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.
To quote Section 409A: An NDCP by any other name is still an NDCP
When the topic of nonqualified deferred compensation plans (NDCPs) is raised, there are certain arrangements that immediately come to mind. Supplemental executive retirement plans (SERPs) in the style of defined benefit plans, straight deferral-only plans, “401(k) mirror plans,” and excess plans are among the vehicles that clearly must be parked in the 409A compliance lot. Employers who offer such arrangements for their select group of top management and/or highly compensated employees have been inundated with information on this topic and most likely have already taken measures to address this requirement with a 409A-compliant plan document and operational procedures. However, it is crucial to note that the Internal Revenue Code Section 409A rules cast a very wide net when it comes to the definition of what constitutes a NDCP. Accordingly, employers need to regularly inventory and review their various compensation/benefits agreements in order to determine if any existing and/or new arrangements are structured in a manner that creates a 409A NDCP. This blog will highlight points to consider when conducting this 409A “to be or not to be” determination process.
The get out of 409A free exemptions
Before beginning the inventory and review process, plan sponsors may be able to immediately wean out some arrangements from consideration if they qualify for a 409A exemption. The 409A rules specifically exempt some from coverage; these include but are not limited to the following:
• Qualified retirement plans under Code Sections 401(a) or 401(k)
• Qualified annuity plans under Code Section 403(a)
• Tax-sheltered annuity arrangements under Code Section 403(b)
• Eligible deferred compensation plans under Code Section 457(b)
• Qualified governmental excess benefit arrangements under Code Section 415(m)
• Simplified Employee Pension (SEP), Salary Reduction SEP (SARSEP), and Savings Incentive Match Plan for Employees (SIMPLE) plans under Code Section 408
• Plans involving deductible contributions to a Code Section 501(c)(18) trust
• Certain foreign plans as described in 409A
• Certain welfare benefits (e.g., any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan)
• Any Archer Medical Savings Account as described in Section 220
• Any health savings account (HSA) as described in Section 223
• Any other medical reimbursement arrangement, including a health reimbursement arrangement (HRA), that satisfies the requirements of Section 105 and Section 106, such that the benefits or reimbursements provided are not includible in income
The who, what, and when of 409A coverage
Because 409A applies to all “service providers” (i.e., any entity that provides a service to another entity) and “service recipients” (i.e., any entity that receives a service from another entity), its regulatory reach is not limited to just arrangements between “employers” and “employees”. As a result, any entity that is a party to such an exchange (whether an individual or an organization) could be a candidate for 409A coverage. Accordingly, organizations should not merely focus on compensation arrangements covering their executive employee groups. Arrangements covering rank-and-file employees, directors, partners, independent contractors, consultants, and even other organizations potentially bear the risk of being subject to 409A.
Unless an exemption (see above) or exception (see below) is available, 409A applies to any arrangement that provides for a “deferral” of compensation. Such deferral arrangements may be elective or non-elective. It could be a paragraph in an employment agreement for just one individual or a 50-page document for a group. Even if it is informal (e.g., communicated through an internal memo) or even oral (i.e., the classic “handshake agreement”), 409A could come into play if a deferral is recognized. The types of arrangements that may not ordinarily be associated with NDCPs but still should be reviewed for possible 409A implications include but are not limited to the following:
• Employment agreements
• Certain bonus payments
• Severance agreements
• Stock options
• Offer letters
• Restricted stock units
• Consulting agreements
• Phantom stock
• Change-in-control agreements
• Certain reimbursement agreements
• Director fee deferrals
• 457(f) “ineligible” plans
The above-described “deferral” of compensation will be deemed to have occurred for purposes of Section 409A if the plan terms and relevant facts and circumstances give participants a “legal and binding right” to taxable compensation that “is” or “may be” payable in a later year. The 409A rules make it clear that the only instance when there would be no “legal and binding right” and thus no “deferral” would be if the service recipient retained the discretion to unilaterally reduce or eliminate the amount of compensation to be paid. The rules specify that the same is not true (i.e., a deferral would occur) when the compensation may be reduced or eliminated by operation of the objective terms of the plan, such as the application of a nondiscretionary, objective provision that creates a substantial risk of forfeiture. For example, assume an employer enters an agreement with a group of its employees in 2016 to pay such employees 10% of their compensation in 2020. If the agreement is structured so that the employer retains the unilateral right to reduce or eliminate the promised 10% payment, there is no 409A deferral. In contrast, assume that the agreement does not contain such right (i.e., the employer cannot reduce or revoke its promise to pay) but does require that the employees complete five years of service before they become vested in the promised benefit. In this case, even though the benefit would be forfeited if the participant terminates employment before completing five years of service, a 409A deferral will occur.
Exceptions to the rule
If the discovery process described above uncovers potential 409A NDCPs, there may still be some hope for the arrangements to be 409A-free if they qualify for a specific exception. One such exception is known as the “Short-Term Deferral Exception,” which generally excludes arrangements that pay amounts to participants by no later than March 15 of the year following the year in which that amount becomes “vested” (please see my blog from March 11, 2015, here, for a more in-depth description of this exception). Another exception applies only to those arrangements that fall under the category of “severance pay.” Under this exception, the arrangement will be considered 409A-free if the separation pay is made in connection with an involuntary separation from service or participation in a window program, provided the amounts to be paid meet the following requirements:
1. They do not exceed the lesser of two times the participant’s annual pay or two times the Internal Revenue Code section 401(a)(17) limit for the year (e.g., $265,000 for 2016).
2. They are paid in full no later than December 31 of the second year following separation from service.
The truth will set you 409A-free—or at least make you 409A-compliant
Even though 409A has now been with us for over a decade, it continues to present challenges to “service recipients” and “service providers” alike. While not intended as an exhaustive analysis of all the “ins” and “outs” of 409A coverage, the preceding information provides employers with a summary of the basic issues and alerts them of the need to be vigilant in monitoring their various compensation arrangements in order to determine if and when such arrangements must comply with 409A. The key is early detection so that if the arrangement is subject to 409A, it can be designed and operated in a manner that complies with the 409A rules. Consequently, employee benefit consultants and ERISA counsel should be contacted prior to implementation to assist with this assessment.