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.
A particularly perplexing piece of the Pension Protection Act of 2006 (PPA) is Internal Revenue Code section 409A(b)(3), which creates a mandatory funding (i.e., a cash contribution) connection between a plan sponsor’s tax-qualified defined benefit (DB) plan and any nonqualified deferred compensation plan (NDCP) it maintains. Sponsors are prohibited from “funding” an NDCP for certain highly paid employees if circumstances arise that either actually or potentially jeopardize their DB plans’ funding status. The puzzle lies neither with the purpose of this rule nor its desired effect. True to PPA’s overall goal of protecting qualified DB plans, the prohibition put some teeth into the message that DB plan funding must take priority over dedicating corporate assets to NDCPs. Consequently, sponsors must continue to look closely at their DB plan funding before leaping into funding any NDCPs.
While the statute’s intent seems clear enough, the dilemma is in the details or, in some cases, the lack thereof. As currently written, and still absent any clarifying guidance, the statute raises a host of questions, including:
• Which employees are actually affected by the funding restraints?
• What does “fund” mean in this context?
• How does the law affect a sponsor’s ability to pay NDCP benefits?
• What are the ramifications for deferral-only plans?
When do restrictions apply?
NDCP restrictions apply during the appropriately named “restricted period,” which goes into effect:
• When the “employer” is a debtor in a federal or state bankruptcy proceeding. (Note: Throughout this article, “employer” means the NDCP sponsor and any other employers in the same control group.)
• Six months before or after the date that an underfunded DB plan of the employer is formally terminated and approved by the Internal Revenue Service (IRS) and/or Pension Benefit Guaranty Corporation (PBGC).
• During any period when an employer’s DB plan is “at-risk,” which generally means the plan has more than 500 participants and the assets of the plan represent less than 80% of the value of the benefits earned under the plan.
Are all NDCP participants affected by the funding restraints?
The funding restraints of the NDCP only apply if an individual is identified as an “applicable covered employee” of the employer. This term includes not only presently “covered employees” of the employer but also captures any employees who were “covered employees” of the employer at the time of those employees’ termination of employment. The term “covered employee” has a two-pronged definition:
1. The principal executive officer (or an individual acting in that capacity during the last completed fiscal year) or an employee whose total compensation is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of the employee being among the three highest compensated officers for the taxable year (not counting the principal executive officer), as described in tax code section 162(m)(3) and clarified by IRS Notice 2007-49.
2. An officer, director, or shareholder who owns 10% or more of a publicly traded company’s equity (i.e., an individual subject to the requirements of section 16(a) of the Securities Exchange Act of 1934).
While the application of these definitions to NDCP sponsors that are publicly traded is clear-cut, the extent, if any, of their applicability to private companies is the subject of debate. Some analysts have argued that private companies are completely exempt. Their rationale is that such companies generally would not be subject to the Securities Exchange Act of 1934, which would by definition exclude them from coverage under prong 2 of the above definition. In prong 1, they argue that the reference is to section 162(m)(3), which is part of section 162(m) and deals with the $1 million deduction limit for publicly traded companies. Accordingly, they ask, “How can this definition apply to private companies if it is from a code section governing publicly held entities?”
Getting a legal opinion before relying on that interpretation is advisable. If prong 1 applies to private companies, it may only apply on a limited basis, given that they have no employees “whose total compensation is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of the employee being among the three highest compensated officers.” Thus, in a private company, if anyone is affected, it would only be the principal executive officer. The IRS has not confirmed or denied a total exemption for private companies and no timetable for clarifying guidance has been announced, so the conservative approach for such companies (absent the above-referenced legal opinion) may be to treat the principal executive officer as an “applicable covered employee.”