401 Chaos

Thanks jpod. That was sort of my take as well. I can see where such an arrangement might make sense if the Company were not going to provide the compensation unless it went to a 457(f) plan. Perhaps that would end up being the company's ultimate position here anyway but the 457(f) arrangement was initially floated / requested by the executive / consultant under the assumption there was a general tax advantage and it would be a win-win for both parties (i.e., instead of asking for 15,000 more per year in salary, they asked for 15,000 more to a 457(f) plan). I suspect the company might end up agreeing to provide more under a 457(f) plan than they would have if paid out currently but I doubt the difference would be substantial and the company would just assume to avoid the whole 457(f) arrangement for relatively small amounts for one person.

Not really a question about the detailed overlap between the two sections, etc. but more a big picture question based on the interaction of the two rules and presumed increased regulatory focus / scrutiny on 457(f) arrangements as a result of 409A. My question is this--does it really make any tax sense for an executive to want to have amounts go to a 457(f) plan as opposed to being able to get the same amounts paid currently. In this case, the company could probably be convinced to pay the same or nearly the same amounts now as it will set aside under the 457(f) Plan although that hasn't been officially decided. Amounts going to the 457(f) plan will be subject to forfeiture if executive does not remain employed through x date which coincides with end of employment term and the individual's planned retirement. Deferred amounts will be paid to executive upon his "retirement" or shortly thereafter. It seems unlikely that the individual will leave the company before x date so, although real, the risk of forfeiture is not particularly great. Executive desires to defer amounts on advice of financial consultant. The consultant thinks that deferring recognition of income (and thus taxes) until the executive's retirement is a good thing tax wise. I am no so certain that is the case in a 457(f) context though. Given 409A and recent rumblings about the IRS's skepticism of, and likely future clarification to, the significant risk of forfeiture rules under 457(f), the employer is not interested in linking vesting / substantial risk of forfeiture under 457(f) to a noncompete. The Company also would not likely permit Exec to make a "rolling risk of forfeiture" if current plans change and the executive continues employment past x date. In short, the company fully intends that amounts going to the 457(f) plan will vest and be paid to executive on x date as long as the executive remains employed through such date. In this scenario, the vesting / payment date is mid-year so that the deferred amounts (plus earnings) will all be paid to the individual in a year in which he will have earned significant income from his regular salary through mid-year. If, as planned, he retires after that time and has no other regular salary for the year, it may be that he has a lower overall income as compared to the prior year. However, he will undoubtedly have some salary increases over the next few years and there will be some special bonus payments in the retirement year that may jack total pay up. As a result, I suspect the Executive would have a significant income in his retirement year and thus is likely to be in roughly the same tax bracket as he is currently. In short, there is no clear guarantee that the deferred amounts will be paid out in a tax year in which the Executive clearly has a much lower income. As a result, I don't see any clear tax advantage to deferring the amounts. If I were him, I would prefer to get the amounts now and invest on my own to try and get capital gain / dividend tax treatment instead of having all earnings taxed at ordinary income rates. And that doesn't even address the fact that the amounts going to the 457(f) plan will be subject to forfeiture. What would be ideal----and what I suppose I'm really getting at with this question----is whether there is any way in having the deferred comp amounts vest and be paid out in the tax year following his retirement (or maybe even later) so that there is a real chance he will be in a lower tax bracket. Given the company's reluctance to try and tie vesting to a noncompete or permit some rolling risk of forfeiture and 457(f)'s requirement that amounts be taxed when they are no longer tied to a substantial risk of forfeiture (i.e., conditioned upon the future performance of substantial services), I'm just not getting where a 457(f) arrangement makes any sense. What does the financial consultant see that the company does not?

Steeler, I am confused. Would you have to exercise / lapse within 2.5 months of taxable year following year of grant or year of vesting (i.e., no longer subject to a substantial risk of forfeiture)? I agree that wanting to grant discounted options to comply with 409A would be a very unusual thing. I have, however, seen folks suggest that tying vesting and exercise to a change in control of the issuer as defined in 409A may make some sense under 409A in cases where an employee is unlikely to really have much gain or exit possibility unless and until a change in control occurs. Would welcome your thoughts on that.

Thanks Just Me. That's where I am too. I agree it shouldn't come up all that often but we see a fair bit of last hired, first fired sort of thinking, particularly in group layoff situations which I think are subject to the same 2 times limit as well. I also agree that it should not be that big of a deal to comply with 409A here, particularly in a private company context. Unfortunately, the employment lawyers really like to have their cake and eat it too by insisting on paying the severance in installments but then pushing to qualify for a 409A exception rather than having to think through possible 409A compliance. Having to distinguish between recent hires and those employed in the prior year just adds another wrinkle or trap for the unwary. A separate but related issue on the compliance front that I have not heard directly addressed since release of the final regulations. Employment lawyers will typically provide for severance payments made in installment to be paid in accordance with the company's regular payroll schedule or something similar. I have heard some practioners say that such a provision is not definite enough to comply with 409A while others have suggested that is too extreme a concern (i.e., that anybody who thinks you would change normal payroll practice simply to alter severance payments has never had to change payroll timing). Anybody see anything in the final regulations or heard any informal IRS guidance that addresses this issue or suggests that ability to pay within a given calendar year when specific payment date is not specified covers this issue.

Thanks for thought on the short-term deferral exception. I agree that would make things easier; however, the company has some specific reasons for desiring a long-term installment payment plan in this situation due to some particular cash-flow concerns as well as a desire to police noncompete provisions and possible offsets in the case of future employment. As a result, I'm still considering the applicability of the 2 times pay calculation for recent hires. I can see where the IRS would want to use prior year amounts in order to avoid potential abuses if allowed to use current salary as a benchmark for the severance amounts but it seems a bit harsh to think that should prohibit application to anybody not working in the preceding year, particularly since the amount is subject to the two times 401(a)(17) limit as well. Thanks

Hoping somebody can help me out. I must be missing a wrinkle or something obvious but do not recall hearing this issue specifically addressed and do not see in the final regulations a way to cover an employee under the 2 times pay separation pay plan exception if the employee was hired in the same year as the year of termination and thus had no compensation from the service recipient in the the year prior to the termination year. Is it supposed to be the case that the separation pay plan exception only applies to employees that were employed with the employer for at least part of the preceding year or is this interpreted as simply allowing 2 times the employee's annual rate of pay at time of termination in such situations? Unfortunately, the terms in the final regulations do not appear to be defined or cross-referenced in a way that helps clarify this issue.

Masteff, Thanks very much. I understand your and QDRO's point on that issue. What I was hoping to get at with this post was whether or not it was absolutely required to define employer on a controlled group basis or not. My general review of the 401(k) regulations, for example, references severance from employment with the employer that maintains the Plan. It was not clear to me whether that absolutely requires a controlled group definition of the employer or if there is some flexibility with that since the Plan appears to have gone out of its way to try and distinguish between only those members of the controlled group that were participating employers in the Plan. Thanks.

I don't know. Perhaps it was a goof or perhaps it was intentional. All I can do is read the Plan as drafted, scratch my head and ask questions. I think in most cases the distinction works out to the participants' advantage. The Plan is not forcing the participants transferred to a foreign sub to take their money out, it merely permits them to do so. In cases where the folks plan to move permanently, I can see where the individuals may desire to get at their accounts immediately and sail across the sea (or over the Rockies) or whatever as compared to having to leave the money in there until no longer employed with any member of the controlled group.

QDROPhile, That is a good question. I did not draft the original plan and so am not sure why it was drafted that way or whether that is even an acceptable approach but the plan does use the broader Affiliated Employer category on the Years of Service issue. As a practical matter, I believe the Company has many more employees come from foreign subs to the U.S. whom they like to give credit to but relatively few people leaving the U.S. for foreign subs.

Have a question I've never dealt with directly before and would appreciate any general thoughts or advice as to the way most plans / employers treat these situations. Have a large client with a few large foreign subsidiaries (Canada, UK) that are all part of the Plan Sponsor's controlled group but are not, obviously, included as "Related Employers" in the 401(k) Plan. The subs instead have their own country-specific pension programs. If a U.S. employee participating in the 401(k) Plan transfers permanently to one of these foreign subs (i.e., changes residency, begins participating in foreign sub plans), is there any reason not to treat them the same as any other terminating employee under the 401(k) Plan. That is to say, wouldn't they become entitled to a distribution upon the transfer to a foreign subsidiary that is not a "Related Employer." The Plan document generally permits distribution upon a severance from employment with the Employer (which term includes those Related Employers that have been added to / adopted the 401(k) Plan). The term "Employer" does not include "Affiliated Employers" or those other members of the controlled group that have not signed on as Related Employers. Accordingly, it seems to me the Plan would consider any transfer to a foreign sub the same as a routine termination of employment for Plan distribution purposes. Does this seem correct / routine. One thing that bothers me about this is that the Plan does recognize service with an Affiliated Employer as Years of Service for vesting credit. So people transferring into the U.S. from a foreign sub would get credit for their service with the foreign sub under the Plan. However, someone leaving the U.S. for a foreign sub will presumably cease participation and vesting in the 401(k) Plan and possibly forfeit a portion of their account even though they continue working for an Affiliated Employer. I know the reason for giving service credit on the front end is a bit of a different issue but just wondering if there is any reason why somebody leaving the U.S. for an Affiliated Employer should be treated differently from a routine termination. For example, should the transferred employee continue to accrue vesting credit and not have a distribution right as long as they remain employed with the Affiliated Employer?

Searched for this issue but did not find anything on point and would be grateful for anybody that might point me in the right direction for further research. Our company received a request from the lawyer of one of our participants who was recently injured in a car accident. Per our arrangement with our TPA, the TPA is seeking subrogation / reimbursement for the health plan amounts paid on the injured participant's behalf. The lawyer has written back requesting all variety of plan documents so they can determine if our plan has an acceptable reimbursement policy. They also include a lengthy warning reminding us of the penalties for failure to respond within 30 days and for taking any action against the participant for exercising his ERISA rights. One of their requests is for certification by the Dept. of Labor that our plan is an approved ERISA Plan. In addition, they note that any reimbursement they make will be offset by a pro rata share of the attorney's 1/3 contingency fee. I have never seen such a letter before and was just wondering if this was familiar to others? The whole thing seems a bit suspicious to me--as if it is intended either to try and scare us away from enforcing the subrogation provision and/or possibly to cause us some exposure to ERISA penalties or weakened position on the reimbursement request for failure to provide all possible plan documents in a timely fashion. Also, I have never heard of anything along the lines of the DOL certifying that a plan is an "approved" ERISA plan so don't know where that comes from. Anybody ever seen a similar request before. Finally, my vary limited research suggests that offsetting the reimbursement recovery for attorney fees may be possible and that this is an issue that appears to vary from circuit to circuit. Anybody able to shed any light on these items? Thanks.

Randy, I read the commentator to be asking whether the "good faith" ISO standard could be extended / applied to general (non-ISO) valuations as well and assumed that only the ISO "good faith" rule would apply to ISOs even after 409A. I too have not heard anybody actually suggest that both standards apply to ISOs; however, I wouldn't want to be the one to really try and convince the Service that there was a "good faith" effort to value an ISO if that effort would clearly fail the 409A requirements.

MJB, I was really just trying to make two points. The first point is that getting money back from employees is a pain. As to your specific question, it seems to me the employees should have already had income / withholding taxes withheld on the bonus amounts since they have already been paid to the employees, albeit erroneously. Thus, I think the employer has generally satisfied its tax / withholding requirements on these amounts and all that is left is to be paid is for the employee to pay the 409A excise taxes. (I wouldn't think there would be penalties and interest due since the employer presumably withheld income taxes owed at the time of payment and those amounts should have been timely paid.) If an employer wanted to try and self-correct this situation (and I'm not saying that is allowed), it could be difficult to convince the employee to give back the money. The employees have already received it, presumably paid taxes on it, and many have likely spent it and therefore may not be able to pay it back easily or quickly. As you noted, the 409A tax piece is the employee's responsibility so seems the most the employer can do is point out that obligation if the money isn't returned as part of a self-correction. If the employer desires to try self-correction, seems they could notify the employees of the excise tax issue and the ability to avoid that by returning the money. Hopefully most employees would follow through with the excise tax payment on their own if they don't / cannot return the money as part of the self-correction and things get reported / taxed as Steelerfan describes. Regardless of whether employees return the money or not, I would not be surprised if some employees don't complain and look for the employer to help them. They could say that because it was the employer's fault the amounts were paid incorrectly, the employer should give them extra amounts / bonuses now to help pay back the amounts previously paid if they want to self-correct. Alternatively, if there is no self-correction attempt or employees do not or cannot participate in one, it would not surprise me if the employees don't come looking for the employer to cover the 20% excise tax. Note, I'm not saying the employer has any obligation to cover those amounts--merely saying that I've seen employees make such arguments in similar situations. My second point was that although self-correction is not expressly authorized, I think you could make an argument that it should be the preferred remedy here and, from a policy perspective, is better than treating the payments as Steelerfan notes and subjecting the employees to the excise tax. My rationale for that is that allowing employees to receive these amounts due to a mistake could give rise to abuses. The erroneous (early / accelerated) distribution of these amounts could, if mistakes are manipulated, be viewed the same as the old haircut provisions (although at 20% it would be a steep haircut to be sure).

I haven't read the RR so I may be missing something but was generally assuming that the bonus amounts had already been taxed as wages since they should be subject to normal payroll withholding. It seems to me the employer arguably has to unwind those prior tax withholdings and get the after-tax amounts back from the employees. Unfortunately, in my experience asking for (and getting) the money returned is never as easy as it sounds.

Alright, alright. You are both correct that the employer cannot / should not take the 20% from the paychecks. My apologies--it was an off-the-cuff response and not intended to be legal advice to anyone. Seems still though that you have to tell the employees that you will report it as a noncompliant distribution thus the IRS will be looking for the 20% excise tax from somewhere. My main point was just that the employer probably needs some hook or threat to the 20% excise tax piece in order to convince the employees to return the money (if that is what they decide to do).

Perhaps so but I'm not convinced the Service is going to let employers off the hook in getting the 20% excise tax when they know there has been a violation.

I agree with others that there is no clear answer in the final regulations and that the IRS needs to provide guidance as to self-correction in this area. From a policy perspective, I think the IRS should clearly prefer and allow for the return of the erroneously paid amounts without consequences. That would simply be putting everybody back in the position they would have been in had the mistake not occurred. To allow participants to keep these amounts would be a failure to comply with the irrevocable elections and arguably an accelerated distribution under 409A. Although not the intent in this case, it seems that allowing such administrative mistakes to go uncorrected could potentially give rise to the sorts of abuse the IRS is trying to avoid under 409A. For example, executive changes his mind about a previous deferral election and possibly arranges for an "administrative glitch" to avoid that deferral. Now for the hard part--getting the participants to pay back those amounts. I suppose arguing to them that the payments were a 409A violation and that the 20% excise tax will be taken out of their paychecks may help get the money returned but some group will no doubt demand that the company help out with this payback by providing them an additional bonus since they may have already spent the money. Good luck.

J Simmons, Thanks very much for your thoughts. I think the prohibition on reimbursing premiums paid on coverage through a spouse's policy takes me back to just providing cash, unfortunately. In the particular case at hand, most of the employees with outside coverage have it through spousal coverage rather than simply on their own. The other issues you raise also seem to favor not adopting a MERP as a simple, low-maintenance alternative. The employer in this case already pays the premiums on the remaining limited benefits items so, for better or worse, the $300 stipend would generally need to go to health insurance premiums to really accomplish it's goal. There just isn't anything else to cover on a pre-tax basis to offset that contribution. Unless someone else has creative alternatives, I think all that means the employer will end up paying cash, subject to taxes, to those employees not participating in the group plan. Thanks.

I am getting more and more questions from employers who, for one reason or the other, would like to essentially provide each employee a health insurance "stipend" that could be used to pay for coverage under the employer's group plan or, alternatively, for premiums for other coverage if an employee elects not to participate in the employer's group health plan. In most cases, this seems to arise as a matter of "fairness" for the owners. The thinking is basically that they are willing to pay $X amount for group health insurance premiums for those employees participating in the employer's group plan so, therefore, they should be willing to pay the same amount to employees who forego coverage under the employer's plan when they have health insurance coverage elsewhere (e.g., spousal coverage, individual health insurance plans, etc.). I have worked with employers who have established "opt-out" or "cash-out" programs under their cafeteria plans to make sure that those employees who actually elect coverage under their employer's plan are not subject to constructive receipt concerns by the IRS. One of the challenges of that approach, however, seems to be that the employees getting the stipend amount rather than coverage under the employer palnn must recognize the stipend in income and pay taxes on it while employees covered under the company's plan basically get the stipend on a pre-tax or "tax free" basis. The "fairness" rationale then leads the business owners to consider providing a tax "gross-up" or additional amounts to the non-electing employees in order to make up for the different tax treatment. Also, as I understand it, having the employer contribute the stipend as an employer contribution or flex dollars to a health FSA for those employees not electing employer plan coverage poses big problems because the health FSA rules do not permit participants to use the account to pay for health insurance premiums. All of this has me wondering if the better approach is not be to establish a simple medical reimbursement plan whereby the employer agrees to reimburse all eligible employees for amounts spent on health insurance premiums up to a maximum monthly stipend amount. For example, if an employee is willing to give each employee up to $300 per month to cover the cost of major health insurance premiums (whether under the employer's group health plan or through other coverage), as long as the employer requires proof that the amounts are essentially being paid in arrears to reimburse the employee for legitimate health insurance costs, shouldn't those payments be tax free? Would this vary if the amounts being reimbursed were premiums paid by a spouse on a pre-tax basis under a cafeteria plan sponsored by a spouse's employer? Would this potentially be discriminatory if the reimbursement formula provided for payments of 50% of monthly health insurance premium costs up to a maximum of $300 per month? Perhaps that depends on which employees are getting the maximum reimbursement amounts and which are not. Granted requiring a receipt / proof of premium payments would be a real pain but it seems to me it's preferrable to having the stipend treated as taxable income to those participants that do not elect coverage under the employer's plan. I don't see many folks with these sorts of reimbursement plans these days--at least not outside the very small company / nonprofit sector. Admittedly, I also don't see many employers who are willing to pay a stipend or otherwise make a contribution to the cost of health insurance coverage outside of the employer's own plan but the interest in such programs seems to be on the rise. I would be grateful for any thoughts on the best or most tax-efficient way to make these sorts of programs work. Thanks.

Harry, Thanks for your comments. I was under the impression (probably erroneously) that some states had more or less voluntarily given up on going after nonqualified deferred compensation amounts paid out to former residents over less than 10 years following enactment of the Pension Source Act. However, I have not been able to find any surveys of various state tax positions on this subject. Is it your experience that all states generally impose income taxes on amounts not exempted by the Pension Source Act or will we simply need to look at each state in which we have employees separately. Thanks

I just wanted to follow up on rpolete's reply below to see if anybody had any recent experience with states attempting to go after distributions from nonqualified plans to individuals who worked in the state when the compensation was deferred under the plan but have moved out of state and are nonresidents of the former "work state" when distributions are actually made. My understanding is that the Pension Source Act (4 U.S.C. § 114) prohibits such efforts by states with regard to distributions from most qualified pension plans and even some nonqualified deferred compensation plans; however, in order to qualify as a nonqualified deferred compensation plan, the distributions must generally be made in equal periodic distributions over (i) the individual's lifetime, or (ii) a period of at least 10 years. We have a nonqualified deferred comp plan that permits lump sum distributions or distributions in equal installments over a period of up to 15 years. As a result, we have some participants with distributions over less than 10 years who would presumably not be protected by the Pension Source Act. Curious if any states are still attempting to go after such distributions or if that activity has generally gone away. Thanks.

Thanks for everyone's thoughts. I am still waiting on copies of the actual contract in place so not sure exactly what that says but I find it hard to imagine that it would be so specific as to expressly prohibit any or all forms of reimbursement as long as the co-pays are getting charged. That said, I'm suspecting the insurer would still be pretty upset if they found out what was going on with reimbursements--whether through the flex plan or otherwise, especially considering the insurer has already called them on their original waiver policy. I think Stuartt put his finger on another reason for my unease here. Something just doesn't feel exactly right to me if you restrict use of funds to services provided by the employer. On the otherhand, it's the employer's funds / contribution so hard to argue they shouldn't be able to restrict the use of those particular amounts if they want to do so. As you might imagine the employer and insurer have other network / provider relationships so they are a bit sensitive to pushing one another too much on some of these points.

Thanks Jacmo. I think the insurer in this case actually has a reasonable point. I believe a large part of the reason for imposing co-pays in insurance arrangements is to impose some cost or obstacle on the individual so they do not "run to the doctor" ever turn thereby running up large bills for the insurance company. If imposing a $25 office copay keeps a person from going for a doctor visit that costs the insurance company $80 every time the person gets the sniffles, it's very important to the insurance company. The insurer isn't saying the person cannot go, they are just making them think about it by requiring them to share in the cost. If office visits become free again then there is no reason for the individual to think twice about seeing the doctor--especially if they are at the doctors office for work any way. I have not seen the group policy or contract but I suspect imposing these copays are part of the contractual arrangement between the group and the insurer and that the insurer has calculated it's premiums based on the notion that these copays and other cost-sharing features will be employed (and will have some of their intended effects of reducing use). I do not dispute that employees could cover these copays etc. with typical flex plan dollars or using other arrangements in the normal course just like any other doctors office copay. However, if the employer contributions are limited solely to office visits for the employer's own office, that really isn't the same as covering those copays like any other. In that case, there is no opportunity cost for the employee in deciding whether to use the amounts for an office visit versus some other medical expense (over the counter medicine, new glasses, etc.). In that case, it seems the employee is right back where they were before since there ultimately will be no out-of-pocket cost to them to going to their own practice group. If the insurance company had a problem with the straight waiver / payment approach, I'm not sure this arrangement is sufficiently distinguishable that the insurance company wouldn't object to it as well.

This is a new one on me but wanted to see if anybody else had ever run across this or something similar. Have a doctors group with a group health plan and cafeteria plan with health FSA. They had a prior practice of waiving group health insurance co-pays and certain co-insurance amounts on office visits / services provided to the practice group's own employees as well as the employees of some other medical groups. Maybe even for dependents of employees as well. Insurer found out about this and, not surprisingly, cried foul. (Insurer said it was concerned about practice group not passing on the co-pays / co-insurance amounts to members thus giving them free access, was concerned about medical group not applying standard rates for all patients, batted around notion of insurance fraud.) Medical group got message that they needed to stop that practice but still wants to provide some form of similar benefit to its employees. Does not want to simply increase salary / pay bonuses to employees because that will be taxable. Similarly, grossing up employees for taxes would be too expensive. So, they brainstormed and now want to provide a fairly significant flat dollar amount employer contribution to the cafeteria plan that can only be used to cover co-pays and co-insurance for services charged by the employer. The amounts would be restricted just to these employer group co-pays / co-insurance amounts and could not be used for any other medical expenses. If the amounts are not used during the year for co-pays and co-insurance amounts, they would be forfeited back to the employer so the practice group, in theory, is not out anything more than under their old policy My first reaction was that this arrangement simply does indirectly what they already had gotten in trouble for doing directly. That is, it provides free use of the group health insurance benefits for their employees without the employees having to give any thought as to how much it will cost them out of pocket. Client then asked, notwithstanding that, if there was a reason under the Section 125 rules that the employer contributions could not be restricted to such a narrow benefit. I haven't researched but that just doesn't seem appropriate although all employees would be entitled to the same dollar amount and same coverage options, presumably even if they didn't have group health insurance coverage through the group. Anybody have thougths? Anybody have suggestions for some other form of benefit that might be provided in lieu of this sort of arrangement? Thanks

Sue, I am not a cafeteria plan expert but my understanding is that Section 125 cafeteria plans can be designed to permit coverage of certain individual or non-employer sponsored insurance policies. Specifically, cafeteria plans can cover certain individual health / medical insurance policies and individual life insurance contracts that are provided to a group of employees. In no event, however, can such policies provide for "deferred compensation" so a cancer policy that provided some payment several years down the line in the absence of a cancer claim, etc. could not be covered but a supplemental disease / cancer policy providing additional benefits for particular claims would be ok. That said, the coverage of such individual policies can raise unique tax, HIPAA, and other compliance issues for employers plus administrative issues along the lines you highlight with respect to payment / reimbursement. As a result, many plans are not drafted to permit such coverage and many employers will refuse to expand their plans to do so. For what it is worth, I believe you could design the plan to handle premium payments / reimbursements in either of the manners you note if you desired to cover these benefits under a cafeteria plan. Again, cafeteria plans are not my thing so I'm interested in seeing if others have different thougths. Good luck.