Publication 5528 (Rev. 3-2024)

Publication 5528 (Rev. 3-2024) Catalog Number 37690C Department of the Treasury Internal Revenue Service www.irs.gov

Nonqualified Deferred

Compensation Audit

Technique Guide

This document is not an official pronouncement of the law or the position of the Service and cannot be

used, cited, or relied upon as such. This guide is current through the revision date. Since changes may

have occurred after the revision date that would affect the accuracy of this document, no guarantees are

made concerning the technical accuracy after the revision date.

The taxpayer names and addresses shown in this publication are hypothetical.

Audit Technique Guide Revision Date: 3/20/2024

Table of Contents

I. Overview ................................................................................................ 4

A. Background / History ...................................................................... 4

B. Relevant Terms ............................................................................... 5

B.1. Funded vs. Unfunded Plans ............................................... 5

II. Law / Authority ...................................................................................... 6

A. Timing of Income for the Employee or Service Provider ............ 6

A.1. Constructive Receipt Doctrine – Unfunded Plans ............ 6

A.2. Economic Benefit Doctrine – Funded Plans ..................... 6

A.3. Section 409A ........................................................................ 7

A.4. Section 409A(b) Rules Regarding Certain Funding

Arrangements ............................................................................ 8

B. Timing of the Deduction for the Employee or Recipient ............. 8

C. When Deferred Amounts are Subject to Employment Taxes ..... 9

III. Name of Issue – When are deferred amounts includible in

employee’s gross income; deductible by the employer; and

considered for employment tax purposes ......................................... 9

A. Description of Issue ........................................................................ 9

A.1. Law/Authority Related to Includability by

Employee/Service Provider .................................................... 10

A.2. Law / Authority Related to Deduction by

Employee/Service Recipient ................................................... 10

A.3. Law/Authority Related to Employment Tax Reporting ... 11

B. When are Deferred Amounts Included in the Employee’s Gross

Income ........................................................................................... 12

B.1. Constructive Receipt Doctrine - Unfunded Plans........... 12

B.2. Economic Benefit – Funded Plans ................................... 12

B.3. Cash Equivalency .............................................................. 13

B.4. Section 409A ...................................................................... 13

B.5. Section 409A(b) Rules Regarding Certain Funding

Arrangements .......................................................................... 15

C. When are Deferred Amounts Deductible by the Employer? ..... 16

D. When are deferred amounts considered for employment tax

purposes? ...................................................................................... 16

D.1. FICA .................................................................................... 17

D.2. FUTA ................................................................................... 17

D.3. Income Tax Withholding ................................................... 17

D.4. Interest Credited to Amounts Deferred ........................... 17

IV. Examination Techniques ................................................................... 18

A. Additional Information .................................................................. 22

V. Example Worksheets / Exhibits ........................................................ 23

I. Overview

(1) A nonqualified deferred compensation (NQDC) plan is an elective or non-

elective plan, agreement, method, or arrangement between an employer and an

employee (or service recipient and service provider) to pay the employee

compensation in the future. In comparison with qualified plans, nonqualified

plans do not provide employers and employees with the tax benefits associated

with qualified plans because NQDC plans do not satisfy all of the requirements

of IRC § 401(a).

(2) Under a nonqualified plan, employers generally only deduct expenses the

employee or service provider recognizes income. In contrast, under a qualified

plan, employers are entitled to deduct expenses in the year the employer makes

contributions even though employees will not recognize income until the later

years upon receipt of distributions.

(3) Issues that arise when examining NQDC include the timing of income inclusion

for the employee or service provider, the timing of the deduction for the

employer or service recipient, and when deferred amounts are subject to

employment taxes.

A. Background / History

(1) Historically, compensation arrangements (that were not qualified plans) between

service recipients and cash-basis service providers could provide for deferral of

compensation by navigating the doctrines of constructive receipt, economic

benefit, and cash equivalence. The enactment of IRC § 409A under the

American Jobs Creation Act of 2004, amendments to IRC § 409A in the Pension

Protection Act of 2006 (PPA), and the enactment of IRC § 457A as part of the

Emergency Economic Stabilization Act of 2008, significantly changed the

landscape with respect to NQDC plans.

(2) Sections 409A and 457A now regulate how certain deferred compensation

arrangements can be structured. IRC § 409A(a) addresses the design and

operation of deferred compensation arrangements, while IRC § 409A(b)

contains restrictions on deferred compensation funding. For example, IRC §

409A(b)(3) provides special requirements if a company with a single employer

defined benefit (DB) plan is in a restricted period (for example, bankruptcy). The

requirements of IRC §§ 409A and 457A apply in addition to the preexisting

fundamental doctrines and theories of income tax previously mentioned in this

paragraph.

(3) While NQDC plans can be referred to by many names, NQDC plans typically fall

into four categories:

• Salary Reduction Arrangements simply defer the receipt of otherwise

currently includible compensation by allowing the participant to defer

receipt of a portion of his or her salary.

• Bonus Deferral Plans resemble salary reduction arrangements; except

they enable participants to defer receipt of bonuses.

• Top-Hat Plans (also known as Supplemental Executive Retirement

Plans or SERPs) are NQDC plans maintained primarily for a select

group of management or highly compensated employees.

• Excess Benefit Plans are NQDC plans that provide benefits solely to

employees whose benefits under the employer's qualified plan are

limited by IRC § 415.

(4) Despite their name, phantom stock plans are NQDC arrangements, not stock

arrangements. Depending on the terms and conditions, restricted stock units

may also constitute NQDC.

B. Relevant Terms

B.1. Funded vs. Unfunded Plans

(1) NQDC plans are either funded or unfunded, though most are intended to be

unfunded because of the tax advantages unfunded plans afford participants.

(2) An unfunded arrangement is one where the employee has only the employer's

"mere promise to pay" the deferred compensation benefits in the future, and the

promise is not secured in any way. The employer may simply track the benefit in

a bookkeeping account, or it may invest in annuities, securities, or insurance

arrangements to help fulfill its promise to pay the employee, as long the

annuities, securities, or insurance policies are owned by the employer and

remain part of the employer’s general assets. Similarly, the employer may

transfer amounts to a trust that remains a part of the employer's general assets,

subject to the claims of the employer's creditors if the employer becomes

insolvent, help keep its promise to the employee. This type of arrangement is

commonly called a “rabbi trust.” Rev. Proc. 92-64 includes model provisions for

a rabbi trust, including a statement that any assets in the trust are subject to

claims of the employer’s general creditors. To obtain the benefit of income tax

deferral, it is essential that the amounts are not set aside from the employer's

creditors for the exclusive benefit of the employee. If amounts are set aside from

the employer's creditors for the exclusive benefit of the employee, the employee

may have currently includible compensation.

(3) A funded arrangement generally exists if assets are set aside from the claims of

the employer's creditors, for example in a trust or escrow account. A qualified

retirement plan is the classic funded plan. A plan will generally be considered

funded if assets are segregated or set aside so that they are identified as a

source to which participants can look for the payment of their benefits. For

NQDC purposes, it is not relevant whether the assets have been identified as

belonging to the employee. What is relevant is whether the employee has a

beneficial interest in the assets, such as having the amounts shielded from the

employer's creditors or the employee has the ability use these amounts as

collateral. If the arrangement is funded, the benefit is likely taxable under IRC §§

83 and 402(b).

(4) It is important to distinguish between a funding arrangement for an unfunded

plan (i.e., the way an employer decides to satisfy its deferred compensation

obligations) and a funded plan. As discussed above, a funded plan arises when

amounts are set aside from the employer's creditors for the exclusive benefit of

the employee. For example, if an employer purchases an annuity in the name of

an employee, such that the employee can look to the annuity for the payment of

benefits if the employer is unable to pay, the employer has created a funded

plan. On the other hand, if the employer purchases an annuity that is owned by

the employer and merely earmarked to pay that employee’s benefits in the

future, they have created a funding arrangement for an unfunded plan, as long

as the annuity is a general asset of the employer.

(5) As discussed in more detail below, while the use of a funding arrangement (such

as a rabbi trust) may not create a funded plan for purposes of IRC §§ 83 or

402(b), an unfunded rabbi trust can nevertheless be subject to tax under IRC §

409A(b) under certain circumstances.

II. Law / Authority

A. Timing of Income for the Employee or Service Provider

A.1. Constructive Receipt Doctrine – Unfunded Plans

(1) The doctrine of constructive receipt is codified in IRC § 451, which states that

income, although not actually reduced to a taxpayer's possession, is

constructively received in the taxable year in which it is credited to the taxpayer's

account, set apart for the taxpayer, or otherwise made available to the taxpayer.

However, income is not constructively received if the taxpayer’s control of its

receipt is subject to substantial limitations or restrictions. See Treas. Reg. §

1.451-2(a).

(2) Whether an employee has constructively received an amount does not depend

on whether the individual drew on funds, but whether he could have drawn on

the funds without substantial limitations or restrictions.

(3) Two Revenue Rulings explain this doctrine: Rev. Rul. 60-31, 1960-1 C.B. 174;

and Rev. Rul. 67-449, 1967-2 C.B. 173.

A.2. Economic Benefit Doctrine – Funded Plans

(1) Under the economic benefit doctrine, if an individual receives any economic or

financial benefit or property as compensation for services, the value of the

benefit or property is currently includible in the individual's gross income.

(2) IRC § 83 codified elements of the economic benefit doctrine by providing that,

generally, if property is transferred to a person as compensation for services,

such person will be taxed at the time of receipt of the property when it is either

transferable or not subject to a substantial risk of forfeiture. If the property is

neither transferable nor subject to a substantial risk of forfeiture, the taxpayer

does not include the value of the property in income until the property is no

longer subject to a substantial risk of forfeiture or the property becomes

transferable (i.e., the property is substantially vested). See Treas. Reg. § 1.83-1.

In general, the amount included in income is the excess of the property’s fair

market value (at the time of vesting) over the amount, if any, paid for the

property.

(3) Treas. Reg. § 1.83-3(e) provides that the term “property” includes a beneficial

interest in assets (including money) which are transferred or set aside from

claims of creditors of the transferor, for example, in a trust or escrow account.

The term “property” does not include an unfunded and unsecured promise to

pay money in the future. Money that is placed in a rabbi trust to pay deferred

compensation in the future, and that remains subject to the claims of the

employer’s creditors would not constitute a transfer of property under IRC § 83.

(4) Under Treas. Reg. § 1.83-3(c), a substantial risk of forfeiture generally exists

where the transfer of rights in property is conditioned, directly or indirectly, upon

the future performance of substantial services.

(5) See Rev. Rul. 67-449 for a discussion of risk of forfeiture.

(6) See Rev. Proc. 92-64 for model provisions for a rabbi trust.

(7) IRC § 402(b) applies the principles of IRC § 83 to amounts transferred by an

employer to a non-exempt trust for the exclusive benefit of an employee.

A.3. Section 409A

(1) Section 409A provides comprehensive rules governing NQDC arrangements

that apply in addition to the long-standing doctrines of constructive receipt,

economic benefit, and cash equivalency. More specifically, IRC § 409A provides

that all amounts deferred under a NQDC plan for all taxable years are currently

includible in gross income (to the extent not subject to a substantial risk of

forfeiture and not previously included in gross income), unless certain

requirements are met. Section 409A became effective with respect to amounts

deferred or vested in taxable years beginning after December 31, 2004. If IRC §

409A requires an amount to be included in gross income, the statute imposes

substantial additional taxes which are assessed against the employee/service

provider and not the employer/service recipient. Employers must withhold

income tax on any amount includible in the employee’s gross income under IRC

§ 409A. However, the employer is not required to withhold the additional taxes.

See Notice 2008-115 for interim guidance to employers and payers on their

reporting and wage withholding requirements with respect to amounts includible

in gross income under IRC § 409A.

(2) While this Audit Guide generally refers to NQDC plans maintained by an

employer for the benefit of its employees, IRC § 409A applies broadly to any

service provider who earns deferred compensation, including employees,

independent contractors, and non-employee directors. However, independent

contractors may be exempt from IRC § 409A under certain conditions.

A.4. Section 409A(b) Rules Regarding Certain Funding Arrangements

(1) As discussed above, in general, if an employer uses a funding arrangement to

pay for deferred compensation, it will not constitute a funded plan subject to

immediate taxation if the funding arrangement does not result in assets being

set aside from the claims of creditors of the employer (e.g., a rabbi trust).

However, IRC § 409A(b) contains three exceptions to deferral.

(2) Under IRC § 409A(b)(1), if the employer uses an offshore rabbi trust, NQDC is

subject to taxation and additional taxes under IRC § 409A once the

compensation becomes substantially vested. Specifically, if assets are set aside

(directly or indirectly) in a trust to pay deferred compensation, and the trust is

located outside of the United States, it will be treated as a taxable transfer of

property for purposes of IRC § 83, even if the assets are available to satisfy

claims of general creditors.

(3) IRC § 409A(b)(2) applies the same rules to so-called “springing trusts.” If the

employer’s NQDC plan contains a provision, or the employer takes action, so

that assets become restricted to the payment of deferred compensation in

connection with a change in the employer’s financial health, it will be treated as

a taxable transfer of property for purposes of IRC § 83, even if the assets are

available to satisfy claims of general creditors. This type of restriction is often

called a “springing trust” because the trust “springs” to life once the condition (an

adverse change in the employer’s financial health) occurs.

(4) Finally, under IRC § 409A(b)(3), the same tax consequences apply if an

employer transfers assets to a rabbi trust for the benefit of company executives

at the expense of funding a single-employer DB plan for rank and file

employees. Specifically, an employer cannot set aside or reserve assets in a

trust or transfer assets to a trust or other arrangement, for payment of NQDC to

“applicable covered employees” during a “restricted period,” even if the assets

remain available to satisfy claims of general creditors. An “applicable covered

employee” is any IRC § 162(m)(3) “covered employee” or any person who is an

insider for purposes of Section 16 of the Securities Exchange Act of 1934. A

“restricted period” includes a period during which the sponsoring employer also

sponsors a single-employer DB plan that is “at risk,” meaning the plan is

underfunded as defined by the regulations under the qualified plan rules. IRC §

409A(b)(3)(B) defines “at-risk status” by reference to IRC § 430(i).

B. Timing of the Deduction for the Employee or Recipient

(1) The employer's compensation deduction for deferred amounts is governed by

IRC §§ 83(h) and 404(a)(5). In general, an amount is deductible by the

employer when the amount is includible in the employee's income. Interest or

earnings credited to amounts deferred under NQDC plans do not qualify as

interest deductible under IRC § 163. Instead, such amounts are treated as

additional deferred compensation deductible under IRC § 404(a)(5).

C. When Deferred Amounts are Subject to Employment Taxes

(1) IRC § 3121(v) governs the treatment of certain deferred compensation and

salary reduction arrangements for Federal Insurance Contributions Act (FICA)

tax purposes. Section 3121(v)(2)(C) provides that for purposes of IRC §

3121(v)(2), a NQDC plan is “any plan or other arrangement for deferral of

compensation” other than a plan described in IRC § 3121(a)(5).

(2) NQDC amounts are taken into account for FICA tax purposes at the later of

when the services are performed or when there is no substantial risk of forfeiture

with respect to the employee's right to receive the deferred amounts in a later

calendar year. Thus, amounts are subject to FICA taxes at the time of deferral,

unless the employee is required to perform substantial future services to have a

legal right to the future payment. This treatment is referred to as the “special

timing rule.” See Treas. Reg. § 31.3121(v)(2)-1(a)(2)(ii).

(3) NQDC is taxed (“taken into account”) only once under what is commonly called

the "non-duplication rule." See Treas. Reg. § 31.3121(v)(2)-1(a)(2)(iii).

(4) A similar rule to the “special timing rule” applies to FUTA. See IRC § 3306(r)(2)

and Treas. Reg. § 31.3306(r)(2)-1.

III. Name of Issue – When are deferred amounts includible in

employee’s gross income; deductible by the employer; and

considered for employment tax purposes

A. Description of Issue

(1) A NQDC plan examination should focus on when the deferred amounts are

includible in the employee's gross income and when those amounts are

deductible by the employer. The examiner should also address if deferred

amounts were properly taken into account for employment tax purposes. The

timing rules for income tax and for FICA/FUTA taxes are different. This guide

discusses each of these concerns below.

(2) The enactment of IRC § 409A significantly changed the rules governing NQDC

arrangements. Under IRC § 409A, NQDC plans must be in writing. While many

plans are extensively detailed, some are nothing more than a few provisions in

an employment contract. In either event, the language of a NQDC arrangement

is just as important as the way the plan is operated. Review the plan documents

to identify provisions that fail to comply with the requirements of IRC § 409A

(document compliance). The NQDC plan must also comply with the operational

requirements applicable under IRC § 409A (operational compliance). That is,

while the parties may have a valid NQDC arrangement on paper, they may not

operate the plan according to the plan's provisions. As noted above, NQDC

arrangements subject to IRC § 409A remain subject to other tax doctrines,

including constructive receipt, economic benefit, and cash equivalency.

(3) Further, as described above, IRC §§ 409A(b)(1)-(3) specifically prohibit the use

of certain NQDC funding arrangements, including offshore rabbi trusts, springing

rabbi trusts, and rabbi trusts funded for the benefit of company executives at the

expense of funding a single-employer DB plan for the benefit of rank and file

employees.

A.1. Law/Authority Related to Includability by Employee/Service

Provider

(1) Includability by Employee / Service Provider

(2) IRC § 409A(a) Inclusion in gross income of deferred compensation under NQDC

plans; rules relating to constructive receipt.

(3) IRC § 409A(b) Inclusion in gross income of deferred compensation under NQDC

plans; rules relating to funding.

(4) Prop. Reg. § 1.409A-4 Calculation of amount includible in income and additional

income taxes

(5) IRC § 451(a) Constructive receipt of income

(6) Treas. Reg. § 1.451-2(a) Constructive receipt of income

(7) IRC §§ 83(a) and 83(h) Property transferred in connection with performance of

services; General rule and deduction by employer.

(8) Treas. Reg. §§ 1.83-1 and 1.83-3 Property transferred in connection with the

performance of services; Meaning and use of certain terms.

(9) IRC § 402(b) Taxability of beneficiary of nonexempt trust

(10) Sproull v. Commissioner, 16 T.C. 244 (1951), aff’d per curiam, 194 F.2d 541 (6th

Cir. 1952) sets forth the economic benefit doctrine.

(11) Rev. Rul. 60-31 A mere unsecured promise to pay is not current compensation.

(12) Rev. Rul. 67-449 General rule for taxable year of inclusion

(13) Notice 2007-34 Guidance regarding the application of IRC § 409A to split-dollar

life insurance arrangements.

A.2. Law / Authority Related to Deduction by Employee/Service

Recipient

(1) IRC § 409A(a) Inclusion in gross income of deferred compensation under NQDC

plans; rules relating to constructive receipt.

(2) IRC § 409A(b) Inclusion in gross income of deferred compensation under NQDC

plans; rules relating to funding.

(3) Prop. Reg. § 1.409A-4 Calculation of amount includible in income and additional

income taxes

(4) IRC § 451(a) Constructive receipt of income

(5) Treas. Reg. § 1.451-2(a) Constructive receipt of income

(6) IRC §§ 83(a) and 83(h) Property transferred in connection with performance of

services; General rule and deduction by employer.

(7) Treas. Reg. §§ 1.83-1 and 1.83-3 Property transferred in connection with the

performance of services; Meaning and use of certain terms.

(8) IRC § 402(b) Taxability of beneficiary of nonexempt trust

(9) Sproull v. Commissioner, 16 T.C. 244 (1951), aff’d per curiam, 194 F.2d 541 (6th

Cir. 1952) sets forth the economic benefit doctrine.

(10) Rev. Rul. 60-31 A mere unsecured promise to pay is not current compensation.

(11) Rev. Rul. 67-449 General rule for taxable year of inclusion

(12) Notice 2007-34 Guidance regarding the application of IRC § 409A to split-dollar

life insurance arrangements.

(13) IRC § 404(a)(5) Deduction for compensation under a deferred payment plan

A.3. Law/Authority Related to Employment Tax Reporting

(1) Treas. Reg. § 31.3121(a)-2(a) Wages; when paid and received

(2) Treas. Reg. § 31.3121(v)(2)-1 Treatment of amounts deferred under certain

NQDC plans.

(3) Treas. Reg. § 31.3121(v)(2)-1(a)(2)(iii) Inclusion in wages only once (non-

duplication rule)

(4) Treas. Reg. § 31.3121(v)(2)-1(c)(1)(ii) Account balance plans definitions

(5) Treas. Reg. § 31.3121(v)(2)-1(c)(2)(i) Determination of the amount deferred;

General rule for non-account balance plans.

(6) Treas. Reg. § 31.3121(v)(2)-1(d) Amounts taken into account and income

attributable thereto.

(7) Treas. Reg. § 31.3121(v)(2)-1(e)(1) Time amounts deferred are required to be

taken into account

(8) IRC § 3306(r)(2) Treatment of certain NQDC plans as wages.

(9) Treas. Reg. § 31.3306(r)(2)-1 Treatment of amounts deferred under certain

NQDC plans.

(10) Notice 2008-115 Reporting and wage withholding under IRC § 409A.

(11) Notices 2008-113 and 2010-6 set forth self-correction programs for operational

and document failures under IRC § 409A, respectively, both as amended by

Notice 2010-80.

(12) As noted above, NQDC arrangements subject to IRC § 409A remain subject to

other tax doctrines, including constructive receipt, economic benefit, and cash

equivalency.

(13) Further, as described above, IRC §§ 409A(b)(1)-(3) specifically prohibit the use

of certain NQDC funding arrangements, including offshore rabbi trusts, springing

rabbi trusts, and rabbi trusts funded for the benefit of company executives at the

expense of funding a single-employer DB plan for the benefit of rank and file

employees.

B. When are Deferred Amounts Included in the Employee’s Gross

Income

B.1. Constructive Receipt Doctrine - Unfunded Plans

(1) Cash basis taxpayers must include gains, profits, and income in gross income

for the taxable year in which the actually or constructively receive the item.

Under the constructive receipt doctrine (codified in IRC § 451(a)), income not

actually in the taxpayer's possession is constructively received by him in the

taxable year during which it is credited to his account, set apart for him, or

otherwise made available so that he may draw upon it at any time, or so that he

could have drawn upon it during the taxable year if notice of intention to

withdraw had been given. However, income is not constructively received if the

taxpayer's control of its receipt is subject to substantial limitations or restrictions.

See Treas. Reg. § 1.451-2(a).

(2) Establishing constructive receipt requires a determination that the recipient had

control of the receipt of the deferred amounts and that such control was not

subject to substantial limitations or restrictions. It is important to scrutinize all

plan provisions relating to each type of distribution or access option. It also is

imperative to consider how the plan has been operating, regardless of the

existence of provisions relating to the types of distributions or other access

options. Employers may use devices such as credit cards, debit cards, and

checkbooks to grant employees unrestricted control of the receipt of the deferred

amounts. Similarly, permitting employees to borrow against their deferred

amounts may result in current income.

B.2. Economic Benefit – Funded Plans

(1) Under the economic benefit doctrine, if an individual receives any economic or

financial benefit or property as compensation for services, the value of the

benefit or property is currently includible in the individual's gross income. More

specifically, the doctrine requires an employee to include in current gross

income the value of assets that have been unconditionally and irrevocably

transferred as compensation into a fund for the employee's sole benefit, if the

employee has a nonforfeitable interest in the fund.

(2) IRC § 83 codified certain elements of the economic benefit doctrine in the

employment context by providing generally that if property is transferred to a

person as compensation for services, the service provider will be taxed at the

time of receipt of the property if the property is either transferable or not subject

to a substantial risk of forfeiture. If the property is neither transferable nor subject

to a substantial risk of forfeiture, the taxpayer does not have income until the

property is no longer subject to a substantial risk of forfeiture or the property

becomes transferable (i.e., the property becomes substantially vested). See

Treas. Reg. § 1.83-1. In general, the amount included in income is the excess of

the fair market value of the property (at the time of vesting) over the amount, if

any, paid for the property.

(3) For purposes of IRC § 83, the term "property" includes real and personal

property other than money or an unfunded and unsecured promise to pay

money in the future. However, the term also includes a beneficial interest in

assets, including money that is transferred or set aside from claims of the

transferor’s creditors, for example, in a trust or escrow account. See Treas. Reg.

§ 1.83-3(e). The term “property” does not include an unfunded and unsecured

promise to pay money in the future. Thus, money that is placed in a rabbi trust to

pay deferred compensation in the future that remains subject to the claims of

creditors of the employer is not a transfer of property under IRC § 83.

(4) Property is subject to a substantial risk of forfeiture if the individual's right to the

property is conditioned on the future performance of substantial services or on

the nonperformance of services (such as a covenant not to compete). In

addition, a substantial risk of forfeiture exists if rights in the transferred property

are conditioned upon the occurrence of a condition related to a purpose of the

transfer and there is a substantial possibility that the property will be forfeited if

the condition is not met.

(5) Property is considered transferable if a person can transfer his or her interest in

the property to anyone other than the transferor from whom the property was

received. However, property is not considered transferable if the subsequent

transferee's rights in the property are subject to a substantial risk of forfeiture.

B.3. Cash Equivalency

(1) Related to the economic benefit doctrine is another legal doctrine examiners

should consider when analyzing a NQDC arrangement: the cash equivalency

doctrine. Under the cash equivalency doctrine, if a promise to pay has certain

characteristics, it is treated as equivalent to cash and gives rise to current

taxation. If a solvent obligor's promise to pay is unconditional and assignable,

not subject to set-offs, and is of a kind that is frequently transferred to lenders or

investors at a discount not substantially greater than the generally prevailing

premium for the use of money, such promise is the equivalent of cash and

taxable in a like manner as cash would have been taxable had it been received

by the taxpayer rather than the obligation. More simply, the cash equivalency

doctrine provides that, if the right to receive a payment in the future is reduced to

writing and is transferable by the service provider, such as in the case of a note

or a bond, the right is considered to be the equivalent of cash and the value of

the right is includible in gross income.

B.4. Section 409A

(1) Section 409A provides that all amounts deferred under a NQDC plan for all

taxable years are currently includible in gross income (to the extent not subject

to a substantial risk of forfeiture and not previously included in gross income),

unless certain requirements are satisfied.

(2) In general, there are four principal requirements. First, an initial deferral election

specifying the time and form of payment must generally be made before the

calendar year in which the employee provides services for which the

compensation is earned. Second, a taxpayer can elect to delay the payment

date or change the form of payment of deferred compensation through a

subsequent deferral election, but only if certain requirements, generally

regarding timing, are met. Third, NQDC can be paid only upon the occurrence of

one or more permissible payment events: a specified time or fixed schedule,

separation from service, unforeseeable emergency, disability, change of control,

or death. Fourth, payment of NQDC cannot be accelerated or delayed except

the regulations permit.

(3) A “nonqualified deferred compensation plan” under IRC § 409A is broadly

defined as any plan, agreement, method, program, or other arrangement that

provides for the deferral of compensation, other than a qualified employer plan

and certain other specified plans. As a default rule, a deferral of compensation

generally occurs if the employee obtains a legally binding right to compensation

in a taxable year, and the compensation is (or may be) payable to the employee

in a later taxable year. However, the “short-term deferral” rule provides an

important exception to IRC § 409A. Under the short-term deferral rule, an

amount to which an employee has a legally binding right that is substantially

vested and that is payable no later than March 15 of the subsequent year is not

subject to IRC § 409A. For example, if the promised amounts are subject to a

substantial risk of forfeiture (i.e., a requirement to perform substantial services or

the attainment of a performance goal which is subject to substantial risk) and the

amounts are to be paid no later than March 15 of the next year after the year in

which the substantial risk of forfeiture lapses (that is, the employee vests in the

compensation), then the amounts are not deferred compensation under IRC §

409A and are therefore not subject to its requirements.

(4) Section 409A provides that deferrals that become includible in the employee’s

income due to a violation of IRC § 409A must be reported separately on Form

W-2 (box 12 code “Z”) and Form 1099 (box 14), as applicable. The amounts are

also subject to an additional 20% income tax and a second tax based on an

imputed underpayment of interest referred to as the “premium interest tax”. The

premium interest tax is computed based on the taxable year in which the amount

was initially deferred or, if later, the first taxable year in which the amount

vested. Amounts included in an employee’s income under IRC § 409A are

wages for employment tax purposes.

(5) Section 409A is not limited to NQDC arrangements with employees. It applies

broadly to any service provider who earns deferred compensation, including

employees, independent contractors, and non-employee directors. Independent

contractors may be exempt from IRC § 409A if certain conditions are met.

B.5. Section 409A(b) Rules Regarding Certain Funding Arrangements

(1) 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). IRC § 409A(b) contains three

exceptions to this rule, however.

(2) Under IRC § 409A(b)(1), if the employer uses an offshore rabbi trust, NQDC is

subject to taxation and additional taxes under IRC § 409A once the

compensation becomes vested. Specifically, if assets are set aside (directly or

indirectly) in a trust to pay deferred compensation, and the trust is located

outside of the United States, it will be treated as a transfer of property for

purposes of IRC § 83, 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.

(3) Likewise, under IRC § 409A(b)(2), if the employer’s NQDC plan contains a

provision, or the employer takes action, so that assets become restricted to the

payment of deferred compensation in connection with a change in the

employer’s financial health, it will be treated as a transfer of property for

purposes of IRC § 83, even if the assets are available to satisfy claims of

general creditors. Income inclusion and the additional IRC § 409A taxes 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).

(4) Finally, under IRC § 409A(b)(3), the same tax consequences apply 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

DB 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 DB plan is in a restricted period).

(5) Under IRC § 409A(b)(3)(A)(ii), an amount set aside for an applicable covered

employee is treated as income under IRC § 83 regardless of whether such

amount is subject to the claims of the employer’s creditors. After such deemed

IRC § 83 transfer, as long as assets remain set aside, any increase in the value

of the assets is treated as an additional transfer, and thus results in additional

tax liability.

(6) For purposes of IRC § 409A(b)(3), a restricted period with respect to a DB plan

means (1) any period in which the company is in bankruptcy; (2) any period in

which the DB plan is in “at-risk” status as defined in IRC § 430(i); or (3) the 12-

month period beginning six months before the plan’s involuntary termination if

the plan does not have sufficient assets to cover benefit liabilities (within the

meaning of ERISA § 4041).

(7) An “applicable covered employee” is any current or former employee of the plan

sponsor or any member of the plan sponsor’s controlled group who is, or was at

the time of their termination of employment, an IRC § 162(m)(3) “covered

employee” or an insider for purposes of Section 16 of the Securities Exchange

Act of 1934.

(8) IRC § 409A(b)(3) applies to the controlled group of which the employer is a

member under IRC § 414. That is, IRC § 409A(b)(3) can apply if the NQDC plan

and the single-employer DB plan in question are sponsored by different

companies within the same controlled group.

(9) Section 409A(b)(3) requires an examiner to review both the NQDC plan (and

operation of the plan) and any single-employer DB 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 (including bankruptcy). An examiner

should consider the following:

• Did the company report assets set aside to pay deferred compensation

to certain key executives while in a restricted period as income to these

employees?

• Did the company report the correct amount of income taxation for these

key executives?

• Review Form 1040 for these key executives to determine if each

executive computed the 20% additional income tax and premium interest

tax.

(10) Go to Section V Example Worksheets and Exhibits: Exhibit 1-page 2.

C. When are Deferred Amounts Deductible by the Employer?

(1) The employer’s compensation deduction is governed by IRC §§ 83(h) and

404(a)(5). In general, an amount is deductible by the employer when the amount

is includible in the employee's income. Interest or earnings credited to amounts

deferred under NQDC plans do not qualify as interest deductible under IRC §

163. Instead, such amounts are treated as additional deferred compensation

deductible under IRC § 404(a)(5).

(2) If deferred compensation is included in gross income earlier due to failure to

meet the requirements of IRS § 409A, as discussed in Issue #1, this

correspondingly accelerates the employer’s deduction.

D. When are deferred amounts considered for employment tax

purposes?

(1) The timing of when there is a payment of wages for FICA and FUTA tax

purposes is not affected by whether an arrangement is funded or unfunded.

However, whether an amount is funded is relevant in determining when amounts

are includible in income and subject to income tax withholding.

D.1. FICA

(1) NQDC amounts are taken into account for FICA tax purposes at the later of

when the services are performed or when there is no substantial risk of forfeiture

with respect to the employee's right to receive the deferred amounts in a later

calendar year. Thus, amounts are subject to FICA taxes at the time of deferral,

unless the employee is required to perform substantial future services for the

employee to have a legal right to the future payment. If the employee is required

to perform future services to have a vested right to the future payment, the

deferred amount (plus earnings up to the date of vesting) is subject to FICA

taxes when all the required services have been performed. FICA taxes apply up

to the annual wage base for Social Security taxes and without limitations for

Medicare taxes.

D.2. FUTA

(1) NQDC amounts are taken into account for FUTA purposes at the later of when

services are performed or when there is no substantial risk of forfeiture with

respect to the employee's right to receive the deferred amounts up to the FUTA

wage base.

D.3. Income Tax Withholding

(1) Employers must withhold income taxes from NQDC amounts at the time the

amounts are actually or constructively received by the employee.

D.4. Interest Credited to Amounts Deferred

(1) In general, the non-duplication rule in Treas. Reg. § 31.3121(v)(2)-1(a)(2)(iii)

operates to exclude from wages interest or earnings credited to amounts

deferred under a NQDC plan. However, Treas. Reg. § 31.3121(v)(2)-1(d)(2)

limits the scope of the non-duplication rule to an amount that reflects a

reasonable rate of return.

(2) In the context of an account balance plan, a reasonable rate of return is a rate

that does not exceed either the rate of return on a predetermined actual

investment or a reasonable rate of interest. Examples of a reasonable rate of

interest are Moody's Average Corporate Bond Yield and the rate of total return

on the employer's publicly traded common stock. Fixed rates are permitted as

long as the rate is reset no later than the end of the fifth calendar year that

begins after the beginning of the period for the amount deferred. For further

information on reasonable rates of return please see examples in Treas. Reg. §

31.3121(v)(2)-1(d). In the context of a plan that is not an account balance plan,

the non-duplication rule only applies to an amount determined using reasonable

actuarial assumptions.

(3) An account balance plan segregates each employee's deferred compensation

account balance on the company's books. An accounting record (an account) is

kept for each participant. The amount an employee elects to defer is credited to

his account, as are the related earnings. The employee's future payments under

the plan are based on the amounts credited to his account as deferred

compensation and the income credited to the employee's account. See Treas.

Reg. § 31.3121(v)(2)-1(c)(1)(ii). This is generally a bookkeeping entry only.

(4) Amounts are taken into account for an account balance plan at the later of when

the services are completed, or when there is no substantial risk of forfeiture. See

Treas. Reg. § 31.3121(v)(2)-1(e)(1).

(5) A non-account balance plan will not have "hypothetical" bookkeeping accounts

that record the employee's deferrals and employee "contributions" and

investment earnings. The amount deferred for a period is not necessarily an

amount the worker has elected not to receive. Rather, the amount deferred, and

thus required to be taken into account, is the present value of the payments the

plan participant has a right to receive in the future. See Treas. Reg. §

31.3121(v)(2)-1(c)(2)(i). Conceptually, the plan is similar to a defined benefit

plan. Thus, if a NQDC plan credits the deferral with excessive interest, or pays

benefits based on unreasonable actuarial assumptions, additional amounts are

taken into account when the excessive or unreasonable amounts are credited to

the participant's account. If the employer does not take the excess amount into

account, then the excess amount plus earnings on that amount are FICA taxable

upon payment.

IV. Examination Techniques

(1) Interview the company personnel that are most knowledgeable on executive

compensation practices, such as the director of human resources or a plan

administrator.

• Determine who is responsible for the day-to-day administration of the

plans within the company. For example, who processes the deferral

election forms, maintains the account balances, and processes the

payments? Administration may be performed in-house by the employer

or by a third-party administrator.

• Review the deferral election forms and any amended or changed

election forms.

• Review the executive compensation disclosures in Securities and

Exchange Commission filings such as the corporation's proxy

statements and exhibits to its annual reports. Proxy statements can be

located by performing an Edgar search for the company's "DEF 14A"

filings. Proxy statements will include a section titled “Compensation

Discussion and Analysis” describing the company’s executive

compensation arrangements, including deferred compensation plans. If

the stockholders are asked to vote on a compensation plan, the proxy

statement (DEF 14A filing) for that particular meeting will have an exhibit

of the plan as an attachment containing detailed disclosures. Annual

reports can be located by performing an Edgar search for the company’s

“Form 10-K” filings. Deferred compensation plans that a company has

adopted should be listed as an exhibit to the annual report (Form 10-K).

Also, review the notes to the financial statements found in the annual

report (Form 10-K). The financial statements for a non-public company

may also contain a description of any nonqualified deferred

compensation arrangements.

• Determine whether the company paid a benefits consulting firm for the

executive's wealth management. Review a copy of the contract between

the consulting firm and the corporation. Determine who is administering

the plan. Determine what documents are created by the administrator

and who is maintaining the documents.

• Determine what funding arrangements, if any, a company uses in

connection with its deferred compensation plans. Funding arrangements

may include trusts, escrows, annuities, or life insurance. Review the

terms of any funding arrangements to determine whether assets are set

aside for the exclusive benefit of employees in a way that triggers the

application of IRC §§ 83, 402(b), and/or the economic benefit doctrine,

or in a way that would be subject to IRC §§ 409A(b)(1)-(3). Note that a

company may not always utilize a formal funding arrangement and may

instead pay for deferred compensation using company cash when the

compensation becomes due.

• Review the ledger accounts/account statements for each plan

participant, noting current year deferrals, distributions, and loans.

Compare the distributions to amounts reported on the employee's Form

W-2 for deferred compensation distributions. Determine the reason for

each distribution. Check account statements for any unexplained

reduction in account balances. Any distributions other than those for

death, disability, or termination of employment need to be explored in-

depth, and Counsel may need to be contacted.

(2) Issues involving constructive receipt and economic benefit generally will present

themselves in the administration of the plan, in actual plan documents,

employment agreements, deferral election forms, or other communications

(written or oral and formal or informal) between the employer and the employee.

The issues may also be present in related insurance policies and annuity

arrangements.

(3) Ask the following questions and request documentary substantiation where

appropriate:

• Does the employer maintain any qualified retirement plans?

• Does the employer have any plans, agreements, or arrangements for

employees that supplement or replace lost or restricted qualified

retirement benefits?

• Does the employer maintain any NQDC arrangements, or any trusts,

escrows, or separate accounts for any employees? If yes, obtain

complete copies of each plan including all attachments, amendments,

restatements, etc.

• Do employees have individual employment agreements?

• Do employees have any salary or bonus deferral agreements?

• Does the employer have an insurance policy, or an annuity plan

designed to provide retirement or severance benefits for executives?

• Are there any board of directors' minutes or compensation committee

resolutions involving executive compensation?

• Review the annual report, financial statements, or SEC filings for a

public company, for terms like “deferred compensation,” “409A,” "Rabbi

Trust," "Top-Hat" Plan, "Supplemental Executive Retirement Plan”

(SERP), "Excess Benefit Plan," etc. Evidence of NQDC deferrals by the

executives may be found in the following:

• An adjustment on Schedule M-3, Part III, Line 18

("Deferred Compensation")

• Form W-2 for the executive shows Medicare wages (box

5) exceeding gross wages (box 1) by more than the

amount deferred under a qualified plan.

• Is there any other written communication between the employer and the

employees that sets forth "benefits," "perks," "savings," "severance

plans," or "retirement arrangements"?

(4) When reviewing the answers and documents received in response to these

questions, look for indications that.

• The employee has control over the receipt of the deferred amounts

without being subject to substantial limitations or restrictions. If the

employee has such control, the amounts are taxable under the

constructive receipt doctrine. For example, the employee may borrow,

transfer, or use the amounts as collateral, or there may be some other

signs of ownership exercisable by the employee, which should result in

current taxation for the employee.

• Amounts have been set aside for the exclusive benefit of the employee.

Amounts are set aside if they are not available to the employer's general

creditors if the employer becomes bankrupt or insolvent. Also confirm

that no preferences have been provided to employees over the

employer's other creditors in the event of the employer's bankruptcy or

insolvency. If amounts have been set aside for the exclusive benefit of

the employee, or if the employee receives preferences over the

employer/service recipient's general creditors, the employee has

received a taxable economic benefit. Also verify whether the

arrangements result in the employee receiving something that is the

equivalent of cash.

• The company has used a funding mechanism that would be subject to

IRC § 409A(b)(1)-(3), even if the company has not set aside assets for

the exclusive benefit of the employee. This would include (1) an offshore

rabbi trust, (2) a springing rabbi trust (i.e., assets transferred to a rabbi

trust in connection with a change in the employer’s financial health), or

(3) a rabbi trust funded for certain key executives during a “restricted

period” with respect to a DB plan, contrary to IRC § 409A(b)(3). In

connection with IRC § 409A(b)(3), the examiner may want to determine

if the employer maintains any qualified retirement plans.

• Look for references to "Defined Benefit" or "Pension" Plan in SEC

statements, financial statements, employee handbooks, or union

contracts.

• Review Schedule M-3, Part III, Line 16 ("Pension and profit-sharing")

• Look for indicators in the financial statements that the Defined

Benefit/Pension Plan may be underfunded or in at-risk status.

• Review Schedule SB of Form 5500, Part I Basic Information line 4,

noting if the box is checked which indicates the plan is in at-risk status

with an Adjusted Funding Target Attainment Percentage of less than

80%.

(5) Other items to consider:

• The employer's deduction must match the employee's inclusion of the

compensation in income. The employer must be able to show that the

amount of deducted deferred compensation matches the amount

reported on the Forms W-2 that were furnished and filed for the year. In

addition, the employer's deduction may be limited by IRC § 162(m).

• Verify that a Schedule M adjustment was made to the Form 1120 for the

amount of deferred compensation expensed on the employer's books

but was not deductible because the compensation was not includible in

income by the employees.

• Generally, the current year's deferrals should be adjusted on the

Schedule M. Note that the employer may have netted the current year's

deferrals against distributions made during the year. This might obscure

the amount that is not deductible. In the year the deferred compensation

is paid, the employer will make an adjustment on the Schedule M for a

deduction that was not expensed on its books that decreases taxable

income.

• Verify that the employer made appropriate Schedule M adjustments in

prior years for amounts distributed and for which the employer took a

deduction in the current year. Determine that the employer did not take a

deduction in the year the employee deferred the income and another

deduction in the year the employer paid the deferred compensation to

the employee. Many deferrals are for more than 5 years - ask the Team

Coordinator if these Schedule M adjustments are still at the audit site. If

the Team Coordinator does not have the Schedule M's for the earlier

years, ask the employer for them. If you determine that the employer

deducted the compensation in the wrong year, consider if a change in

accounting method is appropriate so as not to permit a double

deduction.

• For current year distributions that are excluded from wages for FICA

taxes, verify that these amounts were taken into account in prior years.

• Examine Forms W-2 for proper timing of wage reporting. Income tax

withholding is generally required at the time the funds are distributed to

the participants and is reported in Box 2. Current year distributions are

reported in Box 1 as wages and are also reported in Box 11.

• Deferred amounts are taxable for FICA (Social Security and Medicare)

and FUTA at the later of when the services are performed creating the

right to the amounts or when the amounts are no longer subject to a

substantial risk of forfeiture. When the amounts are taken into account

for FICA and FUTA purposes, the amounts are reported in Box 3 for

Social Security wages (subject to the Social Security wage base) and

Box 5 for Medicare wages. Unless the amount deferred is subject to a

substantial risk of forfeiture, the amount deferred should be included in

wages for FICA and FUTA purposes for the year that the services are

performed creating the right to the amount.

• Analyze the database of Forms W-2 for discrepancies between Box 1

wages and Box 5 Medicare wages. Generally, Box 1 wages plus 401(k)

contributions will equal Medicare wages. If NQDC plans exist, large

differences will occur. Excess Medicare wages generally represent

current year deferrals of income, while shortages indicate current year

distributions.

A. Additional Information

(1) A NQDC plan that references the employer's IRC § 401(k) plan may contain a

provision that could cause disqualification of the IRC § 401(k) plan. IRC §

401(k)(4)(A) and Treas. Reg. § 1.401(k)-1(e)(6) provide that an IRC § 401(k)

plan may not condition any other benefit (including participation in a NQDC)

upon the employee's participation or nonparticipation in the IRC § 401(k) plan.

Review NQDC plans looking for a provision that limits the total amount that can

be deferred between the NQDC plan and the IRC § 401(k) plan. Also look for

any NQDC provision which states that participation is limited to employees who

elect not to participate in the IRC § 401(k) plan. Contact Employee Plans in the

TEGE Operating Division or Counsel in TEGEDC if provisions such as these are

encountered.

V. Example Worksheets / Exhibits

(1) Exhibit 1: Steps to determine if IRC § 409A(b)(3) applies. To determine whether

IRC § 409A(b)(3) applies, the examiner must review both the NQDC plan and

single-employer DB plan to know if an employer is setting aside assets to pay

deferred compensation when in a restricted period (including bankruptcy).