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Guest Article

(From the April 23, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Issues Final 409A Regulations -- Part II

Last week, we looked at what deferred compensation plans are subject to the rules of IRC § 409A. Now we turn to what those rules are and the guidance that the IRS has furnished in the final regulations released on April 10th and published in the Federal Register on April 17th. 72 FR 19234 (April 17, 2007). This article will concentrate on the restrictions on distributions. Future installments will deal with remaining issues.

Section 409A imposes four broad conditions on plans that fall within its scope:

Deferral elections by service providers (employees, independent contractors and corporate directors) must be made before the beginning of the year in which the services related to the deferred compensation are performed. There is an exception for performance-based compensation, where the deadline is six months before the end of the performance period.
The time and manner in which deferred compensation will be distributed must be specified at the time of deferral. After that, it may be changed only under narrowly defined conditions.
The distribution must begin on a date fixed in advance or be triggered by one of five specified events: separation from service, death, disability, change in control of the service provider or unforeseeable emergency.
No amount may be set aside in an offshore rabbi trust for the purpose of making distributions. The IRS discussed this restriction in Notice 2006- 33. There is no further guidance in the final regulations.

What Is a Plan?

The regulations' definition of "plan" is important because, after a violation of IRC § 409A has occurred, penalty taxes are assessed for the individual participant on all deferrals in all aggregated plans. In addition, it is important to focus on which plans and arrangements need amendments and need to carefully monitor distributable events.

The identification of a "plan" doesn't depend on documentation. Although a written plan is required for IRC § 409A compliance, a single 409A "plan" may be embodied in many documents, and one document may contain many plans.

The first principle underlying the concept of a "plan" is that every plan has only two parties: a single service provider and single service recipient. If Corporation X's SERP covers 20 top executives, it is subdivided into 20 plans, one for each participant. Conversely, if Mr. Y participates in his employer's deferred compensation plan and in a fee deferral plan of an unrelated corporation of which he is a director, two plans exist.

The second principle is that every plan is assigned to one of nine categories:

Elective deferrals,
Account balance plans (defined in the same way as under the IRC § 3121(v)(2) regulations and generally corresponding to qualified defined contribution plans) without elective deferrals,
Nonaccount balance plans (also as defined under IRC § 3121(v)(2) and generally corresponding to qualified defined benefit plans),
Separation pay plans under which benefits are payable only upon involuntary termination of employment or termination under a window program (these plans generally are exempt from IRC § 409A; the purpose of this part of the definition is to isolate separation pay plans that are intended to be exempt but fail in operation to meet the conditions for exemption),
Plans that reimburse expenses or provide in-kind benefits,
Split-dollar life insurance arrangements entered into either before or after the issuance of final regulations outlining the tax consequences of these arrangements,
Plans that primarily cover nonresident aliens and satisfy other criteria (a subject for a future article),
Stock rights plans, other than those that are exempt from IRC § 409A, and
All other plans subject to IRC § 409A.

The third principle is that all plans (that is, arrangements between a single service provider and a single service recipient) that fall into the same category are aggregated. Several different arrangements that the parties think of as separate may constitute a single "plan" for IRC § 409A purposes. The major consequence is that a violation by any one of the aggregated plans taints all of them. On the other hand, plans that fall into other categories are unaffected.

Different plans in the same category may have entirely different provisions and may satisfy IRC § 409A in different ways. There are only a very few instances, such as plan terminations, in which they must be treated identically.

The proposed regulations had only four categories. The new catalogue will tend to make the consequences of violations less far-reaching, though it does not obviate the risk that a minor violation can trigger massive tax liabilities for the individual participant.

Distributions -- In General

The cornerstone of the distribution rules is the set of events on which distributions may be predicated. The plan must specify what events will trigger distributions, when they will begin (by reference to the distribution events) and in what form (lump sum, installments or annuity) they will be made. All of these terms must be in place before the service provider obtains a binding right to the deferred compensation, or, in the case of elective deferrals, before the year in which the compensation is earned. Changes can thereafter be made only pursuant to specified rules. Elective postponements ("redeferrals") are allowed if they are made sufficiently far in advance and meet other conditions. Voluntary accelerations at the behest of a participant are proscribed except in specified, limited circumstances including a cash-out of de minimis benefits and certain plan termination payments. The regulations also permit limited accelerations to cope with special circumstances, such as the need to comply with conflict of interest laws or pay taxes, and offer somewhat greater flexibility to delay scheduled payments for brief periods.

Distribution Events

There are six triggering events:

Date certain. A plan may provide that distributions will begin on a particular date, which may be stated explicitly, e. g., "January 1, 2020," or implicitly (e.g., "X's 65th birthday") An event whose date of occurrence is not known at the outset (e.g., "when Y Corporation makes an initial public offering" or "when Z's daughter enrolls in college") is not permitted.
Separation from service. Distributions may be triggered by separation from service, with the proviso that a "specified employee" must wait at least six months after separation before receiving anything. (The distribution may be made immediately, however, if the specified employee dies during the six-month interval.) The definition of a "specified employee" is borrowed largely from the "key employee" definition in IRC § 416(i). The most important differences are, first, only service recipients with publicly traded securities are considered to have specified employees; second, the service recipient may select the date as of which specified employees are identified and then may wait until as late as the first day of the fourth month following to make the identifications effective, after which they remain in effect for 12 months; and, third, alternative methods of designating specified employees are permitted, so long as they are reasonably certain to include everyone who meets the statutory definition. An alternative method will turn more participants into specified employees but may be administratively convenient.
The regulations include rules for distinguishing "real" from nominal separations from service. For an employee, separation is, in concept, termination of employment with the service recipient (including all members of its controlled group); for an independent contractor, it is the expiration of the contract under which he provided services, with no expectation that the contract will be renewed; for a corporate director, it is the expiration of his term of office. The parties' characterization of a service provider's status as a current or ex-employee is not, however, decisive. Under the regulations, someone whose services fall to less than 20 percent of the previous level, based on a 36-month moving average, has presumptively separated from service. Contrariwise, someone who is working at 50 percent or more of the 36-month average presumptively has not separated. Between those extremes, there are no presumptions. Whether separation has occurred is a question of facts and circumstances. The presumptions, too, are rebuttable and the plan can specify its own rules in certain cases.
For these rules, services in all capacities must be aggregated. If an individual ceases common law employment but provides consulting services at more than 20 percent of his prior level, he may not have separated from service. There is an important exception for directors, whose service in that capacity doesn't count toward determining whether they have separated from service as employees, and vice versa.
A paid leave is treated as continued service at a level commensurate with the compensation paid during that time. For instance, a sabbatical on half pay would not lead to a separation from service. Unpaid leaves are ignored in the calculation, but an unpaid absence of longer than six months is treated as a separation at the beginning of the seventh month, unless the employee retains a legal or contractual right to reemployment (under USERRA in the case of military leave, for example). If the leave is on account of disability, it may continue for as long as 29 months before a separation is deemed to take place.
Change in control. A change in control of a corporation (or of a partnership, applying analogous rules) may be a distribution event. It also is one of the events that allows discretionary plan termination by a service recipient. The definition of "change in control" is based on a change of ownership, a change of effective control or sale of substantial assets, similar to the golden parachute rules. One must be careful, though, to ascertain whether a particular change in control affects a particular service provider. A distribution may be made only if the change involves (i) the entity to which the provider directly renders services, (ii) the entity that is responsible for paying his deferred compensation (and only if there is a business reason for it, rather than the direct employer, to be making the payments) or (iii) the direct employer's parent (owner of a majority interest), or the parent's parent, or so on up the chain of control.
A plan may define "change in control" more narrowly than the regulations and may provide that distributions will be made only if the change meets stated conditions, though there will be few circumstances in which this flexibility will be of practical value.
Death. Postponement of payments on account of death, or a change in the form in which they will be paid, is easier than for distributions predicated on a date certain, separation from service or change in control.
Disability. Disability should be stated as a separate distribution event in the plan (i) if the employer's policy is to retain disabled employees on leave for some period of time, in which case it may wish to start making disability distributions before separation from service or (ii) to avoid the six-month mandatory delay in the start of separation-from-service distributions to specified employees. It is important in the latter case that the determination of disability precede termination of employment, so that there is no doubt about the triggering event.
The regulations' definition of "disability" is consistent with the definition for other tax purposes. The service provider must either be unable to engage in substantial gainful employment or have been receiving benefits for at least three months under the service recipient's disability plan, and his inability to work must stem from a "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". A plan may contract this definition but not expand it.
Unforeseeable emergency. The definition of "unforeseeable emergency" is consistent with that of the regulations under IRC § 457. It is intended to be narrow and the participant must have exhausted all other reasonably available resources.

Alternative Distribution Events

A plan need not, and rarely would, provide for distributions upon only a single event. Distributions may be made on the earliest or latest of several events, in any manner that makes it clear when a distribution is due and gives no room for any exercise of discretion by the employer or the participant. Examples are "the earliest of death, disability, unforeseeable emergency or separation from service" or "the later of separation from service or age 70, or upon earlier death."

A distribution that has already begun may be accelerated by the intervention of another event. If a participant is receiving an installment distribution, the plan might provide that the undistributed balance will be paid to his beneficiary in a lump sum upon his death.

Time and Form of Distribution

A distribution need not follow instantly upon its triggering event. In fact, in the case of a distribution to a specified employee on account of separation from service, it can't. The time when payments begin must, however, be determinable by reference to the event (e.g., six months after separation from service" or "one year after a change in control").

Distributions may be made in any manner that leaves no discretion to the parties to decide the amount of particular payments. The basic alternatives are lump sums, installments and annuities. (Both of the latter are payable over a period of years. The difference is that annuities continue for one or more lives, while installments have no life contingencies.)

Different triggering events may be associated with different forms of distribution (e.g., a lump sum upon death and an annuity upon separation from service), but, as a general rule, no event may have alternative forms of distribution. Thus, a participant may not receive a lump sum if he separates from service on an odd-numbered day and installments over ten years otherwise. It is, however, permissible to prescribe different forms of payment if the triggering event occurs before or after a single specified age (e.g., a lump sum before age 55 and an annuity afterward). For distributions on account of separation from service, the dividing line may be based on age, service or a combination of the two, and there may be yet another form for separations that occur within two years after a change in control.

Acceleration of Distributions

The general rule is that there can be no accelerated distribution. The time initially selected for distributing deferred compensation may be accelerated only in exceptional circumstances, most of which involve either the impact of other laws (such as prohibitions against conflicts of interest, which may necessitate severing all financial ties with a former employer, or compliance with judicial domestic relations orders) or the payment of tax obligations related to the deferred compensation itself, such as FICA/HI contributions due upon vesting, income tax due when benefits under IRC § 457(f) plans vest or taxes arising from IRC § 409A violations.

Accelerated distribution of de minimis benefits is permitted under two independent rules. The first allows the service recipient to cash out any benefit with a value no greater than the IRC § 402(g) limitation on elective deferrals ($15,500 in 2007). The distribution must be all of the service provider's rights under the plan. Here the definition of "plan" is significant: all plans in the same category must be considered, while plans in other categories do not need to be. Plans may be freely amended at any time to allow cashouts of this sort, and the distribution may be automatic or in the service recipient's discretion.

The second de minimis rule permits the automatic cashout of all of the remaining installments in a series if their value falls below a threshold established by the terms of the plan. The threshold may be any amount. It can be changed only in accordance with the rules for postponing distributions.

Aside from these special cases, the only way to make distributions earlier than originally projected is to terminate the plan. A service recipient may reserve the right of termination but may exercise it in only three situations:

A plan may be freely terminated and all benefits distributed if the following conditions are satisfied:
- All plans that fall within the same category must be terminated with respect to all service providers who participate in them. Termination for a limited group is not allowed, though the termination need not extend to all categories of plan.
- Distributions on account of the termination may be made no earlier than 12 months after all action necessary to make the termination effective has been completed. Distributions that would have been made absent the termination continue as usual.
- All distributions must be completed no later than 24 months after the date of termination.
- The service recipient may not establish any new arrangements of the same type for any service provider within three years following the date of termination.
- The termination may not "occur proximate to a downturn in the financial health of the service recipient."
A service recipient may terminate a plan (again applying the IRC § 409A definition of that term) during the period beginning 30 days before and ending 12 months after a change in control. All service providers affected by the change must be treated similarly, and the distributions must be completed within 12 months after the corporate action needed to effect the termination is taken.
A service recipient that liquidates under IRC § 331 or in bankruptcy may terminate any or all of its plans, in the latter case only with the approval of the bankruptcy court. Distributions must be made in the calendar year of termination, except that the payment of unvested benefits may be postponed until vesting.

Postponement of Distributions

Postponement is easier than acceleration. There are two broad classes to be considered. First, the regulations contain a number of rules of convenience, under which scheduled payments may be delayed briefly or for good economic or administrative reasons. We will discuss these in a future article dealing with plan administration.

Second, the commencement of distributions may be postponed voluntarily, by either the service provider or the service recipient (to the extent that the plan allows discretionary postponements) if the postponement is for at least five years and does not become effective until at least 12 months after the election is made. The five-year rule does not apply to distributions on account of death, disability or unforeseeable emergency. The 12-month delay in effectiveness means that, if a distribution event occurs during that period, the postponement is ignored and the distribution is made in accordance with the pre-existing plan terms.

The five-year rule is easy to apply to lump sums and annuities. The distribution or annuity starting date is simply pushed back by a minimum of 60 months. As part of the process, a lump sum may be split into installments or converted into an annuity, so long as the starting date is at least five years in the future. Similarly, an annuity may be converted into a lump sum, subject to the same delay.

Installment distributions are trickier. If the plan treats the entire series as a single, spread-out distribution (the default unless it elects the alternative), the rule is the same as for annuities: The first installment is postponed, and the rest are delayed correspondingly. If desired, the series may be converted into a lump sum, to be paid five or more years after the first installment would otherwise have been made. On the other hand, if each installment has been designated as a separate distribution, each may be individually postponed. A lump sum cashout isn't possible (unless all installments are postponed to coincide with the last one, and that one is put off for five years), but the postponement need not affect every payment in the series.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Laura Morrison 202.879.5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

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