IRS Releases Updated Nonqualified Deferred Compensation (409A) Audit Technique Guide

Last month, the Department of the Treasury Internal Revenue Service released an updated Nonqualified Deferred Compensation Audit Technique Guide. IRS had last released a 409A Audit Technique Guide in June 2015. For compensation professionals new to Section 409A, the Guide provides a nice summary, with extensive statutory and regulatory citations, of (a) the four principal requirements that must be satisfied for an amount deferred under a non-qualified deferred compensation (NQDC) plan to avoid being currently includible in gross income (to the extent not subject to a substantial risk of forfeiture and not previously included in gross income), and (b) the legal underpinnings, including the constructive receipt and economic benefit doctrines, in addition to Code Section 409A.

However, most useful to executive compensation professionals may be the information in the Guide on Section 409A(b) Rules Regarding Certain Funding Arrangements., an area the IRS “reserved” for future guidance under its final Section 409A regulations (see, Treas. Reg. § 1.409A-5). Noting the general rule under Code Section 409A(b) 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., a rabbi trust), the Guide highlights the three exceptions to this rule.

1. If the 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 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. If the employer’s NQDC plan contains a “springing” provision, or the employer acts, so 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. If an 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 Guide observes that the application of this last 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.

All executive compensation practitioners should consider reading the Updated Nonqualified Deferred Compensation (409A) Audit Technique Guide.

-Mike Melbinger, CompensationStandards.com July 12, 2021