Executive Compensation Planning: A Practical Guide to Designing and Protecting Executive Pay, Part 3: Deferred Compensation and Section 409A
In Parts 1 and 2, we covered stock options, restricted stock, RSUs, phantom stock, SARs, and the Section 83(b) election. In this installment, we examine nonqualified deferred compensation, SERPs, and Section 409A, the Internal Revenue Code provision that governs the timing and design of nearly all deferred compensation.
For executives approaching retirement or considering a long tenure with a single employer, deferred compensation arrangements can represent a significant portion of total wealth, and a significant source of risk.
Nonqualified Deferred Compensation and SERPs
Nonqualified deferred compensation plans allow executives to defer salary, bonus, or other compensation to a future year, sheltering those amounts from current taxation. They serve as the primary above-qualified-plan retirement savings vehicle for executives who have maximized their 401(k) contributions. The employer receives no tax deduction until the amounts are actually distributed.
Supplemental executive retirement plans (SERPs) operate on a similar tax principle but are funded by the employer rather than through executive deferrals. SERPs are commonly used to restore retirement benefits that qualified plan limits would otherwise cap, making them an effective recruiting tool for senior executives who would otherwise forfeit significant accrued pension benefits by changing employers.
Both arrangements are typically funded through rabbi trusts, allowing assets to be set aside in trust that remain subject to the employer's general creditors in the event of insolvency. This is the fundamental economic risk of deferred compensation: an executive who has accumulated a significant balance in a financially distressed employer may not recover those amounts in bankruptcy.
Section 409A of the Internal Revenue Code governs the design, operation, and distribution of virtually every nonqualified deferred compensation arrangement. Its breadth is remarkable: it reaches NQDC plans, SERPs, phantom stock arrangements, certain RSUs, deferred bonus plans, and even provisions buried in employment agreements that allow the executive to delay a severance payment. The consequences of noncompliance fall entirely on the executive.
Under Section 409A, a deferred compensation arrangement must comply with strict rules governing when deferrals may be elected, when amounts may be paid, and what events may trigger payment. Payment may only be made upon one of six permissible events: separation from service, disability, death, a qualifying change in control, an unforeseeable emergency, or a fixed date or schedule specified in the plan document. Any payment outside these triggers constitutes a violation.
The cost of a 409A violation is severe. The executive must recognize the deferred amount as income immediately (even if it has not yet been received) and pay a 20% additional income tax on that amount, plus interest at the underpayment rate plus one percentage point. Some states impose an additional 20% state excise tax. Correcting a 409A violation after the fact is difficult; plan document failures offer particularly limited correction pathways.
Common traps include stock options granted below fair market value, severance conditioned on a release without a specified payment window, and employment agreements giving the executive discretion over the timing of payment. This last category creates a hidden deferral election that brings the arrangement squarely within 409A's reach.
The IRS has issued guidance on 409A corrections through Notice 2008-113 and Notice 2010-6, but the correction programs are limited in scope and impose their own costs. The best approach is to design compliant arrangements from the outset and conduct regular operational audits.
Next in Part 4: Section 280G and golden parachute payments, the change-in-control tax trap that can blindside executives and companies who haven’t planned ahead.