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 Internal Revenue Service (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.
The first step is to check the plan document to see if it already contains language allowing for such termination and distribution. This is particularly important for grandfathered plans (see the “Honor thy 409A grandfather” blog entry of this series). If the plan is a grandfathered plan that does not contain a provision specifically providing for accelerated distribution upon termination, the plan will need to be amended to include this provision. However, such an amendment would constitute a material modification to the plan, thereby voiding the grandfathered status and requiring the plan to simultaneously be amended to comply with Section 409A. Once the NDCP’s document language is up to speed regarding the necessary language, the next step is for the sponsor to ascertain if it qualifies for any of the three permissible accelerated payment options upon plan termination:
(1) Court-approved distress distributions. At first glance, this exception to the acceleration prohibition may seem to be enabling rather than closing the loophole described above in scenario #1; however, upon closer examination, the exception prevents such abuse by limiting such distributions to those that are made: (a) within 12 months of a corporate dissolution taxed under section 331, or (b) with the approval of a bankruptcy court pursuant to 11 U.S.C. §503(b)(1)(A), provided that the amounts deferred under the plan are included in the participants’ gross incomes in the latest of:
• The calendar year in which the plan termination occurs
• The calendar year in which the amount is no longer subject to a substantial risk of forfeiture
• The first calendar year in which the payment is administratively practicable
(2) Specified change of control cash-outs. An NDCP sponsor may terminate and liquidate a plan and thereby accelerate any payments when the termination occurs within the 30 days prior to, or the 12 months following, a change in control event. Such termination does not violate the anti‐acceleration rule, so long as all NDCPs of a “similar type” are also terminated.
(3) Plan sponsor’s need for speed. This alternative allows the plan sponsor to elect to terminate the NDCP and accelerate payment to participants at its discretion, provided that the following conditions are met:
• The termination and liquidation does not occur proximate to a downturn in the financial health of the plan sponsor
• No payout under the NDCP plan may occur within 12 months of board action to irrevocably terminate the NDCP
• All payments must be made within 24 months of the NDCP termination by the board
• All NDCPs of a “similar type” must also be terminated
• The sponsor must not adopt a new “similar type” of NDCP within 36 months from the date the sponsor first took the board action needed to terminate the NDCP irrevocably
The “similar type” reference cited above in option (2) and in the last two conditions of option (3) relates to the 409A aggregation rules, which are intended to prevent sponsors from evading 409A requirements through the use of multiple NDCPs of the same type. These aggregation rules divide NDCPs into the following nine separate categories: (1) account balance plans with elective deferrals, (2) account balance plans without elective deferrals, (3) non-account balance plans, (4) separation pay plans, (5) plans providing for in-kind benefits or reimbursements, (6) split-dollar plans, (7) foreign-earned income plans, (8) stock right plans, and (9) any other type of NDCP not described in (1) through (8). Previously, there had been a school of thought that the application of this “similar type” rule could be limited to only those NDCPs covering the same participant(s). However, that interpretation turned out to be no more than wishful thinking, as recently issued IRS guidance clarified that the acceleration of payments pursuant to this rule is permitted only if the sponsor terminates and liquidates all plans of the same category that it maintains, and not merely all plans of the same category in which a particular participant actually participates. This guidance also clarified that for purposes of observing the 36-month prohibition on establishing a new NDCP following the termination and liquidation of a plan, the sponsor cannot adopt a new NDCP of the same category as the terminated and liquidated plan regardless of which participants participate in the plan.
A 409A license for acceptable accelerations
There are acceptable reasons as to why an NDCP sponsor needs or wants to terminate and liquidate its plan(s). The 409A rules recognize this possibility but also take into account that unlimited discretion in this area could lead to abuse. Accordingly, when considering such a course of action, an NDCP sponsor should consult its employee benefits consultants and/or legal counsel in order to assist in achieving an acceptable acceleration that gets it to the destination as rapidly as possible while observing the 409A speed limits.