Plan deferred compensation before the election deadline. Review payment terms, employer credit risk, tax timing and administrative responsibilities.

September 16, 2024 · Financial Forte Staff

Historical article: prepared retrospectively using information available as of September 16, 2024.

A valued employee asks to defer a bonus shortly before payment. The request may sound like a simple payroll instruction: keep the money now and pay it in a later year. For nonqualified deferred compensation, the timing of the election can be central to whether the arrangement works as intended.

Review the compensation, service period, election deadline and payment terms before making a promise. Section 409A can govern both the documents and operation of a deferred compensation arrangement, with specific exceptions and potentially significant consequences for failures. Moving the check date alone does not establish a compliant deferral.[1][2]

Start with when the compensation is earned

Under the general initial-election rule, an employee's election to defer compensation for services in a calendar year generally must be made before that year begins. Limited exceptions can apply, including rules involving first eligibility and certain performance-based compensation. Those exceptions have conditions; an annual bonus is not automatically eligible for a later election simply because it depends on performance.[1]

Consider a hypothetical employer discussing its 2025 compensation program in September 2024. Assume Morgan is a calendar-year taxpayer and the proposed arrangement is subject to Section 409A, with no applicable exception to the general initial-election rule. Morgan, a senior employee, wants to defer part of compensation for services to be performed during 2025. The company has time to have the arrangement reviewed and establish the required election process before the applicable deadline.

Now compare a request made in September 2024 to defer a bonus attributable to 2024 services, even though it will be paid in March 2025. Under the general rule, the payment date does not convert those services into 2025 services. The employer needs a specific legal analysis of whether Section 409A applies, including any short-term-deferral exception, and whether an election exception permits the requested change. The March payment date alone does not answer those questions.

The business should not backdate an election or describe a new agreement as though it existed earlier. If the desired treatment is not available, it may be necessary to pay the compensation under its existing terms and plan differently for future service periods. A disappointing answer now can be less costly than creating an unsupported arrangement.

Define the payment promise as carefully as the deferral

The documents should specify the applicable time or event for payment and the form of payment under the rules. A future fixed date and payment upon a defined separation from service are different provisions. Terms that sound flexible in conversation can have specific meanings and restrictions under Section 409A.[1][2]

For an illustration, suppose Morgan would otherwise receive a $60,000 bonus and elects, through an otherwise compliant arrangement, to defer $20,000. Current cash compensation from that bonus would be $40,000 before applicable withholding and other deductions. The deferred $20,000 is a future promise under the plan, not an additional $20,000 received now.

The employer must understand when the future amount becomes payable and how it will be funded. Recording a liability does not itself reserve cash. Three otherwise identical $20,000 promises due together would require $60,000 before any additional credited amounts. If several executives have payments due in the same year, compare those obligations with working capital, other debt and less favorable revenue scenarios.

Morgan needs the same clarity from the employee side. An expense that arises before the scheduled payment does not automatically permit early access. Later changes or acceleration can be restricted, and the employer and employee cannot assume mutual agreement overrides the tax rules.[1][2]

The tax discussion also needs precision. Income-tax treatment, employment-tax timing and deduction timing do not necessarily move together. Avoid telling an employee that every tax is postponed until cash is paid without a review of the actual arrangement.[2]

Explain the employer-credit risk in ordinary language

An unfunded nonqualified promise is different from a participant's account in a qualified retirement plan. The employee needs to understand the employer's obligation and what happens if the business cannot pay. A balance shown on a statement should not imply that assets are protected in the same manner as qualified-plan assets.[2]

That risk may matter especially when the employee already relies on the company for salary and other benefits. Deferring more compensation can increase dependence on the same business. The arrangement may still have value, but it should be evaluated alongside the employee's need for current cash and diversification of financial exposure.

From the employer's perspective, a deferred benefit may support retention or a longer-term compensation objective. It also creates a liability and administrative work. Define what the program is intended to accomplish and how the business will assess it without promising that a payment condition guarantees employees will stay.

Assign oversight before the first election

Legal counsel, tax advisors, payroll and the plan administrator should agree on the responsibilities and calendar. Identify who validates eligibility, approves documents, records elections, tracks payment events and checks payroll reporting. An email expressing an employee's preference is not a complete administrative system.

Some unfunded arrangements for a select group of management or highly compensated employees may qualify for limited ERISA exemptions. That does not mean they have no reporting, disclosure, tax or contractual obligations. Determine the applicable framework instead of copying a 401(k) fiduciary process or assuming no oversight is needed.[3]

Two useful controls are a deadline log with evidence of timely elections and a payment register reconciled with the governing terms. Track late requests and discrepancies before authorizing an exception. The trade-off is professional and administrative cost, which belongs in the compensation budget along with the benefit itself.

Begin the conversation before the compensation year and before managers make commitments. A clearly documented promise can help both parties understand the value and limitations of the arrangement. The most useful plan is one the employer can fund and administer and the employee can evaluate without mistaking a future obligation for unrestricted cash today.

Related reading

Have more questions about nonqualified deferred compensation and employer obligations? Email Dave at dave@financialforte.com to discuss your questions and next steps.

The contact invitation is current; it does not imply this contact path existed on the historical reference date.

Educational information, not personalized investment, tax, legal or benefits advice. Examples use hypothetical assumptions. Verify current rules and your circumstances before acting.

Sources

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