Guest Article
(From the May 07, 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 III
This is the third in a series of articles summarizing the final regulations under section 409A of the Internal Revenue Code. Previous installments discussed the types of nonqualified deferred compensation to which IRC § 409A applies and the restrictions on distributions that it imposes. We now take up the rules governing the initial deferral of compensation.
Background
In the past, any decision to defer the payment of compensation had to be made before actual or constructive receipt. There were few other constraints. With the lack of guidance, many practitioners took the position that an election at any time up to just before receipt was sufficient, though cautious practitioners recommended electing at least a few months in advance.
Section 409A dramatically changes the law. Decisions as to the time and manner in which compensation will eventually be paid must be made before services are rendered. An employee must foresee in 2007 when and how he will want salary or bonus earned in 2008 to be paid, with only limited opportunity to change that decision. For employers, the new rules represent a series of potential traps. Failure to attend to them can result in significant tax penalties.
Deadlines for Initial Deferral Elections
The regulations establish deadlines for making initial deferral elections. These elections deal with three matters: how much compensation will be deferred, when it will be paid and what period it will be paid over. All of the details of distribution must be prescribed at this time, including the event (or alternative events) that will trigger distribution, the point after the triggering event at which it will begin, and whether payments will be made in a lump sum or in the form of installments or an annuity. Only three significant matters may be left for later decision:
- The service provider or the service recipient may be given the right to decide, at the time of payment, whether the distribution will consist of cash or of other property.
- If an annuity payout is specified, the exact form of the annuity may be modified at any time through the annuity starting date, so long as there is no change in actuarial value. Hence, the service provider may wait until then to choose between a life and a joint-and-survivor annuity and to name his beneficiary.
- A rabbi trust may be established at any time as a vehicle for earmarking assets to provide benefits under the plan, unless the service recipient is then in financial distress.
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As a general principle, a service provider may not elect to defer compensation unless he acts before the beginning of the year in which it is earned. (There are slightly different rules for commission income, but they are too specialized for this article.) The pertinent year is his taxable year (almost always the calendar year), except where the compensation is linked to the service recipient's fiscal year. For example, if a company awards bonuses at the end of its July 31st fiscal year, employees may elect as late as July 31, 2008, to defer the bonuses that will be earned in the year ending July 31, 2009. On the other hand, all salary earned during the calendar year 2008 must be deferred, if at all, by an election made no later than December 31, 2007.
This deadline applies not just to the choice of an amount to defer but also to any elections that the service provider has concerning the time or form of distribution. If the amount to be deferred is nondiscretionary, but the plan lets the service provider specify when and how it will be distributed, those decisions must be made before the year in which the pertinent services are performed. A corollary is that, if a service recipient unilaterally establishes a plan in the middle of a year, it must dictate how the first year's accrual will be paid out. There is no opportunity for elections by participants, unless one of the exceptions described below is available.
Special Rules
There are several situations in which the before-the-beginning-of-the year deadline is extended:
- Performance pay. If compensation is based on performance measured over a period of at least 12 months, a deferral election may be made at any time before the earlier of (i) six months before the period ends or (ii) the time when the amount that will actually be paid becomes substantially certain. It is possible for part of the compensation to be readily ascertainable, and thus ineligible for deferral, before the remainder, e. g., if the attainment of a particular level of performance before the end of the period ensures a corresponding payment.
"Performance-based compensation" is defined in some detail. In general, the goals and rewards must be established no later than 90 days after the beginning of the performance period. Bona fide subjective criteria may be included, so long as they relate to the performance of the service provider or of the business unit for which he works and are evaluated by unrelated persons.
One quirk in the regulations is that a service provider may take advantage of the six-month rule only if he works continuously from the beginning of the performance period through the date of the election (or at least from the date on which the performance criteria are set). Someone hired in the middle of a period might be able to make a deferral election under the initial eligibility rule (discussed in the next item), but he could not wait until six months before the period's end.
- Initial eligibility to participate. In the first year in which a service provider is eligible to participate in a plan (bear in mind that a "plan" includes all other plans in the same category, as described in a previous article), he may make a deferral election up to 30 days after his initial date of eligibility, though that election may affect only compensation for services rendered after it is made. Compensation that relates to the year as a whole, such as an annual bonus, must be prorated for this purpose. For example, a service provider who becomes eligible to participate in a bonus plan on June 1, 2008, and makes a deferral election on June 30, 2008, may apply his election to only half of whatever bonus he is granted for calendar year 2008. (The proration is based on days, so the exact portion eligible for deferral in this case is 184/366, June 30th being the 182nd day of the year.) It makes no difference whether the bonus is formula-based or purely discretionary.
If no election is made during the 30-day period, the opportunity to utilize this rule is lost, unless the service provider loses and then regains eligibility to participate in the plan -- and then only if either the period of ineligibility lasts for at least 24 months, or all of the previously deferred compensation is cashed out before the resumption of eligibility.
A special rule gives a service provider the ability to elect the time and form of distributions under a nonelective excess benefit plan (a nonqualified plan that provides benefits beyond those permitted in qualified plans) within 30 days after the end of the first year in which he accrues a benefit under the plan. This is a one-time opportunity. It does not recur if he subsequently accrues benefits under a different excess benefit plan of the same service recipient, even if the second plan falls into a different category from the first. Also, it is not available for elective excess plans, such as a shadow 401(k) plan.
- Elections linked to qualified plans. Many nonqualified plans are integrated with qualified plans, so that the amount deferred under the former depends upon benefits accrued under the latter. The IRC § 409A regulations do not treat changes under a qualified plan as tantamount to deferral elections under a linked nonqualified plan. There is, nonetheless, interaction between IRC § 409A and shadow 401(k) or 403(b) plans. Under these plans, a participant typically makes a single deferral election before the start of the year. Deferrals are then made to the qualified plan to the extent possible. If the deferrals or associated matching contributions contravene some applicable statutory limit (i. e., exceed the IRC § 402(g) or 415 maximum, violate the IRC § 401(k) or (m) "nondiscrimination" standards, or are based on compensation in excess of the IRC § 401(a)(17) limit), they are instead accrued under the nonqualified plan. The regulations permit mid-year changes in the deferral election percentage under the qualified plan, even though the effect is to increase or decrease deferrals under the nonqualified plan. The election under the nonqualified plan may not be changed directly after the year has begun.
Example: A participant in a shadow 401(k) plan elects a 10 percent deferral under the combined arrangement, making this election before the beginning of 2008. Matching contributions are 50 percent of elective deferrals, disregarding deferrals in excess of six percent of compensation. His compensation is $400,000 a year, and he is under 50 years old. The expectation is that he will receive the maximum deferral and matching contribution under the qualified plan. We'll assume that the IRC § 402(g) limit is $16,000 in 2008 and the IRC § 401(a)(17) limit is $230,000, meaning that he will have a $16,000 deferral and a $6,900 matching contribution via the qualified plan; the nonqualified plan will add $24,000 in deferrals and a $5,100 match. Contrary to that strategy, he drops his qualified plan deferral election to zero shortly after the beginning of the year. As a consequence, his nonqualified deferrals and match will rise to $40,000 and $12,000, respectively. That is permitted by the regulations. He could not, however, increase or decrease the overall 10 percent deferral election. His mid-year election can alter only the allocation of deferrals between the qualified and nonqualified plans, not his total elective deferrals and matching contributions.
- Forfeitable rights. Whenever deferred compensation is subject to a substantial risk of forfeiture, the time and manner of its distribution may be determined up to 30 days after the service provider obtains a legally binding right (the meaning of which is discussed below). The election must be made at least 12 months before the earliest date on which vesting could possibly occur. Earlier vesting by reason of death, disability or change of control is permissible, but the new election is ignored if any of those events occurs during the 12-month waiting period.
Example: On January 1, 2009, a company awards a bonus to an executive, subject to forfeiture if he separates from service before March 15, 2010, other than by reason of death or disability. Barring an election to the contrary, the bonus will be paid upon separation from service. On January 31, 2009, he elects to defer payment until the later of separation from service or January 1, 2025. Because this election was made within 30 days after his obtaining a legally binding right to the bonus and at least 12 months before the earliest possible vesting date (ignoring the acceleration of vesting on death or disability), it is valid under IRC § 409A. If he remains at the employer through March 15, 2010, the bonus will be paid in accordance with his election. If he dies or becomes disabled before March 15, 2010, the election will have no effect, and he or his beneficiary will receive an immediate distribution.
- Severance pay. Negotiated severance pay, to which the service provider previously had no legally binding right, may include any otherwise permissible provisions concerning the amount, time and form of payment, regardless of the fact that the related services were arguably performed in the past. This rule is also available for terminations under a window program; the legally binding right is not deemed to arise until the election to separate under the program becomes irrevocable.
- Short-term deferrals and changes of control. Short-term deferrals (required to be distributed no later than 2½ months after the end of the year in which they vest) are exempt from IRC § 409A, but an election to postpone payment beyond the short-term deferral period may be made only in accordance with the rules for elective postponement of distributions. Hence, the election may not become effective until at least 12 months after it is made and must delay payment for no less than five years. A postponement election for a short-term deferral may permit payment on account of a change of control, even if that does not result in a five-year delay.
- Change from nonresident alien to resident status. A nonresident alien who becomes a resident alien is given a grace period, until the end of his first taxable year as a U.S. person, to defer compensation earned during that year, as well as any previously accrued deferred compensation that was subject to a substantial risk of forfeiture at the beginning of the year. (Prior deferrals that vested while he was a nonresident alien are exempt from IRC § 409A.) A resident alien who becomes a nonresident and later resumes resident status gets the benefit of this rule again, but only if he was a nonresident for at least three years.
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Decisions made by service recipients have a more liberal deadline. The amount of deferred compensation, and the time and manner of payment, must be specified either before the participant acquires a "legally binding right" to the compensation or before the deadline for an elective deferral, whichever is later.
The term "legally binding right" contemplates the formation of a bilateral contract between the service provider and the service recipient. Therefore, it does not exist while the parties are in the process of negotiating an employment agreement. The service recipient's retention of discretion to reduce compensation unilaterally may indicate that the service provider does not have a legally binding right, if that discretion is unconditional, is exercisable by someone who is unrelated to, and not under the control of, the service provider, and otherwise has "substantive significance". For example, an employee's legally binding right to a bonus whose amount is fixed by his employer solely in its discretion generally does not come into being until the bonus is declared.
A substantial risk of forfeiture doesn't negate the existence of a legally binding right; it is simply one of the terms of the agreement that must be fulfilled by the service provider in order to get paid. By the same token, one can have a legally binding right to compensation whose amount will be determined in the future on the basis of a formula, even if the formula includes subjective factors. The distinction between employer discretion and subjective factors in a performance appraisal will be important in some cases. If the parties want to avoid creating a legally binding right, they should make it clear that the service recipient has complete discretion over the amount of compensation, without so much as the minimal obligation of good faith. There must be nothing in the agreement that will permit a disappointed service provider to bring a successful breach of contract action.
The effect of the alternative deadline for service recipients is that unilateral deferrals do not have to be put into place before services are performed. For instance, an employer may, in December 2008, grant a discretionary bonus for that year payable in 2015. A service provider would by that time be able to elect to defer only a small portion of the bonus.
| The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.
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Copyright 2007, Deloitte. |
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