Plan Termination and Intentional 409A Failure

[kgr12]

A couple of nervous employees are pressuring their financially strapped employer to terminate their deferred compensation plan and pay them out immediately. They are essentially saying "we'll take the current tax hit and pay the additional 20% tax, because 80% of a loaf is better than none if you go under." It's completely contrary to the 409A-compliant plan document, so the document would either have to be amended or ignored for this to happen. Either way, the violation of 409A would be intentional/knowing on the part of the employer, and not only consented to but encouraged by the participating employees.

I recognize that a plan termination isn't permissible under 409A when it is "proximate to a downturn in the financial health of the service recipient," and distribution following termination is supposed to take place at least 12 and no more than 24 months following the termination. Nevertheless, what other than the 20% additional tax keeps the employer from terminating a deferred compensation plan and paying the benefits in spite of 409A? (Putting aside, for the moment, any penalties and interest for underpaying tax in a prior year, if that would even be applicable here.)

I recognize that such a maneuver undermines the intent and spirit of 409A, and I'm loathe to recommend to an employer that it intentionally and/or knowingly run afoul of a tax code requirement, but really, in such a circumstance, doesn't the 20% tax operate as nothing more than a haircut provision?

There are a few things which I can think of that should make the employer and employees think twice: (1) if the employer does go under, other creditors of the employer could argue that they were defrauded by the collusion of the employer and the employees; (2) properly reporting the violation potentially opens them all up to a lot of scrutiny (audits and the like); and (3) IRS could argue (although I think the facts ultimately would show otherwise) that the whole plan was a sham from the get-go and that the plan's benefits should have been included in income in the year of the deferral, so penalties and interest apply.

What else am I missing here?

[Guest Salvador A Mander]

I agree that it's just a haircut. As you gather, 409A doesn't impose substantive rules but only imposes a tax and penalty (and higher interest rate).

In addition to your considerations below, if your client is a public company and the employees are senior level employees, I suspect there could be security law issues relating to the accelerated payment, but that's not my field so I can't speak to that. Just a thought.

[kgr12]

Thanks .

I should have mentioned, but didn't, that the employer is closely held, so there are no shareholder/security law issues per se.

[jpod]

Doesn't the interest charge increase the penalty to something in the aggregate that is greater than 20%?

[Guest Salvador A Mander]

Doesn't the interest charge increase the penalty to something in the aggregate that is greater than 20%?

Yes, but if the 409A tax and penalty income is paid at the time of the violation, there shouldn't be any interest.

[jpod]

Sal: Not true. See 409A(a)(1)(B)(i)(II) and (ii). I am not talking about interest due to late payment of taxes. Depending upon the facts the combination of regular income tax, 20% penalty, and interest charge could equal or exceed the amount of the deferred compensation (unless there is some guidance from IRS which I missed which says that the total tax can't exceed the amount of the deferred compensation).

[Guest Salvador A Mander]

Sal: Not true. See 409A(a)(1)(B)(i)(II) and (ii). I am not talking about interest due to late payment of taxes. Depending upon the facts the combination of regular income tax, 20% penalty, and interest charge could equal or exceed the amount of the deferred compensation (unless there is some guidance from IRS which I missed which says that the total tax can't exceed the amount of the deferred compensation).

Good point - the interest goes back to the time of the first deferral or, if later, when it was no longer subject to a SROF.

I'm unaware of any such guidance ref in your post above.