Many people expect to see significant tax reform in the near future now that Republicans are in control of Congress and President Trump is in office. Among the changes being discussed are reduced marginal tax rates for individuals, lower corporate tax rates and the elimination of the surtax on net investment income. It’s uncertain, however, when (and if) such changes will be implemented and how long reduced tax rates will last.
Assuming that tax rates are reduced, and that favorable rates won’t last forever, what does this mean for compensation programs? Many executives and business owners will want to take advantage of this window of opportunity by deferring or accelerating compensation so that it’s received while rates are low. As you consider strategies for timing compensation payments, however, it’s critical to be mindful of Internal Revenue Code Section 409A.
Sec. 409A in a nutshell
Sec. 409A is designed to prevent executives, other employees and certain independent contractors from using nonqualified deferred compensation arrangements — including bonus plans, supplemental executive retirement plans and discounted stock options — to defer income taxes while retaining control over the timing of benefits. Violations result in immediate taxation of vested benefits and a 20% excise tax, plus interest.
Certain arrangements are exempt from Sec. 409A, including qualified retirement plans and “bona fide” vacation, sick leave, compensatory time, disability and death benefit plans.
Sec. 409A is complex, but in a nutshell, it restricts an employee’s ability to manipulate the timing of income as follows:
- An election to defer income must be made before the year in which the compensation is earned. For example, if you wish to defer a portion of your 2018 compensation to 2019, you must make the election by the end of 2017. There are exceptions for new employees, certain qualifying performance-based compensation and certain bonus plans. (See “Limited exception allows deferral of bonus payments.”)
- Deferred compensation must be paid (a) on a specified date or according to a fixed payment schedule, or (b) after the occurrence of a specified event, such as death, disability, separation from service, change in ownership or control of the employer, or an unforeseeable emergency.
- Once scheduled, payments may be deferred further, provided an election is made at least 12 months in advance and the new payment date is at least five years after the originally scheduled date.
Generally, once an election is made to defer compensation, payments can’t be accelerated except, as discussed below, in limited circumstances.
Sec. 409A generally prohibits companies from paying deferred compensation earlier than scheduled. This prohibition makes it difficult to accelerate payments to take advantage of tax cuts. There are, however, 13 limited exceptions to the antiacceleration rule. Most of the exceptions involve extraordinary circumstances, such as payments needed to comply with a domestic relations order, pay employment taxes or meet certain other obligations. However, one exception — for plan termination — may create tax-planning opportunities for some businesses.
Under this exception, an employer may accelerate deferred compensation payments without violating Sec. 409A, provided the payments are made in connection with termination and liquidation of the plan and:
- The plan isn’t terminated because of a downturn in the employer’s financial condition,
- All similar nonqualified deferred compensation plans are also terminated,
- No payments are made within 12 months after termination,
- All payments are completed within 24 months after termination, and
- The employer doesn’t adopt any similar plans within 36 months after the termination was initiated.
Terminating a plan is one option for taking advantage of lower tax rates. But before choosing this strategy, it’s important to consider its impact on your company’s compensation programs.
Accelerating and deferring income is a tried-and-true strategy for making the most of fluctuating tax rates. But when nonqualified deferred compensation plans are involved, it’s important to plan carefully to avoid running afoul of Sec. 409A.
Sidebar: Limited exception allows deferral of bonus payments
Internal Revenue Code Section 409A generally requires you to make an election to defer compensation in the year before you earn it. This makes it difficult to defer compensation to take advantage of declining tax rates. Suppose, for example, that lawmakers enact a tax cut that takes effect in 2018. To defer a portion of your 2017 income to next year, an election would have been required by the end of 2016.
Sec. 409A contains a limited exception for short-term deferrals that allows a business to defer certain bonus payments to the following tax year. A bonus plan is deemed to comply with Sec. 409A if 1) it provides for bonuses to be paid no later than 2½ months after the end of the tax year (or, if later, the employer’s fiscal year) in which bonuses become fully vested, and 2) recipients do not have the power to designate the year of payment.