If you are an employer that sponsors a Non-Qualified Deferred Compensation Plan (“NQDC Plan”), we’ve got some good news and some bad news.
Bad News/Good News
Let’s start with the bad news. The IRS is likely to step up its audits of NQDC Plans. Non-compliance with the tax rules can result in tax consequences much more severe than landing on the above-pictured Monopoly game board square.
But here’s the good news. The IRS recently issued an updated Nonqualified Deferred Compensation Audit Techniques Guide which provides an excellent overview of NQDC Plans and highlights an examiner will be looking for in an audit examination.
The Audit Guide points out IRS concerns whether the NQDC Plan is complying with Section 409A of the Internal Revenue Code. Simply stated (and it’s far from that), Section 409A generally provides that a NQDC Plan comply with various rules regarding the timing of deferrals and distributions.
The penalty for non-compliance is severe in that all amounts deferred under the plan for the current year and all previous years become immediately taxable, plus a 20% penalty tax, to the extent the compensation is not subject to a “substantial risk of forfeiture” and has not previously been included in gross income.
The IRS is also concerned with other tax rules governing NQDC Plan including:
- When are deferred amounts includible in an employee’s gross income?
- When are deferred amounts deductible by the employer?
- When are deferred amounts taken into account for employment tax purposes?
Here are four important considerations in designing and administering a NQDC Plan:
First, it might be prudent to have your Plan document and Plan administration reviewed for compliance with the IRS audit focus. It may possible under IRS correction programs to correct NQDC Plan document and operational errors before an audit.
Second, the Audit Guide provides a reminder that a 401(k) plan may not condition, directly or indirectly, any other benefit with the exception of matching contributions, upon the employee’s electing to make or not to make 401(k) under the arrangement. For example, the IRS will be looking for provisions in the NQDC Plan that
- Limits the total amount that can be deferred between the NQDC plan and the Company’s 401(k) plan, or
- States that participation is limited to employees who elect not to participate in the 401(k) plan.
In either of these plan provisions are found in the audit, the examiner is instructed to contact the Employee Plans division of the IRS that oversees 401(k) and other qualified plans. The rest, they say, can be history.
Third, an unfunded NQDC Plan can be exempt from a majority of the provisions of ERISA as long as it constitutes a “Top Hat” Plan. What’s a “Top Hat Plan”? It’s a plan maintained by an employer for a “select group of management or highly compensated employees”. It’s another one of those “facts and circumstances” situations, but the courts have provided guidance over the years.
Finally, the exemption from ERISA’s annual reporting requirement is not automatic. The plan sponsor must notify the Department of Labor within 120 days of the plan’s adoption. That notice can be as basic as a one-paragraph letter, and an annual Form 5500 filing is not necessary.
As the old idiom goes, Forewarned is forearmed.