Deferred Compensation for Law Firm Partners
Most Big Law firms offer non-qualified deferred compensation (NQDC) plans allowing partners to defer a portion of their distributions to later years. Used correctly, this is a major tax-savings tool. Used wrong, 409A penalties can cost you 20% of the entire balance.
How NQDC works at law firms
By December 15 of each year (for the following year's earnings), you elect: how much to defer, and when to take distributions. The firm holds the deferred amounts in a general account (not in a trust — it remains firm assets, subject to firm solvency risk). Deferrals grow at the firm's reference rate or a notional investment return.
When distributions start — based on your pre-elected schedule — you receive the deferred balance plus growth, taxed as ordinary income in the year of distribution.
Section 409A — why the rules are so strict
Congress enacted section 409A after the Enron collapse exposed executives manipulating NQDC plans. The rules are draconian:
- Elections are irrevocable. Once December 15 passes, you can't change the deferral amount or distribution schedule for that year's earnings.
- Distribution timing is locked. You can only take money out per the pre-elected schedule. You can't accelerate on emergency.
- Re-deferrals require 5-year delay and 12-month advance notice. Changing a distribution date is possible but not easy.
- Violation penalties: entire NQDC balance becomes immediately taxable + 20% penalty tax. Devastating.
Distribution design dimensions
When you elect distribution schedules, you're choosing between:
- Fixed dates (e.g., "pay out over 10 years starting 2035"). Predictable. Simple. Doesn't adapt to your life.
- Event-triggered (retirement, separation from service). Paid out when you leave the firm. Aligns with retirement income need.
- Lump sum vs. installment. Installment spreads tax, but 409A complexity grows. Lump sum is simple but stacks income in one year.
A realistic example
Firm solvency risk
NQDC balances are unsecured firm obligations. If your firm dissolves (rare but real for smaller firms, and some major firms have come close historically), your deferred comp is at creditor risk. This is why deferred comp at shaky firms is a worse idea than at rock-solid ones, even when the tax math looks similar.
Lateral implications
Leaving the firm generally triggers distribution per your pre-elected schedule. Some firms have "bad boy" provisions that forfeit NQDC if you lateral to a competitor within a restrictive period — read your plan documents.
Optimize your NQDC election
December 15 is closer than you think. Get a specialist's analysis before you sign this year's election form.