Section 409A Basics: Deferral Elections and Discretionary Bonuses

The Final Regulations under Code Section 409A took effect nearly five years ago. By now those of us who regularly deal with deferred compensation issues have fully internalized the core requirements of Section 409A. We have even managed to sensitize our clients and other professionals to the possibility that Section 409A issues can arise in a variety of contexts outside the strict parameters of a formal deferred compensation arrangement. Nevertheless, certain simple questions still cause us to revisit basic Section 409A concepts simply because the answers we produce are frequently jarring (even to us) and frustrating (for employers). One such question relates to the timing of deferral elections made with respect to discretionary bonuses.

Here’s a familiar hypothetical. Suppose an employer announces that it will award discretionary bonuses for services performed in 2012, and will decide which employees will receive bonuses and in what amounts at the beginning of 2013. If the employer wishes to make available to its employees the possibility of deferring all or a portion of the bonuses that they may or may not receive in 2013 (with respect to services performed in 2012), when must those deferral elections be made? Countless employers establish discretionary bonus programs that operate in exactly this way, and yet the answer to the question always causes us to double check the rules under Code Section 409A. That is because the answer requires us to reconcile an apparent conceptual inconsistency between a core statutory requirement and a key regulatory definition.

The Section 409A regulations state that a plan or arrangement provides for a “deferral of compensation” if an employee has a “legally binding right” during a taxable year to compensation that, pursuant to the terms of the plan or arrangement, is or may be payable in a later taxable year. See Regulations Section 1.409A-1(b)(1). An employee does not have a “legally binding right” to compensation, however, if the compensation may be unilaterally reduced or eliminated by the employer after the services creating the right to the compensation have been performed. In our example, the employer determines the amount of the bonus in its sole discretion in the taxable year after the year in which the services are performed. The employer may award a large bonus, a small bonus, or no bonus to any or all of the eligible employees. Under this bonus program, therefore, an employee does not have a legally binding right to the bonus until the bonus is determined and announced (in our example, 2013) – only then has the employer relinquished its unilateral discretion to reduce or eliminate the bonus. So one would think that an employee has least until the end of the performance period (2012 in our example) to make a deferral election as to the completely discretionary bonus that is not yet determined or announced. But one would be wrong.

Code Section 409A(a)(4) generally provides that compensation for services performed during a taxable year may be deferred at an employee’s election only if the election to defer the compensation is made not later than the close of the taxable year preceding the year in which the services are rendered. This rule is developed, in a somewhat convoluted way, in Regulations Section 1.409A-2(a)(1), which attempts to explain how and when an initial deferral election must be made with respect to a given “period of service.” The regulation does recognize the tricky interplay between the “legally binding right” concept and the “period of service” concept when it comes to bonuses. It says that, in our example, an employee who could receive a discretionary bonus in 2013 with respect to services performed in 2012 would have to make the deferral election (if at all) prior to the end of 2011. But if there were any doubt, the Preamble to the Section 409A regulations (in paragraph VI.A) disposes of the matter in no uncertain terms. The Preamble states: “even where [a] bonus is discretionary such that the legally binding right to the bonus does not arise under after the period of service for which the bonus is paid has begun, [an employee’s] deferral election must occur before the year in which the period of service begins” unless some other exception applies (such as the special rules relating to performance-based compensation).

Employers always seem surprised that an employee can be expected to make a deferral election more than one year before the employee even knows whether he or she is eligible for a bonus. Somehow that just doesn’t seem reasonable. Yet, every time we check, we find that is what Code Section 409A requires.