The Internal Revenue Service recently released an updated Nonqualified Deferred Compensation Audit Technique Guide. This FGMK article highlights key elements of the updated guidance.
On June 1, 2021, the Internal Revenue Service (the “IRS”) released an updated Nonqualified Deferred Compensation Audit Technique Guide (the “Guide”), last updated in June 2015. The Guide summarizes statutory and regulatory citations of the following:
The Guide provides new information on Section 409A(b) - Rules Regarding Certain Funding Arrangements, an area the IRS “reserved” for future guidance. The general rule under Section 409A(b) is that if an employer uses a funding arrangement to pay for deferred compensation, typically it will not constitute a funded plan subject to current taxation if the funding arrangement does not result in assets being set aside from the claims of the employer’s creditors (e.g., which a rabbi trust does not do). The Guide highlights the three exceptions to this rule.
1. Employer uses an offshore rabbi trust. The assets set aside in a trust located outside of the United States will be treated as a transfer of property under Internal Revenue Section 83 subject to taxation once the compensation becomes vested, even if the assets are available to satisfy claims of general creditors. This rule does not apply to assets located in a foreign jurisdiction if substantially all the services to which the NQDC relates are performed in such jurisdiction.
2. The employer’s NQDC plan contains a “springing” provision, or the employer acts in a manner that assets become restricted to the payment of deferred compensation in connection with a change in the employer’s financial health, even if the assets are available to satisfy claims of general creditors. Section 409A taxes would apply to vested deferred compensation as of the earlier of the date when (a) the plan includes the “springing” provision or (b) the assets become restricted to the payment of deferred compensation (e.g., the plan does not include a “springing” provision but the employer transfers assets to a rabbi trust in connection with an adverse change in the employer’s financial health).
3. The employer transfers assets to a rabbi trust for the benefit of certain executives (“applicable covered employees”) at the expense of funding a single-employer defined benefit plan within its controlled group for rank-and-file employees or if the employer’s NQDC plan provides for the restriction of assets to the provision of benefits (when the company’s single-employer defined benefit plan is in a restricted period). The amount set aside for an applicable covered employee would be treated as income to those employees regardless of whether such amount is subject to the claims of the employer’s creditors, and any increase in the value of the assets would be treated as an additional taxable transfer.
The application of the third exception would require an examiner to review both the NQDC plan (and operation of the plan) and any single employer defined benefit plan of any member of the controlled group to know if an employer set aside assets to pay deferred compensation when in a restricted period.
The ultimate message here is that Section 409A audits remain a focus of the IRS and given the substantial potential tax penalties – 20 percent excise tax, plus late payment penalties – it is important to document and operate non-qualified deferred compensation plans in compliance with Section 409A.
The summary information in this document is being provided for education purposes only. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.
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