WSGR ALERT

A Road Map for Traditional Nonqualified Deferred Compensation Plans under the Final Section 409A Regulations

May 17, 2007

On April 10, 2007, the U.S. Treasury and Internal Revenue Service (IRS) issued final regulations under Internal Revenue Code Section 409A (Section 409A). We previously have issued several Client Alerts regarding various aspects of the final regulations, including highlights, stock rights, and separation pay arrangements.

This Client Alert focuses on the application of Section 409A and the final regulations to traditional nonqualified deferred compensation plans (NQDC plans) and is intended to help guide companies through some of the more complex provisions of the final regulations that are applicable to NQDC plans. However, this Client Alert does not address every aspect of the rules and companies that maintain NQDC plans should consult with legal counsel.

General

1. If a NQDC plan is not properly amended for Section 409A, what are the tax consequences?

Under Section 409A, unless certain requirements are satisfied, amounts deferred under a NQDC plan are includable in the gross income of the participants,1 even if all accounts are not actually paid to an employee, unless such amounts are subject to a substantial risk of forfeiture. In addition, such deferred amounts are subject to an additional 20 percent federal income tax, interest, and penalties. Certain states also have adopted similar tax provisions. (For example, California also imposes an additional 20 percent state tax, interest, and penalties.)

2. When are the final regulations effective?

The final regulations are effective as of January 1, 2008. Prior to that date, companies and participants may rely on previous guidance and transition relief set forth under Notice 2005-1, the proposed regulations under Section 409A, and other subsequent notices. Alternatively, if desirable, companies and participants retroactively may apply the final regulations prior to January 1, 2008. Doing so may be advantageous with respect to rules for which the final regulations have provided additional clarity.

Plans Subject to Section 409A

In general, a plan that provides for "deferred compensation" is a "nonqualified deferred compensation plan" that must comply with Section 409A and the final regulations. This section of the Client Alert provides a brief explanation of the provisions in the final regulations defining "nonqualified deferred compensation plans" and "deferred compensation."

3. What is a "nonqualified deferred compensation plan" under Section 409A?

A "nonqualified deferred compensation plan" includes any agreement, method, program, or other arrangement that provides for "deferred compensation" (see Q&A No. 6 below) regardless of the number of participants covered under the plan. By definition, a traditional NQDC plan is a nonqualified deferred compensation plan within the meaning of Section 409A.

4. Are there any deferral-type employee benefit plans that are not considered NQDC plans?

Yes. The final regulations specifically exclude certain types of plans, including qualified employer plans (e.g., 401(k), tax-deferred annuities, etc.), certain foreign plans (e.g., if the compensation deferred is exempt from federal taxation by a tax treaty or a foreign social security system), and certain welfare benefit plans (e.g., vacation leave, sick leave, compensatory time, disability pay, or death benefit plans).

5. Does Section 409A require similar types of NQDC plans to be aggregated into a single plan?

Yes. In identifying the arrangements that comprise a NQDC plan, companies will need to aggregate NQDC plans of similar type in accordance with the plan aggregation rules set forth in the final regulations. These plan aggregation rules establish the following nine types of NQDC plans: (1) elective account balance plans, (2) nonelective account balance plans, (3) nonaccount balance plans, (4) separation pay plans, (5) reimbursement or in-kind benefit plans, (6) split-dollar life insurance arrangements, (7) foreign plans, (8) stock rights, and (9) other plans.

The plan aggregation rules provide that a Section 409A violation with respect to one NQDC plan can negatively affect all other arrangements of the same type that are required to be aggregated together and in which a participant participates. Fortunately, a Section 409A violation with respect to one participant will not necessarily cause a Section 409A violation with respect to all participants, nor will such a violation affect any other arrangement that is not required to be aggregated.

6. When does a plan provide for deferred compensation?

The final regulations broadly state that a plan provides for deferred compensation if, under the terms of the plan and the relevant facts and circumstances:

  • a participant has a legally binding right during a taxable year to compensation; and
  • the compensation is (or may be) payable to the participant in a later taxable year.

7. What is a "legally binding right"?

Whether a participant has a "legally binding right" to compensation will depend on the relevant facts and circumstances. In general, a legally binding right will include a statutory right or a contractual right enforceable under the applicable law governing the contract. Although the final regulations do not provide substantial guidance concerning this legally-binding-right concept, the final regulations do clarify that a participant's legally binding right to a nontaxable amount paid in a future tax year is not deferred compensation. Such an amount will be taxable, and thus deferred compensation, if the participant received the right to such amount in exchange for, or has the option to exchange the right for, a taxable amount that is not in connection with a cafeteria plan. In addition, the final regulations provide that a participant generally will not have a legally binding right to receive compensation to the extent that the company has discretion to unilaterally reduce or completely eliminate such compensation unless the company's discretion is conditional or lacks substantive significance.

Example: Widget Company maintains a bonus plan. On March 1, 2008, Widget Company grants Ethan a $10,000 bonus payable on March 1, 2009 (with reasonable interest). Ethan has a legally binding right to the bonus as of March 1, 2008, since he has a contractual right enforceable under contract law.

8. Are there arrangements that are exempt from the definition of deferred compensation?

Yes. Despite the broad definition of deferred compensation, the final regulations do provide several helpful exemptions from the definition of deferred compensation (which are briefly described below). However, many of these exemptions will not provide relief for NQDC plans:

  • Certain stock rights. Please see our Client Alert on stock rights for additional information.
  • Short-term deferrals and certain separation pay plans. Please see our Client Alert on separation pay arrangements for additional information.
  • Certain foreign arrangements, including foreign plans covered by tax treaties or other international agreements, tax equalization agreements, etc.
  • Other exemptions related to indemnification arrangements, nontaxable benefits, legal settlements, split-dollar life insurance arrangements, and educational benefits.

Complying with Section 409A

9. In order to comply with Section 409A, must a NQDC plan be in writing to be established and maintained under Section 409A?

Yes. A NQDC plan must be in writing and must reflect the requirements of Section 409A, which require the company to establish the material terms of the plan, including: (1) the amount (or an objective, nondiscretionary formula to determine the amount) of deferred compensation payable to a participant; (2) the payment schedule or the payment-triggering events that will result in payment to a participant; (3) the conditions under which a participant may make an initial and subsequent deferral elections; (4) in some cases, the conditions under which the plan may accelerate payment of deferred compensation; and (5) if the company is publicly traded, the requirement that the plan will delay payment due to the six-month delay rule applicable to specified employees.

10. If a NQDC plan has a general Section 409A savings clause to comply with Section 409A, is that sufficient?

No. Most NQDC plans will require amendments to comply with the final regulations. A savings clause that states that the NQDC plan will comply with all of the Section 409A requirements is not sufficient. The IRS has stated that they have no intention of providing model amendments that a company may adopt to comply with Section 409A. Consequently, a company should be working with legal counsel to develop a roadmap to address the action items listed at the end of this Client Alert.

11. When is a NQDC plan established?

A NQDC plan is considered established on the latest of: (1) the adoption date, (2) the effective date, or (3) the date on which the material terms of the plan are set forth in writing. For this purpose, the IRS will view each NQDC plan separately and will not aggregate similar NQDC plans pursuant to the plan aggregation rules discussed above. In addition, the IRS will treat each legally enforceable, unwritten NQDC plan that is effective prior to December 31, 2007, as established for purposes of Section 409A as of either the adoption date or the effective date, whichever is later, provided that the plan sets forth in writing all of the material terms by the end of this year.

Initial Deferral Elections

NQDC plans typically permit participants to elect the time and form of payment of the compensation deferred under the plan. For example, a plan may permit a participant to defer a portion of his or her 2008 salary until a later year (e.g., 2010) and permit a participant to elect to receive such deferred compensation in the form of a lump-sum or installment payments.

The final regulations set forth detailed requirements with respect to initial deferral elections that address not only ongoing deferral elections for existing participants, but also deferral elections for new participants, deferral elections with respect to certain types of compensation (including performance-based compensation), and other matters. To the extent a company's NQDC plan permits participants to elect the time and/or form of payment of deferred compensation, the company should review its plan to determine which of the initial deferral elections apply and whether the plan will need to be modified to comply with the final regulations.

12. To comply with Section 409A, when must a participant make his or her initial deferral election?

NQDC plans that permit a participant to elect the time or form of payment must require the participant to make a deferral election no later than the end of the taxable year prior to the taxable year in which the participant will perform the services related to the deferred compensation.

Example: Widget Company sponsors a NQDC plan under which Meg may elect to defer a percentage of her salary for 2008. Meg has participated in the NQDC plan in prior years. Her election will comply with Section 409A, as long as she elects to defer the percentage of salary, including an election as to the time and form of payment, no later than December 31, 2007.

13. Must the deferral election be irrevocable to comply with Section 409A?

Yes, an election to defer compensation must become irrevocable no later than the latest date permitted under the initial deferral election rules. However, an election will be considered irrevocable even if the company or participant makes a subsequent election to change the time and form of payment under the subsequent deferral rules or the NQDC plan provides for an exception to the anti-acceleration rules. A NQDC plan may allow a participant to change his or her election at any time before the last permissible date for making such an election.

Example: Widget Company's NQDC plan provides that Lois may elect to defer a percentage of her salary for 2008 and that such election will remain in effect until changed or revoked, but as of December 31, 2007, the election becomes irrevocable for 2008. Since December 31, 2007, is the last permissible date to make the election, Lois could change her election at any time up to December 31, 2007 without running afoul of Section 409A.

14. Must the company make an election if the NQDC plan generally does not permit participants to make any deferral elections?

Yes. NQDC plans that do not permit a participant to elect the time or form of payment must require the company to designate the time and form of payment by no later than: (1) the date the participant has a legally binding right to the deferred compensation; or (2) the end of the taxable year prior to the taxable year in which the participant will perform the services related to the deferred compensation.

Example: Widget Company has a taxable year ending September 30. On July 1, 2008, Widget Company enters into a legally binding obligation to pay Lois a $10,000 bonus. The amount is not subject to a substantial risk of forfeiture and does not qualify as performance-based compensation. Widget Company does not permit Lois to make an election as to the time and form of payment. Unless the amount is payable in accordance with the short-term deferral rule, Widget Company must specify the time and form of payment on or before July 1, 2008, to satisfy the initial deferral election rules.

15. Are there special rules for new hires?

Yes. When a participant first becomes eligible to participate in a NQDC plan, the plan may permit the participant to make a deferral election within 30 days of becoming eligible. If the plan does not permit participants to make deferral elections, the plan or the company must specify the time and form of payment within 30 days after the date the participant first becomes eligible to participate in the plan.

Of course, this deferral election may only apply to compensation paid for services performed after such election. In addition, the plan only may permit a participant to make this deferral election to the extent that the participant currently is not eligible under a similar plan maintained by the company (please see the plan aggregation discussion above).

16. When does a participant first become eligible to participate in a NQDC plan?

For purposes of determining when a participant first becomes eligible to participate in a plan, the final regulations include the following special rules:

  • A participant who is no longer eligible to participate in a plan and has taken a complete distribution will be a newly eligible participant when he or she again becomes eligible.
  • A participant who is no longer eligible to participate in a NQDC plan and does not take a full distribution will be a newly eligible participant when he or she has not accrued any benefit under the plan, other than earnings, for a period of 24 months.

17. When does a participant in an excess benefit plan first become eligible to participate in a NQDC plan?

If a participant is eligible for benefits under an excess benefit plan, the participant is considered a newly eligible participant as of January 1 following the first year in which the participant accrues a benefit under the excess benefit plan. If permitted under the plan at that time, the participant has until January 31 of that year to make an election as to the time and form of payment, which applies to benefits accrued under the plan with respect to services performed in the prior taxable year. For purposes of the final regulations, an "excess benefit plan" means a NQDC plan that does not permit deferral elections and solely provides deferred compensation equal to the additional benefits a participant could have accrued under a qualified employer plan absent the Internal Revenue Code or plan limits on contributions or benefits.

Example: Widget Company's defined contribution plan provides for a contribution equal to 20 percent of Meg's salary of $300,000, or $60,000. However, in 2007, Internal Revenue Code Section 415 limits the contribution made on Meg's behalf to $45,000. Widget Company may credit the remainder of the contribution ($15,000) to the company's excess benefit plan.

18. Are there special election rules under the final regulations for short-term deferrals that are not otherwise deferred in accordance with the initial deferral rules?

Yes. In the event that a participant does not otherwise elect to defer a short-term deferral in accordance with the initial deferral rules, a participant still may make a deferral election with respect to a short-term deferral, provided that the election complies with the subsequent deferral rules. As such, the participant must make the deferral election at least 12 months prior to, and defer payment at least five years after, the date at which the payment is no longer subject to a substantial risk of forfeiture.

Under a transition rule, a participant may make an initial deferral election with respect to short-term deferral amounts that remain subject to a substantial risk of forfeiture on or after January 1, 2008, as long as the participant makes such an election on or before December 31, 2007.

Example: On March 1, 2008, Widget Company grants Ethan a $10,000 bonus payable on March 1, 2010 (with reasonable interest) provided Ethan remains employed with Widget Company through March 1, 2010. The bonus does not qualify as performance-based compensation and Ethan participates in another account balance NQDC plan. He does not make an initial deferral election on or before March 31, 2008. However, Ethan still may elect to defer the bonus provided that: (1) the election may not become effective for 12 months and (2) he must defer the payment at least five years after March 1, 2010 (the first date the payment could become substantially vested). As such, Ethan may make an election before March 1, 2009, provided that the election defers the payment to a date on or after March 1, 2015 (other than a payment due to death, disability, unforeseeable emergency, or a change-in-control event).

19. Are there special election rules under the final regulations for performance-based compensation?

Yes. The final regulations provide a limited exception for performance-based compensation from the general rule governing initial deferral elections. This exception permits deferral elections with respect to performance-based compensation after the beginning of the taxable year in which the participant will perform the services, provided that:

  • the participant makes the deferral election on or before the date that is six months prior to the end of the related performance period;
  • the participant performs services continuously from the later of: (1) the beginning of the performance period or (2) the date the company establishes the performance criteria, through the date the participant makes the deferral election; and
  • the amount of performance-based compensation that will be earned is not readily ascertainable (e.g., the performance goals are not certain to be achieved at the time the participant makes the deferral election).

Example: Meg is entitled to performance-based compensation in the amount of $10 for every widget she sells in excess of 1,000 during the period from January 1, 2007, through December 31, 2008. As of June 30, 2008 (six months before the end of the performance), Meg has sold 1,500 widgets without making a deferral election. As a result, Meg's deferral election with respect to her performance-based compensation on June 30, 2008, may not include the $5,000 that she is certain to receive as of that date ($10 per widget for 500 widgets).

20. What is performance-based compensation?

For purposes of the final regulations, performance-based compensation is compensation to which a participant will be entitled upon satisfying organizational or individual performance goals for a performance period that is at least 12 months in duration.

21. When must performance goals be established?

The company must establish the performance goals within 90 days of the commencement of the performance period. In addition, achievement of the performance goals must be substantially uncertain at the time the company establishes such performance criteria.

22. Do restricted stock units or performance share awards provide for deferred compensation within the meaning of Section 409A?

Restricted stock units and performance share awards typically are settled at the time or shortly after the awards vest. Awards that are structured in this way generally satisfy the short-term deferral rule under the final regulations (please see our Client Alert on separation pay arrangements for additional information) and therefore generally are exempt from Section 409A. However, restricted stock units and performance share awards may include certain provisions that otherwise make them subject to Section 409A. For example, if a restricted stock unit award accelerates vesting upon a termination of employment for good reason and the good- reason trigger does not satisfy the safe harbor definition of good reason or the general rule under the final regulations, the award will be subject to Section 409A and must comply with the six-month delay rule. In addition, as discussed in the following question, an individual may elect to defer settlement of a restricted stock unit or performance share award, at which time the award will be subject to Section 409A. There may be other features or vesting acceleration triggers that otherwise raise Section 409A concerns. Consequently, companies should have their restricted stock unit and performance share awards reviewed by legal counsel to the extent such awards include vesting acceleration triggers or deferral features.

23. When can the settlement of restricted stock units or performance share awards be deferred?

The initial deferral and subsequent deferral rules apply to restricted stock units and performance share awards in the same fashion as such rules apply to a traditional NQDC plan. Consequently, an individual could make an election to defer settlement of a restricted stock unit or performance share award in accordance with the general rule. Complying with the general rule, however, may not always be desirable or feasible, as such an election would need to be in place prior to the year in which the award is granted. Alternatively, the holder of a restricted stock unit or performance share award could elect to defer settlement of such award as follows:

  • If the restricted stock unit or performance share award qualifies as performance-based compensation, the holder of such award could make an initial deferral election at any time on or before the date that is six months before the end of the related performance period, provided that the requirements described in Q&A No. 19 are satisfied.
  • A holder of a restricted stock unit or performance share award could make an initial deferral election within 30 days of the grant of such award, provided that the vesting of such award is contingent on the holder providing services for at least 12 months following the date of election (see Q&A No. 22 above).
  • If the restricted stock unit or performance share award does not otherwise qualify as performance-based compensation or does not require at least 12 months of service following the date of election, the holder of such award could still defer settlement of such award, but the deferral election would need to comply with the subsequent deferral rules.

As companies review existing awards that have been deferred or contemplate permitting deferral elections for existing or new awards, they will need to carefully consider the circumstances under which settlement of such awards will be accelerated (e.g., change in control). Although a restricted stock unit or performance share award may not necessarily be subject to Section 409A and the final regulations upon grant, once a deferral election has been made, the award will be subject to Section 409A and the final regulations, including the rules on permissible payment events and anti-acceleration.

24. When must a participant make an initial deferral election when the payment is subject to a forfeiture restriction?

A participant may make an initial deferral election within 30 days of obtaining a legally binding right to a payment in a future year that is subject to a requirement that a participant continue to provide services through a certain date (the "forfeiture restriction"). The participant must make this election at least 12 months before the first date on which the forfeiture restriction might lapse, without regard to the fact that the forfeiture restriction could lapse earlier upon death or disability of the participant or a change in control of the company.

Example: On June 1, 2007, Widget Company provides Lois with the right to a bonus payable on June 1, 2009, provided that Lois is still employed with the company on that date. On or before July 1, 2007 (i.e., 30 days after obtaining the right to the payment), Lois may elect to defer the bonus payment because it is subject to a forfeiture restriction for at least 12 months after she makes the deferral election. If the bonus was payable on June 1, 2008, she would not be able to make an initial deferral election under this provision.

25. What if the company's fiscal year is not a calendar year and a participant's initial deferral election is based on fiscal year compensation?

If a company has a fiscal year other than the calendar year, a participant must make a deferral election with respect to "fiscal year compensation" no later than the close of the company's fiscal year preceding the first fiscal year in which the participant performs services for such compensation. For this purpose, fiscal year compensation generally would include a bonus paid to an employee based on a service period related to the company's fiscal year, but would not include a bonus paid to a participant based on a calendar year or salary paid to a participant during the fiscal year.

Example: If Ethan receives a bonus based on services performed during Widget Company's fiscal year ending September 30, 2009, where Ethan receives payment after September 30, 2009, Ethan must make a deferral election before October 1, 2008, with respect to such compensation.

26. When can a participant make an initial deferral election for separation pay?

A participant may elect to defer separation pay at any time prior to obtaining a legally binding right to such separation pay, provided that he or she is entitled to such pay as a result of arm's length negotiations at the time of the separation from service or as a result of participating in a retirement window program (whether voluntary or involuntary). Please see our Client Alert on separation pay arrangements for more details.

27. Are there special election rules under the final regulations for commission payments?

Yes. The rules governing deferrals of commissions are fairly complex and depend on whether the commission is a sales or investment commission. However, the final regulations clarify when the services related to a particular commission begin for purposes of determining when a participant must make an initial deferral election with respect to a commission. As discussed in the general rule above, the initial deferral election must be in place before the beginning of the taxable year in which the participant provides the services related to the compensation to defer.

28. When must a participant make an initial deferral election for sales commissions?

Generally, participants must make initial deferral elections by December 31 of the year prior to the year in which the company receives payment from the customer for the sales related to the commissions. However, the company may elect to tie the service period to the date of sale, in which case participants must make initial deferral elections by December 31 of the year prior to the year in which the sales related to the commissions occur.

29. When must a participant make an initial deferral election for investment commissions?

The service period for investment commissions is the 12-month period preceding the date on which the company calculates the investment commission for the participant. A participant must make an initial deferral election by December 31 of the year prior to the year in which the service period commences. For example, if the company calculates investment commissions on June 1, 2009, the participant must make an initial deferral election by December 31, 2007.

30. What is a NQDC "linked" plan?

A "linked" plan is a NQDC plan in which the calculation of the amount deferred relates to a qualified employer plan (e.g., a defined benefit plan or 401(k) plan). The two plans are linked if the amount deferred under the NQDC plan is calculated: (1) using the qualified employer plan formula, but without applying the limitations imposed on qualified plans under the Internal Revenue Code, or (2) as an amount offset by some or all of the qualified employer plan benefits. Since the NQDC plan and qualified employer plan are linked, changes in the amount, timing, or form of payment of compensation deferred under the qualified plan will generally affect the amount, timing, or form of payment of compensation deferred under the NQDC plan.

31. Does an election change under a qualified employer plan that is linked to a NQDC plan constitute a deferral election for purposes of Section 409A?

No. The final regulations generally provide that an election change under the qualified plan (or broad-based foreign plan) that results in a change in the amount deferred under the NQDC plan will not constitute a deferral election under the NQDC plan for purposes of Section 409A, provided: (1) the time or form of payment under the NQDC plan does not change, and (2) the change in the amounts deferred under the NQDC plan does not exceed the change in the amounts deferred under the qualified plan or a broad-based foreign plan, as applicable.

32. Does Section 409A place any restrictions on a participant's ability to change his or her cafeteria plan elections during the year?

No. Generally, a permissible election change under a cafeteria plan that results in a change in the amount deferred under a NQDC plan does not constitute a deferral election under the NQDC plan for purposes of Section 409A.

33. How does Section 409A apply to deferring part-year compensation throughout the year?

To comply with Section 409A, a participant must elect to defer all or a portion of any part-year compensation prior to the time at which services for such part-year compensation begins. In addition, the election must not defer payment beyond the last day of the 13th month following the first date of the service period.

Example: Meg provides services which routinely begin on the second Monday of August in one year and end on the first Friday of June of the subsequent year. Meg elects to receive her compensation ratably over the period beginning on the second Monday of August in one year and ending on the last day of August in the subsequent year. Provided that Meg's election occurs before the second Monday in August, Meg will be deemed to have made a timely deferral election under Section 409A.

34. Does Section 409A place any restrictions on permitting special deferral elections required under USERRA?

No. For purposes of Section 409A, a participant satisfies the initial deferral election rules to the extent that such deferral election is necessary to satisfy the requirements of the Uniformed Services Employment and Reemployment Rights Act of 1994 (USERRA), as amended.

35. Do participants have to make new initial deferral elections if they made or could have made a prior election in compliance with Section 409A?

Generally, no. The final regulations provide transition relief with respect to certain initial deferral elections. Pursuant to this transition relief, the following initial deferral elections will satisfy Section 409A:

  • an initial deferral election made prior to January 1, 2008, in compliance with the proposed regulations or other transition guidance under Section 409A, even if the deferral period extends beyond December 31, 2007;
  • an initial deferral election made by the deadline set forth in the plan if the plan was established before April 10, 2007, and, under a reasonable good-faith interpretation of existing guidance, a participant could have made an initial deferral election at any time after December 31, 2007, but before December 31, 2008 (e.g., performance-based compensation); or
  • an initial deferral election made by December 31, 2008, if the plan was established before April 10, 2007, and, under a reasonable good-faith interpretation of existing guidance, a participant could have made an initial deferral election, after December 31, 2008.

Subsequent Changes in the Time and Form of Payment

NQDC plans often allow participants to change their initial deferral elections with respect to the time and/or form of payment of compensation deferred under the plan. Such plans also often address circumstances in which a participant's deferral automatically will be deferred beyond the original payment date or event.

36. Are there specific rules governing when a participant or company may otherwise change the time and/or form of payment of deferred compensation after an initial election?

Yes. If a plan permits a participant or a company to make a subsequent election to delay a payment or change the form of payment set forth in the participant's initial deferral election, the plan must provide the following:

  • the subsequent deferral election will not be effective for at least 12 months;
  • except with respect to payment as a result of death, disability, or unforeseeable emergency, the new payment date must be at least five years later than the original payment date; and
  • the participant or company must make the subsequent deferral election at least 12 months prior to the original payment date if the deferred compensation will be paid at a specified time or pursuant to a fixed schedule.

Example: Ethan participates in a NQDC plan. He initially elects to be paid in a life annuity at age 65. Ethan wishes to change the payment form to a lump-sum payment. As long as Ethan makes the subsequent election on or before his 64th birthday, he may elect to receive the lump-sum payment at age 70 without violating Section 409A.

37. If a participant's initial deferral election provides for two or more payment events, may the participant change the time and form of payment for each event separately?

Yes. The subsequent deferral rules described above apply separately to each payment due at each payment event. For example, a plan provides for payment upon January 1, 2009 (a fixed date), or separation from service, whichever is earlier. Provided that the participant remains employed and makes his or her election on or before January 1, 2008, the participant may elect to change the payment to January 1, 2014 (an additional deferral of five years) or separation from service, whichever is earlier.

38. What constitutes a "payment" for purposes of applying the subsequent deferral rules?

For purposes of determining the "payment" to which the subsequent deferral election will apply, the final regulations generally provide that a payment will include each separately identified amount payable to a participant under a plan on a determinable date. For example, a lump-sum payment of a participant's entire account balance payable on January 1, 2010, is the payment to which the subsequent deferral rules would apply.

39. Are life annuities or a series of installment payments considered as a single payment or multiple payments?

With respect to life annuities, the final regulations generally treat payments made pursuant to a life annuity as a single payment to be made on the date the annuity is scheduled to commence. Similarly, the final regulations treat a series of installment payments as a single payment to be made on the date the first installment is scheduled to be paid unless the plan provides at all times with respect to a participant's deferred compensation that each installment payment is a separate payment. Consequently, for purposes of deferring the commencement of an annuity or series of installment payments or changing the form of payment, the subsequent deferral rules will apply as if the entire amount is payable in a lump sum on the date the annuity or series of installments is scheduled to commence.

Example: If Meg's deferred compensation will be paid in an annuity commencing on January 1, 2010, she would have to elect to defer the commencement of the annuity by January 1, 2009, and the new commencement date must be on or after January 1, 2015. Meg also could change the form of payment from installments to a lump sum.

40. Can a change in the form of payment result in a more rapid payment schedule?

Generally, yes. A change in the form of payment that results in a more rapid schedule generally will not be an impermissible acceleration, provided that such change is made in accordance with the subsequent deferral rules.

Example: Meg could elect to receive the deferred compensation in the form of a lump sum rather than in 10 installments (that were treated as a single payment under Section 409A). Provided that such election is made at least 12 months before the first scheduled installment payment and payment is deferred for at least five years from the first scheduled installment payment, Meg's subsequent deferral election will not violate the anti-acceleration rules.

41. When can a company delay a payment beyond the scheduled date or event and not run afoul of Section 409A?

Under the circumstances described below, the company may delay the payment of deferred compensation beyond the scheduled date or event. Provided that the company treats all similarly situated participants equally, such a delay will not be subject to the subsequent deferral rules described above.

  • Payments subject to Section 162(m) - If the company reasonably anticipates that it will not be able to deduct the payment due to Internal Revenue Code Section 162(m), the company may delay the payment. The company, however, must make the delayed payment either: (1) during the participant's first taxable year in which the company reasonably anticipates, or should reasonably anticipate, that the company could take a deduction for the payment; or (2) during the period commencing on the date of the participant's separation from service and ending on the later of December 31 of the year the participant separates from service or two-and-a-half months after the participant separates from service.
  • Payments in violation of federal securities laws - If the company reasonably anticipates that making the payment would result in a violation of the federal securities laws or other applicable law, the company can delay the payment, provided that company makes the payment as soon as such payment would not cause such violation.
  • Other events and conditions - Any event or condition as prescribed by the commissioner of the IRS.

In addition, the final regulations permit the plan to delay the payment of deferred compensation where such payment would otherwise jeopardize the company's ability to continue as a going concern. However, the payment must then be made in the first taxable year in which the payment will not negatively affect the company's status as a going concern.

42. Does the subsequent change in time and form of payment rules apply to a participant's right to make an election under USERRA?

The final regulations provide that a participant satisfies the rules regarding subsequent changes in the time and form of payment for purposes of Section 409A to the extent such subsequent change in the time or form of payment made by the participant is necessary to satisfy the requirements of USERRA.

Permissible Payment Events

As noted above, NQDC plans typically allow participants to select the time and form of payment of compensation deferred under the plan. Alternatively, such plans may automatically provide for the time and form of payment. In either case, Section 409A and the final regulations identify only six circumstances in which a plan may permit a distribution of a participant's deferred compensation.

43. What are the six permissible payment events under which a NQDC plan may permit a distribution?

  1. The participant's separation from service
  2. The participant becoming disabled
  3. The participant's death
  4. A time or a fixed schedule specified under the plan
  5. A change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation
  6. The occurrence of an unforeseeable emergency

44. Can a participant elect to receive payment upon the earlier (or later) of two or more permissible payment events?

Yes. The final regulations allow a plan to permit participants to elect to receive payment of deferred compensation upon the earlier of (or later of) two or more of these events. For example, a participant could elect to receive payment upon the earlier of a fixed date or separation from service. However, as noted above, the subsequent deferral rules and the anti-acceleration rules will apply to each payment event separately.

Separation from Service

The final regulations set forth specific rules governing when an employee or independent contractor will separate from service for purposes of Section 409A. Our previous Client Alert regarding separation pay arrangements includes a detailed discussion of these rules. However, we have also included a brief description of these rules as they apply in the context of a NQDC plan.

45. When does an employee "separate from service" for purposes of Section 409A?

An employee will separate from service on the date the employee dies, retires, or otherwise terminates employment with the company (including any companies that are part of the company's controlled group, such as subsidiaries). Whether a termination of employment has occurred will depend upon the particular facts and circumstances. For example, if an employee quits or is fired and will have no future contact or relationship with the company, the employee clearly has terminated employment.

46. Is there a separation from service if an employee is absent from work due to military leave, sick leave, or a bona fide leave of absence?

Not necessarily. An employee will remain an employee during a military leave, sick leave, or other bona fide leave of absence, provided that the employee returns from leave within six months or otherwise has a legal or contractual reemployment right (e.g., USERRA). A leave of absence is only bona fide to the extent that the company and employee reasonably expect that the employee will return from leave. Consequently, companies should be mindful of this rule in connection with any salary continuation or terminal-leave programs that otherwise treat an individual as an employee even though the company does not expect the individual to perform any meaningful services in the future.

47. Do the final regulations provide any guidance on when an employee may have separated from service, even though the employee may still be providing services to the company?

Yes, the final regulations provide some guidance on when an employee may be considered separated from service as described below.

  • Permanent Reduction in Services to 20 Percent - An employee will be presumed to have terminated employment where he or she provides, either as an employee or independent contractor, bona fide services of no more than 20 percent of the average level of services performed by the employee during the immediately preceding 36-month period (or, if shorter, the length of employment).
  • Permanent Reduction in Services to 50 Percent - An employee will be presumed not to have terminated employment where he or she provides, either as an employee or independent contractor, bona fide services of at least 50 percent of the average level of services performed by the employee during the immediately preceding 36-month period (or, if shorter, the length of employment).
  • Permanent Reduction in Services Specified in the Plan - A plan may specify a percentage between 20 to 50 percent at which an employee will be deemed to have terminated employment. Such provision can be effective only on a prospective basis.

48. When does an independent contractor separate from service according to Section 409A?

An independent contractor generally will separate from service on the date the contract with the company expires. However, a separation will not occur to the extent that the company expects or anticipates renewing the contract or otherwise employing the independent contractor as an employee.

49. Are there special rules if a participant provides services as an employee and an independent contractor?

Yes. A participant providing services as an employee and as an independent contractor must cease providing services in both capacities to incur a separation from service for purposes of Section 409A.

50. What about an employee who is also a director of a corporation?

A participant providing services both as an employee and a member of a company's board of directors must only cease providing services as an employee to receive a distribution of deferred compensation from a plan: (1) in which the individual participates solely as an employee, and (2) that the company does not aggregate with another plan in which the individual participates as a director.

Delayed Payment for Specified Employees

51. Are specified employees required to wait before receiving payment?

Yes. If a participant is a specified employee, a NQDC plan must, by its terms and in practice, delay payment of any deferred compensation payable as a result of such participant's separation from service for at least six months (and one day) following the participant's separation. For this purpose, a specified employee is generally a key employee of a public company. The final regulations provide that this six-month delay does not apply to any payments that are not subject to Section 409A. Please see our Client Alert on separation pay arrangements for additional information concerning the rules applicable to specified employees.

Disability

52. May a participant receive a distribution due to becoming disabled?

Yes. A NQDC plan may distribute a participant's deferred compensation in the event he or she becomes disabled. For this purpose, the participant is disabled if:

  • the participant 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 last for a continuous period of not less than 12 months; or
  • the participant is, by reason of any medically determinable physical or mental impairment that can be expected to result in death or last for a continuous period of not less than 12 months, receiving disability compensation for at least three months under the company's accident and health plan.

53. Who determines if the participant is disabled?

Any person, including the administrator of a disability insurance program, may determine whether a participant is disabled, as described above. However, a plan may provide that a participant will be deemed disabled if so determined by the Social Security Administration or Railroad Retirement Board.

54. May a NQDC plan provide for the cancellation of the participant's deferral election if the participant becomes disabled?

Yes, a plan may provide for the cancellation of a deferral election in the event the participant becomes disabled. The cancellation must occur by the later of: (1) the December 31 of the year in which the participant becomes disabled, or (2) two-and-a-half months after the participant becomes disabled. For this purpose, disability means any medically determinable physical or mental impairment resulting in the participant's inability to perform the duties of the participant's position or any substantially similar position, where such impairment can be expected to result in death or last for a continuous period of not less than six months.

55. Should companies review the provisions in their NQDC plans concerning disabilities?

Yes. If a company's NQDC plan permits distributions upon disability and/or provides for the cancellation of a participant's deferral election upon a disability, the company should review the NQDC plan's definition of disability to ensure that it otherwise complies with the final regulations.

Death

56. May a NQDC plan distribute deferred compensation due to the death of the participant?

Yes, a NQDC plan may distribute a participant's deferred compensation upon death. A NQDC plan also may provide for payment upon the death of a specified employee, notwithstanding the six-month delay rule.

Specified Time or Fixed Schedule

57. Can a participant elect a specific payment time or payment based on a specific schedule?

Yes. A participant (or the company, for that matter) may elect at the time of deferral to receive the deferred compensation at a specified time or pursuant to a fixed schedule. To do so, the final regulations require that at the time of deferral:

  • The payment date or dates be nondiscretionary and objectively determinable (e.g., January 1 of each year following the year in which the participant separated from service). For this purpose, a participant (or the company) may select a year (2010) or a period of time within a calendar year, as opposed to a specific date (April 1, 2010); and
  • The amount to be paid on such date(s) be objectively determinable (i.e., 10 equal installments). For this purpose, the amount may be limited to a specific amount or determined based on a nondiscretionary formula (e.g., each installment payment may be no more than 1 percent of the company's net income for the previous calendar year).

58. Are there specific timing requirements for reimbursements or in-kind benefits subject to 409A?

Yes. The final regulations generally require that:

  • the plan only reimburse expenses incurred during an objectively prescribed period;
  • the amount paid in one calendar year not affect the amount available in a subsequent year (e.g., a plan may not provide for a reimbursement of up to $30,000 over a period of three years);
  • the participant receive payment no later than December 31 of the calendar year following the year in which the participant incurred the expenses; and
  • the reimbursement or in-kind benefit is not subject to liquidation or exchange for another benefit.

59. Are there specific timing requirements for gross-up payments?

A NQDC plan must provide for the payment of a tax gross-up (e.g., Internal Revenue Code Section 280G tax gross-up) no later than December 31 of the calendar year following the year in which the participant must pay the related tax to the taxing authority.

Change in Ownership or Effective Control of a Corporation

60. If a company experiences a change in control, may this trigger a payment of deferred compensation?

Yes. A plan may provide that a participant's deferred compensation will be distributed in the event of a change in control. For this purpose, a change in control includes a change in ownership of the corporation, a change in the effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation. Each term is specifically defined in the final regulations, but may not be consistent with other Internal Revenue Code changes in control definitions. Consequently, companies permitting payment upon a change in control should ensure that they understand the differences between a change in control for purposes of Section 409A and change in control for purposes of Internal Revenue Code Section 280G and their equity plans.

61. In a change in control context, are milestone payments or escrow amounts paid to employees subject to Section 409A?

Generally, yes. Deferred payments with respect to the achievement of certain milestones (e.g., an earnout) or expiration of a warranty period (e.g., an escrow) that are based upon payments to employees for stock owned or stock rights held by such employees in connection with a change in control will not trigger Section 409A if:

  • the employees receive payments on the same schedule and under the same terms and conditions as shareholders of the company with respect to the change in control; and
  • the employees receive such payments within five years of the change in control.

62. If vesting (and payment) of deferred compensation would accelerate due to a change in control, can the parties agree to waive such acceleration?

Generally, yes. The final regulations provide some flexibility with respect to service conditions that would otherwise lapse upon a change in control. The final regulations allow the company to extend or modify these conditions and remove the change in control acceleration. Such an extension or modification will not be subject to the subsequent deferral rules and will not violate the anti-acceleration rules provided that: (1) the change in control is a bona fide transaction between the company and one or more parties unrelated to that company or the participant, and (2) as modified, the deferred compensation remains subject to a substantial risk of forfeiture.

Unforeseeable Emergency

63. May a NQDC plan distribute deferred compensation if a participant incurs an emergency or a hardship?

Yes, similar to 401(k) plans, a NQDC plan may permit a distribution of a portion of a participant's deferred compensation upon the occurrence of an unforeseeable emergency. The maximum amount to be distributed may not exceed the amount reasonably necessary to satisfy the emergency (including amounts necessary for any taxes or penalties associated with the distribution). In addition, a distribution may not be made to the extent that the unforeseeable emergency is, or may be relieved through other resources, including stopping deferrals under the plan, insurance, or liquidation of other assets.

64. What is an unforeseeable emergency?

An unforeseeable emergency is a severe financial hardship to the participant resulting from: (1) an illness or accident of the participant, the participant's spouse, the participant's beneficiary, or the participant's dependent (as such term is defined in the final regulations); (2) a loss related to the participant's property due to a casualty; or (3) other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the participant's control.

Examples of potential unforeseeable emergencies include:

  • imminent foreclosure of, or eviction from, the participant's primary residence;
  • payment of medical expenses; or
  • funeral expenses related to a spouse, beneficiary, or dependent.

65. May a plan provide for cancellation of a participant's deferral election if they take a distribution due to an unforeseeable emergency?

If a participant receives a payment under the plan due to an unforeseeable emergency, the plan may provide for the cancellation (not suspension) of the participant's deferral election under the plan.

Additional Guidelines for Permissible Payment Events

66. Are there alternatives with respect to the date payment actually will be made when the payment trigger is an event and not a specified time or fixed schedule?

Yes. Where the payment event is separation from service, death, disability, change in control, or unforeseeable emergency, a NQDC plan can provide that:

  • payment will be made on the date of the event or a specific date following the event (e.g., December 31st of the taxable year in which the participant separates from service);
  • payment will be made according to a schedule based on the date of separation from service, death, disability, change in control, or unforeseeable emergency (e.g., 10 equal annual installments on each anniversary of the participant's separation from service); or
  • payment will be made within a period of time identified by the participant in his or her deferral election. Such period must either: (1) begin and end within one taxable year of the participant, or (2) be not more than 90 days, provided that the participant generally may not designate the taxable year of payment.

67. May a NQDC plan allow a participant to elect alternative payment dates?

No, a plan generally may not permit a participant to elect alternative dates or schedules for a particular payment event.

Example: It would not be permissible for Ethan to elect that a payment be made on January 1, 2009, if a separation from service occurs on a Monday, or January 1, 2010, if a separation from service occurs on a Wednesday. However, with respect to death, disability, change in control or unforeseeable emergency, the final regulations would permit Ethan to elect to receive either a lump sum or series of installment payments if, for example, a change in control occurred before or after a certain date (e.g., age 55).

68. What if the payment is not made on the exact date?

With respect to all permissible payment events (including payment on a specified date or pursuant to a fixed schedule), the final regulations provide some flexibility to the extent that a payment is not actually made on the exact date specified by the plan or the participant's election. More specifically, a payment will not violate Section 409A or the final regulations as long as:

  • the participant receives the payment: (1) on the date specified under the plan, (2) a later date within the same calendar year, or (3) if later, by March 15th of the year following the date specified under the plan; or
  • the participant receives such payment within the 30-day period prior to the payment date.

In either case, the participant could not have directly or indirectly designated the taxable year of the payment.

69. What happens if the company refuses to pay deferred compensation to a participant on the due date?

If a participant makes a reasonable, good-faith effort to collect the payment and the company has refused payment, then the payment by the company on a later date will not violate Section 409A. The IRS will presume that the participant did not make a reasonable, good faith effort to collect payment if the participant does not: (1) notify the service recipient of a demand for the payment within 90 days of the last day to make a timely payment under the plan, and (2) take additional enforcement action within 180 days thereafter.

70. Does Section 409A provide any transition relief for payments that commence prior to January 1, 2008?

Yes. If a participant commenced receipt of payment under the plan or satisfied all events necessary to receive payment prior to January 1, 2008, and such payment is not in compliance with the final regulations, the plan may continue to provide such payments under the existing plan terms or cease payments, if any, on or before December 31, 2007, and amend the plan to provide for payments in compliance with Section 409A and the final regulations.

Prohibition of Accelerated Payments

In general, the final regulations prohibit the acceleration of otherwise scheduled payments except in specific situations.

71. May a NQDC plan allow participants to accelerate the time at which they were otherwise scheduled to receive compensation deferred under the plan, subject to a penalty (e.g., 10 percent haircut)?

Generally, no. Section 409A and the proposed regulations made very clear that such permissive acceleration provisions no longer were acceptable under NQDC plans that were not otherwise grandfathered, and that accelerated payments would only be allowed under very limited circumstances. The final regulations similarly preclude accelerated payments except under very limited circumstances. In general, the final regulations provide that a NQDC plan that is not otherwise grandfathered may not, by its terms, permit the acceleration of any payment of deferred compensation, and no such accelerated payment may be made regardless of the plan terms.

72. What NQDC plans have been grandfathered for purposes of Section 409A and the final regulations?

NQDC plans that were adopted prior to January 1, 2005, and have not been materially modified on or after October 3, 2004, are grandfathered so that they are not subject to Section 409A with respect to deferrals made before January 1, 2005. Consequently, a grandfathered plan may permit a participant to elect an accelerated payment provided that the grandfathered plan had originally provided for such right.

Example: Meg deferred amounts into a grandfathered plan prior to December 31, 2004, which are payable upon her separation from service. The grandfathered plan also permits Meg to take an accelerated distribution at anytime, provided that she forfeits 10 percent of the distributed amount (i.e., a 10 percent haircut provision). In 2010, and prior to her separation from service, Meg may, without violating Section 409A, elect to take an accelerated distribution from the grandfathered plan less the 10 percent haircut, provided that the distribution amount is limited to deferrals made on or before December 31, 2004, including earnings on such deferrals. However, Meg may not use the 10 percent haircut to accelerate distribution with respect to any amounts deferred after December 31, 2004, including earnings.

73. Do the final regulations allow for any payment accelerations?

Yes. Despite the broad prohibition in the final regulations concerning accelerated payments, the final regulations do allow payment accelerations in the following circumstances:

74. Are there any other situations when a payment can be accelerated under the final regulations?

Yes. The final regulations permit a plan to specifically provide for an accelerated payment or permit the company to exercise discretion to accelerate payment under certain circumstances, some of which are described below. However, only the company, and not the participant (either directly or indirectly), may have discretion to accelerate payment under these circumstances.

  • Plan Termination and Liquidation - Accelerated distributions may be paid due to a termination and liquidation of the plan:
    • within 12 months of certain corporate dissolutions;
    • within 30 days preceding or 12 months following a change in control, provided that all similar plans aggregated with the plan are also terminated and liquidated (please see the plan aggregation rules discussed above); or
    • after 12 months but within 24 months of the date the company irrevocably terminates the plan and all similar plans (please see the plan aggregation rules discussed above), provided that the plan termination does not occur in connection with a downturn in the financial health of the company and the company does not otherwise adopt a similar plan within three years.

  • Qualified Domestic Relations Order - Accelerated distributions may occur for an alternate payee to the extent necessary to comply with a qualified domestic relations order.
  • Taxes - Accelerated distributions may be paid in an amount necessary to cover any income tax (e.g., federal, state, or local), employment tax (e.g., FICA or the Railroad Retirement Act), foreign, or other tax withholding obligation that arise with respect to the deferred compensation under the plan.
  • Limited Cash-outs - A plan may either require or give the company discretion to require a complete distribution in a lump-sum payment of a participant's deferred compensation under all plans aggregated with the plan (as determined by applying the plan aggregation rules). This provision and, to the extent applicable, the company's exercise of discretion must be in writing prior to payment. In addition, the amount of the cash-out must not exceed the Internal Revenue Code Section 402(g) limit applicable to qualified plans (i.e., $15,500 in 2007).
  • Payment Upon Income Inclusion under Section 409A - Accelerated payments to the extent a participant must include deferred compensation in income as a result of a violation of Section 409A.
  • Certain Offsets - A plan may permit an accelerated payment to a participant to cover a debt owed to the company if: (1) the participant incurred the debt in the ordinary course of the service relationship, (2) the offset does not exceed $5,000 per calendar year, and (3) the payment occurs on the due date of the debt.
  • Bona Fide Disputes as to a Right to a Payment - A plan may permit an accelerated payment to a participant, which is the result of the settlement of a bona fide dispute between the company and the participant as to whether the participant is entitled to a deferred compensation payment.

Action Items

Employers should perform the following action items within the next several months:

  • Identify all existing NQDC plans.
  • Review each existing plan to determine what provisions are not compliant with Section 409A.
  • Document how each plan was operated in good-faith compliance with Section 409A effective as of January 1, 2005.
  • Analyze the terms of individual NQDC plans to ensure consistency among all NQDC plans, particularly with respect to plans aggregated together for purposes of Section 409A.
  • Determine if any noncompliance issues may be resolved under one of the Section 409A transition rules.
  • Amend plans and related summaries to comply with Section 409A no later than December 31, 2007.

For More Information

This Client Alert is intended only as a general summary of the impact of the final Section 409A regulations on nonqualified deferred compensation plans. We strongly advise you to seek professional assistance with respect to your specific issues.

If you have any questions regarding this Client Alert, please contact any member of the Wilson Sonsini Goodrich & Rosati Employee Benefits & Compensation practice:

John Aguirre (650) 565-3603    Thuy Le (650) 849-3329
Heather Aune (858) 350-2213    John Ludlum (801) 993-6410
Michael Baker (650) 565-3902    Scott McCall (650) 320-4547
Melody Barker (415) 947-2029    Michael Montfort (202) 973-8815
Ralph Barry (858) 350-2344    Cisco Palao-Ricketts (650) 565-3617
Jessica Bliss (650) 849-3470    Roger Stern (650) 320-4818
Madeleine Boshart (415) 947-2057    David Thomas (650) 849-3261
Jason Flaherty (650) 849-3268    Jackie Tokuda (650) 565-3904
Jessica Janov (858) 350-2351    Michelle Wallin (650) 565-3620


 

1 For purposes of this Client Alert, any individual who receives a benefit under a NQDC plan is a "participant" or an "employee." The examples and explanations in this alert all assume that the participant/employee is a calendar-year taxpayer. The company to which the participant provides services is the "company."

Circular 230 Compliance: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this memorandum is not intended or written to be used, and cannot be used, for the purpose of (a) avoiding penalties under the Internal Revenue Code, or (b) promoting, marketing, or recommending to another party any transaction or matter addressed herein.