Tag Archives: nonqualified deferred compensation plans

Observing the 409A speed limit on payment accelerations after an NDCP termination

Pizzano-DominickThis 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.

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The DB/NDCP funding conundrum

Pizzano-DominickThis 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.”

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Sponsors and participants must follow 409A true to form

Pizzano-DominickThis 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 last month’s blog explored the permissible times NDCP distributions may occur under section 409A of the tax code, this month’s entry examines the rules surrounding the forms of payment that may be offered under these plans. Accelerations and deferrals can just as easily be effected with a choice of form (e.g., lump sum versus installment payments) as they can with timing elections. These two sets of rules are connected because they share a common purpose: proving some degree of flexibility while preventing the type of excessive control that 409A was enacted to eliminate. The following will examine how sponsors can ensure that their NDCP forms follow 409A function.

First step: Grounding form flights of fancy
NDCP participants are used to the free-flowing flexibility of the qualified plan world in which they can typically wait right up until their benefit commencement date (BCD) before having to commit to the form of payment under which they wish to have their plan benefits distributed. A further false sense of flexibility may arise from pre-409A provisions, which permitted the linking of the form of payment from the NDCP to the form of payment elected by the participant under the qualified plan that the NDCP was intended to supplement. These were most prevalent in defined benefit (DB) style NDCPs but occasionally also appeared in some defined contribution (DC) ones. The 409A rules do allow grandfathering of prior amounts (see the “Honor thy 409A grandfather” entry of this series for details); however, such linking is prohibited for benefits attributable to post-December 31, 2004, accruals or contributions.

Because the rules governing NDCP form elections for such amounts are much more rigid, NDCP sponsors must make sure they clearly communicate these differences to participants, develop the appropriate 409A-compliant plan designs for their executive groups, and vigilantly administer their NDCPs in accordance with such designs. The rules for 409A generally require that a participant’s form of payment under a NDCP be designated much earlier than would be the case under a qualified plan. For most NDCPs, the rule requires participants to elect their form of payments when they first become eligible for the NDCP. Accordingly, sponsors need to provide participants with sufficient notice and means to make this election prior to the expiration of their initial eligibility periods (i.e., generally 30 days from the date they are first designated as eligible).

Exceptions to the rule
There are two exceptions to this rule requiring participants to make form elections to be made when first eligible:

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The NDCP dirty dozen: Timing is everything

Pizzano-DominickThis 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
3. Disability
4. Death
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.)

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IRS proposes deferred compensation rule for governmental and tax-exempt entities

The Internal Revenue Service (IRS) has issued a long-awaited proposed rule on nonqualified deferred compensation plans (NDCPs) maintained by tax-exempt organizations (other than churches and certain church-controlled entities) and state and local governments. The proposed rule provides guidance for plan sponsors in determining when amounts are includable in employees’ incomes, the amounts that are includable, and the types of arrangements that are not subject to the requirements of tax code section 457. The proposed rule, which plan sponsors may rely upon immediately, also aligns the requirements for 457(f) plans with section 409A NDCPs. However, this Client Action Bulletin focuses on what many plan sponsors and participants may consider the most significant portion of the proposed rule: the expanded definition of a “substantial risk of forfeiture” (SROF) in 457(f) plans.

IRS proposes additional guidance for nonqualified deferred compensation under 409A

Concluding that clarifications and modifications could help taxpayers comply with the requirements applicable to nonqualified deferred compensation plans (NDCPs) under tax code section 409A, the Internal Revenue Service (IRS) issued additional guidance in the form of a proposed rule. Compliance with the 409A requirements enables individuals covered by and employers sponsoring NDCPs to avoid adverse tax treatment of the amounts payable under these arrangements. The proposed rule, which taxpayers may rely upon immediately, is lengthy and complex, covering a diverse range of topics, most of which are beyond the scope of this Client Action Bulletin, which focuses on four key areas that may have the broadest application to NDCP sponsors.