This blog is part of a 12-part series entitled The nonqualified deferred compensation plan (NDCP) dirty dozen: An administrative guide to avoiding 12 traps.
In the first part of this series, we examined the need to inventory and examine all compensation arrangements in order to ascertain which ones are nonqualified deferred compensation plans (NDCPs) and thus subject to 409A. One of the main reasons that such proactive analysis is strongly recommended is that, chances are, if the employer does not know an arrangement is subject to 409A, the arrangement most likely is not supported by a 409A-compliant document. So just what constitutes a 409A-compliant document? Well, the 409A rules make it clear that each NDCP must include the following material terms in writing:
Individuals or group to be covered
The amount to which the participant has a right to be paid (or in the case of an amount determinable under an objective, nondiscretionary formula, the terms of such formula)
Time of payment
Form of payment
If the plan permits a deferral election, such election also must be documented either in the actual plan document or by reference in the plan document to forms that are completed and executed by participants on a timely basis.
Also, the six-month delay rule for any payment triggered by a separation from service of a key employee of a publicly traded company must be stated in the NDCP by the later of either the plan sponsor's stock becoming publicly traded or the participant becoming a specified employee (i.e., generally a key employee as determined under the qualified plan top-heavy rules). Accordingly, plan sponsors may wish to include this provision even if their companies are privately held currently so as to avoid a violation in the event that they go public in the future and then neglect to add this information to the document.
No compliance cover from blanket savings clauses
"Blanket savings clauses (i.e., clauses stating that notwithstanding anything in the plan to the contrary, the plan is to be administered or construed in a 409A-compliant manner) will neither establish compliance nor cure structural defects. The 409A rules state that, for purposes of determining whether or not the terms of a plan satisfy 409A, general provisions of the plan that purport to nullify noncompliant plan terms, or to supply required specific plan terms, are disregarded. Consequently, if an NDCP contains terms that do not meet the requirements of 409A or fails to contain plan terms necessary to meet the requirements of 409A, the plan will violate the requirements of 409A regardless of whether the plan contains such a savings clause. For example, if the NDCP permits distributions as the result of disability or change of control, its definition of these terms must match the 409A-required definitions.
Better certain and safe than vague and sorry
Internal Revenue Service (IRS) guidance has clarified that ambiguous definitions of payment events in plan documents will not automatically result in document failure (e.g., a plan provision that calls for payment upon termination of employment instead of upon a defined 409A separation from service). However, if the plan provision or similar provisions in other plans have been interpreted or administered in a manner that would violate 409A, the plan provision will be treated as causing a document failure.
As a result, in addition to the material terms that 409A requires to be included in the NDCP document, there are other provisions that sponsors may wish to specify in the plan to assist in operational compliance. Using the termination versus separation contrast as an example, the arrangement in question may simply state that payment of benefits from the plan is triggered by the participant's termination of employment from the plan sponsor. However, under 409A, such distributions may only be made if the facts and circumstances surrounding the termination meet the 409A definition of a "separation from service" (the unique characteristics of this definition will be explored in Part 8 of this series, which will cover timing of distributions). As a result, if a participant has a termination of employment, but continues to provide significant services to the plan sponsor (e.g., as a consultant to the company), amounts paid in connection with the termination of employment may trigger 409A penalties, unless payment is delayed until a separation from service occurs. Conversely, noncompliance can also occur if the current facts and circumstances of the participant's employment situation do meet the criteria of a 409A separation from service, but the NDCP fails to distribute the benefits because the plan sponsor is not aware that a 409A separation from service has been triggered. Accordingly, it may be prudent to include a 409A-compliant definition of "separation from service" in the NDCP document to assist in preventing such oversight.
An ounce of prevention is worth a pound of correction
The IRS has established two separate programs that allow NDCP sponsors to correct 409A compliance failures: one for operational failures and another for plan document failures. Provided that the failures are caught and corrected on a timely basis and otherwise eligible for these programs (i.e., only certain failures are eligible and there are a number of conditions that must be met to qualify for correction), these self-correction opportunities can enable participants to avoid some, if not all, of the harsh tax penalties that apply when a plan fails to comply with 409A in operation or written form. Nevertheless, because of the somewhat limited scope of these fix-it programs as described above, NDCP sponsors should strive to construct rock solid plan documents that leave no room for error.
The IRS guidance regarding the document correction program separates the document failures into the following categories:
Impermissible definition of an otherwise permissible payment event
Impermissible payment periods following a permissible payment event
Certain impermissible payment events and payment schedules
Failure to include the six-month delay for specified employees
Provisions allowing impermissible initial and subsequent deferral elections
Certain ambiguous plan terms
Therefore, NDCP sponsors should focus on these areas when reviewing their existing or new NDCP documents to ensure that such documents adequately address the provisions required to comply with 409A. Several NDCP sponsors and practitioners have requested that the Treasury Department and the IRS publish model amendments to assist in meeting these 409A provisions. However, because of the complex and varied universe of deferred compensation plans, the Treasury Department and the IRS do not believe that it is feasible to publish such model amendments. Therefore, NCDP sponsors should continue to seek the assistance of their employee benefit consultants and ERISA counsel to design, draft, and administer NDCP documents that comply with 409A.
In the first part of this series, we examined the need to inventory and examine all compensation arrangements in order to ascertain which ones are nonqualified deferred compensation plans (NDCPs) and thus subject to 409A. One of the main reasons that such proactive analysis is strongly recommended is that, chances are, if the employer does not know an arrangement is subject to 409A, the arrangement most likely is not supported by a 409A-compliant document. So just what constitutes a 409A-compliant document? Well, the 409A rules make it clear that each NDCP must include the following material terms in writing:
Individuals or group to be covered
The amount to which the participant has a right to be paid (or in the case of an amount determinable under an objective, nondiscretionary formula, the terms of such formula)
Time of payment
Form of payment
If the plan permits a deferral election, such election also must be documented either in the actual plan document or by reference in the plan document to forms that are completed and executed by participants on a timely basis.
Also, the six-month delay rule for any payment triggered by a separation from service of a key employee of a publicly traded company must be stated in the NDCP by the later of either the plan sponsor's stock becoming publicly traded or the participant becoming a specified employee (i.e., generally a key employee as determined under the qualified plan top-heavy rules). Accordingly, plan sponsors may wish to include this provision even if their companies are privately held currently so as to avoid a violation in the event that they go public in the future and then neglect to add this information to the document.
No compliance cover from blanket savings clauses
"Blanket savings clauses (i.e., clauses stating that notwithstanding anything in the plan to the contrary, the plan is to be administered or construed in a 409A-compliant manner) will neither establish compliance nor cure structural defects. The 409A rules state that, for purposes of determining whether or not the terms of a plan satisfy 409A, general provisions of the plan that purport to nullify noncompliant plan terms, or to supply required specific plan terms, are disregarded. Consequently, if an NDCP contains terms that do not meet the requirements of 409A or fails to contain plan terms necessary to meet the requirements of 409A, the plan will violate the requirements of 409A regardless of whether the plan contains such a savings clause. For example, if the NDCP permits distributions as the result of disability or change of control, its definition of these terms must match the 409A-required definitions.
Better certain and safe than vague and sorry
Internal Revenue Service (IRS) guidance has clarified that ambiguous definitions of payment events in plan documents will not automatically result in document failure (e.g., a plan provision that calls for payment upon termination of employment instead of upon a defined 409A separation from service). However, if the plan provision or similar provisions in other plans have been interpreted or administered in a manner that would violate 409A, the plan provision will be treated as causing a document failure.
As a result, in addition to the material terms that 409A requires to be included in the NDCP document, there are other provisions that sponsors may wish to specify in the plan to assist in operational compliance. Using the termination versus separation contrast as an example, the arrangement in question may simply state that payment of benefits from the plan is triggered by the participant's termination of employment from the plan sponsor. However, under 409A, such distributions may only be made if the facts and circumstances surrounding the termination meet the 409A definition of a "separation from service" (the unique characteristics of this definition will be explored in Part 8 of this series, which will cover timing of distributions). As a result, if a participant has a termination of employment, but continues to provide significant services to the plan sponsor (e.g., as a consultant to the company), amounts paid in connection with the termination of employment may trigger 409A penalties, unless payment is delayed until a separation from service occurs. Conversely, noncompliance can also occur if the current facts and circumstances of the participant's employment situation do meet the criteria of a 409A separation from service, but the NDCP fails to distribute the benefits because the plan sponsor is not aware that a 409A separation from service has been triggered. Accordingly, it may be prudent to include a 409A-compliant definition of "separation from service" in the NDCP document to assist in preventing such oversight.
An ounce of prevention is worth a pound of correction
The IRS has established two separate programs that allow NDCP sponsors to correct 409A compliance failures: one for operational failures and another for plan document failures. Provided that the failures are caught and corrected on a timely basis and otherwise eligible for these programs (i.e., only certain failures are eligible and there are a number of conditions that must be met to qualify for correction), these self-correction opportunities can enable participants to avoid some, if not all, of the harsh tax penalties that apply when a plan fails to comply with 409A in operation or written form. Nevertheless, because of the somewhat limited scope of these fix-it programs as described above, NDCP sponsors should strive to construct rock solid plan documents that leave no room for error.
The IRS guidance regarding the document correction program separates the document failures into the following categories:
Impermissible definition of an otherwise permissible payment event
Impermissible payment periods following a permissible payment event
Certain impermissible payment events and payment schedules
Failure to include the six-month delay for specified employees
Provisions allowing impermissible initial and subsequent deferral elections
Certain ambiguous plan terms
Therefore, NDCP sponsors should focus on these areas when reviewing their existing or new NDCP documents to ensure that such documents adequately address the provisions required to comply with 409A. Several NDCP sponsors and practitioners have requested that the Treasury Department and the IRS publish model amendments to assist in meeting these 409A provisions. However, because of the complex and varied universe of deferred compensation plans, the Treasury Department and the IRS do not believe that it is feasible to publish such model amendments. Therefore, NCDP sponsors should continue to seek the assistance of their employee benefit consultants and ERISA counsel to design, draft, and administer NDCP documents that comply with 409A.