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.
While most nonqualified deferred compensation plan (NDCP) sponsors will be hard-pressed to find humor in 409A compliance, they may be willing to acknowledge that proper administration of NDCP distributions shares at least one common attribute with a winning comic performance: for the NDCP to successfully stand up in front of the most demanding critic—i.e., the Internal Revenue Service (IRS)—without facing any heckling, the plan must practice precision timing with its distributions to participants. Just as a comedian must work not to deliver a punch line too early or too late, an NDCP needs to avoid improper accelerations or delays of participant payments. A failure to do so can elicit a most unpleasant response in the form of a cacophony of catcalls and boos from participants, or an IRS audit discovery of 409A noncompliance, thereby triggering the resultant penalties.
This blog entry examines some of the toughest timing tests for the satisfactory operation and administration of NDCPs under section 409A of the tax code.
Activating the trigger
Section 409A severely restricts employer and/or executive discretion on the timing of distributions. It identifies six permissible NDCP distribution triggers, which generally must be established within 30 days of the date the executive first becomes eligible to participate in the plan:
1. A specified payment date (i.e., a future distribution date is designated either by the employer and/or executive upon the participant’s initial eligibility)
2. Separation from service
5. Change in ownership or control of a corporation
6. Unforeseeable emergency
Except for death, each trigger has its own special 409A definition, along with complicated rules regarding how it may be applied. There is also a separate rule that permits the attachment of a “window” period to the applicable trigger. Under this rule, the participant may not designate the taxable year of payment; and such period must either both begin and end within one taxable year or must not be more than 90 days.
Recent IRS guidance expanded the permissible early payout alternatives to an NDCP participant’s beneficiaries in cases of death, disability, or unforeseeable emergencies. The guidance also clarifies that the NDCP may provide that the occurrence of death, disability, or an unforeseeable emergency may accelerate a schedule of payments that has already commenced prior to a participant’s or beneficiary’s death.
One of the most complex triggers happens to be one of the most commonly used: the “separation from service” distribution trigger. This trigger will not pose problems when the separation is clear-cut and final, such as a full retirement, resignation, or termination of employment. However, employment separations are often not so simple, such as where an executive’s duties are scaled back from his or her previous role (e.g., under a “phased retirement” scenario) or where a key employee “retires” but is then retained to consult as an independent contractor. Depending on the extent of the cutback and the terms of the NDCP, the plan may risk either prematurely commencing payment or impermissibly delaying a distribution that should commence. This may occur if the employer and/or the executive’s idea of what constitutes a separation does not align with the guidance under 409A. Although it basically is a facts-and-circumstances test, 409A considers a termination to have occurred if the employer and employee reasonably anticipate that either of these two conditions applies:
1. No future services will be performed after a certain date.
2. The rate of bona fide services to be performed after such date will not exceed 20% of the average rate of services performed over the preceding 36-month period (or the full period, if less than 36 months). (If the new rate of services is over 20% but less than 50%, such reduction may be treated as a separation from service under 409A, provided special rules are met.)