As we approach the end of the year, it is important for employers to perform a final compliance review of their existing nonqualified deferred compensation arrangements.
December 31, 2020: Deadline to Amend Nonqualified Deferred Compensation Plans
As a result of amendments made to Section 162(m) of the Internal Revenue Code (Code) by the Tax Cuts and Jobs Act (TCJA), certain mandatory delayed payment provisions appearing in many nonqualified deferred compensation plans (NQDC) maintained by publicly traded corporations could create a costly payment trap for employers.
Prior to the passage of the TCJA, it was common for NQDC Plans maintained by publicly traded companies to contain payment provisions that expressly delayed the payment of benefits to the extent necessary to ensure compliance with the $1,000,000 deduction limitation imposed by Section 162(m). To this end, Treas. Reg. §1.409A-2(b)(7)(i) permitted a NQDC Plan to delay a payment if the employer reasonably anticipated that the scheduled payment would not be deductible under Section 162(m).
To the extent a NQDC Plan adopted this approach, payments could be delayed until such time as the payment would be deductible for federal income tax purposes. When applied, this limitation typically resulted in the deferral of a payment until such time as (i) the payment did not result in the participant’s annual compensation exceeding the $1,000,000 deduction, or (ii) the executive was no longer a “covered employee” for purposes of Section 162(m) (e.g., upon the executive’s termination of employment).
The TCJA, however, modified the definition of “covered employee” under Section 162(m) such that an executive will remain a “covered employee” for purposes of Section 162(m) even after the termination of their employment. Consequently, NQDC Plans that contained mandatory delayed payment provisions risk having such payments delayed indefinitely.
Fortunately, following passage of the TCJA, the IRS issued special transition relief that allows employers to remove these mandatory delayed payment provisions without giving rise to an impermissible acceleration under Section 409A. In order to take advantage of this relief, however, affected employers must amend their NQDC Plans by December 31, 2020 to remove the mandatory delayed payment provisions. Accordingly, publicly traded employers should review their NQDC Plans to determine whether such year-end plan amendments are warranted.
Don’t Forget to Withhold FICA Taxes on Vested Deferred Compensation Benefits
Under federal tax law, non-qualified deferred compensation benefits are subject to a special timing rule that requires the employer to withhold Social Security and Medicare taxes (FICA taxes) when such benefits vest. While the use of this special timing rule is required, many employers fail to properly follow this withholding obligation thereby exposing the employer to potential tax penalties and, in the worst case scenario, claims from participants for the value of lost benefits. For example, if an employer fails to apply the special timing rule when the benefits vest, all of the participant’s future benefit distributions (including the earnings thereon) will be subject to FICA taxes on a “pay as you go” basis at the tax rates in effect at the time of distribution.
As 2020 comes to a close, employers are reminded to review their employment tax withholding obligations for NQDC Plans in order to ensure compliance and mitigate against the risk under-withholding penalties and benefit claims by participants. To this end, it is important to recognize that non-qualified deferred compensation benefits can take various forms, including elective and mandatory deferred bonus arrangements, supplemental executive retirement plans (SERPs), retirement restoration plans, phantom stock arrangements and certain types of equity awards.
- Depending on the terms of the award, restricted stock units (RSUs) and/or performance units with delayed payment dates (or deferral features) can give rise to non-qualified deferred compensation.
- Time-based RSUs awards that provide for accelerated vesting upon retirement can also give rise to non-qualified deferred compensation. For example, if a participant has satisfied the conditions to retire as of the grant date, the IRS will treat the award as vested and subject to FICA taxes on the grant date notwithstanding the fact that the award settles in a future year.
- Employers must also be vigilant in identifying any new arrangements that may have been implemented during the year, including arrangements created under the terms of an employment agreement.
For purposes of satisfying the special timing rule, the tax regulations also contain a rule of administrative convenience. Under this rule, an employer may treat non-qualified deferred compensation benefits that have become vested during the year as taxable and subject to withholding on any later date within the same calendar year. For example, if a participant’s deferred compensation benefits became vested on April 1 (or any other date in the current calendar year), the employer may take this vested benefit into account in the final payroll in December. Accordingly, employers should review their NQDC Plans to determine whether any year-end withholding adjustments are warranted.