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To Defer or Not to Defer, That Is the Question: Same Year Deferral Options under Section 409A

With the 2016 tax return season now in the rearview mirror, it’s time to consider what financial planning options can be taken to defer 2017 and later compensation. In particular, if anticipated tax-reform efforts result in lowering individual tax rates, individuals may wish to defer 2017 income into later years. One such option is to take advantage of certain same-year deferral opportunities permitted under Section 409A of Internal Revenue Code of 1986, as amended (Section 409A).

As background, Section 409A sets forth certain specific requirements with respect to the timing of initial elections to defer compensation. In general, an election must be made in the calendar year prior to the calendar year in which the services for such compensation are first performed. This is why deferral elections with respect to calendar year compensation, such as base salary and annual bonuses tied to the calendar year, are generally required to be made by December 31 of the calendar year that precedes the year in which the services for such compensation are first performed. However, under certain circumstances, it is permissible under Section 409A to make an initial deferral election after the calendar year has commenced.

Newly Eligible

If an employer has never adopted a nonqualified deferred compensation plan that permits employees to defer compensation and/or an employee had not previously been eligible to participate in the employer’s nonqualified deferred compensation plan, Section 409A permits a newly eligible employee to make an initial deferral election during the calendar year. In order to make an initial deferral election midyear, (i) the employee must make the deferral election within 30 days of first becoming eligible to participate in the deferred compensation plan and (ii) the election can only relate to compensation paid for services that are performed after the election is made. For this newly eligible deferral election to be available, the employee must not have been previously eligible to participate in any other nonqualified deferred compensation plan of the employer that is required to be aggregated with such plan under the Section 409A regulations (e.g., if the employee was eligible to participate in the plan but did not elect to participate, the newly eligible deferral election would not be available). If the employer has an existing nonqualified deferred compensation plan, this newly eligible election opportunity would generally be available for new hires and/or promotions to a position that would make the employee first eligible for the plan. This opportunity would also be available for an employer that had not previously adopted a nonqualified deferred compensation plan; however, it is not available as a replacement for an existing plan.

Performance-Based Compensation

If an employee is eligible to receive a performance-based bonus and such bonus qualifies as “performance-based compensation” under the Section 409A regulations, an initial deferral election may be made with respect to such bonus so long as the election is made at least six months prior to the end of the performance period for such bonus. For example, a qualifying calendar-year bonus would need an initial deferral election by June 30. In order to qualify as performance-based compensation, the Section 409A regulations provide that the compensation must be contingent on the satisfaction of preestablished organizational or individual performance goals for a performance period of at least 12 months. The performance goals must also generally be objective, established within 90 days of the beginning of the performance period, and substantially uncertain to be met at the time the performance goals are set. This option would be available to any employer that has an annual bonus or long-term bonus program that meets the performance-based compensation requirements of the Section 409A regulations, provided that the bonus is not readily ascertainable at the time the election is made.

Fiscal Year Bonus Compensation

If an employer’s fiscal year is not the calendar year, a deferral election opportunity is available for any fiscal year compensation payable by such employer, provided that the deferral election is made prior to the beginning of the applicable fiscal year. An example of fiscal year compensation is a bonus program of an employer that measures performance over the employer’s fiscal year (e.g., June 1 through May 31). This election would not be available for an employer that has a calendar year bonus program, even though the employer’s fiscal year is not the calendar year, nor, in any case, for the base salary of an employee paid after the beginning of the fiscal year.

Takeaways

The foregoing are a couple of examples under Section 409A of initial deferral elections that can be made after the calendar year has begun. If any of these are to be considered, it is important to ensure that all of the requirements under Section 409A are met for such deferral elections. Since the above are just a summary of these requirements, employers should be sure to consult with counsel before implementing any of these approaches. As a result, if you are questioning whether you can defer after the calendar year has begun—the answer is yes, provided you fall within a Section 409A midyear deferral election exception. If such an exception is not available to you, it’s not too early to start thinking about deferral elections and implementing a deferral program for 2018 compensation.

Copyright © 2017 by Morgan, Lewis & Bockius LLP. All Rights Reserved.

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About this Author

Partner

David B. Zelikoff is a partner in Morgan Lewis's Employee Benefits and Executive Compensation Practice. Mr. Zelikoff is experienced in all facets of employee benefits and executive compensation, including qualified plans, nonqualified deferred compensation plans and arrangements, equity compensation plans, employee benefits issues in mergers and acquisitions, employment matters, securities issues relating to employee benefits and executive compensation, executive compensation issues for REITs, and welfare plans.

Mr. Zelikoff is also actively involved in pension...

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