In 2014, the IRS began an audit initiative specifically aimed at nonqualified deferred compensation (“NQDC”) compliance under Section 409A. Then in June of this year, presumably based at least in part on common areas of non-compliance identified through the initiative, the IRS issued Section 409A Audit Guidelines for its agents. As a result, it is now more likely that employment tax audits will include a review of NQDC arrangements, making this an excellent time to review those arrangements. In many cases, Section 409A documentation and operational problems can be corrected, thereby avoiding significant tax consequences, provided the problems are identified in time.
More and more businesses are using NQDC arrangements to provide incentives for valued executives. But developing and managing these arrangements properly can be difficult. Seemingly minor missteps in documentation or operation can result in significant penalties under Section 409A, which imposes strict requirements relating to plan distributions, acceleration of plan benefits, and elections under the plan. This article focuses on certain best practices and common mistakes and problem areas under Section 409A (with a brief detour to cover special issues for NQDC arrangements referred to as top hat plans) that we have seen in the NQDC arrangements that we have reviewed, including
- giving an employer discretion to accelerate NQDC payments
- failing to properly manage participant forfeitures of NQDC payment amounts when seeking to reduce such amounts
- treating a participant’s change from full-time to part-time as a separation from service that triggers NQDC payments without taking the regulations that define a separation from service into account
- allowing participants to delay NQDC payments (so-called re-deferrals) without taking account of the narrow rules permitting re-deferrals for so-called top hat plans (NQDC arrangements for a select group of management or highly compensated employees), failing to comply with Department of Labor filing requirements and failing to provide for ERISA-compliant claims procedures
Performing an NQDC Review
An NQDC review generally involves three phases: (1) identifying arrangements that may involve nonqualified deferred compensation; (2) determining whether such arrangements are subject to Section 409A and, (3) analyzing whether the arrangements that are subject to Section 409A comply with all of the requirements of Section 409A.
Identifying Potential NQDC Arrangements. All employment agreements are possible NQDC arrangements, whether or not the agreement or any section of the agreement is styled as such. In addition, bonus plans, stock option plans, and change-of-control agreements all raise Section 409A issues. Severance pay plans may also be subject to Section 409A unless an exemption applies.
Determining Which NQDC Arrangements Are Subject to Section 409A. To be subject to Section 409A, an arrangement must establish a legally binding right to compensation that is payable in a later tax year. However, certain arrangements that meet this requirement are nevertheless exempt from the Section 409A requirements, including: Qualified retirement plans, tax-deferred annuities, simplified employee pensions, and SIMPLE retirement accounts, which are not considered NQDC plans; some welfare benefit plans, such as bona fide vacation leave, sick leave, compensatory time, disability pay, and death benefit plans; so-called short-term deferrals (i.e., where the employee receives the compensation within 2½ months after the end of the tax year of the employer or employee, whichever is later); and nonstatutory stock options and stock appreciation rights on employer stock if they are not “in the money” on the date of grant (i.e., are worth substantially more than the exercise price on that date) and there is no other feature for deferral of compensation.
Determining Whether an NQDC Arrangement Complies with Section 409A. There are four general requirements in Section 409A. They relate to: (1) the initial deferral election, (2) the timing of payments, (3) acceleration of payments, and (4) later deferral elections. Each of these requirements must be spelled out in the plan document, and the plan must be operated in accordance with them.
Initial deferral elections. In general, an employee must make the initial election to defer compensation before the year in which the services are performed. In an employee’s first year of eligibility, he or she may make a deferral election in the first 30 days of participation, but the election may apply only to compensation earned after the election was made. An election to defer performance-based compensation that is based on a performance period of 12 months or more must be made no later than six months before the period ends.
Timing of payments. Payments under an NQDC arrangement must be made at a fixed date, under a fixed schedule, or upon any of the following five events: separation from service; death; disability; change in ownership or control; or unforeseeable emergency. If the timing of payment is based on one of these types of events, the arrangement must designate an objectively determinable date or year after the event on which payment is to be made. So-called haircut provisions, which provide that the participant may take a payment at any time so long as the payment is of a reduced amount, are prohibited under this rule.
Common Mistake #1: This “haircut” prohibition can be confused with a participant’s ability to forfeit the right to a portion of a payment without changing the time or form of payment, leading companies, participants and their advisors to unnecessarily limit downward adjustments to deferred compensation amounts that meet the forfeiture requirements in the Section 409A regulations.
Determining when a separation from service event has occurred can present some unique challenges, especially where a participant wants to work part-time for a while before retiring. Under the Section 409A regulations, a separation from service occurs as of the date after which the employer and employee “reasonably anticipate” that either: (i) the employee will perform no services; or (ii) the level of bona fide services the employee will perform (in any capacity—employee or contractor) will permanently decrease to no more than 20 percent of the average level of bona fide services performed over the immediately preceding 36-month period (or the full period of employment if less than 36 months). The sole relevant factor is what the parties reasonably anticipate the level of services to be in the future. This is determined by the facts and circumstances of the situation. Also, an employee is presumed to have separated from service where the 20 percent test is satisfied and presumed not to have separated from service where the level of bona fide services performed continues at a level that is 50 percent or more. No presumption applies in between. However, the 20 percent standard can be modified by agreement to be somewhere between 20 percent and 50 percent generally as long as the provision is in place at the time the deferral occurs under the arrangement in the first instance.
Best Practice #1. We have found that when a deferred compensation agreement addresses this part-time issue in writing, it is less likely that impermissible payouts will occur.
Anti-acceleration rule. Payments of deferred compensation generally may not be accelerated. There are some exceptions to this rule, such as for payments necessary to comply with a domestic relations order, payments necessary to comply with conflict-of-interest rules and for certain payments when plans are terminated.
Common Mistake #2. A common misconception in connection with acceleration of payments is that the employer can have the power to accelerate payment. Under Section 409A, neither the employer nor the employee can have the power to accelerate payment.
Re-deferral elections. An NQDC arrangement may allow an employee to elect to delay or change the form of a payment only if the following conditions are met:
- the election may not take effect until at least 12 months after the date on which it was made;
- if the election relates to a payment that isn’t on account of death, disability, or unforeseeable emergency, the first payment for which the election is made must be deferred for at least five years; and
- any election related to a payment at a specified time or under a fixed schedule may not be made less than 12 months before the date of the first scheduled payment.
NQDC arrangements are not required to set forth these re-deferral requirements. As a result, it is not uncommon to find in a review of NQDC arrangements that employers have granted impermissible re-deferrals without being aware that they are violating Section 409A.
Best Practice #2. Rather than assuming that employers will consult their tax advisors before granting a re-deferral, the better practice is to include the requirements in the agreement.
Correcting Section 409A Errors
Because the Section 409A rules are complex, compliance errors are likely to occur. The consequences of those errors are severe. All amounts deferred under a noncompliant NQDC arrangement are included in the employee’s income. Interest is imposed on that income at a rate one percentage point higher than the interest rate on tax underpayments. On top of that, an additional tax equal to 20 percent of the compensation required to be included in gross income is imposed.
Recognizing this, the IRS has issued notices that provide procedures that allow taxpayers to avoid the full impact of the income inclusion and additional taxes under Section 409A under certain circumstances. There are separate correction programs for failures in NQDC documents and failures in the operation of NQDC arrangements. However, eligibility requirements limit the scope of these programs, including requirements that limit relief to (i) corrections made within specified periods, (ii) failures that are inadvertent and unintentional, (iii) failures specifically described in the notices, (iv) failures that the employer has taken commercially reasonable steps to avoid and (v) NQDC arrangements that are not under audit by the IRS.
Many NQDC arrangements are designed to benefit only a select group of management or highly compensated employees. These plans, commonly referred to as top hat plans, are exempt from the ERISA participation, benefit accrual, vesting and fiduciary rules, but extra steps must be taken to exempt a plan from ERISA’s reporting and disclosure rules. Top hat plans are not exempt from ERISA’s general enforcement rules.
To be exempt from most of ERISA’s reporting and disclosure rules, the plan administrator must file a simple statement with the Department of Labor (“DOL”) and provide plan documents to the DOL in the unlikely event they are requested. This statement must be filed within 120 days of adoption of the plan. Filing the statement exempts the top hat plan from providing a summary plan description and filing Form 5500. Under existing regulations the statement is filed on paper, but under newly proposed regulations (which are effective immediately on a voluntary basis), notice must be filed electronically. To access the top hat statement website, go to https://www.askebsa.dol.gov/efile/Home/tophat.
Common Mistake #3. Our NQDC reviews have identified top hat plans for which the DOL statement has not been filed. However, a correction procedure exists for certain employers that have failed to file the notice in a timely manner.
Top hat plans are not exempt from ERISA’s general enforcement rules. This means, for instance, that top-hat plans must comply with the normal claims and appeals procedures that apply to qualified plans. It also means that the only remedies available to top-hat plan participants are those set forth in ERISA.
Best Practice #3. Our NQDC reviews have identified top hat plans that do not include these procedures. While some practitioners argue that the claims and appeals procedures need not be set forth in a top hat plan, the better practice is to include them. Even if they are not required to be in the plans, there is no dispute over whether they apply, and including the procedures in the agreement will increase the likelihood that they will be followed.
We can assist in your Section 409A and top hat plan compliance efforts by showing you how your NQDC arrangements should be documented and administered to avoid Section 409A and top hat plan violations, how to correct certain violations that may occur, and how to take commercially reasonable steps to keep the arrangements in compliance. In addition, we can review any new arrangements that you enter into for Section 409A and top hat plan compliance.