Taxable Income and Deferred Compensation Substantial Risk of Forfeiture

A recent IRS Chief Counsel memorandum illustrates what is meant by a substantial risk of forfeiture as it applies to nonqualified deferred compensation. On November 1, 2014, an employee entered into an agreement with the employer to defer $15,600 of the employee’s salary that would otherwise have been paid during 2015, with payment of the deferred amount to be made as a lump-sum payment on January 1, 2018. The lump-sum payment on January 1, 2018 would be made only if the employee continued to provide substantial future services for the employer until December 31, 2017. Under the agreement, the employer was to add 25% of the deferred amount ($15,600 × 25% = $3,900) to the total due the employee so that on January 1, 2018, the employee would receive $19,500. The issue was whether or not the $15,600 of income earned in 2015 qualified to be deferred and taxable in 2018 under IRC section 409A.

Under IRC section 409A, compensation may be deferred under a nonqualified deferred compensation plan and taxable in a future year if the compensation is subject to a substantial risk of forfeiture. The regulations say that a substantial risk of forfeiture exists if the receipt of deferred compensation is conditioned on the performance of substantial future services or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial [Reg. §1.409A-1(d)(1)]. The regulations explain that a substantial risk of forfeiture occurs if the present value of the amount subject to the substantial risk of forfeiture is materially greater than the present value of the amount the service provider otherwise could have elected to receive absent such risk of forfeiture.

In this case, the present value of the amount deferred by the employee is 25% greater than the amount the employee otherwise could have received absent the addition of the substantial risk of forfeiture. The IRS said a 25% increase in the present value of the amount a service provider could have received absent the risk of forfeiture is a material increase. Accordingly, the combined deferred amount of 2015 salary ($15,600) plus the deferred amount of the employer’s matching contribution ($3,900) is subject to a substantial risk of forfeiture for purposes of IRC section 409A until December 31, 2017.

12/5/2016 THE TAXBOOK
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