Retirement Benefits Planning Update

Retirement Benefits Planning Update Editor: Harvey B. Wallace II, Berry Moorman PC, The Buhl Building, 535 Griswold Avenue, Suite 1900, Detroit, MI 48228–3679, hwallace@berrymoorman.com.

Retirement Benefits Planning Update provides information on developments in the field of retirement benefits law. The editors of Probate & Property welcome information and suggestions from readers.

Nonqualified Deferred Compensation—Sweeping New Provisions

New Code § 409A, adopted as part of Pub. L. No. 108–357, the American Jobs Creation Act of 2004 (the Act), requires that, unless certain specified requirements are met, all compensation deferred under nonqualified deferred compensation plans (NQDCPs) for tax years beginning after 2004 must be included in each affected employee participant’s income to the extent the income deferred is not subject to a substantial risk of forfeiture. A participant’s rights to deferred compensation are subject to a substantial risk of forfeiture only if the participant’s benefits are conditioned upon the future performance of substantial services. Code § 409A(d)(4). Note, however, that Code § 409A(e)(5) directs the Secretary of the Treasury to prescribe regulations disregarding a substantial risk of forfeiture if the risk is illusory or if an executive is able to control the acceleration of the lapse of a substantial risk of forfeiture. To avoid income inclusion under Code § 409A, an additional tax equal to interest from the date such compensation is considered to be first deferred and a 20% penalty, each NQDCP must contain (and be operated in accordance with) specific restrictions on plan distributions, on the acceleration of benefit payments, and on participant elections (both initial elections to defer compensation and subsequent elections to change the timing of the distribution of compensation after its initial deferral).

The definition of NQDCP is expansive, encompassing all retirement plans and other arrangements that defer compensation except for (1) qualified employer plans including qualified pension, profit sharing, stock bonus plans, Section 403(a) annuities, Section 403(b) annuities, U.S. and state governmental plans, SEPs, SIMPLEs, and eligible Section 457(b) plans, or (2) bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plans. Code § 409A(d)(1). Thus, the new rules apply to salary and bonus deferral plans (other than deferrals paid within two-and-a-half months after the year in which services were performed), supplemental executive retirement plans (SERPs), nonqualified stock option plans (except a plan that provides for the grant of an option with an exercise or strike price that is not less than the fair market value of the stock on the date of grant and does not include deferral provisions upon the option’s later exercise), stock appreciation rights, phantom stock plans, ineligible Section 457(f) plans of governmental and tax-exempt employers, and severance pay plans that involve deferred vested payments. Code § 422 incentive stock options and Code § 423 employee stock purchase plans are not affected by the new provision.

Existing plans that provide for the deferral of compensation after 2004 will need to be frozen and new or amended plans adopted to comply with Section 409A. Within 60 days after the date of enactment, the IRS is specifically directed to issue guidance providing for a limited period during which NQDCPs adopted on or before December 31, 2004, can be amended without violating the new rules to adopt the new restrictions for post-2004 deferrals and to provide participants the opportunity to terminate participation and/or cancel outstanding deferral elections for amounts earned after 2004. Act § 885(f).

Distributions Restrictions

Under Code § 409A(a)(2), distributions of deferred compensation from a NQDCP may not be made earlier than:

• the participant’s separation from service as determined by the secretary,

• the date the participant becomes disabled (as defined below),

• the participant’s death,

• a specified time (or under a fixed schedule) specified under the plan at the date of the deferral of such compensation,

• a change in ownership or effective control of the corporation (or in the ownership of a substantial portion of the corporation’s assets) to the extent provided by the Secretary, or

• the occurrence of an unforeseeable emergency.

In the case of an employee of a publicly traded corporation who is a “key employee” within the meaning of Code § 416(i), distributions may not be made before the date that is six months after the date of the employee’s separation from service or the employee’s date of death, if earlier. Code § 409A(a)(2)(B)(i). In determining whether a participant has separated from service, the employer aggregation rules of Code § 414(b) and (c) apply, except as otherwise provided by Treasury regulations, so that a separation from service would not occur if an employee who is terminated by one controlled group employer continues employment with another controlled group member. Code § 409A(d)(6).

A participant is considered to be disabled if the participant, by reason of any medically determinable physical or mental impairment that can be expected to result in death or to last for a continuous period of not less than 12 months, (1) is unable to engage in any substantial gainful activity or (2) is receiving income replacement benefits for a period of not less than three months under an accident and health plan covering employees of the participant’s employer. Code § 409A(a)(2)(C). According to the Conference Report (H. Rep. No. 108–755) at 520, the Secretary of the Treasury is to prescribe regulations within 90 days after the date of enactment identifying the changes in ownership, control, or asset ownership of a corporation that would be considered to permit distributions to be made. These regulations are expected to be similar to, but more restrictive than, the definition of changes of control for Code § 280G—the golden parachute provisions.

An unforeseeable emergency is a severe financial hardship to the participant resulting from (1) an illness or accident of the participant or the participant’s spouse or dependent, (2) the loss of the participant’s property because of casualty, or (3) other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant. Distributions may be made only to the extent necessary to meet such emergency (and to cover taxes reasonably anticipated to result from the distributions) and only after taking into account the extent to which the hardship is or may be relieved through reimbursement or compensation by insurance or otherwise or by liquidation of the participant’s assets (to the extent such asset liquidation would not, itself, cause severe financial hardship). Code § 409A(a)(2)(B)(ii).

No Acceleration of Benefits

Under existing (pre-2005) NQDCPs, the accelerated distribution of deferred compensation at the election of the participant is frequently permitted if a penalty is imposed. For example, a participant’s withdrawal of deferred compensation may result under such a plan in a forfeiture of a portion of the benefit (such as a 10% “haircut”) or a restriction on the participant’s ability to participate in further deferrals under the plan for a period of time following the distribution. Distributions in the discretion of an unrelated plan administrator are also sometimes provided. Under Code § 409A, distributions are generally restricted to specified events beyond the control of the participant such as disability, unforeseeable emergency, or corporate change of control. No acceleration of the specified time or schedule of payments set out in the plan or elected by the participant at the initial time of deferral will be permitted except as may be provided in regulations. Code § 409A(a)(3). The Conference Report (at 521) suggests that the Treasury may permit the acceleration of benefits for reasons beyond the participant’s control such as a court-approved settlement incident to divorce or a need to comply with federal conflict-of-interest requirements. Accelerated distributions will also likely be permitted for the payment of employment taxes on plan benefits, to eliminate minimum amounts of benefits by lump-sum payment upon a distribution event, and to pay income tax upon the vesting of an interest in an ineligible Section 457(f) plan (to the extent tax would have been withheld on such amount were it paid as wages).

Participant Elections

In the case of plans under which compensation is deferred at the election of the plan participant, except as may be otherwise provided by regulations, compensation may generally be deferred for a taxable year only if the election to defer is made no later than the close of the preceding taxable year. In the first year in which a participant becomes eligible to participate, an election may be made (for services performed after the election is made) within 30 days after the participant becomes eligible. In the case of any performance-based compensation that relates to services performed over a period of at least 12 months, a participant election may be made no later than six months before the end of the period. Code § 409A(a)(4).

At the time that the initial election to defer is made, the plan’s terms or, if the plan grants an election to the participant, the participant’s election must specify the time and form of benefit payment. Differing times of payment may be provided for differing distributions (for example, a lump-sum payment on death and installments on disability or retirement). Conf. Rep. at 522. Amounts that are payable upon the occurrence of an event are not considered payable at a specified time unless the event must occur at a specific time (for example, the attainment of a stated age). Conf. Rep. at 520. Plans may permit a participant to make a subsequent election to change the initially provided (or elected) time or schedule for payments provided that:

• the election may not take effect until at least 12 months after it is made;

• except for elections related to payments on disability, death, or an unforeseeable emergency, the first payment for which such election is made must be deferred for a period of not less than five years from the date initially set for such payment; and

• in the case of a payment specified at the time of initial deferral to be made at a specified time (or under a fixed schedule), the election may not be made less than 12 months before the date of the first scheduled payment.

Code § 409A(a)(4)(C).

Income Inclusion, Interest, and Penalty

If, at any time during an NQDCP’s taxable year, the plan fails to include the restrictions regarding distributions, acceleration of benefits, or participant elections in the plan document or fails to follow the restrictions in the plan’s operation, all compensation deferred under the plan for that taxable year (and all preceding post-2004 years) will be includible in the gross income of the participants to whom the failure relates (the “affected participants”), except to the extent the plan benefits are subject to a substantial risk of forfeiture or have been previously included in income. Code § 409A(a)(1)(A). Earnings applicable to the includible deferred compensation are also includible. Conf. Rep. at 525. If deferred compensation is included in an affected participant’s gross income upon the violation of a Section 409A restriction (or upon a subsequent expiration of a substantial risk of forfeiture), the included amount is also subject to (1) an additional tax equal to 20% of the included amount and (2) interest at the federal underpayment rate plus 1% on the underpayments of tax that would have occurred had the amounts thus required to be included in income been included in income for the year or years in which first deferred (or, if later, in the year or years such amounts were no longer subject to a substantial risk of forfeiture). Code § 409A(a)(1)(B).

The time at which amounts of deferred compensation were first deferred is to be determined in accordance with Treasury regulations that will, inter alia, cover when a deferral occurs in the case of a nonelective plan (such as a NQDCP that is a defined benefit plan) and an elective plan (for which the time of the participant’s election to defer will not be determinative). Code § 409A(e)(1); Conf. Rep. at 519. Amounts required to be included in income under Section 409A will be reportable on Forms W-2 (for employees) and 1099 (for independent contractors) and will be wages for withholding tax purposes. Code § 3401(a). Form W-2 will also report the total amount of deferrals under a NQDCP in the year in which such deferrals occur except to the extent future Treasury regulations provide a minimum threshold below which no reporting is required. Code § 6051(a)(13). Employer reporting rules will apply to all deferrals (whether or not paid) and to any amounts includible in income that are not treated as wages. Code § 6041(g).

Funding Limitations

With a view to the Enron experience, Congress intended Section 409A, in part, to prevent the premature withdrawal of deferred benefits. As “unfunded” benefits, the reserves or assets set aside to pay NQDCP benefits (whether held as an earmarked portion of the employer’s assets or held in a rabbi trust) are expected to be subject to the creditors of the employer until the time at which the plan contemplates distribution to the participant. If a plan provides that any assets will be restricted to the payment of NQDCP benefits in the event of a change in the employer’s financial health (or if assets are, in fact, so restricted), a transfer of property within the meaning of Section 83 will be deemed to have occurred for such compensation. Code § 409A(b)(2). Such a transfer will result in the benefits being included in the participant’s taxable income and the application of interest and the 20% penalty to the affected participant’s benefits. Similarly, if assets are set aside in a trust or an arrangement for the purpose of paying NQDCP benefits and the assets are located outside of the United States (or at the time of any later transfer offshore), they will be considered to be transferred for purposes of Section 83 (whether or not the assets are available to satisfy the claims of the company’s creditors) and income inclusion, interest, and the 20% penalty will occur for the affected participant’s benefits. An exception is made if substantially all of the services to which the NQDCP relates are performed in the foreign jurisdiction and the Secretary is to issue regulations exempting offshore trust arrangements that do not place plan assets beyond creditors. Code § 409A(b)(1) and (c)(3). In the case of both the financial health and offshore trust provisions, any increases in the value of, or earnings from, the assets after the initial inclusion in the affected participant’s taxable income are treated as additional transfers of property. Conf. Rep. at 523.

Grandfathered Plans

Compensation deferred (that is, both earned and vested) before January 1, 2005, will not be subject to Section 409A unless a material modification (other than a modification permitted by IRS guidance) is made after October 3, 2004, to the NQDCP plan under which the compensation is to be paid. Act § 885(d)(2)(B). The addition of any benefit, right, or feature will be considered a material modification. If a plan is grandfathered and not materially modified, further deferrals of benefits earned and vested before January 1, 2005, under the plan will not be subject to Section 409A but will be governed by the constructive receipt, economic benefit, and Code § 83 transfer of property concepts that applied exclusively before the new law. Conf. Rep. at 526. Note that the restrictions of new Code § 409A serve as an overlay on the existing rules. For example, a Section 457(b) plan must still comply with the Code § 457(b) provisions not inconsistent with Code § 409A. In addition, the existing rules continue to apply if they result in an inclusion of deferred compensation in a participant’s income at a time earlier than the time required by Code § 409A. Code § 409A(c).