actually or constructively paid.6

      Planning Point: In an important case development, in 2016 a Federal District Court (affirmed on appeal by the 11th circuit) held that an employer was responsible under the plan provisions for some FICA taxes paid by its plan participants on plan benefits because of its failure to withhold FICA taxes in connection with a SERP during the active working life of those plan participants rather than at the time the benefits were paid.7

      The participants argued that the employer was obligated to pay those taxes under the plan and by failing to withhold during the working period they incurred FICA taxes on their benefits that would not have been due otherwise. Because of annual caps on total FICA contributions, the FICA taxes were often muted or avoided entirely for deferred compensation plan participants, except for the Medicare portion. Under the application of the FICA rules to the plan, by failing to withhold on FICA during the working period, their benefits were thereby subjected to FICA taxation as paid contrary to the plan provisions.


      1Peterson v. Comm., 827 F.3d 968 (11th Cir. 2016).

      2. See IRC Secs. 3121(v)(2)(A), 3121(v)(2)(C); Treas. Reg. §31.3121(v)(2)-1(a)(2); Buffalo Bills, Inc. v. U.S., 31 Fed. Cl. 794 (1994), appeal dismissed without opinion, 56 F.3d 84, 1995 U.S. App. Lexis 27184 (Fed. Cir. 1995); Hoerl & Assoc., P.C. v. U.S., 996 F.2d 226 (10th Cir. 1993), aff’g in part, rev’g in part, and remanding 785 F. Supp. 1430 (D. Colo. 1992); Let. Ruls. 9443006 (fn. 1), 9442012, 9417013; 9347006, 9024069 as revised by Let. Rul. 9025067; TAMs 9051003, 9050006.

      3. See IRC Secs. 3306(r)(2), 3306(b)(1).

      4. Treas. Reg. §§31.3121(v)(2)-1(f), 31.3306(r)(2)-1(a).

      5. IRC Secs. 3121(v)(2)(B), 3306(r)(2)(B).

      6. Treas. Reg. §§31.3121(v)(2)-1(a)(2)(iii), 31.3306(r)(2)-1(a).

      7Davidson v. Henkel Corp., 2015WL 74257 (E.D. Mich. 2015). It is understood that the employer eventually settled with the participants for a significant portion of the taxes including a tax gross up (as well as attorneys’ fees).

  • 3577. When is a nonqualified deferred compensation plan excluded for purposes of determining FICA and FUTA taxes?

    • The following plans and benefits are not considered deferred compensation “wages” for FICA and FUTA purposes (but may well be a “nonqualified deferred compensation plan” for 409A purposes and includible for income tax purposes for noncompliance):

      (1) Stock options, stock appreciation rights, and other stock value rights, but not phantom stock plans or other arrangements under which an employee is awarded the right to receive a fixed payment equal to the value of a specified number of shares of employer stock

      (2) Some restricted property received in connection with the performance of services

      (3) Compensatory time, disability pay, severance pay, and death benefits

      (4) Certain benefits provided in connection with impending termination, including window benefits

      (5) Excess (golden) parachute payments

      (6) Benefits established twelve months before an employee’s termination, if there was an indication that benefits were provided in contemplation of termination

      (7) Benefits established after termination of employment

      (8) Compensation paid for current services1


      1. Treas. Reg. §§31.3121(v)(2)-1(b)(4), 31.3306(r)(2)-1(a).

  • 3578. How is the amount deferred for employment tax purposes impacted by whether the account is an account balance plan or a nonaccount balance plan?

    • The manner of determining the amount deferred for employment tax purposes under Section 3121 for a given period depends on whether the deferred compensation plan is an account balance plan or a nonaccount balance plan.1

      Account Balance Plan

      A plan is an account balance plan only if, under its terms, a principal amount is credited to an employee’s individual account, the income attributable to each principal amount is credited or debited to the individual account, and the benefits payable to the employee are based solely on the balance credited to the individual account.2 This is the typical voluntary top hat salary/bonus deferral plan and the defined contribution version of an employer-paid supplemental plan.

      If the plan is an account balance plan, the amount deferred for a period equals the principal amount credited to the employee’s account for the period, increased or decreased by any income or loss attributable thereto through the date when the principal amount must be taken into account as wages for FICA and FUTA purposes. See Q 3576 for a discussion of the application of the Code Section 3121 “nonduplication rule” to account balance plans.

      The regulations explain that “income attributable to the amount taken into account” means any amount that, under the terms of the plan, is credited on behalf of an employee and attributable to an amount previously taken into account, but only if the income is based on a rate of return that does not exceed either the actual rate of return on a predetermined actual investment or a reasonable rate of interest, if no predetermined actual investment has been specified.

      Nonaccount Balance Plan

      If the plan is a nonaccount balance plan, the amount deferred for a given period equals the present value of the additional future payment or payments to which the employee has obtained a legally binding right under the plan during that period; that is, when they become vested and no longer subject to a substantial risk of forfeiture The present value must be determined as of the date when the amount deferred must be taken into account as FICA taxable “wages,” using actuarial assumptions and methods that are reasonable as of that date.3

      With respect to these defined-benefit-type plans, the IRS has ruled privately that when a deferred compensation plan promises to pay a fixed amount in the future, the “amount deferred” is the present value of the expected benefits at the time when the benefits are considered wages for FICA purposes. The discount (that is, the income attributable to the amount deferred) is not treated as wages in that or any later year.4 Thus, if the deferred compensation payments under such a plan do not vest (i.e., become nonforfeitable) on retirement, then the present value of the expected payments will be treated as wages for FICA purposes in the year of retirement.

      An employer may treat a portion of a nonaccount balance plan as a separate account balance plan if that portion satisfies the definition of an account balance plan and the amount payable under that portion is determined independently of the amount payable under the other portion of the plan.5

      The “income attributable to the amount taken into account” means the increase, due solely to the passage of time, in the present value of the future payments to which the employee has obtained a legally binding right, the present value of which constitutes the amount taken into account, but only if determined using reasonable actuarial methods.6

      Final Section 3121 regulations provide that an amount deferred under a nonaccount balance plan need not be taken into account as wages under the special timing rule (see Q 3577) until the earliest date on which the amount deferred is reasonably ascertainable. An amount deferred is reasonably ascertainable when there are no actuarial (or other) assumptions needed to determine the amount deferred other than interest, mortality, or cost-of-living assumptions.7 For example, the IRS ruled that a participant’s benefits under an IRC Section 457 plan (Q 3584) would not be subject to FICA tax simply because the plan’s age and service requirements had been met, because benefits were not “reasonably ascertainable” at that time. Similarly, the benefits would not be subject to income tax withholding at that time, because they are not treated as constructively received until actually received for income tax withholding.8

      Planning Point: It usually is better not to vest an employee in employer amounts subject to forfeiture until immediately before payment is scheduled to start, because there is currently no refund or credit ability for FICA taxes paid if the employee should leave the employer and forfeit his or her benefit under the plan. It usually is desirable to vest the benefit in the final year the employee is actively at work when the participant is above the wage limit and effectively incurs no FICA/FUTA taxation on the amounts (except for the portion that has no cap) By employing this strategy, the benefit payments avoid FICA/FUTA taxation following retirement. This strategy also reduces the risk that the employer will be liable for these employment taxes on post retirement payments by failing to include them during the participants’ active working period when there would be little actual FICA/FUTA tax on the amounts, whether incrementally vested on portions of the benefit or vested on the entire benefit just prior to retirement.9

      No amount deferred under a deferred compensation plan may be taken into account as FICA or FUTA wages before the plan is established.10


      1. Treas. Reg. §§31.3121(v)(2)-1(c)(1), 31.3306(r)(2)-1(a).

      2. Treas. Reg. §§31.3121(v)(2)-1(c)(1), 31.3306(r)(2)-1(a).

      3. Treas. Reg. §§31.3121(v)(2)-1(c)(2), 31.3306(r)(2)-1(a).

      4. TAMs 9051003, 9050006.

      5. Treas. Reg. §§31.3121(v)(2)-1(c)(1)(iii)(B), 31.3306(r)(2)-1(a).

      6. Treas. Reg. §§31.3121(v)(2)-1(d)(2), 31.3306(r)(2)-1(a).

      7. Treas. Reg. §§31.3121(v)(2)-1(e)(4)(i), 31.3306(r)(2)-1(a).

      8. TAM 199902032.

      9. See, Davidson v. Henkel (Q 3576) in the Planning Point for discussion of a case in which a group of participants sought recovery from the employer in such a failure to include such deferred compensation amounts during their active employment period.

      10. Treas. Reg. §§31.3121(v)(2)-1(e)(1), 31.3306(r)(2)-1(a).

  • 3579. Are self-employed individuals and corporate directors subject to FICA and FUTA taxes for deferred compensation arrangements?

    • Self-employed individuals pay Social Security taxes through self-employment (“SECA”) taxes rather than FICA taxes. Deferred compensation of self-employed individuals is usually counted for SECA tax purposes when it is includable in income for income tax purposes.1 Deferred compensation of self-employed individuals generally is counted for SECA purposes when paid, or when it is constructively received, if earlier.2

      Likewise, corporate directors who defer their fees generally count those fees for SECA purposes when paid or constructively received (Q 3541).3 This pattern of SECA imposition makes deferral of board fees a less attractive deferral technique for corporate directors as compared to deferred compensation for executive employees.

      For a discussion of the SECA taxation of deferred commission payments to self-employed life insurance agents, see Q 652.


      1. See IRC Sec. 1402(a); Treas. Reg. §1.1402(a)-1(c).

      2. See, e.g., Let. Ruls. 9609011, 9540003.

      3. IRC Secs. 1402(a), 5123(a); Treas. Reg. §1.1402(a)-1(c); Let. Rul. 8819012.