substantial risk of forfeiture

[Guest ladycpa2]

My client wants to set up a phantom stock plan that would allow cash bonuses to be converted to phantom awards and then they are eligible to take 20% of their awards in cash 5 years after the initial award. If they don't take it they can defer but if they leave for any other reason than death, disability or retirement they forfeit any awards they haven't converted. It is also nonelective. It seems to me that they can decide to defer 12 months prior to the scheduled payment for 5 years. During that 5 year period if they were to die, become disabled or retire, they would get their awards in their account but otherwise it would continue to be subject to the substantial risk of forfeiture. If they leave during that 5 year period of subsequent deferral they would lose everything. Does anyone see a problem with my analysis or compliance with 409A?

[QDROphile]

Please explain "It seems to me that they can decide to defer 12 months prior to the scheduled payment for 5 years." I can't make out what you are saying. Are you saying that they can elect 12 months before year 5 to take 20% in cash? Or do they elect the 20% 12 months before the initial award that starts the 5-year clock? You have also said nothing about when the election is made to take the phantom stock instead of the cash bonus.

[namealreadyinuse]

would allow cash bonuses to be converted to phantom awards

It sounds like the timing of these elections will be important. The deferral elections will have to be made before the service period. Also, your statement that they are non-elective doesn't make sense considering the first sentence.

The second observation is that you don't have to impose subject the funds to a substantial risk of forfeiture. It can be vested unless this is a 457(f) plan. In fact, the Treasury does not believe that elective salary deferrals will ever be made subject to a [legitimate] substantial risk of forfeiture.

It sounds like you are adding complexity for no tax reason.

[Steelerfan]

It seem as though something is missing in the facts. The"straight" bonus portion would need to be deferred prior to the start of the service period and would normally be elective, but if they can subsequently elect to convert their bonuses to phantom stock units with an additional 20% "kicker", then the 20% could be an additional amount that they would only get if they stay and make a valid subsequent election (the 12 and 5 rule as I call it for short hand). In that case it seems you could subject the additional 20% to an SRF. Another way to accomplish this goal without the need for a subsequent election would be to make the entire portion of the bonus mandatorily deferred, essentially a nonelective phantom stock unit (i.e, no choice to take cash, but must defer, then give additional 20% and subject the whole amount to SRF). You will have to decide what to do about phantom dividends if you want to be thorough about it.

[Guest ladycpa2]

It seem as though something is missing in the facts. The"straight" bonus portion would need to be deferred prior to the start of the service period and would normally be elective, but if they can subsequently elect to convert their bonuses to phantom stock units with an additional 20% "kicker", then the 20% could be an additional amount that they would only get if they stay and make a valid subsequent election (the 12 and 5 rule as I call it for short hand). In that case it seems you could subject the additional 20% to an SRF. Another way to accomplish this goal without the need for a subsequent election would be to make the entire portion of the bonus mandatorily deferred, essentially a nonelective phantom stock unit (i.e, no choice to take cash, but must defer, then give additional 20% and subject the whole amount to SRF). You will have to decide what to do about phantom dividends if you want to be thorough about it.

[Guest ladycpa2]

I apologize that I didn't make this more clear. This bonus they receive is automatically deferred (nonelective) and is converted to phantom units based on the value of the stock as of the date of the bonus. They are then eligible to elect a distribution of up to 20% of the initial award 5 years later, 20% of the initial award 6 years later, etc. So I think in order to comply with 409A they would have to elect 12 months prior to the eligibility date of the 20% initial award to defer that another 5 years. So if someone was awarded phantom stock on February 1, 2008, they would be eligible to take 20% of that award on February 1, 2013. If they wanted to defer that 20% they would have to make that subsequent election by February 1, 2012 and defer it until February 1, 2018. If they deferred and then left say in 2014, they would lose all those awards. Thanks for your responses.

[Steelerfan]

Your 409A analysis looks correct to me-unless you can make the argument that no legally binding right to the bonus attaches until they are eligible to elect the first 20% payout (you need a legal opinion on that), then in that case there has been no initial election until their election to take the 20%, which would occur simultaniously with the LBR. If that is the case, you don't have to do it 12 months in advance. But as a practical matter, if I were an executive, I wouldn't want to make a deferral under this arrangement. It's not an attractive design because the exec can lose an amount he will no doubt consider to have been earned and you'll end up with a plan that just pays out in 5 year installments.

As a planning matter, I would not bother with any additional deferral feature under the arrangement you describe unless they make all their elections prior to when the legally binding right to the initial bonus attaches (or prior to the service period to be safer) and initially elect to receive payment, e.g., after 5 years of employment, but again noone will want to futher defer if they can lose it. If you want a golden handcuff, why not just do a service-based restricted stock unit plan (payable in the form of cash) that forfeits if you leave before the end of the 5-year period, and pays out immediately at the end of the 5-year forfeiture period to satisfy the short-term deferral provision of 409A? Then you can mess around with additional deferral features, made either at the time the legally binding right to the bonus attaches or in accordance with the subsequent election rules 12 months prior to the end of the SRF.