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Violation of 409A: Effect on Grandfathered Amounts


Guest BRich

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409A (statute and regs) says that if you fail to meet 409A, amounts deferred under a nonqualified plan FOR ALL TAXABLE YEARS are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income.

The regs also provide that unless the plan is materially modified after 10-3-04, 409A applies only to amounts deferred on and after 1-1-05.

Suppose someone established a nonqualified plan in 2000 to which they made substantial annual deferrals. Suppose further that the person never paid attention to the changes brough about by 409A and continued to make deferrals under the noncompliant plan during '05 and '06.

The deferrals during '05 and '06 are definitely subject to 409A. However, if the plan was never modified, are the pre-'05 deferrals grandfathered (i.e., protected from 409A)? The language "FOR ALL TAXABLE YEARS" (above) suggests that all deferrals under the plan are subject to 409A.

Can anyone confirm that I have this right? Is there any way to salvage the pre-'05 deferrals?

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Guest Harry O

A pre-2005 vested deferral is only subject to 409A if the plan is materially modified after 2004. A material modification is generally the addition or enhancement of a benefit or right under the plan. It is not clear under your facts if this occurred. Just because the plan didn't comply with 409A for 2005 and 2006 deferrals doesn't mean it was "materially modified". We need more facts about what happened in 2005 and 2006. In addition, the transition rules are fairly broad so you can usually find a way around suspected 409A violations in 2005 and 2006.

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A pre-2005 vested deferral is only subject to 409A if the plan is materially modified after 2004. A material modification is generally the addition or enhancement of a benefit or right under the plan. It is not clear under your facts if this occurred. Just because the plan didn't comply with 409A for 2005 and 2006 deferrals doesn't mean it was "materially modified". We need more facts about what happened in 2005 and 2006. In addition, the transition rules are fairly broad so you can usually find a way around suspected 409A violations in 2005 and 2006.

Harry O,

Thanks for responding.

No modifications were ever made to this plan. I am concerned though that since the statute uses the phrase "FOR ALL TAXABLE YEARS" that the pre-2005 grandfathered amounts are subject to 409A.

Do you interpret the "FOR ALL TAXABLE YEARS" to mean "for all taxable years to which 409A applies as determined by the regulations" (i.e., all years that are not grandfathered)?

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Guest Harry O

Yes.

I think the statute is clear on this point.

The only way you can drag pre-2005 vested deferrals into the world of 409A is if you materially modify the plan with respect to these amounts.

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Another important item. I agree that the transition rules are flexible enough that you can get back to 12/31/2004 to separate your grandfathered plan (all contributions and vested amounts as of 12/31/2004), and the plan after 12/31/2004 (all post 12/31/2004 contributions and earnings and pre 1/1/2005 unvested amounts), so long as there has been no action that would contitute a material modification of the plan in the interim so as to make grandfathering impossible.

However, you will need to be able to identify and separately administer the pre1/1/2005 grandfathered amounts and the post 12/31/2004 amounts if the IRS comes around to audit the sponsor's situation. You'll need proof of what is the grandfathered amount and what is not.

This far down the road it may be difficult if not impossible to retroactively identify more than a balance on 12/31/2004, so unless your current plan administrative capability can separate the earnings attributable to the grandfathered portion after 12/31/2004, and also the nongrandfathered portion, your sponsor and its participants may have to settle for a fixed grandfathered amount. That does simplify the grandfathered earnings record-keeping (there is none), but does lose any advantage for all future post-12/31/2004 earnings attributable to the grandfathered portion that the sponsor would ideally like to obtain by grandfathering.

Which raises the question- is there a good reason to grandfathering, like a "haircut" provision or much better definitions for distribution (e.g., "own occ" disabililty definition) in the old plan??

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