Focus on Compliance: Timing of Bonus Deferral Elections
Jun 27, 2018
Internal Revenue Code Section 409A (“IRC 409A”) requires that elections to defer compensation be made only at specified times. An election to defer compensation that is made later than permitted under IRC 409A is not valid, and would preclude the intended deferral of income.
Deferral Election Timing Rules
As a general rule, unless one of the exceptions described below applies, a bonus may be deferred only if the election to defer is made by the end of the employee’s taxable year immediately preceding the year in which the services giving rise to the bonus will be performed. For example, in order to defer an annual bonus earned during a calendar year and paid in the first quarter of the following calendar year, the deferral election must be submitted before January 1 of the year the bonus is earned.
New Plans/Initial Year of Eligibility
An exception to the general rule exists for executives who first become eligible to participate during the middle of the tax year. This exception would apply not only to executives who first become eligible to participate in a pre-existing plan during a tax year, but also to any executives who first become eligible to participate due to the establishment of a new plan during the middle of a tax year. Executives who first become eligible to participate in the plan in the middle of a calendar year do not need to wait until the following calendar year to defer compensation. They may enroll within 30 days after initial eligibility. Examples of new eligibility include (i) promotion to a planeligible position within the company; (ii) transfer to an affiliated employer who participates in the plan from an affiliate who does not participate; (iii) new hires and rehires who, prior to their rehire, received a complete distribution from the plan after their termination of employment; (iv) participants in the plan who became ineligible and remained ineligible for at least 24 months; and (v) company adopts a plan of its type for the first time.
The deferral elections will apply to compensation for services performed after the election becomes effective. The effective date is specified in the plan document or election agreement, but is not later than the 30th day after the employee is first eligible to enroll. Once effective, the election cannot be changed for the rest of the year. Ideally, a salary deferral election should specify the first payroll period beginning after the effective date when deductions from the participant’s pay will begin. For bonus earned over a period of time, the deferrable portion is calculated by prorating the full bonus over the performance period remaining after the election is effective. For example, employee P becomes eligible to enroll on March 1 and files a deferral election for his bonus earned over the calendar year on March 15 (within 30 days of March 1). The election provides that it is effective on the date it is filed. The deferrable portion of the bonus based on a March 15 effective date is 271/365 or 74% of the bonus. The election form can be designed to limit the bonus deferral in this example to 70%. The same proration approach would apply to quarterly or semi-annual bonus earned during the year, using the number of days in the performance period for the fraction.
A special rule applies to commissions. Since commission-based compensation does not have a specified “performance period”, tax regulations treat it as earned on the date the sale closes or the customer pays. For example, an election that becomes effective on March 15 to defer 100% of commissions could apply to a sale that closes on March 16. There is no requirement to prorate, even though the employee had been working on the sale prior to his or her eligibility to participate in the plan.
Another exception to the general rule applies to bonuses that qualify as “performance- based compensation.” An election to defer a performance-based bonus can be made at any time prior to the date which is six months prior to the end of the bonus performance period, provided (i) the bonus is neither substantially certain to be paid nor readily ascertainable in amount, and (ii) the employee has been employed continuously from the beginning of the performance period (or the date the bonus criteria were established, if later) through the date the election to defer is made. For example, a participant may defer up to 100% of an annual bonus earned over the calendar year by filing a deferral election no later than June 30 of that year.
Because an employee must have been employed continuously from the date the bonus criteria were established through the date the election to defer is made, this special timing rule for performancebased compensation will not generally be available to persons hired after the beginning of the performance period.
A bonus qualifies as performance-based compensation where the amount of, or right to, the bonus is subject to the attainment of pre-established organizational or individual performance goals over a period of at least 12 consecutive months, during all of which time the employee is employed. The goals must be documented in writing no later than 90 days after the date the performance period begins, and at a time when the outcome is substantially uncertain.
Awards that vest over a period of at least 12 months may be deferred with an election that becomes effective any time before the award is made. If the vesting period is 13 months or more, the election may be made up to 30 days after the award is made. Common examples of vesting awards include long-term incentive compensation awards and restricted stock unit awards (“RSUs”). Once the election period closes, it may still be possible to defer some or all of the vesting award, but the election can apply only to compensation that vests 12 or more months after the election is effective and the earliest the participant may receive the deferred compensation is five years after the vesting date.
Example: Company C grants Employee E a restricted stock unit award on March 1. The RSU vests 100% on the third anniversary of the award. E may file a deferral election no later than March 31. E decides not to file an election, however. Later on, E changes his mind and decides he would like to defer. An election may be filed by March 1 of the year prior to vesting, provided the RSU is not paid for at least five years after it vests.
Elections to Defer Long-Term Incentive Bonuses or Other “Short-Term Deferrals”
A fourth exception to the general rule applies to bonuses that are considered “short-term deferrals.” A bonus is a short-term deferral if it is paid within 2-1/2 months after the end of the year in which the right to the bonus becomes vested. An election to defer such a bonus can be made through the date which is 12 months prior to the date the bonus becomes vested. However, the bonus must be deferred for a minimum of five years from the date the bonus vests, even if there is an earlier termination of employment.
For example, a company establishes a long- term incentive plan that pays bonuses to executives based on performance over a three-year period beginning January 1, 2011 and ending December 31, 2013. Any executive employed on December 31, 2013 is eligible to receive the bonus that is earned (if any), with payment made in February of 2014. Because the bonus is paid within 2-1/2 months of the date it vests, it is a short-term deferral. An election to defer all or any portion of the long-term incentive bonus can be made up through December 31, 2012. The bonus must be deferred to at least January 1, 2019 (five years after the vesting date of December 31, 2013).
More Than One Rule May Apply
Frequently, a bonus that cannot be deferred under one of the election timing rules can be deferred under another rule. For example, E who started his career at Company C ten years ago is promoted to Vice President on June 1 and is eligible to defer into the plan on that date. Upon promotion, E becomes eligible for the senior management annual bonus program based on performance during the calendar year and receives an RSU award that vests on June 1, three years later. The RSU is payable if EBITDA increases by 10% per year each year during the three year period. Under the 30-day rule for newly eligible employees, E may defer (i) salary for payroll periods beginning on or after July 1; (ii) up to 50% of the annual bonus under the pro-ration rule; and (iii) none of the RSU because the grant occurred prior to filing a deferral election. However, E may defer up to 100% of the bonus and 100% of the RSU grant under the performance based pay rules.* E may also be able to defer 100% of the RSU under the rules for deferring vesting awards within 30 days after grant and at least 12 months prior to vesting.
*Note that the employee is required only to be employed from the date the annual bonus benchmark is established through the date of deferral; it is not necessary for the employee to be a Vice President eligible for the bonus program at the time the performance criteria are established. In order to provide maximum flexibility, the plan document should set forth as many of the election timing rules as could apply to the types of compensation that an employer pays.
Newport Group employs a staff of attorneys who are available to discuss questions you may have regarding the timing of bonus deferral elections or your non-qualified deferred compensation plan generally. Our attorneys have a combined 60 years of experience in the insurance, banking, executive compensation and employee benefits industries. If you would like to discuss this or any topic with a member of our legal staff, please contact your Relationship Manager.
Newport Group, Inc. and its affiliated companies do not render tax or legal advice and the material contained within should not be interpreted or relied upon as constituting tax or legal advice. You should consult your tax or legal advisors with respect to specific tax or legal decisions.