| P R O B A T E & P R O P E R T Y September/October 2007 Vol. 21 No.5 |
| Articles from other issues of Probate and Property |
Retirement Benefits
Planning Update
Retirement Benefits Planning Update Editor: Harvey B. Wallace II, Berry Moorman, P.C., The Buhl Building, 535 Griswold Avenue, Suite 1900, Detroit, MI 48226-3679, 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.
Highlights of Final Section 409A Regulations
The January/February 2005 Retirement Benefits Planning Update column described the provisions of Code
§ 409A that imposed new restrictions on nonqualified deferred compensation plans beginning in 2005. In general, unless a plan of deferred compensation is excepted from Code § 409A, the plan must specify, in advance of the deferral, the amount of compensation deferred (or its method of determination), its time and method of payment, and any ability to defer the initially specified date of payment or to change the initially provided method of payment in accordance with the Code § 409A prescriptions on such changes. In the May/June 2005 Retirement Benefits Planning Update, the transition rules for plans in existence at the end of 2004 were outlined. Final Treasury Regulations under Code § 409A, issued on April 17, 2007 (T.D. 9321, 2007-19 I.R.B. 1123), become effective on January 1, 2008. The following paragraphs briefly highlight some of the provisions of the lengthy regulations requiring attention before the end of 2007.
Plan Agreement Required
As of January 1, 2008, any existing deferred compensation arrangement that does not fall within one of the enumerated exceptions to Code § 409A’s broad scope must be reduced to writing to avoid having the compensation deferred under the plan included in each plan participant’s taxable income in 2008 and subjected to a 20% additional tax and interest on the deferred compensation from the date or dates of deferral. Treas. Reg. § 1.409A-1(c)(3). The written plan is only required to set forth in one or more documents the material provisions of the plan in a manner consistent with the provisions permitted under Code § 409A. These material provisions include specifying, at or before the time the compensation amount is deferred, the amount (or the method or formula for determining the amount) of deferred compensation and the time and form of payment of that compensation. If the arrangement provides that either the service provider (the employee, for example) or the service recipient (the employer, for example) may make an initial election to defer compensation, the plan must set forth the conditions under which such an election may be made, and, if subsequent deferral or change of method of payment elections are permitted to be made by either the employer or the employee, the conditions under which such elections may be made also must be stated. There is no requirement that a plan specify the circumstance under which benefits may be accelerated (though any acceleration must comply in operation with the limited exceptions to the Code § 409A prohibition on accelerated payments). In the case of a publicly traded corporation that is an employer, the plan must provide that distributions may not be made to a specified employee (as defined in the plan or by the default provisions of the regulations) before the date that is six months after the employee’s separation from service or, if earlier, the employee’s death. Treas. Reg. § 1.409A-1(c)(3)(v). For the purposes of assessing whether or not the plan’s material terms conform to the requirements of Code § 409A, savings clauses that “purport to nullify noncompliant plan terms, or to supply any specific plan terms required . . . are disregarded.” Treas. Reg. § 1.409A-1(c)(1).
Although plans are required to operate in good faith in accordance with Code § 409A after December 31, 2004, existing plans do not have to be retroactively amended to delete provisions that fail to conform to Code § 409A for the period from January 1, 2005 (the initial effective date of Code § 409A) through December 31, 2007 (Preamble § VIII.B.). Transition guidance is provided in Notice 2005-1, 2005-2 I.R.B. 274, published as modified on January 6, 2005, in section XI.C. of the preamble to the proposed regulations published on October 4, 2005 (REG-158080-04, 2005-2 C.B. 786 [70 Fed. Reg. 57,930]), and in Notice 2006-79, 2006-43 I.R.B. 763. In order to avoid the immediate income taxation of compensation deferred before January 1, 2008, good faith compliance with the transitional guidance or with the final regulations may have to be demonstrated from the plan’s records. For Code § 409A compliance, the regulations generally aggregate all plans of the same kind in which a specific employee participates so that an operational failure to comply with Code § 409A for one of the plans causes the compensation deferred under all of the other plans in that grouping to be included in the participant’s income. The final regulations increase the number of aggregation groups to nine (from four under the proposed regulations), which are (1) account balance plans that provide only for nonelective deferrals, (2) account balance plans that provide for elective deferrals, (3) nonaccount balance plans, (4) separation (severance) pay plans, (5) plans providing for in-kind benefits and reimbursement of expenses, (6) split dollar life insurance arrangements, (7) foreign earned-income plans, (8) stock rights plans, and (9) all other plans. Treas. Reg. § 1.409A-1(c)(2). The plan aggregation rules, however, do not apply to the plan documentation requirement so that the failure to properly document one plan in a particular aggregation group will not cause other plans in that group in which the employee participates to violate Code § 409A. Treas. Reg. § 1.409A-1(c)(3)(viii).
Triggering Events—In General
The final regulations clarify that the plan may specify a date of payment that is other than the date on which the permissible payment event occurs as long as the specified payment date (or stream of payment dates under a fixed schedule) is objectively determinable and not subject to discretionary modification at the time the event occurs. A plan may thus provide that a payment is to be made during a designated taxable year (or years) of the employer (payments to be made in each of three taxable years following the year in which the event occurs, for example). A plan may provide for payment on the earliest or latest to occur of more than one permissible payment event. Treas. Reg. § 1.409A-3(b). A payment is treated as being made on the date or event specified in the plan if the payment is made on such date or on the date of the event or on any date within the taxable year of the employer in which the date or event occurs that is no more than 30 days before or is after the specified date or the date of the event (or within two-and-a-half months after the close of the taxable year in which the date or event occurs) as long as the employee cannot designate the taxable year of payment. If the payment cannot be made on the specified date as determined above because the calculation of the amount payable is not administratively practicable because of events beyond the control of the employer or if making the payment would jeopardize the ability of the employer to continue as a going concern, the payment will nonetheless be treated as being made on the date specified in the plan if it is made during the first taxable year of the employer in which the amount is calculable or the payment would not jeopardize the employer, as the case may be. Treas. Reg. § 1.409A-3(d). A plan may provide for an alternative method of payment in the case of a payment triggered by disability, death, change of control, or unforeseeable emergency depending on whether or not the event occurs before or after a single specified date (payments on or before an attained age of the employee might be payable as a lump sum while payments triggered after that age as an annuity, for example). In the case of payments triggered by a separation from service event, different distribution methods may be provided (1) if separation occurs within two years after a change of control or (2) before or after a stated date, a stated age, or the attainment of a stated combination of age and service. Treas. Reg. § 1.409A-3(e).
Optional Plan Provisions—Separation from Service
In addition to the material provisions that must be included in a plan document to satisfy the final regulations, it may be desirable to include provisions that anticipate future events or that provide definitions that are different from those that apply under the regulations in default of a specific plan provision. For example, in the case of a nonpublicly traded employer company that may, in the future, be likely to enter into an IPO, provisions regarding the identification of specified employees and the required six-month distribution delay for specified employees or for postponement of distributions the deduction for which would otherwise be disallowed under Code § 162(m) may be better included at the outset than accomplished by a pre-IPO amendment to the plan. In the case of several of the six permissible triggering events for distributions (a participant’s separation from service, disability, or death, a specified time or fixed schedule, a change in employer control, or the occurrence of an unforeseeable emergency), the final regulations provide expanded definitions and alternative interpretations that may be adopted in the plan agreement. In general, a plan’s definition of a triggering event must fall within the bounds of the regulatory description of the event but may be narrower in scope. If the event on which deferred compensation is paid under the plan is outside of the required definition, the plan will violate Code § 409A unless the payment can fall within the short-term deferral exception discussed below.
A separation from service from an employer occurs if the employee dies or otherwise terminates employment with the employer. A bona fide leave of absence (one in which there is a reasonable expectation that the employee will return to perform services for the employer) is ignored if the period of the leave does not exceed six months (or, in the case of any physical or mental impairment that can be expected to result in death or continue for at least six months and causes the employee to be unable to perform the duties of his or her position, 29 months). If the employee has a statutory or contractual right to reemployment, longer leaves of absence are similarly ignored. If an employee fails to return from a bona fide leave of absence, employment is deemed terminated on the day after the leave is scheduled to end. Termination of employment occurs when the facts and circumstances indicate that the employer and the employee reasonably anticipate that the employee will perform no further services for the employer after a certain date or that the level of services the employee will perform (either as an employee or as an independent contractor) after such date would decrease to a level equal to 20% or less of the average level of services performed by the employee during the immediately preceding 36-month period (or full period of employment, if employed for less than 36 months). A plan may specifically provide for a different level of reasonably anticipated reduction in services (greater than a 20% reduction but less than a 50% reduction) provided the plan provision is specified on or before the date on which separation from service is designated as a time of payment. Treas. Reg. § 1.409A-1(h)(l).
As implied above, an individual who is an employee and is also an independent contractor of a service recipient or becomes an independent contractor on ceasing to be an employee (becomes a consultant to the employer company, for example) is generally not considered to have separated from service unless both relationships have ended. If a service provider is both an employee and a member of the board of directors of the employer, the employee’s separation from service is determined without regard to the director status. Similarly, if the individual terminates as a director, continuing employment is disregarded in determining the individual’s separation from service for deferred compensation receivable as a director. Note that whether a service provider is an independent contractor for a particular service recipient for these purposes depends, in part, on whether or not the service provider is engaged in a trade or business and also provides significant services to two or more other unrelated service recipients. Treas. Reg. § 1.409A-1(b)(2). In the event that an employer transfers substantial assets (such as the assets of a plant or division or all the assets of a trade or business) to an unrelated seller and the employees of the selling employer become employees of the buyer corporation, the buyer and the seller may specify in writing no later than the closing date of the transaction whether the employees of the selling corporation have experienced a separation from service for purposes of any nonqualified deferred compensation plan of the selling corporation, provided that all employees continuing employment with the buyer must be treated consistently. Treas. Reg. § 1.409A-1(h)(4) and (5).
Fixed Time or Schedule
Amounts are payable at a specific time or under a fixed schedule if a specific amount (or a nondiscretionary formula to determine the amount) is specified at the time of deferral and the payment dates are nondiscretionary and objectively determinable. A payment schedule can be linked to a specific date, to another permissible distribution event, or to the date on which a substantial risk of forfeiture lapses. For example, a plan could provide for a bonus payment on the condition that the employee complete three years of service unless an IPO occurs (in which case the three-year service requirement lapses). The plan could then provide that, on the benefit’s vesting (the earlier to occur of the IPO or completion of three years of service), the employee is entitled to payment on each anniversary of the substantial risk of forfeiture’s lapse. Under such a specified payment plan, any discretionary acceleration of the risk of forfeiture such as an acceleration of vesting schedule will be disregarded. A distribution date linked to an event whose time of occurrence is not already known (such as the sale of an employer asset by an employer or the date of an employer’s IPO) is not a fixed distribution date unless the event also causes the benefit to vest (that is, it represents the lapse of a substantial risk of forfeiture). The final regulations discuss and give examples of objective and nondiscretionary benefit formulas and permissible benefit offsets for Social Security and disability plan benefits provided that the offset of scheduled benefits results in a reduction in benefits and not a deferral of the benefits that are offset. Treas. Reg. § 1.409A-3(i).
Change in Control
A change of control of an employee’s employer, or of any corporation that is further up in a chain of corporations (each of which is majority-owned by its parent), may be specified as a triggering event. A plan may provide that any or all of three change-of-control events will trigger payment—(1) a change in ownership resulting from a more than 50% change in stock ownership (mea-sured by voting power or value), (2) a change in effective control that occurs when, within a 12-month period, a person or group acquires 30% of the voting power or when a majority of the board of directors of the ultimate parent corporation is replaced by directors not endorsed by previous board members, or (3) a change in ownership of a substantial portion of corporate assets when a person or group acquires 40% of the gross fair market value of the company’s assets over a 12-month period. A plan may narrow the definition by increasing the above percentages. Treas. Reg. § 1.409A-3(b)(5). An employer may reserve the discretion to terminate and liquidate a plan under irrevocable action taken within 30 days preceding or 12 months following a change in control event. Treas. Reg. § 1.409A-3(j)(4)(ix).
Definition of Deferred Compensation
Unless an exception to Code § 409A applies, a plan provides for deferred compensation if an employee acquires a legally binding right to compensation in one taxable year (regardless whether or not that right is subject to conditions such that the right is not immediately enforceable) and the compensation may be paid in a later taxable year. No legally binding right exists if payment of the compensation is completely in the discretion of the employer (assuming the employer is unrelated to the employee). Treas. Reg. § 1.409A-1(b). If a plan defers compensation but fails to conform to the distribution restrictions and prohibition on benefit acceleration of Code § 409A, the deferred compensation for the year of deferral and all prior years is included in the participant’s income unless the deferred compensation is subject to a substantial risk of forfeiture, in which case the deferred compensation is generally included in the participant’s income in the later year in which the risk of forfeiture lapses (or, put another way, the right to the compensation is both earned and vested). Code § 409A(a)(1)(i). Deferred compensation is subject to a substantial risk of forfeiture if the employee’s entitlement to receive the amount is conditioned on the performance of substantial future services or on the occurrence of a condition related to the purpose of the compensation and the possibility of forfeiture is substantial. Accordingly, if compensation is subject to a cliff vesting schedule (no benefit is payable unless the employee completes 10 years of service, for example), the compensation is not subject to inclusion in the employee’s taxable income under Code § 409A until 10 years of service have been completed. If deferred compensation is subject to a graded vesting schedule (10% for each year of service, for example), 10% of the amount would be earned and vested after one year and included in the employee’s taxable income under Code § 409A if the plan failed to comply. A condition (or event) related to the purpose of the compensation may include the employee’s involuntary separation from service without cause, the completion of an IPO, or the attainment of a prescribed level of the employer’s earnings or equity value. Treas. Reg. § 1.409A-1(d).
Short-term Deferrals
Even if a legally binding right to compensation arises in an earlier taxable year, there is no deferral of compensation if the compensation is received (actually or constructively) no later than two-and-a-half months after the taxable year in which the employee becomes vested in the right to receive the compensation as long as the plan does not permit payment to occur at a later date. For this purpose, the pertinent taxable year is either the employer’s or the employee’s taxable year, whichever ends later. The determination of whether a plan’s provision provides for payment within the short-term deferral period is made at the time the legally binding right is created. The fact that payment is, in fact, made within the short-term deferral period will not prevent deferred compensation from being included in the employee’s taxable income under Code § 409A unless the plan provisions assure that no payment may be made after the end of the applicable two-and-a-half month period (for example, on the occurrence of an event that may occur at a later date). Treas. Reg. § 1.409A-1(b)(4). If a plan specifically states that payment will be made during the two-and-a-half month period (and not merely before the end of that period), payment can be made at any time during the calendar year in which the two-and-a-half month period ends under the general rules for payments payable on a specified date described above.
Redeferral Provisions
A plan may provide for the further deferral of a payment or a change in its method of payment if the Code § 409A conditions for postponement are met—(1) the election to delay payment must be made not less than 12 months before the scheduled payment date, (2) the election to postpone may be effective no earlier than 12 months after it is made, and (3) the postponement must be for at least five years (except in the case of a payment on death, disability, or unforeseen emergency). The redeferral rules are applied on a payment-by-payment basis (provided that each payment is separately identified as payable on a determinable date) except that the entitlement to a life annuity is treated as a single payment with a payment date as of the commencement of the life annuity. In the case of a series of installment payments, the plan must provide that the series of payments will be treated as a right to a series of separate payments for each payment to be recognized as separate. The final regulations clarify that the redeferral rules apply not only to employee elections but also to employer elections to postpone any payment date as well. The redeferral election rules apply to distributions that are initially designated as short-term deferrals (even though a short-term deferral is not considered to be a deferral of compensation under Code § 409A), and a plan may provide for an election to postpone the payment beyond the two-and-a-half month period in which vesting occurs under either the initial deferral rule or the redeferral rule. Treas. Reg. § 1.409A-2(b).
Separation Pay Plans
In addition to the short-term deferral exclusion discussed above, the final regulations clarify a number of the statutory exclusions from Code § 409A coverage. Like the short-term deferral rule, the separation pay plan exclusion allows amounts to be paid to specified employees of publicly traded corporations during the six-month period following termination of employment if the criteria are met (because, in either case, the Code § 409A and six-month delay in payment provisions do not apply). A separation pay plan is not subject to Code § 409A to the extent that (1) payment is made on an involuntary separation from service, a voluntary separation for good reason (as defined in the regulations), or under a window program; (2) the amount of the payments do not exceed two times the employee’s annualized compensation for the preceding taxable year or, if less, two times the Code § 401(a)(17) compensation limit for the year of separation (the 2007 limit is $225,000 and two times that limit is $450,000); (3) the payments are made no later than the end of the second calendar year after the year of separation; and (4) the separation pay plan provides benefits in addition to those provided under any deferred compensation arrangement maintained for the employee (that is, the separation plan payments do not offset or cause the forfeiture of Code § 409A benefits). Treas. Reg. § 1.409A-1(h) and (n).
Stock Options and SARs
Under the final regulations, nondiscounted compensatory stock options and stock appreciation rights (for both public and private company stock) are excluded from Code § 409A if certain criteria are met. For stock options, the exercise price may never be less than the fair market value of the stock on the date of grant, the number of shares subject to the option must be fixed at the date of grant, and the inclusion of income cannot be deferred beyond the exercise or disposition of the option (or, if restricted stock is received on exercise, beyond the date of the substantial vesting of the stock received). Similarly, for stock appreciation rights (SARs), the compensation payable cannot be greater than the excess of the fair market value of the stock on the date of exercise over the fair market value on the date of grant of a fixed number of shares specified at the time of grant and the arrangement may not include any provision that would defer income inclusion beyond the exercise date. Under the final regulations, the stock subject to the option may be stock of the employee’s employer or stock of any corporation in a chain of parent corporations of the employer company, requiring at least 50% interest by each parent corporation (or, if there is a business reason for the grant, a 20% interest). Stock of a subsidiary of the employer corporation does not qualify. Eligible stock may have a liquidation preference, but a dividend preference feature is not permitted. The final regulations provide extensive guidance on the criteria for establishing the fair market value of the stock involved. Treas. Reg. § 1.409A-1(b)(5).
Other Excluded Plans
The final regulations grant or expand a number of exceptions in addition to the statutory exclusions from Code § 409A for qualified plans, welfare benefit plans, certain foreign plans, restricted property taxable under Code § 83, and statutory stock options and the exclusions described above for short-term deferrals, separation pay, and conforming stock options and SARs. Compen-sation paid at the end of a normal payroll period that overlaps taxable years is not deferred. Treas. Reg. § 1.409A-1(b)(3). If paid before the end of the second year following an employee’s separation from service, an employer may provide for the reimbursement of expenses or provide in-kind benefits to cover expenses. Treas. Reg. § 1.409A-1(b)(9)(v). Indemnifications, liability insurance, and legal settlements are excluded from the definition of deferred compensation (provided that a legal settlement may not accelerate deferred compensation otherwise subject to Code § 409A. Treas. Reg. § 1.409A-1(b)(10) and (11). The provision of taxable education benefits is not considered deferred compensation. Treas. Reg. § 1.409A-1(b)(12). Benefits that would otherwise be excluded from income are not rendered subject to tax by Code § 409A. Treas. Reg. § 1.409A-1(b)(1).
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