Calculating Deferrals to a Defined Benefit Plan SERP?

[Guest SCUDDESLER]

We posted a message a view days ago, but have yet to receive a response--which causes us to think that either our questions were nonsensical or we are the only firm in the country thinking through AJCA issues relating to defined benefit type SERPs. Since it is unlikely that we are unique in the latter sense, I will try to more clearly state the issues (as we understand them).

Code Section 409A applies to “nonqualified deferred compensation plans” which are defined in IRS Notice 2005-1 as “any plan. . . that provides for the deferral of compensation (within the meaning of Q&A-4).” Q&A-4 in IRS Notice 2005-1 provides that “[a] plan provides for the deferral of compensation only if, under the terms of the plan and the relevant facts and circumstances, the service provider has a legally binding right during a taxable year to compensation that has not been actually or constructively received and included in gross income, and that, pursuant to the terms of the plan, is payable to (or on behalf of) the service provider in a later year.” There is a general consensus, which we believe is correct, that a defined benefit type SERP qualifies as a nonqualified deferred compensation plan and, as a result, as a plan subject to Code Section 409A.

Plans subject to Code Section 409A must comply with a number of new rules. For purposes of this post, we are concerned with (1) the rule requiring completion and submission of a "deferral election", (2) the rule requiring that annually deferred compensation be reported on Form W-2 (or Form 1099, as appropriate) and (3) for purposes of applying the grandfather rules, the rule dictating how much of a participant's benefit in a defined benefit type plan was earned prior to January 1, 2005.

The last rule is relatively easy to understand because it is explained in Q&A-17(a). However, the IRS, to our knowledge, has yet to flesh-out guidelines relating to the computations necessary to satisfy rules (1) and (2). In order to comply with rule (1), a 2005 deferral election must be completed by March 15, 2005. Since we cannot be the only firm concerned with whether a defined benefit type SERP is subject to rule (1) (despite Grumpy455's response to our earlier post) and, if so, how the amount of the deferral in that context should be quantified, we are soliciting comments/suggestions from other similarly-situated practioners. Any comments are greatly appreciated. Thanks.

[KJohnson]

A SERP is obviously deferred compensation, but there is no deferral election in a SERP. An employee has no choice on whether to receive cash or defer an amount.

The deferral election rules only apply "if the plan provides that compensation for services performed during a taxable year may be deferred at the participant's election..."

[Guest SCUDDESLER]

Thanks for your response--it is helpful. We apparently agree that a DB-type SERP is a deferred compensation arrangement. As a result, it seems to follow that some compensation is being deferred each year. Let's set aside the deferral election issue for a moment.

The following excerpt was taken from a recent newsletter from Milliman (BOB-04-01):

"If the SERP fails to comply with any of the new statutory reporting requirements, all compensation deferred under the SERP becomes taxable. The calculation of the deferred amount to report will be particularly difficult under a defined benefit plan SERP. . . [and] the AJCA itself provides no guidance for this calculation, leaving Treasury to issue regulations. The Conference Report also allows Treasury not to apply the reporting requirement to deferral amounts that are not “reasonably ascertainable.” However, until Treasury issues regulations, plan sponsors will have little to guide them. Moreover, while AJCA dictates time frames by which Treasury must provide guidance in certain areas, no such directive applies to this particular issue."

To return to my observation at the outset that "some compensation is being deferred each year", a fundamental question seems to be whether the amount of compensation deferred each year is "reasonably ascertainable". If it is, then it seems that same amount will be subject to not only the reporting requirement but also the deferral election requirement (although I guess, in anticipation of your response, the annually reported deferral may not be made "at the participant's election"). Alternatively, if the amount of compensation deferred is not reasonably ascertainable, then there is no reporting requirement and presumably no deferral election requirement either (it would seem strange for an amount that is not reasonably ascertainable to be made at the participant's election--how could such an election be made).

Do you agree with this analysis?

[Guest LeeNunn]

IRC Section 409A definitely includes non-account balance plans such as defined benefit SERPs.

The amount earned and vested at 12/31/04, for purposes of grandfathering, is the present value of the benefit the particpant would have received if he quit on that day and elected the payout at the earliest possible date. This amount might be substantially less than vested amounts payable at age 65.

To the extent that amounts earned before 12/31/05 are covered by 409A, participants must make payout elections before 12/31/05. Going forward, participants must make payout elections when they first join the plan. Other than switching between various forms of life annuities, these elections are irrevocable for practical purposes. SERPs rarely offer in-service accounts and most participants won’t want a second election that causes them to wait five years after separation from service to begin receiving benefits.

The W-2 reporting in box 12 will probably follow the FICA rules. A-26 uses the term ascertainable, which sounds like the resolution date used in the FICA regs for non-account balance plans.

[KJohnson]

Also, as a practical matter what are you doing for the medicare portion of FICA? It seems like there is already a mechansim in this regard for "non-account" balance plans to determine the amount subject to FICA each year.

Sorry LeeNunn I just read the last couple sentences of your post and see you have just covered this point.

[Guest LeeNunn]

Actually, I was just comparing the FICA rules for non-qualified non-account balance plans to the W-2 box 12 requirements for non-account balance plans in IRB 2005-2.

You raise a good point. Some employers forget about 1.45% Medicare tax. The calculation is more complicated for DB plans, especially restoration plans, than it is for DC plans.

[Guest SCUDDESLER]

I am not sure what the previous messages mean, but there seems to be a consensus, at least among the two respondents, that while the benefits provided by a DB-type SERP constitute deferred compensation, the amounts deferred cannot be quantified (ascertained) on a year-to-year basis or, put differently, that such amounts are not subject to the deferral election rules or the reporting rules imposed by Section 409A.

[E as in ERISA]

For the reporting issue, I think that question 26 of Notice 2005-1 indicates that the generally rule is that they woud be reported, unless they are in fact non-quantifiable. They may be harder to quantify than account balance -- but that does not make them nonquantifiable. You use FICA regs 31.3121(v)(2)-1©(2) methods -- calculate present value using normal form of benefit, actuarial assumptions and methods, etc. Under 31.3121(v)(2)-1(e)(4)(i)(B), it will be ascertainable if you know the amount, form and commencement date (and you use certain assumptions to supply those terms if not exactly known).

I think that the deferral election rules only apply if there is actually a deferral election by the participant. For employer funded plans I think those rules don't apply.