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.)
The service period following a 409A-permitted separation takes into account work performed both as an employee and independent contractor. Thus, a retiring executive who is rehired as a consultant will be subject to the above test. Additional relevant factors must also be considered, such as the employer’s past practices and reasonable expectations, and its treatment of the executive as an employee for some purposes (e.g., eligibility for medical benefits).
There had been some confusion over when NDCP sponsors should use the general “separation from service” standard (i.e., “20%/36-month rule”) applicable to employees, as compared with the specific rule that applies only to independent contractors. Under the 20%/36-month rule, a participant who is an employee separates from service if the employer and employee reasonably anticipate that the level of services to be performed after a certain date (as an employee or an independent contractor) would permanently decrease to no more than 20% of the average level of services performed (as an employee or an independent contractor) over the immediately preceding 36-month period. Meanwhile, the independent contractor rule indicates that the participant separates from service upon the expiration of the contract(s) under which services are performed for the NDCP sponsor.
Recent IRS guidance confirmed that when making a determination for a participant who changes employment status from employee to independent contractor or vice versa, sponsors must always first look to the 20%/36-month rule. Thus, if this rule is met when the individual changes status, the participant is considered separated from service under the terms of the plan. The new guidance clarifies how to handle situations where applying the 20%/36-month rule does not result in a separation from service at the time a participant changes status from an employee to an independent contractor. In such cases, the NDCP sponsor can then instead rely on the independent contractor rule, i.e., upon expiration of the contract(s), to determine the date the participant’s future separation of service occurs.
Distributions cued from the trigger
Once a distribution trigger is activated, the 409A compliance clock begins ticking and NDCP sponsors must deliver their payments on a timely basis. Although the 409A rule acknowledges the administrative impracticality of sponsors being able to deliver the payments on the exact date that the trigger occurs, it also prevents excessive manipulation of the actual payment date. Consequently, payments are 409A-compliant only if made by the later of: the end of the calendar year in which the trigger occurs; or the 15th day of the third month following the date the trigger occurs. If the plan specifies a payment date trigger, payment may be made up to 30 days before the trigger date. In all cases, the executive must be directly and indirectly prohibited from designating the taxable year of the payment. Recent IRS guidance clarified that the rules applicable upon the participant’s death also apply to amounts payable upon the death of any beneficiary who has become entitled to amounts payable upon the participant’s death. Also, recognizing the need for a longer period to resolve certain issues related to the participant’s death (e.g., confirming the death and completing probate), the proposed rule also creates a separate timing rule for an amount payable following the death of a participant or a participant’s beneficiary: the amounts may be paid at any time beginning on the date of death and ending on December 31 of the calendar year following the calendar year of death. The new guidance provides NDCP sponsors significant flexibility regarding the administrative and/or plan amendment options they can use to incorporate this extended payment deadline.
In practice, the 409A distribution rules may pose particular problems for NDCP sponsors that maintain non-grandfathered arrangements under which the distribution provisions can no longer be tied to the sponsor’s qualified retirement plan. Too many sponsors apply the “wait and see” approach permissible under qualified plans (i.e., no benefit distributions are made until the terminated participants claim the benefit). However, while qualified plan rules permit post-termination benefits to remain unpaid up to April 1 of the year following the year in which the participant attains age 70-1/2, such open-endedness is not permitted under 409A. Therefore, NDCP sponsors must take great care to monitor the occurrence of any of the triggers, possibly outsourcing the administration to a third party with the appropriate resources to coordinate the timely processing of distributions. In addition, because the final processing of distributions may require information such as current address or marital status from NDCP participants, sponsors should educate executives on the necessity of timely commencements of benefits after a trigger occurs. Free from the participant disclosure requirements applicable to qualified plans, NDCP sponsors often take a minimalist approach to participant communication. However, they should consider the complexity of the 409A rules and the high cost of noncompliance. Providing participants a summary plan description to facilitate their understanding and cooperation could be beneficial for both parties.
Mandatory vs. permissible delays
The 409A rule provides that certain circumstances mandate a delay of distributions while others warrant a permissible delay.
A mandatory six-month delay applies to the separation from service trigger only to key employees of publicly traded (U.S. or foreign exchange) companies. Rather than having to identify these employees and possibly missing one or more of them, an NDCP sponsor may instead opt to delay payments for all covered employees for six months after separation from service, regardless of their key-employee status.
The permissible delay is allowed under specific conditions, one at the discretion of either the NDCP participant or sponsor, and the other only at the election of the sponsor.
• Generally, the participant or the sponsor may delay the payment if: (a) deferral election will not be effective until at least 12 months after it is made; (b) payment is deferred for at least five years from the date it would have been payable absent the election; and (c) election is made at least 12 months before payments were originally scheduled to be made. The applicability of the conditions depends on the specific triggering event or date trigger.
This permissible delay rules offer flexibility in certain situations. The 12-month deferral election condition, for example, may be particularly troublesome when the circumstances—such as a separation from service—dictate that the executives include the NDCP distribution as income in a tax year in which they also earned substantial salaries. To allow for a deferral election in this situation, an NDCP design could use a specified payment date trigger in lieu of a separation from service. For example, assume the plan sets attainment of age 50 as the trigger. As executives approach age 49 (i.e., 12 months before the trigger date), they must decide whether to defer payments to age 55. If they have substantial savings and anticipate their earnings to continue at high levels, chances are they will opt for the deferral. They then will have a similar decision to make as they approach age 54 (i.e., whether to defer to age 60) and, if they elect that deferral, again as they edge toward age 59. If their talents are in high demand and their finances secure, they will most likely remain in the top income tax brackets during these years even if they terminate employment with the NDCP sponsor. Under such circumstances, the desire to defer the income may be sufficient to endure the risks of leaving the benefits in the plan after departure (e.g., they will no longer have influence on a company’s bottom line and the benefits remain subject to the creditors of the sponsor in the event of its insolvency).
• The NDCP sponsor may permit a delay of payment because of certain business concerns. The 409A rule requires that the business concern (such as cash-flow issues) and the time for the later payment are determined by a prespecified, objective, nondiscretionary formula related to the sponsor’s business performance. For example, the formula may call for payments in any given year to be limited to a certain percentage of cash flow. A delay is also permitted if the scheduled payment would jeopardize the ability of the sponsor to continue as a going concern. Under these circumstances, the plan will remain in 409A compliance as long as the payment is made in the first year in which the concern is eliminated. The rules also spell out the conditions for employers to delay payment to avoid the $1 million compensation deduction limitation, but only until the first year the payment would not exceed the cap or the employee separates from service. In addition, the 409A rules also address payment failures that are due to the NDCP sponsor’s refusal to pay or its inadvertent delay, requiring, in either case, no collusion between the participant and the sponsor. In these types of situations, the participant must provide timely notice to the sponsor that the benefit is due and unpaid; the 409A rules proscribe the details of such notice.
Not so fast: Prohibition of accelerations and exceptions
While the acceleration of payments is generally prohibited under 409A, there are some specific exceptions, which include the following:
1. Compliance with a qualified domestic relations order (QDRO)
2. Compliance with ethic agreements or conflicts of interest laws
3. Payment of state, local, foreign, or employment taxes, taxes arising from a 409A violation, or taxes upon vesting in a 457(f) plans
4. Limited cash-outs up to a designated dollar amount (409A uses the 401[k] annual deferral dollar limit, which is $18,000 for 2016), provided that if a participant is in two or more NDCPs of the same type (as specified by the 409A aggregation rules), the plans must be aggregated to determine if the cash-out may apply
5. Settlement of a dispute as to a participant’s right to a deferred amount
6. Plan termination or liquidation in connection with certain events (e.g., designated corporate dissolutions or bankruptcies and change in control events) or, at the discretion of the sponsor, subject to various restrictions and limitations
The acceleration exception described above in (1) and (2) give NDCP sponsors peace of mind because they know they can comply with these requirements without running afoul of 409A. The exception in (3) is particularly practical, as it permits the use of plan assets to meet these tax obligations rather than the participant doing so out of pocket. The exceptions in (4), (5), and (6) create opportunities for a quicker disbursement of funds, enabling the sponsor to realize administrative cost savings by virtue of no longer having to maintain the recordkeeping and other costs associated with the applicable benefit. However, sponsors should discuss with their advisors the specific rules under 409A attached to each of these exceptions prior to utilization.
The last laugh
Will the NDCP’s final act of distributing benefits bring smiles to the recipients’ faces? Not likely if such distributions fail to comply with the 409A rules and thereby expose participants to substantial penalties: 409A failures require participants to include all previously deferred amounts under the NDCP in gross income and pay on this amount income taxes, employment taxes, and a 20% penalty tax, as well as interest and penalties on this amount at the underpayment rate plus 1% and underpayment penalties. Thus, executives should be extremely motivated—on their own or with appropriate prodding by the NDCP sponsor—to cooperate in perfecting the NDCP’s timing so as to not bomb in front of that toughest and most crucial crowd—the IRS. And because the complex setup of the various 409A distribution rules leaves very little room for operational ad libs, NDCP sponsors must work to tighten up their payment routines in order for the participants to enjoy the full amount of these distributions.