This blog is part of a 12-part series entitled “The nonqualified deferred compensation plan (NDCP) dirty dozen: An administrative guide to avoiding 12 traps.” To read the introduction to the series, click here.
Nonqualified deferred compensation plans (NDCPs) are designed to run their course at the usual payment pace with the only designated distribution pit stops made along the way being those specifically prescribed by the plan’s provisions. Internal Revenue Code Section 409A (409A) serves as an ever waving yellow caution flag warning NDCP sponsors of the consequences of accelerating distributions (see the “Timing is Everything” blog entry from this series for description). So the question arises, what is an NDCP sponsor to do when it concludes that its vehicle for high performance executives is now no longer running smoothly and/or too costly to maintain on a per participant basis?
Prior to 409A going into effect, many NDCPs contained provisions permitting the sponsor to terminate the plan at its discretion and distribute benefits as soon as possible after such termination. This unlimited distribution discretion upon termination created the potential for the following two suspect scenarios under which sponsors and participants could violate the spirit (if not technically the rules in effect at that time) of how the IRS intended NDCPs to be administered:
Pre-409A suspect scenario #1: Until distributed, NDCPs’ benefits are required to remain subject to the creditors of the sponsor in the event of the sponsor’s insolvency in which case the participants have no greater rights than such creditors. There were cases where, because the plan sponsor was on shaky financial ground with the prospect of insolvency looming, the decision was made to terminate the NDCP so that the participants could “take their money and run” before the sponsor’s insolvency became official and the fate of any NDCP assets were left to the judgment of a bankruptcy court.
Pre-409A suspect scenario #2: Even before 409A, NDCPs were governed by the general tax principle of “constructive receipt,” which generally provides that participants should be taxed on benefits if they could potentially have access to such benefits even if they did not actually access them. Consequently, NDCPs could not contain provisions that would allow participants to withdraw funds while still employed. However, prior to 409A, there were no statutory restrictions preventing sponsors from terminating plans, distributing benefits to the participants, and then immediately creating new programs to provide future benefits, thereby in effect creating a loophole around the prohibition against “no withdrawals while employed” rule.
Recognizing there may still be legitimate reasons for an NDCP sponsor to want or need to terminate its plan(s) and distribute benefits, 409A does allow for an exception to its general prohibition against accelerations of payments. However, in an effort to prevent future occurrences of the past abuses described in scenarios #1 and #2, the 409A rules mandate that such payments will only be permissible upon certain specified circumstances. The remainder of this blog entry will review those cases where 409A raises the green flag for such early payments upon a plan’s termination.