Tax Aspects of Nonqualified Deferrred Compensation: Avoiding Constructive Receipt

Tax Aspects of Nonqualified Deferrred Compensation: Avoiding Constructive Receipt

Employers and executives must be sure to avoid the doctrine of constructive receipt when drafting deferred compensation arrangements. Specific provisions required by IRC Section 409A must be included in deferred compensation plan, and adhered to by the parties. Statutory requirements include election timing requirements, distribution parameters, non-acceleration of benefits, and funding re-striction.


The general rule of IRC Section 409A, is twofold:

(1) If the plan under which compensation is deferred does not satisfy the statutory requirements, all income for the taxable year of failure of the plan, and for all prior taxable years, is includible in the gross income of the employee, or other service provider, intended to benefit from the plan.

(2) In addition to penalties and interest, a penalty of twenty percent (20%) of the failed deferral is imposed on the employee or service provider.

The rule does not apply if the deferred amount is subject to a substantial risk of forfeiture, or to a short term deferral that is actually or constructively received by the service provider within two and one-half months after the end of the providor's taxable year.

The effect of the rule, if a deferral does not comply with the statutory requirements, is that in the year of the intended deferral, the service provider will be deemed to be in constructive receipt of the compensation earned, notwithstanding the fact that he or she may, by contract, not be paid until a later taxable year. The compensation involved is not subject to taxation more than once, but the requirement of paying tax prior to the actual receipt of income can be a heavy and unwelcome burden.

The drastic consequences of a failure to comply with IRC Section 409A have generated much interest from, and attention by, commercial, industrial, and service enterprises, as well as from their tax counsel and advisors.


IRC Section 409A supplements and overrides, in some respects, the previously controlling statutory and case law on constructive receipt. Section 409A imposes restrictions and limitations on the design of deferred compensation arrangements, and severely limits the flexibility in structuring nonqualified deferred compensation that was available under prior law. If the plan design meets the Section 409A standards, then the general constructive receipt principles, developed under prior law, must be satisfied as well. If, on the other hand, taxability occurs because of the failure to meet the Section 409A standards, the tax must be paid regardless of the previously recognized legal principles. That is not to say that any compensation is taxed to the executive twice--it is not. However, as indicated, non-compliance with this Code section may accelerate the taxability of income to a date earlier than would be required under general deferred compensation principles.

The statutory requirements of Section 409A must be included in the document creating the deferred compensation arrangement, and the plan must be operated in accordance with those requirements. The statute is supplemented by extensive Treasury Regulations issued in 2007.

Legally Binding Right

The applicability of the statute and the regulations depends upon whether the particular plan provides for a deferral of compensation. For this purpose, a plan is deemed to provide for a deferral of compensation if, under the terms of the plan and the relevant facts and circumstances, the executive has a legally binding right during a taxable year to compensation that is payable to (or on behalf of) the executive in a later year. The executive does not have a legally binding right to compensation if that compensation may be reduced unilaterally or eliminated by the employer (or other person) after the services creating the right to the compensation have been performed. However, if the facts and circumstances indicate that discretion to reduce or eliminate the compensation is available or exercisable only upon a condition, or such discretion lacks substantive significance, the executive will be considered to have a legally binding right to the compensation. For example, where the executive to be paid has effective control over the person making the decision to reduce or eliminate compensation, such discretion will not be treated as having substantive significance.


... [T]he Section 409A restrictions and limitations apply to all nonqualified deferred compensation programs. They must appear in the plan document, and the plan must be operated in accordance with the terms of the document. If the requirements of the section are not satisfied, the deferred compensation becomes includible in the executive's current gross income for tax purposes. In addition, an automatic twenty percent penalty tax applies, as well as interest and an understatement of income penalty.


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