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Section 409A Compliance
Voluntary Deferral and Account Balance Plans

11.8.2005

On September 29, 2005, the Treasury Department and IRS issued long-awaited proposed regulations regarding deferred compensation agreements under Section 409A of the Internal Revenue Code. This alert, the second in a series regarding Section 409A compliance and the proposed 409A regulations, discusses the rules governing deferral elections and the time and form of benefit payments under voluntary deferral arrangements and other "account balance" plans.

Voluntary Deferral and Account Balance Plans - Overview

One of the most common types of nonqualified deferred compensation plan is the voluntary elective deferral plan. In this and other types of "account balance" plans, the participant's deferred compensation benefit is based on a bookkeeping account balance. The participant's voluntary elective deferrals are credited to this account, along with any employer matching or other contributions. Often these plans provide that the bookkeeping account will earn interest (at a fixed or variable rate). More recently, many of these plans have been designed so that the bookkeeping account balance will experience gains or losses based on the performance of one or more notional benchmarks.

Deferral Election Requirements

In general, Section 409A provides that an election to defer compensation for services performed during a calendar year must be made (and must be irrevocable) by the end of the preceding calendar year. The deferral election also must specify the time and form of payment of amounts deferred under the plan.

There are several exceptions to the general rule, including special provisions covering short-term deferrals, ad hoc mid-year grants, commissions and fiscal year employers. In addition:

  • Newly eligible participants - When an individual first becomes a participant in an account balance plan, he or she may make the initial deferral election within 30 days after becoming eligible. This initial election can only be applied to compensation for services performed after the participant's election. Also, this exception does not apply if the participant has already been eligible under another account balance plan maintained by the employer.
  • Performance-based compensation - So long as the compensation has not yet become reasonably certain, a participant may elect to defer performance-based compensation as late as six months prior to the end of the performance period. Performance-based compensation generally means compensation that is contingent on the satisfaction of pre-established organizational or individual performance criteria. The performance period must be at least 12 months long.

The deferral election rules apply with equal force to matching and other non-elective employer contributions to the participant's deferred compensation account balance. The employer's contribution is treated as the "deferral", and the time and form of payment must be specified no later than the time of the deferral. To satisfy this requirement, the plan may specify the time and form of payment or it may allow the participant to elect the time and form of payment.

Benefit Payments

Section 409A restricts how an arrangement may define the time and form of benefit payments. A deferred compensation plan or election must provide that payments will be made only upon one or more of the following events:

  • A fixed date or under a fixed schedule - Definitely determinable amounts may be payable on a date or dates that are objectively determinable at the time the amount is deferred. For example, a participant may elect to receive payments in substantially equal installments beginning on the participant's 65th birthday.
  • Separation from service - The plan or election may provide that payments will be made (or begin) when the participant separates from service. For an employee, this would be his or her bona fide termination of employment. For an independent contractor, this would be the bona fide expiration of the contract. If the participant is a "key employee" of a publicly-traded company, payments due to separation from service must be delayed at least six months following such separation from service.
  • Death.
  • Disability - The plan or election may provide that payments will be made (or begin) when the participant becomes disabled, based on a definition of "disabled" under Code Section 409A.
  • Change in ownership or control - An arrangement may permit distribution upon the occurrence of an event that, under IRS regulations, constitutes a change in ownership, a change in effective control, or a change in the ownership of a substantial portion of the assets of a corporation.
  • Unforeseeable emergency - An arrangement may allow hardship distributions, provided that the distribution amount is limited to the amount reasonably necessary to satisfy the emergency. The hardship must constitute an unforeseeable emergency under Section 409A.

A deferred compensation arrangement may provide for payment upon more than one of the events described above. For example, a plan may provide that benefit payments shall commence upon the earliest of attainment of age 55, separation from service, death, disability, or unforeseeable emergency.

Subsequent Elections to Change the Time and Form of Payment

Subject to certain limitations, a deferred compensation arrangement may allow participants to change the time and form of payment. If a plan permits the participant to make a subsequent election to delay a payment or change the form of payment, it must impose the following conditions:

  1. The participant's election may not take effect until at least 12 months after the date on which such election is made; and
  2. With respect to payments to be made for reasons other than death, disability or unforeseeable emergency, the participant's election must delay the first payment for at least 5 years from the date such payment otherwise would have been made; and
  3. With respect to payments to be made at a specified time or pursuant to a fixed schedule, the participant's election must be made at least 12 months prior to the date of the first scheduled payment.
These rules may also be used to permit a participant to "re-defer" receipt of short-term deferrals that previously have not been subject to Section 409A. In general, a short-term deferral is an amount that will be paid no later than March 15 of the calendar year following the year the amount is no longer subject to a substantial risk of forfeiture (or, if later, two and one-half months after the end of the employer's fiscal year in which the amount is no longer subject to such a risk). To re-defer a short-term deferral, the participant must make an election at least 12 months before the short-term deferral vests, and payment must be delayed at least five years from the vesting date.

Limited Acceleration of Benefits

A plan may not permit the acceleration of the time or schedule of any payment except under limited circumstances. The exceptions allow acceleration:

  • to comply with a domestic relations order,
  • to comply with certain conflict of interest rules,
  • to pay income taxes on benefits that vest under a Section 457(f) plan of a tax-exempt or governmental employer,
  • to pay certain de minimis payments relating to a participant's termination of interest in the plan,
  • to pay employment taxes,
  • to prevent a nonallocation year under an employee stock ownership plan,
  • in connection with the cancellation of deferrals due to an unforeseeable emergency or hardship, or
  • to pay benefits includible as income for a violation of Section 409A.

The proposed regulations would also allow accelerated payment upon termination of the arrangement. The proposed regulations would allow termination of a plan following a qualifying change in control, upon dissolution of the employer (if the employer is a corporation), or following the employer's bankruptcy if the bankruptcy court approves the termination. An employer can also cease to provide all deferred compensation of a particular type (e.g., all account balance plans) if the termination satisfies various requirements and the employer does not adopt a new arrangement of the same type at any time during the following five years.

Plans Linked to Qualified Plans

401(k) wrap and excess plans are types of nonqualified account balance plans designed to coordinate with the employer's qualified 401(k) plan. Typically certain amounts are allocated to the account balance plan to the extent that that they otherwise cannot be contributed to the qualified plan because of nondiscrimination testing or other plan limits. As a result, the calculation of amounts allocated to the account balance plan may be affected by changes made under the qualified plan or adjustments to applicable qualified plan limits. The proposed regulations provide that an amendment of the qualified plan to increase or decrease benefits under that plan, a change in the applicable plan limits and certain other occurrences under the qualified plan are not treated as a deferral election or an acceleration of payment under the account balance plan, even if the action or event results in more amounts deferred.

Future Alerts

Future alerts on Section 409A compliance will cover in greater depth various issues, including exclusions from Section 409A coverage (e.g. short-term deferrals and severance and separation pay arrangements), SERPs, employment agreements, bonus and performance pay arrangements, equity compensation and split dollar.

This article was originally co-written by Louis B. Meyer, a Partner in Poyner Spruill's Employment Law section. Meyer was appointed by Gov. Bev Perdue as District Court Judge for the Tenth Judicial District in August of 2012.

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