Nonqualified Plans in General
Employers establish nonqualified plans for Key Employees to supplement: (1) employer-provided retirement and pre-retirement deferred compensation benefits that are provided under the employer’s qualified plans; and (2) voluntary, tax-favored savings opportunities available to their Key Employees.
In today’s highly competitive market for Key Employees, nonqualified plans are an important means by which employers attract, motivate, reward, and retain their talent.
Over the last decades, nonqualified plans have assumed increased importance as qualified plans are subject to significant restrictions. These restrictions mean qualified plans are not able to provide Key Employees with enough savings to adequately prepare for retirement. Consequently, nonqualified plans typically benefit a select group of Key Employees whose qualified benefits are otherwise limited by law.
In general, a Key Employee does not consider contributions to an unfunded nonqualified plan as gross income until the Key Employee receives money from the plan. Conversely, amounts contributed to a funded nonqualified plan are typically considered as income at the time of vesting. See 26 USC §§ 83, 402(b), 409A, 451.
However, it is important to understand this issue is more nuianced. The Key Employee defers taxation on this compensation only if the terms of the deferred compensation plan document do not violate the constructive receipt, cash equivalence, and economic benefit doctrines, and the requirements of Internal Revenue Code Section § 409A.
The Doctrine of Constructive Receipt
Under the doctrine of constructive receipt, income is taxable when an employee actually or constructively receives it. See 26 USC § 451(a); see also 26 CFR § 1.451-1(a). Income is “constructively received” if a key employee’s control over its receipt is not subject to substantial limitations or restrictions. See 26 CFR § 1.451-2(a). Therefore, income is taxable, even if the cash is not in the taxpayer’s possession, whenever it is “available.” Whether income is “available” is based on a factual analysis of the plan’s limitations and restrictions. A well-constructed, unfunded plan should not lead to taxable income until it is received by the Key Employee.
Internal Revenue Code Section 409A
Internal Revenue Code Section 409A layers on additional rules applicable to nonqualified plans. See generally 26 USC 409A. Section 409A imposes rules that apply to the timing of contributions, credits, and distributions. These rules also include restrictions on participant elections.
If a Plan does not satisfy these statutory requirements :
(1) all income for the taxable year of failure of the plan, and for all prior taxable years, is includible in the gross income of the employee, or service provider, intended to benefit from the plan; and
(2) the plan imposes a twenty percent (20%) penalty on the employee or service provider, in addition to other penalties and interest. See 26 USC 409A(a)(1).
If a deferral does not comply with the statute, the Key Employee is in constructive receipt of the compensation, whether or not the employee is in possession of the compensation.
The Section 409A statutory requirements apply to all nonqualified deferred compensation programs. The plan document must satisfy the rules, and the plan must operate in accordance with its terms, or significant penalties apply.