[Examples assume calendar year taxpayers.] Acme Company pays annual bonuses earned in 2012 on February 14, 2013. Because the bonuses are paid within 2½ months after the end of the year in which they vest, the arrangement qualifies for the short-term deferral exception, and Section 409A does not apply.
A long-term incentive plan provides awards based on performance over the three-year service period beginning January 1, 2012, and ending December 31, 2014. Bonuses vest at the end of the three year period–that is, no benefit is payable if a participant terminates employment before January 1, 2015. Awards are paid on March 1, 2015. Because the awards are paid within 2½ months after the end of the year in which they vest, this arrangement qualifies for the short-term deferral exception, and Section 409A does not apply.
An employer’s separation pay plan provides for a lump sum payment equal to one-times pay to any employee whose service is involuntarily terminated. If the lump sum is paid to an employee by March 15 of the year following termination of employment the arrangement will qualify as a short-term deferral, and Section 409A will not apply.
The short-term deferral exception applies even if an employee has a right to defer payment beyond the 2½ month deadline, as long as the employee doesn’t actually exercise that right. If, however, the employee does elect to defer the payment beyond the 2½ month deadline, the arrangement will be subject to Section 409A.
Example(s): On January 1, 2012, ABC Company promises to pay John $50,000 if he is still employed by ABC on December 31, 2018. John forfeits his right to the $50,000 if he terminates employment before that date. John has the right to defer the payment until 2024, but he does not elect to do so. Since John’s right to the payment vests at the end of 2018, the arrangement will qualify as a short-term deferral, and Section 409A will not apply, if ABC pays the $50,000 to John no later than March 15, 2019.
A plan doesn’t need to specify a payment date to be eligible for the short term deferral exception. However, the exception is not available if the plan specifies a payment event or date that will, or may, occur after the end of the short-term deferral period. For example, if an arrangement provides that compensation will be paid upon an employee’s separation from service, which may occur in a future year, the arrangement will be deemed to provide for a deferred payment, and the short-term deferral rule will not be available, even if payment is in fact made within the applicable 2½ month period.
In certain cases, an employer can pay benefits after the 2½ month deadline and still satisfy the short term deferral exception. The employer must establish that payment by the deadline would either (a) jeopardize the employer’s ability to continue as a going concern, or (b) be administratively impracticable, and the impracticality must have been unforeseeable by the employer.
Substantial risk of forfeiture
In general, compensation is subject to a substantial risk of forfeiture if an employee will not receive the deferred compensation unless certain conditions are satisfied. This is also commonly referred to as “vesting.” The concept of substantial risk of forfeiture is important under Section 409A for three reasons:
- If a NQDC plan fails to satisfy Section 409A’s requirements, the compensation will be subject to federal income tax and penalties in the year the compensation is no longer subject to a substantial risk of forfeiture–even if the benefits aren’t payable until some time in the future.
- The short term deferral exception is available only if compensation is paid within 2½ after the year in which the compensation is no longer subject to a substantial risk of forfeiture.
- In general, pre-2005 deferrals are grandfathered, and are not subject to Section 409A, if they are earned and vested (that is, no longer subject to a substantial risk of forfeiture) by December 31, 2004.
Section 409A contains it’s own definition of substantial risk of forfeiture: compensation is subject to a substantial risk of forfeiture if it is conditioned on the performance of substantial future services for the employer, and the risk of forfeiture is substantial.
Example(s): AAA Corporation agrees in 2012 to pay Beth, the CEO, $100,000 if she is still employed on December 31, 2014. If Beth terminates employment before that date, she receives nothing. The payment is contingent on Beth providing substantial future services, and is subject to a substantial risk of forfeiture.
Compensation is also subject to a substantial risk of forfeiture if payment is contingent on the occurrence of a condition that’s related to a purpose of the compensation, and the risk of forfeiture is substantial. The condition must relate either to the employee’s provision of services to the employer, or to the employer’s business activities or organizational goals.
Example(s): AAA Corporation agrees in 2012 to pay Beth, the CEO, $100,000 if the company earns $10 million in 2014. If the company does not reach its goal, Beth receives nothing. The payment is contingent on a condition relating to the employer’s organizational goals, and is subject to a substantial risk of forfeiture.
Compensation that’s conditioned on an employee’s involuntary separation from service without cause is considered subject to a substantial risk of forfeiture, if the possibility of forfeiture is substantial.
Compensation is not subject to a substantial risk of forfeiture merely because the right to the compensation is conditioned on refraining from performing services. For example, compensation that’s subject to forfeiture if an employee violates a non-compete agreement is not subject to a substantial risk of forfeiture for Section 409A purposes.
In general, a risk of forfeiture that’s added after an employee obtains a legally binding right to the deferred compensation is disregarded for Section 409A purposes. So called “rolling risks of forfeiture,” where a risk of forfeiture is extended by agreement of the parties before it lapses (that is, before the compensation vests), common in IRC Section 457(f) plans, are not recognized under Section 409A.
The definition of substantial risk of forfeiture in IRC Section 89 does not apply for Section 409A purposes. The two definitions are similar, but not identical.
Section 409A’s written plan requirement
In order satisfy Section 409A, the material terms of a NQDC plan must be committed to writing. This must occur no later than March 15 of the year following the year the employee obtains a legally binding right to compensation payable under the plan. A plan satisfies the written plan requirement if the document or documents constituting the plan specify the amount of compensation the employee has a right to be paid, the payment schedule or payment triggering events, the conditions under which a initial and subsequent deferral elections may be made, and provisions describing the six-month delay applicable to payments to “specified employees” upon separation from service.
Example(s): Widget Company makes a legally binding promise in 2012 to make a nonforfeitable $10,000 payment to Joan in 2018. The written plan requirement will be satisfied if Widget commits the arrangement to writing no later than March 15, 2013.
A special rule applies if compensation earned in one calendar year will be paid in the immediately following calendar year. In this case the arrangement must be committed to writing no later than December 31 of the first calendar year. For example, if a bonus is earned in 2012, and is payable the following June 1, the arrangement will satisfy Section 409A’s written plan requirement only if the material terms of the arrangement are committed to writing no later than December 31, 2012.
Where a plan allows an employee to make an initial deferral election, or a subsequent deferral election, the conditions under which those elections may be made must be set forth in writing no later than the date the employee’s election must become irrevocable under Section 409A.
The plan aggregation rules described above in “What is a ‘plan’ for Section 409A purposes?” do not apply to the written plan requirement. Accordingly, if one plan violates Section 409A because it is not committed to writing, other plans of the same type that are committed to writing will not be adversely impacted.
Even though qualifying short-term deferrals aren’t subject to Section 409A, it generally makes sense to commit those arrangements to writing anyway. That way, if payment is delayed for some reason beyond the 2½ month deadline, the plan may be able to satisfy some other provision of the statute or regulations. But if the arrangement isn’t in writing, those alternative methods of satisfying Section 409A won’t be available, and a violation of Section 409A may occur. Short-term deferral arrangements should also be in writing if employees have the right to defer payment beyond the 2½ month deadline.
Even though Section 409A was generally effective with respect to compensation deferred after 2004, the IRS, through series of transition rules, extended the deadline for most plans to comply with Section 409A’s written plan requirement until December 31, 2008.
Section 409A’s deferral election rules
Initial deferral elections–general rule
The most common NQDC plans allow employees to voluntarily elect to defer all or part of their annual pay, bonus, or other compensation. In general, in order to satisfy Section 409A and avoid adverse tax consequences, an employee’s initial election to defer compensation must be made, and become irrevocable, before the start of the employee’s tax year in which the compensation is earned. Compensation is earned in the year the employee performs the services that result in the compensation.
An employee’s initial deferral election must specify both the amount of the deferral and the time and form of payment (unless the plan itself specifies how or when payment will be made). So-called “evergreen” deferral elections–elections that remain in effect from year to year until prospectively changed or revoked by an employee–are generally permitted.
Example(s): Jim is eligible for a bonus payable in 2014 based on services Jim performs in 2013. Under Section 409A, Jim can elect to defer payment of his bonus if he makes his deferral election no later than December 31, 2012 (that is, prior to the start of 2013–the year in which Jim earns the bonus). Jim’s election must specify both the time he wishes to receive the payment, and the form of the payment. The plan can let Jim change or revoke his deferral election up until December 31, 2012, at which time his election must become irrevocable. (Note the special rule for performance-based compensation, below.)
A plan can let employees make multiple payment elections. For example, an employee could elect to receive 25 percent of his or her account balance at age 50 and the remaining 75 percent at age 60, or elect different forms of payment for certain different distribution events (for example, a lump-sum upon disability, and an annuity at retirement).
In some cases an employee may not have the right under a NQDC plan to elect the time or form of payment of deferred compensation. In this case the plan itself must designate the time and form of payment no later than the date the employee has a legally binding right to the compensation or, if later, the latest date the employee would have been allowed to make an initial deferral election with respect to the compensation under Section 409A.
Special rules apply to the deferral of sales commission and investment commissions.
Initial deferral elections–new participants
While initial elections to defer compensation normally must be made before the start of the year in which the compensation is earned, a special rule allows a new participant to make an initial deferral election up to 30 days after becoming a participant. The deferral election can’t be retroactive; that is, the deferral election must apply only to compensation earned after the date of the election.
If compensation is based on a performance period (for example, an annual bonus), and the performance period has already started, the amount the employee can defer is determined by multiplying the total amount of the compensation for the performance period by the ratio of the number of days remaining in the performance period over the total number of days in the performance period.
Example(s): Kathy becomes a new participant in the Newton Corporation Voluntary Deferral Plan on October 1, 2012. The Plan allows participants to defer up to 50 percent of base salary, and 100 percent of annual bonuses. As a new participant Kathy can make a deferral election for 2012 on or before October 31, 2012 (30 days after she becomes a participant). On October 10, Kathy elects to defer 20 percent of base salary she earns from October 11 through December 31, 2012. Kathy also wants to defer as much as she can of her 2012 annual bonus. Since there are 81 days left in the calendar year, and a total of 365 days in 2012, 81/365, or 22.2 percent, of Kathy’s 2012 bonus is eligible for deferral.
Exercise caution in identifying new plan participants. If an employee who is newly eligible for Plan A already participates in Plan B, and Plans A and B must be aggregated because they are of the same type (see “What is a ‘plan’ for Section 409A purposes?” above), then the employee is not considered a new participant in Plan A, and is not eligible for this special deferral election rule.
If an employee ceases to be an “active participant” in a NQDC plan for at least 24 months, the plan can again treat the employee as a new participant (subject to the plan aggregation rule discussed above). An employee is considered an “active participant” if the employee is eligible to accrue benefits under the plan, even if the employee chooses not to participate.
If an employee has been paid all amounts deferred under the plan, and on and before the date of the last payment the employee is not eligible to continue to participate in the plan after the last payment, then the employee can be treated as a new participant if he or she again becomes eligible to accrue a benefit under the plan in the future.
Initial deferral elections–performance-based compensation
While initial elections to defer compensation normally must be made before the start of the year the compensation is earned, elections to defer “performance-based compensation” can be made at any time up until six months before the end of the performance period used to determine the compensation. An employee’s election to defer performance-based compensation must be made before the amount of that compensation is known or readily ascertainable. In addition, this special rule is available only if the employee performs services continuously from the later of the beginning of the performance period, or the date the performance criteria are established, until the date the employee makes the deferral election.
A bonus or other compensation is treated as performance-based if (a) the compensation is based on services performed over a period of at least consecutive 12 months (b) payment is contingent on the satisfaction of organizational or individual performance criteria, and (c) the performance criteria aren’t substantially certain to be met at the time of the deferral election. An employer can establish the performance criteria up to 90 days after the start of the performance period (provided the outcome is substantially uncertain at the time the performance criteria are established).
Example(s): Alan earns a bonus in 2012 that’s payable in August, 2013. If the bonus qualifies as performance-based compensation, Alan can elect to defer payment of the bonus at any time up until June 30, 2012.
An incentive plan provides for awards based on performance over the three-year service period beginning January 1, 2012, and ending December 31, 2014. Awards are payable on April 1, 2015. If the arrangement qualifies as performance-based compensation, an employee can elect to defer payment of his or her award up until June 30, 2014. The employer must establish the performance criteria for the plan no later than March 31, 2012.
Equity-based compensation is performance-based if it is based solely on an increase in the employer’s value, or a share of stock of the employer, after the date of the grant or award.
Performance-based compensation does not include any amount that will be paid either regardless of performance, or that’s based on a level of performance that is substantially certain to be met at the time the criteria is established.
Initial deferral elections–“ad hoc” compensation
In general, an election to defer compensation must be made prior to the start of the year in which the compensation is earned. But what happens if an employer awards compensation to an employee mid-year for services performed in that year, and the employee wants to defer payment of the compensation to a later date? How can an employee make an initial deferral election that complies with Section 409A if the year has already begun and the employee isn’t eligible for the “new participant” deferral election rule?
The final regulations answer these questions by allowing an employee to make a mid-year deferral election of “ad-hoc” compensation awards if all of the following conditions are satisfied:
- the compensation is subject to forfeiture if the employee fails to perform services for at least 12 months
- the employee makes the deferral election no later than 30 days after the date of grant, and
- the deferral election is made at least 12 months before the forfeiture period ends (disregarding any accelerated vesting on account of death, disability, or change in control)
Example(s): On April 30, 2012, Jupiter Company awards Anne 1,000 restricted stock units (RSUs) for her past services, exercisable in 2019. Anne will forfeit the RSUs if she terminates employment before January 1, 2015. Ann would like to defer payment of the RSUs to 2024. Ann has until May 30, 2012, (30 days following the grant date) to make an initial deferral election that satisfies Section 409A.
Initial deferral elections–“ad hoc separation pay”
If an employer provides separation pay to an employee upon the employee’s voluntary or involuntary separation from service, and the separation pay is subject to bona fide arms-length negotiations at the time of separation, then the employee can make an initial deferral election with respect to that separation pay at any time before he or she obtains a legally binding right to the payment. This rule applies even if the separation pay is expressed or calculated based on the employee’s prior service. The rule allows the employee to make a choice between a current benefit and a deferred benefit, or to choose the time and form of payment of the deferred compensation.
This rule does not apply to any separation pay the employee had a legally binding right to receive before the arms-length negotiations.
Example(s): Ben and his employer, ABC Corporation, agree that Ben will terminate his employment immediately, and that he will receive $100,000, $10,000 for each of his 10 years of service. Even though the separation payment is based on Ben’s prior service, he can negotiate with ABC Corporation to receive the payment currently or at some future date, in a lump sum or some other form, without violating Section 409A’s initial election rules.
Subsequent deferral elections
After an employee makes an initial deferral election the employee may want to further delay the payment date and/or change the form of payment. NQDC plans can allow these subsequent deferral elections (sometimes called “second elections”) but only if all of the following requirements are satisfied:
- The election can’t take effect for at least 12 months after the date the election is made
- If the election relates to benefits payable at a specified time or pursuant to a fixed schedule, the election must be made at least 12 months before the date the payment is scheduled to be made
- If the election relates to benefits payable upon separation from service, or at a specified time or pursuant to a fixed schedule, the payment date must be deferred for a period of at least five years from the date the payment would otherwise have been made
The term “payment” for purposes of the subsequent deferral rule means each separately identified amount the employee is entitled to receive on a determinable date. If an employee is entitled to receive his or her NQDC plan benefit in installments, the plan can treat the installment payments either as a single payment, or as a series of individual payments, for purposes of the subsequent election rules. A life annuity is generally treated as a single payment.
Even though the acceleration of NQDC plan benefits is generally prohibited, if the subsequent deferral election rules described above are satisfied, an employee can in certain cases make a new election that results in a more rapid payment schedule.
Example(s): Amy has previously elected to receive her NQDC plan benefits in ten annual installments beginning on July 1, 2013. The plan treats installments as a single payment. Amy has now decided that she would rather receive a lump sum payment. Amy can make a new election at any time up until July 1, 2012 (12 months before the original payment date). Amy can elect that the lump sum be paid on any date on or after July 1, 2018 (five years after the original start date). The new election will satisfy Section 409A even though each of the ten scheduled installment payments isn”t delayed for 5 years, and even though Amy has effectively accelerated the payment of a portion of her NQDC plan benefit.
The facts are the same as above, except that the plan treats installments as a series of separate payments. In this case, Section 409A is satisfied only if Amy makes a separate election with respect to each installment payment. And each payment must be delayed for at least 5 years from the date it was originally scheduled to be paid.
In certain instances, the NQDC plan can provide for the delay of a scheduled payment as long as all similarly situated employees are treated on a relatively consistent basis. These delays will not be subject to the subsequent deferral rules, and will not violate Section 409A’s requirement that the plan pay benefits upon a permissible payment event. The specific cases where payments can be delayed are: (a) where the employer’s tax deduction would be lost if the payment was made as scheduled due to application of Code Section 162(m), (b) where the payment would violate federal securities laws or other applicable law if paid as scheduled, and (c) upon such other circumstances as specified by the IRS.
Initial deferral elections–short-term deferrals
As discussed earlier, short-term deferrals are exempt from Section 409A even if an employee has a right to defer payment beyond the 2½-month deadline, as long as the employee doesn’t exercise that right. But how do the initial deferral election rules apply to an employee who decides that he or she does want to defer the payment, since the service period has already begun? When does the deferral election need to be made in order to satisfy Section 409A? The final regulations answer these questions by applying the “subsequent election” rules discussed above (but substituting the vesting date for the payment date). Specifically, an employee can elect to further delay payment of a short term deferral if all of the following are satisfied:
- The election can’t take effect for at least 12 months
- If the election relates to benefits payable at a specified time in the future, the election must be made at least 12 months before the date the employee’s right to the payment vests
- The first payment under the new election must be at least 5 years later than the date the employee’s right to the payment vests (except for distributions on account of death, disability, unforeseeable emergency, or change in control)
Example(s): Ajax Corporation agrees on January 1, 2012, to pay Rick a $25,000 bonus on March 1, 2015, if he is still employed on that date, otherwise the bonus is forfeited. Absent a deferral election by Rick, Section 409A would not apply to the arrangement because it would qualify as a short-term deferral (assuming payment is made on a timely basis). Rick decides he would like to defer receipt of the payment. He must make his initial deferral election before March 1, 2015 (12 months before Rick’s right to the payment vests) and the election must defer payment to a date on or after March 1, 2020 (unless the payment is due to death, disability, unforeseeable emergency, or change in control).
NQDC plan elections tied to qualified plan elections
Prior to the enactment of Section 409A it was common for a NQDC plan (for example, a defined benefit SERP) to provide that an employee’s NQDC plan benefit would be paid at the same time and/or in the same form as the employee’s qualified plan benefit. This practice is no longer permitted, because allowing NQDC plan benefits to be controlled by an employee’s qualified plan election could circumvent Section 409A’s deferral election and anti-acceleration provisions. Employees must now make separate payment elections for qualified and nonqualified plans.
IRS transition rules allow NQDC plan payments beginning before 2009 to be controlled by qualified plan elections, but only if permitted under the terms of the NQDC plan as in effect on October 3, 2004. See IRS Notice 2007-86 for additional details.
In some cases, the amount deferred under a NQDC plan is linked to the benefit accrued in a qualified employer plan. For example, a NQDC plan might provide for a pension benefit equal to the additional amount the employee would have received under the employer’s qualified pension plan if the Section 415 benefit limits did not apply. The nonqualified plan benefit might, as a result, increase or decrease based on the statutory limits that apply to the qualified plan. The final regulations continue to allow plans to be linked in this manner. The regulations provide that any increase in benefits under the NQDC plan will not be treated as a “deferral election” requiring compliance with Section 409A’s initial deferral election rules, but only if: (a) there is no change in the time or form of payment under the NQDC plan, and (b) any increase in benefits under the NQDC plan does not exceed the amount of the reduction in the qualified plan benefit. (This same rule applies to NQDC plans that provide a benefit that’s offset by the amount of benefits provided under a qualified plan.)
So-called “wraparound plans,” where deferrals between a qualified 401(k) plan and a NQDC plan are linked, are still permitted, subject to certain requirements. See “Wraparound plans,” below.
Section 409A’s plan distribution requirements
To satisfy Section 409A, a plan must provide for the distribution of NQDC plan benefits either at a specified time (or pursuant to a fixed schedule), or upon the occurrence of one or more of the following distribution events:
- Separation from service
- Change in control event
- Unforeseeable emergency
A plan may provide that earnings will be paid at a separate time, or in a different form, from the payment of the deferred compensation itself.
A plan can provide that payment will be made on the earliest of, or latest of, more than one event or time.
In general, if an employer makes a payment to an employee that is a substitute for a payment of deferred compensation, the IRS will treat the payment as a payment of the deferred compensation itself. So if the payment doesn’t satisfy Section 409A’s distribution rules, tax and penalties may apply.
Payment upon separation from service
A NQDC plan can pay benefits to an employee after the employee separates from service. IRS regulations contain a complicated definition of separation from service, and that definition must be used to determine when a “separation from service” has occurred that can trigger a distribution from the plan.
In general, an employee separates from service if the employee dies, retires, or otherwise has a termination of employment with the employer. However, the employment relationship is treated as continuing intact (that is, a separation has not occurred and distribution can not be made) while an employee is on military leave, sick leave, or other bona fide leave of absence, if the leave does not exceed six months or, if longer, for as long as the employee retains a right to reemployment under any applicable law or contract.
In the case of certain medical leaves of absence, the six month period may be extended to 29 months.
Whether an employee has terminated employment is based on whether the employee and employer reasonably anticipate either that (a) no further services will be performed after a certain date, or (b) that the level of bona fide services the employee will perform after that date (whether as an employee or as an independent contractor) will permanently decrease to no more than 20 percent of the average level of services performed over the immediately preceding 36-month period (or the full period the employee provided services to the employer if the employee has been providing services for less than 36 months). A plan can substitute a percentage ranging from 20 percent to 50 percent under certain conditions.
An employee isn’t treated as having separated from service if the employee leaves one employer and goes to work for a related employer. The “employer” for this purpose is defined as including all entities that would be treated as part of the employer’s controlled group under IRC Section 414(b) and (c), but using a 50 percent, instead of 80 percent, ownership level. A plan may instead use an ownership level ranging from 20 percent to 80 percent, but an ownership level of less than 50 percent may be used only where such use is based on legitimate business criteria, as defined in the regulations.
Plans can adopt a “same desk” rule for Section 409A purposes, allowing unrelated parties to an asset purchase agreement to decide whether employees of the selling corporation that continue in their same positions with the purchaser of the assets will be treated as separating from service for Section 409A purposes. The plan must treat all employees consistently (regardless of position at the seller), and that treatment must be specified no later than the closing date of the asset purchase transaction. For this purpose, a sale of assets means a transfer of substantial assets, such as a plant or division or substantially all of the assets of a trade or business.
In general, an independent contractor is considered to have separated from service with the employer upon the expiration of the contract (or, in the case of more than one contract, upon the expiration of all the contracts) under which services are performed for the employer, if the expiration constitutes a good faith and complete termination of the contractual relationship.
If an individual provides services to an employer both as an employee and as an independent contractor, the individual must separate from service both as an employee and as an independent contractor in order to be treated as having a separation from service that can trigger a distribution from a NQDC plan.
Payment upon separation from service–special rules for “specified employees”
If an employee is a “specified employee,” the plan generally can’t begin paying benefits to the employee on account of a separation from service until six months following the employee’s separation from service. A “specified employee” is a key employee of a publicly-traded company. Key employees are generally identified using the qualified plan “top-heavy” rules found in IRC Section 416(I).
The Section 409A regulations provide complicated rules for identifying specified employees.
A plan can either (a) hold all payments that are due for the six month waiting period, and then pay a lump sum to the specified employee after the 6 months period expires, or (b) delay each scheduled payment for 6 months.
This rule only applies to payments made on account of separation from service. Payments made because of disability, on account of hardship, or at a particular time do not have to be delayed for 6 months.
In order to avoid undercounting specified employees, and to simplify administration, a plan may provide that payments to all plan participants upon separation from service will be delayed for six months, regardless of whether the employee is a specified employee. Plans can also use alternative methods for identifying specified employees, provided that the alternative method (a) is reasonably designed to include all specified employees, (b) is an objectively determinable standard, (c) doesn’t provide a direct or indirect election to any employee regarding the application of the rule, and (d) results in no more than 200 employees being identified as specified employees as of any date.
Special rules apply to the identification of specified employees following a corporate transaction, such as a merger or spin-off.
Section 409A is not violated if payment to a specified employee is made before the end of the six-month period due to a domestic relations order, to satisfy a Federal, state, local, or foreign ethics law, or to pay certain employment taxes.
Payment upon disability
A NQDC plan can pay benefits to an employee if the employee becomes disabled. An employee is considered disabled if he or she meets one of the following two requirements:
- The employee is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or can be expected to last for a continuous period of not less than 12 months
- The employee is, by reason of any medically determinable physical or mental impairment that can be expected to result in death or can be expected to last for a continuous period of not less than 12 months, receiving income replacement benefits for a period of not less than three months under his or her employer’s accident and health plan
A plan can provide that an employee will be deemed to be disabled if he or she is determined to be totally disabled by the Social Security Administration.
Payment upon a change in control
A NQDC plan can pay benefits to an employee if there is a change in the ownership or effective control of the employer, or a change in the ownership of a substantial portion of the employer’s assets. The Section 409A regulations contain detailed rules for determining when there has been a change in control that can trigger a distribution from a NQDC plan.
Payment on account of an unforeseeable emergency (hardship)
A NQDC plan can pay benefits to an employee if the employee has an unforeseeable emergency. An unforeseeable emergency is a severe financial hardship resulting from: (a) an illness or accident affecting the employee, the employee’s spouse or dependent, or the employee’s plan beneficiary; (b) the loss of the employee’s property due to casualty; or (c) other similar extraordinary and unforeseeable circumstances arising out of events beyond the control of the employee.
Section 409A regulations provide the following examples of other circumstances that may qualify as an unforeseeable emergency: (a) the imminent foreclosure of, or eviction from, the employee’s primary residence; (b) the need to pay medical expenses, including non-refundable deductibles and prescription drugs; and (c) the need to pay funeral expenses for a spouse, beneficiary, dependent, or plan beneficiary.
The amount distributed can’t exceed the amount reasonably necessary to satisfy the financial hardship, plus any taxes and penalties reasonably anticipated as a result of the payment. Distributions aren’t allowed if the hardship can be relieved through reimbursement by insurance or otherwise, or by liquidation of the employee’s other assets (unless the liquidation would itself cause a severe financial hardship to the employee).
A plan can provide for the cancellation of an employee’s deferral election upon making a payment due to an unforeseeable emergency. However, in this case, the additional compensation available to the employee as a result of the cancellation of the deferral must be taken into account when determining the amount reasonably necessary to satisfy the employee’s financial hardship.
A payment due to an unforeseeable emergency may be made even though the financial need could instead be satisfied through an available distribution from a grandfathered nonqualified deferred compensation plan, or from another nonqualified deferred compensation plan that’s also subject to Section 409A.
Payment at a specified time or pursuant to a fixed schedule
A NQDC plan can pay benefits to an employee at a specified time, or pursuant to a fixed schedule. To satisfy Section 409A, objectively determinable amounts must be payable at a date or dates that are nondiscretionary and objectively determinable at the time the compensation is deferred. Benefits aren’t considered to be payable at a specified time if they are payable upon the occurrence of an event. For example, a plan can pay benefits to an employee when the employee attains a specific age (e.g., age 65) because the benefits are payable at a specified time. But benefits can’t be paid “when my child starts college,” because this is the occurrence of an event, and the payment date is not objectively determinable at the time the compensation is deferred.
A payment will be considered to be made at a specified time or pursuant to a fixed schedule if it is made upon the date a substantial risk of forfeiture lapses.
General distribution rules
The Section 409A regulations contain complex rules regarding how and when payments can, or must, be made in order to satisfy Section 409A.
In general, a plan can specify only one time and form of payment for each separate distribution event (death, disability, separation from service, change in control, and unforeseeable emergency). For example, a plan can not require a lump sum payment upon termination of employment within the first five years of employment, and installments upon termination after five years of employment, because both are “separation from service” events, and only one form of payment is allowed.
Of course, a plan can allow an employee to elect (in an initial or subsequent deferral election) which form of payment will apply, as long as that election applies to any separation from service.
There are a number of exceptions to the above rule. For distribution events other than separation from service, a plan can provide for one schedule of payments if an event occurs on or before a certain date, and a different schedule of payments if the event occurs after the specified date. For example, a plan could provide that an employee will receive a lump sum payment if he or she becomes disabled on or before age 55, and installments if he or she becomes disabled after age 55.
For distributions on account of separation from service, a plan can provide for a different time and/or form of payment under each of the following circumstances:
- Separation from service within a specified period (not to exceed two years) following a change in control event
- Separation from service before or after a specified age, or combination of age and years of service, and
- All other separations from service
In order for a payment to be considered made as a result of a particular distribution event (separation from service, death, disability, unforeseeable emergency, or change in control), a plan must either specify that the “payment date” is the date of the event, or alternatively, provide that payment will be made:
- On a date that’s objectively determinable and nondiscretionary at the time the distribution event occurs (for example, a plan can provide that payment upon a change in control will be made in a lump sum on the 6-month anniversary of the change in control event)
- In accordance with a schedule that is objectively determinable and nondiscriminatory based on the date the event occurs
- During a designated taxable year of the employee that’s objectively determinable and nondiscriminatory at the time the distribution event occurs (for example, a plan can provide that an employee will receive three substantially equal payments in the three tax years following the year the employee separates from service), or
- During a designated period that is objectively determinable and nondiscriminatory at the time the distribution event occurs, but only if the designated period both begins and ends within the same taxable year of the employee, or the designated period is not more than 90 days and the employee can not specify the taxable year of payment (other than through a subsequent election that meets the rules described earlier)
A distribution is treated as made on the payment date if it is made on that date, or within a later date in the same taxable year of the employee or, if later, by the 15th day of the third calendar month following the payment date, so long as the employee can not, directly or indirectly, designate the taxable year payment will be made. Similarly, a distribution is treated as made on the payment date if it is made no earlier than 30 days before the payment date, and the employee can not, directly or indirectly, designate the taxable year payment will be made.
A plan can specify that payment will be made as soon as administratively practicable following a distribution event. In this case, the plan must restrict payment to a specific taxable year of the employee, or a designated period not to exceed 90 days, and the employee must not have the ability to select the taxable year of payment.
If the calculation of the amount of a payment is administratively impracticable due to events beyond the control of the employee, the payment will generally satisfy Section 409A if it is made during the first taxable year of the employee in which the payment is able to be calculated. Similarly, if payment would jeopardize the employer’s ability to continue as a going concern, payment can be made instead during the first taxable year of the employee in which it will not have that effect.
Section 409A’s acceleration prohibition
Section 409A generally prohibits the acceleration of scheduled benefit payments from NQDC plans. There are, however, numerous exceptions from the general rule. A NQDC plan can provide that benefit payments will be accelerated for one or more of the following reasons:
- To satisfy a domestic relations order
- To comply with certain conflict of interest and ethics laws
- To pay state and local taxes, RRTA taxes, and foreign taxes imposed on the employee’s NQDC plan benefit before it is distributed to him or her
- To pay certain FICA and RRTA taxes on compensation deferred under the plan
- To pay income taxes due as a result of a vesting event in a Section 457(f) plan
- To cash out small benefits (discussed below)
- To pay any income tax due as a result of the plan’s failure to comply with 409A
- To settle, as a result of an arms length negotiation, a bona fide dispute regarding the employee’s right to receive the deferred compensation
A plan may also give the employer, but not the employee, the discretion to accelerate a deferred payment upon the occurrence of one of the permitted acceleration events listed above (other than acceleration as a result of a bona-fide dispute).
A NQDC plan’s written document generally doesn’t need to specify the conditions under which accelerated payments may be made, but the employer must demonstrate that an accelerated payment complies with the requirements of Section 409A and applicable regulations.
It’s important to distinguish the acceleration of payments from the acceleration of vesting. An employer can accelerate the vesting (but not the payment) of an employee’s NQDC plan benefit at any time without violating Section 409A.
Example(s): A NQDC plan provides for the lump sum payment of an employee’s vested benefit upon separation from service. Benefits under the plan generally vest after 10 years of service. An employee with 5 years of service is approaching retirement. The employer can reduce the vesting requirement from 10 to 5 years of service, allowing payment to the employee when he or she retires. In this example, even though vesting has been accelerated, the benefit payment is made as a result of a qualifying event (separation from service), and Section 409A is satisfied.
A prohibited acceleration of benefits does not occur if payment is made, in accordance with either the employee’s initial deferral election or the terms of the plan, upon the occurrence of an intervening event prior to a scheduled payment date. For example, a NQDC plan may provide that benefit payments due in the future may be paid immediately in the event the employee separates from service, dies, becomes disabled, or has an unforeseeable emergency, or upon a change in control event.
If a NQDC plan is amended to add a new payment event, or to delete an existing payment event, a prohibited acceleration occurs if the amendment could result in the employee receiving a plan benefit sooner than he or she would have absent the amendment. However, a NQDC plan can generally be amended to allow payment upon death, disability, or unforeseeable emergency, even if the amendment could result in earlier payment of the employee’s benefit.
A NQDC plan can provide that a participant’s deferral election will be cancelled if the employee becomes disabled, has an unforeseeable emergency, or the employee receives a hardship distribution from his or her employer’s 401(k) plan. These cancellations will not be treated as a prohibited acceleration of benefits under Section 409A.
Mandatory lump-sum distribution not prohibited acceleration
A NQDC plan can require (or can provide the employer with the discretion to require) a mandatory lump sum payout of an employee’s plan benefit, regardless of the employee’s payment election, if the employee’s account balance is less than a dollar amount specified in the plan, not to exceed the IRC Section 402(g) deferral limits ($17,000 for 2012, $16,500 for 2011). The payment must result in the termination and liquidation of the employee’s entire interest in the plan. A plan that doesn’t contain a cashout provision can be amended to add one. These cashout payments are not considered a prohibited acceleration of benefits under Section 409A.
The plan’s cash-out provision must be executed and effective, and any exercise of employer discretion evidenced in writing, no later than the date the payment is made to the employee.
An employer can cash out an employee’s benefit even if the employee hasn’t separated from service–the employer may exercise its discretion any time an employee’s benefit is less than the dollar amount specified in the plan. The plan aggregation rules apply, so an employer can’t use this rule to cash out an amount under one arrangement but not another arrangement where the two arrangements are treated as a single plan (see “What is a ‘plan’ for Section 409A purposes,” above).
Payment upon termination of the plan
An employer may generally make payments to participants upon termination of a deferred compensation plan if the employer (a) terminates all plans of the same type, (b) makes no payments within 12 months of the termination date, other than benefit payments that would have been made absent the plan termination, (c) distributes all benefits to participants within 24 months of the termination date, and (d) doesn’t adopt a new plan of the same type within 3 years. A termination covered by this rule is not treated as violating Section 409A’s anti-acceleration provisions.
A plan termination and liquidation will not qualify for this exception if it is proximate in time to a downturn in the financial health of the employer.
The Section 409A regulations also provide rules under which a NQDC plan may be terminated, and benefits distributed, as a result of a change in control event, or upon the liquidation of the employer.
“Haircut” provisions prohibited
Before Section 409A was enacted, NQDC plans often allowed so-called “haircut” withdrawals. Employees could request payment of plan benefits at any time if they agreed to forfeit a specified percentage (for example, 10 percent) of the payment. As a result of Section 409A’s anti-acceleration rules, haircut provisions are no longer permitted.
The IRS has not yet issued any guidance on Section 409A’s funding rules.
Offshore trusts and other arrangements
NQDC plan benefits are often informally funded by a rabbi trust. The existence of a trust doesn’t result in current taxation to participants if the trust’s assets are subject to the claims of the employer’s general creditors. Some employers, however, have funded their rabbi trusts with offshore investments in a way that, for all practical purposes, places the trust assets beyond the reach of the employer’s creditors.
Section 409A effectively prohibits the investment of NQDC plan assets outside of the United States by taxing plan participants on the value of those assets at the time they’re set aside in an offshore trust (or other arrangement specified by the IRS), or when they’re transferred offshore. Any subsequent increase in the value of the assets is also treated as a taxable event. Amounts included in an employee’s gross income are subject to an additional 20 percent penalty tax, plus interest.
Triggers based upon the financial health of the employer
Prior to Section 409A, NQDC plans often included a “trigger” that required plan funding in the event of a change in the employer’s financial health. Section 409A effectively prohibits this practice. If a NQDC plan includes a trigger, plan participants will be taxed on the value of the assets subject to the trigger. Amounts included in gross income are also subject to an additional 20 percent penalty tax, plus interest.
A taxable event occurs even if the plan merely provides for this contingency, even if a transfer of assets never actually takes place.
Funding during “restricted periods”
Effective August 17, 2006, the Pension Protection Act amended Section 409A to provide that if, during a “restricted period,” an employer sets aside assets in a rabbi trust or other arrangement to fund nonqualified deferred compensation benefits for an “applicable covered employee,” that employee will be subject to income tax, an interest charge, and a 20 percent penalty on the amount set aside.
A restricted period is (1) any period in which a single-employer defined benefit pension plan of an employer is in at risk-status, (2) any period in which the employer is in bankruptcy, and (3) the period that begins six months before and ends six months after the date any defined benefit pension plan of the employer is terminated in an involuntary or distress termination. The provision does not apply with respect to assets set aside before a restricted period.
“Applicable covered employee” means any (1) covered employee of a plan sponsor; (2) covered employee of a member of a controlled group which includes the plan sponsor; and (3) former employee who was a covered employee at the time of termination of employment with the plan sponsor or a member of a controlled group which includes the plan sponsor. “Covered employees” include the chief executive officer of the employer, the four highest compensated officers for the taxable year (other than the chief executive officer), and individuals subject to section 16(a) of the Securities Exchange Act of 1934.
What happens if a plan doesn’t comply with Section 409A?
There are three significant federal income tax consequences if a plan fails to comply with Section 409A:
- An employee’s deferrals for the current year and all prior years are subject to immediate taxation if vested. If not vested, the deferrals are taxed as they vest (that is, when they’re no longer subject to a substantial risk of forfeiture)
- The amount included in an employee’s gross income is subject to an additional 20 percent penalty tax, and
- Interest is charged at the tax underpayment rate plus one percent
The American Jobs Creation Act requires that employers report (also on Forms W-2 and 1099-MISC) amounts included in a plan participant’s gross income as a result of a NQDC plan’s failure to comply with Section 409A. Amounts included in an employee’s income are also considered wages for tax withholding purposes. Notice 2008-115 provides interim guidance on these reporting and wage withholding requirements, including guidance on calculating the amount included in an employee’s income under Section 409A. The guidance is effective for calendar year 2008, and continues in effect in subsequent calendar years until further guidance is issued by the IRS. Employers can instead rely on IRS proposed regulations that also provide guidance on calculating amounts included in gross income under Section 409A, and the calculation of penalty taxes, provided that the employer complies with all of the provisions of the proposed regulations.
There are two types of Section 409A failures–plan document failures and operational failures. A plan document failure occurs when the plan document contains provisions that aren’t allowed under Section 409A (for example, the plan allows haircut distributions). An operational failure occurs when the plan terms are consistent with Section 409A, but the employer operates the plan in a way that violates Section 409A. In the case of a plan document failure, the adverse tax consequences described above will generally apply to all plan participants. In the case of an operational failure, only those participants affected by the failure will have adverse tax consequences.
Example(s): Consistent with Section 409A, the Smith Company NQDC Plan provides that plan benefits will be paid only upon separation from service, disability, or death. Smith, however, agrees to let Lisa withdraw $100,000 from her deferred compensation account so that Lisa can purchase a new home. This is an operational violation of Section 409A. In this case, since only Lisa was actually given the right to take an early distribution, only she (not other plan participants) will be in violation of Section 409A.
The IRS, in Notice 2008-113, has provided transition relief and guidance on the correction of certain NQDC plan operational failures. The relief includes:
- Methods for correcting certain operational failures during the taxable year of the employee in which the failure occurs, to avoid income inclusion under Section 409A, and
- Transition relief limiting the amount includible in income for certain operational failures occurring in taxable years of the employee occurring before January 1, 2010, where only limited amounts are involved
Notice 2008-113 is generally effective for tax years beginning on or after January 1, 2009. For tax years beginning before January 1, 2009, employers may rely either on Notice 2008-113, or its predecessor, Notice 2007-100. Notice 2008-113 was amended in certain respects by Notice 2010-6, which primarily provides transition relief with respect to plan document failures.
Application of Section 409A to specific arrangements
Severance pay plans
Severance pay plans (referred to as “separation pay” plans in the IRS guidance) are generally subject to Section 409A. However, there are a number of important exceptions, described below. These exceptions can be used individually, or in combination.
Severance pay that’s provided as a substitute for, or a replacement of, compensation deferred under another NQDC plan is not eligible for any of the exceptions described in this section.
Section 409A does not apply if the aggregate amount of benefits payable to an employee from a severance pay plan is less than or equal to the IRC Section 402(g) deferral limit for the year of separation ($17,000 in 2012).
Employers often retain discretion to eliminate or reduce severance benefits at any time. In this case, an employee generally won’t have a vested right to severance benefits until the employer makes a binding promise to pay benefits, typically upon separation from service. In this case, the separation pay plan can be designed to meet the short-term deferral exception, and avoid application of Section 409A, by providing that all severance benefits will be paid to an employee no later than 2½ months after the year in which the employee separates from service.
Separation pay plans are also generally exempt from Section 409A if the separation pay (a) is limited to the lesser of two times the employee’s compensation or two times the Section 401(a)(17) compensation limit for the year of separation ($250,000 in 2012), and (b) the separation pay is paid to the employee no later than the end of the second year following the year the employee separates from service. This exception applies where the payment is made due to the employee’s involuntary separation from service, voluntary separation for good reason in certain cases, or participation in a window program. The exception doesn’t apply to a plan that provides severance benefits if an employee voluntarily separates from service.
If a plan would qualify for this last exemption except that the separation pay exceeds the “two times pay” limit, only the excess over the limit will be subject to Section 409A. The right to payment up to the applicable limit will not be subject to Section 409A. As a result, the six month delay for payments to specified employees on account of separation from service will not be required for payments up to the “two times pay” limit, but will be required for the excess amount).
An employee’s compensation for purposes of the “two times pay” limit is the annual rate of pay for services the employee provides to the employer in the year prior to the employee’s separation from service.
Section 409A generally doesn’t apply to an employer’s reimbursement of certain expenses (such as reasonable outplacement expenses, reasonable moving expenses, and medical expenses) in connection with an employee’s separation from service. Eligible expenses generally must be incurred by the employee no later than the end of the second year following the year in which the employee terminates employment.
Even though reimbursed expenses must generally be incurred by the end of the second year following separation from service, reimbursements can be paid through the end of the third year following separation from service. Medical expenses may be reimbursed during the period the employee would be entitled to COBRA coverage if he or she elected such coverage and paid the applicable premiums.
Nonqualified stock options
While nonqualified (nonstatutory) stock options are generally subject to Section 409A, they may be exempt if structured properly. In general, nonqualified stock options are exempt from Section 409A if: (a) the exercise price is never less than the fair market value of the underlying stock on the grant date; (b) the number of shares subject to the option is fixed on the grant date; (c) taxation of the options is governed by IRC Section 83; and (d) there are no deferral features (other than the deferral of recognition of income until the exercise or disposition of the option). Stock appreciation rights (SARs) are generally treated the same as nonqualified stock options for Section 409A purposes. The regulations refer to nonqualified stock options and SARs collectively as “stock rights.” For the exclusion from Section 409A to apply, a stock right must relate to “service recipient stock.”
SARs are deferred compensation plans under which employees are entitled to a payment (usually in cash) equal to the appreciation in the value of a share of the employer’s stock from the grant date of the SAR to the exercise date.
In general, service recipient stock is any class of stock that qualifies as common stock under IRC Section 305, regardless of whether another class of common stock is publicly traded or has a higher aggregate value outstanding, and regardless of whether the class of stock is subject to transferability restrictions or buyback rights. Service recipient stock includes not only stock of the corporation for which the employee was providing services at the date of grant, but also stock of certain members of the employer’s controlled group of corporations.
In some cases, modification of the terms of a stock right may be treated as the grant of a new right (which must again be reviewed for compliance with Section 409A). A modification is any change that may result, directly or indirectly, in a reduction in the exercise price of the right.
In general, if a stock right’s exercise period is extended, the right is generally treated as having a deferral feature from the original grant date, subjecting the stock right to Section 409A. However, a stock right won’t become subject to Section 409A solely because the stock right’s exercise period is not extended beyond the earlier of (a) the original maximum term of the stock right or (b) 10 years from the original date of grant. But if a stock right is “underwater” (i.e., the fair market value of the underlying stock at the time of the extension is less than or equal to the exercise price) the exercise period can be extended without limit.
If an employee has a right to the payment of accumulated dividend equivalents that’s contingent on the exercise of a stock option, the arrangement may be treated as a discounted stock option, subject to Section 409A.
Restricted property (restricted stock, secular trusts, funded excess benefit plans, and nonqualified annuities)
Section 409A doesn’t apply to the transfer of restricted property from an employer to an employee. Restricted property is generally property that an employee may forfeit if the employee fails to satisfy certain conditions (for example, working for a specified period of years). This rule applies, for example, to grants of restricted stock, transfers to nonqualified trusts taxable under Code Section 402(b) (for example, certain secular trusts), and transfers to nonqualified annuities taxable under IRC Section 403(c).
Section 409A does apply to phantom stock plans, restricted stock unit (RSU) plans, and similar arrangements which do not involve transfers of property under IRC Section 83. In addition, Section 409A generally applies to an arrangement under which an employee obtains a legally binding right to receive vested property in a later year.
In a typical wraparound (or “wrap”) plan, an employee determines how much he or she wants to defer in the aggregate each year to the employer’s qualified 401(k) plan and the NQDC (wraparound) plan. The employee’s deferrals flow first into the wraparound plan and then, at year-end, when the 401(k) plan’s discrimination testing is complete, the maximum amount the employee is eligible to defer to the 401(k) plan is “transferred” from the wraparound plan to the 401(k) plan. The remaining deferral, if any, remains in the NQDC plan. There was initial concern when Section 409A was enacted that these plans would no longer be permitted, because it would be difficult, if not impossible, for them to meet Section 409A’s deferral election and anti-acceleration rules. However, under the IRS final regulations, the typical wraparound plan described above is still allowed.
While the conclusion is easy to state, the technical rules that apply to wraparound plans (and any other plans that link qualified and nonqualified plan deferral elections in general) are as follows:
- An employee’s action (or inaction) with respect to a 401(k) plan deferral election that increases or decreases an employee’s NQDC plan deferrals will not be treated as either a deferral election (requiring compliance with the initial deferral election rules) or a prohibited acceleration of the payment of NQDC plan benefits, as long as the employee’s aggregate NQDC plan benefits do not increase by more than the 402(g) limit for the year ($17,000 in 2012), plus catch-up contributions if the employee is age 50 or older ($5,500 in 2012).
- Similarly, an employee’s action (or inaction) with respect to 401(k) plan deferrals or after-tax elections that results in an increase or decrease in the amount of matching contributions credited to the employee’s NQDC plan account will not be treated as a deferral election or an acceleration of the payment of benefits if the amount credited to the employee’s aggregate NQDC plan accounts never exceeds 100 percent of the match the employee could have received in the qualified plan if statutory benefit limits did not apply (for example, Section 415 limits and compensation limits).
- The employee’s action (or inaction) with respect to the 401(k) plan can not affect the time or form of benefit payments from the NQDC plan.
Split dollar plans
Split dollar plans that provide only death benefits aren’t subject to Section 409A. Similarly, split-dollar plans that are taxed as loans aren’t subject to Section 409A. However, “equity” type split dollar plans generally are subject to the new rules.
In 2003, the IRS issued regulations that radically revised the taxation of split dollar plans. The revised rules apply to split dollar arrangements entered into after September 17, 2003. A split dollar plan entered into before that date is grandfathered, and generally receives more favorable income tax treatment. However, to retain that grandfathered status, the contract can’t be materially modified after September 17, 2003. If it is, it’s treated as a new split dollar arrangement subject to the revised tax rules. Many split dollar plans were frozen in 2003 to take advantage of the more favorable tax rules that grandfathering provided, or terminated altogether, and few new equity split dollar plans are currently being adopted.
As discussed earlier, Section 409A generally doesn’t apply to pre-2005 deferrals. But if a split dollar plan is subject to Section 409A, the mere fact that it was entered into before September 18, 2003, doesn’t mean that it’s entirely grandfathered for Section 409A purposes. According to Notice 2007-34, any increase in the policy cash value attributable to continued services performed, compensation earned, or premium payments or other contributions made on or after January 1, 2005, will not be grandfathered for Section 409A purposes. The Notice indicates that employers can generally use any reasonable method of determining the grandfathered and non-grandfathered portions of the split dollar benefit. Alternatively, employers can use a safe harbor allocation method provided in the Notice.
If a split dollar plan is subject to Section 409A, then it generally needed to be amended to comply with the new rules no later than December 31, 2008. This raised the question of whether the Section 409A amendments would be considered a material modification that would cause the split dollar plan to lose it’s September 17, 2003, grandfathered status for income tax purposes. Notice 2007-34 provided that a split dollar plan that was amended to comply with (or to avoid application of) Section 409A would not be treated as having been materially modified (and therefore would retain it’s grandfathered tax status for income tax purposes) if all five of the following requirements were met:
- The employer or employee made a determination that Section 409A was applicable to the arrangement, and that the arrangement wasn’t in compliance
- The employer or employee had made a determination that the amendment would bring the split dollar arrangement into compliance with Section 409A, or result in Section 409A no longer being applicable to the arrangement
- The amendment consisted solely of definitional changes (for example, the definition of a separation from service or disability), or changes to the payment timing requirements (including elections related to the time and form of payment), or changes to the conditions under which all or part of the benefit under the arrangement would be forfeited (such as an acceleration of a vesting requirement)
- The amendment established a time and form of payment consistent with those under which the benefits could have been paid under the terms of the arrangement before the amendment, and
- The modification didn’t materially enhance the value of the benefits to the employee under the arrangement
Tax reporting and withholding
The American Jobs Creation Act of 2004, which added Section 409A, also amended the Code to require that employers report NQDC plan deferrals to the plan participant and the IRS on Form W-2 (for employees) and Form 1099-MISC (for nonemployees). The Act also requires that employers report (also on Forms W-2 and 1099-MISC) amounts included in a plan participant’s gross income as a result of a NQDC plan’s failure to comply with Section 409A. Amounts included in an employee’s income are also considered wages for tax withholding purposes. Notice 2008-115, as amended by Notice 2010-6, provides interim guidance on these reporting and wage withholding requirements, including guidance on calculating the amount included in an employee’s income under Section 409A.
Section 409A applies to compensation deferred in taxable years beginning after December 31, 2004. In general, amounts deferred prior to 2005 (and earnings on those deferrals) aren’t subject to Section 409A. This means that grandfathered amounts can continue to be administered in accordance with the plan’s terms, even if those provisions wouldn’t satisfy Section 409A. An amount is considered deferred before January 1, 2005, if, before that date, the employee had a legally binding right to the compensation, and the right to the amount was earned and vested.
Deferred amounts that were not earned, or were not vested, as of December 31, 2004, are subject to the provisions of Section 409A.
For account balance plans (for example, a deferral plan), the grandfathered amount is the employee’s vested account balance on December 31, 2004, plus any additional contributions to the account that were earned and vested as of December 31, 2004 (plus any earnings on those grandfathered amounts that accrue after December 31, 2004).
For non-account balance plans (for example, a defined benefit SERP), the grandfathered amount is generally the present value of the employee’s vested benefit as of December 31, 2004, determined as if the employee (a) voluntarily terminated employment without cause on that date, (b) received payment at the earliest possible date permitted under the plan, and (c) received benefits in the form with the maximum value. Any increase in the present value of the future payments each year due to the passage of time is generally considered “earnings” and also grandfathered.
If the amount an employee actually becomes entitled to receive under a non-account balance plan, in the form and at the time actually paid, (determined under the terms of the plan as of October 3, 2004, and disregarding any service by the employee after 2004) is greater than the originally determined grandfathered amount, then that higher amount will become the grandfathered amount.
For equity based plans, the grandfathered amount is the vested amount that was available to the employee on December 31, 2004, or that would have been available if the equity right were immediately exercisable on that date, plus any earnings on the grandfathered amount (that is, any increase in the amount payable due to appreciation in the underlying stock after 2004). (The grandfathered amount does not include any exercise price or other amount that must be paid by the employee.)
Loss of grandfather status
If a NQDC plan in existence on October 3, 2004 is “materially modified” after that date, it will lose its grandfathered status, and all deferrals under the plan, even those deferred prior to 2005, will be subject to Section 409A. A modification to a NQDC plan is material if a benefit or right existing on October 3, 2004, is materially enhanced, or a new material benefit or right is added, and that material enhancement or addition affects amounts earned and vested before January 1, 2005–even if the enhanced or added benefit would be permitted under Section 409A.
Example(s): Neptune Corporation amends it’s NQDC plan to provide that grandfathered amounts can be withdrawn if the participant establishes that he or she has an unforeseeable emergency. The addition of this right would be a material modification, even though Section 409A generally permits distributions on account of unforeseeable emergencies.
The following is a non-exhaustive list of actions do not result in a material modification:
- The employer’s exercise of discretion over the time and manner of payment of a benefit, if that discretion is provided under the terms of the plan as of October 3, 2004
- The employee’s exercise of a right permitted under the plan as in effect on October 3, 2004
- Amending a plan to bring it into compliance with Section 409A
- Amending a plan to reduce existing benefits (for example, by deleting a haircut provision)
- A cessation of deferrals under, or termination of, a plan pursuant to the provisions of the plan (but amending a plan to provide participants with an election whether to terminate participation in the plan would be a material modification)
- Changing certain plan investment measures
- The establishment of, or contributions to, a rabbi trust
- If a NQDC plan provides for payment in the form of a life annuity, amending the plan to permit employees to choose between the existing life annuity benefit, and other forms of annuity payments that would be treated as a single form of payment under Section 409A
- Complying with a qualified domestic relations order (QDRO)
- Amending a plan to include a limited cashout feature
An action that would otherwise constitute a material modification, resulting in loss of grandfathered status, won’t be treated as a material modification if the employer rescinds the action by the earlier of (a) a date before the right is exercised (if the change granted a discretionary right), or (b) the last day of the employee’s taxable year in which the change occurred.
Example(s): Acme Corporation amends it’s NQDC plan on March 1 to allow employees to change the time and form of payment of grandfathered benefits, without realizing that such amendment would constitute a material modification to the plan resulting in loss of grandfathered status. On November 1, before any employee has made a new election, the company rescinds the amendment. The NQDC plan will not be considered materially modified, and grandfathered status will be retained.