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By Louis R. Richey, J.D., SRVP
McCamish Systems Retirement Group - 409A Plan Services, McCamish Systems, LLC, Atlanta, GA
Although §409A 1 imposes strict rules on the timing of employee deferral elections, there may still be opportunities for companies to establish nonqualified deferred compensation arrangements for certain 2009 compensation amounts. This may particularly be the case with respect to certain performance bonuses for calendar year 2009. In addition, there may be opportunities to establish new plans that would allow employees to defer some or all of their compensation for services to be performed after the plans are put in place.
Under the general deferral election timing rules of §409A, an employee's deferral election is required to be made on or before the beginning of the calendar year in which the related services are performed.2 For example, if an employee wants to defer a portion of his or her 2010 base compensation, the employee would have to make an irrevocable deferral election no later than December 31, 2009. There are, however, two special deferral election timing rules under §409A that may allow for mid-year deferral elections, or elections after the beginning of the calendar year in which the related services are performed.
First, there is a special deferral timing rule for performance-based compensation, which provides that the deferral election with respect to such compensation can be made no less than six months before the end of the performance period, provided such performance period is at least 12 months and the deferral election is made before the amount is calculable and substantially certain to be paid.3 For example, if an annual bonus for calendar year 2009 is payable in March 2010 and otherwise qualifies as performance-based compensation, an employee could elect to defer up to 100% of the bonus as late as June 30, 2009. However, if that election is made one day later, on July 1, 2009, under the new plan/new employee special election timing rule discussed below, the maximum deferral opportunity drops to 50% of the bonus (i.e., only a pro-rata deferral would be permitted if the conditions for the new plan/new employee rule can be met).
Second, there is a special deferral election timing rule for new plans and newly eligible employees, which provides that the initial deferral election generally must be made within 30 days of initial eligibility and can only apply to compensation for services performed after the election.4 For example, if on June 1, 2009 an employer establishes a new plan effective July 1, 2009, an employee could elect on or before June 30, 2009 to defer some or all of his or her compensation for services performed on or after July 1, 2009. It should be emphasized, however, that the plan aggregation rules apply for purposes of this exception, and therefore, if an employee was previously eligible to participate in another plan of the same type (e.g., another elective account plan), the employee generally will not be eligible for this special rule with respect to the new plan.5
These mid-year deferral election opportunities are discussed in greater detail below.
Special Deferral Timing Rule for “Performance-Based Compensation”
The §409A definition of “performance-based compensation” is not the same definition used under §162(m).6 Under §409A, performance-based compensation generally is defined as an award that is:
(1) variable and contingent on the satisfaction of pre-established organizational or individual performance criteria (quantitative as well as qualitative factors), and
(2) not obviously attainable and ascertainable at the inception of the bonus performance period or when the election to defer is made.
In addition, operationally the bonus must have been communicated in writing to the participants within the first 90 days of the start of the performance year (e.g., by April 1 in the case of a calendar year performance plan). The bonus also must cover a 12 month period of performance and the participant must have worked the entire performance period.7 (See the attached Exhibit A for a more detailed Performance-Based Compensation Quick Qualification Checklist.)
Moreover, under the special timing rule for a new elective deferral plan, § 409A essentially provides for a 30-day deferral election period for newly eligible employees.8 Accordingly, the sooner an initial deferral election can be made the better. In fact, new plans that start the plan enrollment process after June 1, 2009, will need to remind the employees who are eligible that they still only have until June 30, 2009, to submit their elections if they want to defer their performance-based compensation for 2009, even though the initial 30-day deferral election period might run past June 30, 2009 (e.g., a 30-day enrollment window from June 15, 2009, through July 15, 2009). For this reason, most employers will want to enroll the employees in a new calendar year plan by June 30, 2009, at the latest, to take advantage of the special deferral timing rule for performance-based compensation.
Special Deferral Timing Rule for New Plans or Newly-Eligible Employees
A new elective deferral plan generally should start as early in the year as possible to maximize the employees' deferral opportunities on all compensation attributable to services performed after the plan is established and the deferral election is made. The plan design should also permit deferral of salary, commissions and most other types of compensation, as well as bonus compensation, to provide participants the most attractive and flexible deferral opportunity. The maximum salary deferral allowed in the first plan year is the remaining salary due to be paid, subject to any other limitations on amount set by the sponsor. Here again, the sooner the plan gets started the larger the amount of compensation that is eligible for deferral in the first plan year.
What about Companies with Fiscal Year Performance-Based Compensation Plans?
There may still be mid-year deferral opportunities for fiscal year bonus plans that qualify as performance-based compensation under §409A (e.g., a performance bonus payable on account of an employee's performance for the fiscal year beginning April 1, 2009, and ending March 31, 2010). The process for a fiscal year bonus plan is to determine the end of the fiscal year bonus performance period, and subtract six months and one day to determine the §409A deadline for performance-based compensation. This may or may not help in 2009. Remember that the fiscal year bonus still must meet the §409A definition of “performance-based compensation” to obtain the special 100% maximum deferral election opportunity.
What About Companies Failing Qualified Plan Nondiscrimination Testing?
Many qualified 401(k) plans failed their nondiscrimination testing last year and more are expected to fail this year because of the impact of economic conditions on lower paid participants. For some companies this was a new experience. However, such qualified plan testing failures seem likely to repeat and expand in 2009, in light of continuing negative economic trends and companies dropping their 2009 401(k) employer incentive matching contributions. Elimination of employer matches will likely further discourage participation by lower paid employees and thereby increase qualified plan nondiscrimination testing failures. Therefore, a company that failed its 2008 qualified plan testing and is facing a similar problem in 2009 should consider installation of a nonqualified deferral plan as soon as possible to help solve the current deferral limitations for its highly compensated employees. The nonqualified deferral plan can also address 401(k) caps and “includible compensation” limitations and any “lost” company contributions because of the 401(k) nondiscrimination testing failures in order to provide parity to its affected employees.
A nonqualified “401(k) wrap plan” feature might be in order. Section 409A seems to continue to permit this nonqualified plan design so long as the prior IRS private letter ruling guidance is followed.9 However, companies must now separately consider the risk of the application of the DOL position on the timeliness of qualified plan deposits under this design.10 Even if a “401(k) wrap plan” design is not used, a simple nonqualified deferral plan design would allow highly compensated employees to defer larger amounts this year into the nonqualified plan in anticipation of returning 401(k) contributions for 2009, and an early start to a plan makes this goal easier to accomplish. Of course, implementation of a nonqualified deferral plan assumes the company has prospective continuity, future economic viability and healthy cash flow, and is not facing bankruptcy or reorganization.
Companies that are anticipating paying performance bonuses and/or who may fail their 2009 qualified 401(k) nondiscrimination tests should consider establishing a new nonqualified deferred compensation plan mid-year in 2009. To qualify for the special deferral timing rule for performance-based compensation, the plan would have to be established and an irrevocable election to defer up to 100% of the bonus would have to be in place by June 30, 2009. Otherwise, an employee would be limited to a maximum deferral opportunity based only on bonus compensation attributable to services for the remainder of the year (i.e., only a pro-rata deferral would be permitted if the conditions for the new plan/new employee rule can be met).
In addition, even if a company does not anticipate paying performance-based compensation for 2009, companies may want to consider establishing a new plan to provide their employees with an opportunity to defer some or all of their compensation attributable to services after the plan is established and irrevocable deferral elections are made, particularly if a company anticipates that it will not satisfy the nondiscrimination tests for its 401(k) plan in 2009.
However, there are a number of conditions that must be satisfied before these special deferral timing rules can be utilized. Accordingly, before any of these special rules are relied upon, a company should consult with its tax and employee benefit advisors to make sure that all of the conditions for using the special rules can be satisfied.
409A “Performance-Based Compensation” Quick Qualification Checklist
The following questions must all receive a “YES” answer (except for question #6) for compensation to qualify as “performance-based compensation” and claim the special participant election treatment under the §409A that permits the final irrevocable deferral election to be made 6 months prior to the end of the bonus performance period. Question #6 sorts out the portion of compensation (if any) that does not qualify for the special election opportunity because of the §409A requirement that the bonus amounts be nonascertainable at the time of the deferral election. Sorting the nonascertainable from the ascertainable amounts may require some review.
(1) Were the requirements to receive the incentive compensation communicated in writing to the participants not later than at least 90 days into the performance year? Yes __ No __
(2) Does the performance plan period and each participant's active participation run for a sequence of 12 full calendar months (quarterly performance periods, etc. do not qualify)?
Yes __ No __
(3) Is this the only elective account balance plan that the eligible employee(s) currently participate in? Yes __ No __
(4) Is the plan based upon communicated quantitative and qualitative factors rather than being wholly discretionary? Yes __ No ___
(5) Will the deferral elections be made not later than 6 full calendar months prior to the end of the performance period (prior to July 1 for calendar year performance plans)? Yes __ No __
(6)What part of the compensation is NOT readily ascertainable (calculable & substantially certain to be paid) as of the election deadline (only the portion of bonus that is not yet ascertainable as of the date may qualify for the special election if other factors met)?
__ All of the bonus (up to 100% election)
__% of total
This article and checklist are intended for informational purposes only and do not constitute a legal opinion or advice to plan sponsors of existing plans or prospective plan sponsors, and may not be used as an opinion or advice. Moreover, per IRS Circular 230, this information may not be used to avoid any income tax penalties imposed by the IRS and cannot be used as a legal or tax opinion in connection with the marketing of the plans discussed in the article. If a corporation desires such an opinion concerning §409A or its potential impact on and deadlines for an existing plan or potential plan, it must consult with its own tax and other professional legal or accounting advisors.
For more information, in the Tax Management Portfolios, see Brisendine, Veal and Drigotas, 385 T.M., Deferred Compensation Arrangement, and in Tax Practice Series, see ¶5710, Nonqualified Deferred Compensation.
1 Added to the Code by §885 of the America Jobs Creation Act of 2004, P.L. 108-357, 118 Stat. 1418.
2 Regs. §1.409A-2(a)(3). See also Preamble to Proposed 409A Regulations, REG-158080-04, 70 Fed. Reg. 57930 (10/4/05), V.A.
3 Regs. §1.409A-2(a)(8). See also Preamble to Final 409A Regulations, T.D. 9321, 72 Fed. Reg. 19234 (4/17/07), VI.C.
4 Regs. §1.409A-2(a)(7). A pro rata percentage is permitted to be deferred based upon the number of days remaining in the performance period divided total days in the performance period (365 if calendar).
5 The final regulations provide that the requirements of §409A generally are applied as if a separate plan is maintained for each employee and all arrangements of the same type in which the employee participates are aggregated and treated as a single plan. For this purpose, the final regulations aggregate the following nine categories of plans separately: (a) elective account balance plans; (b) nonelective account balance plans; (c) nonaccount balance plans; (d) separation pay arrangements (but only to the extent payable solely upon an involuntary separation from service or as a result of participation in a window program); (e) split-dollar life insurance arrangements; (f) reimbursement plans; (g) stock rights; (h) foreign plans; and (i) all other plans. See Regs. §1.409A-1(c).
6 Compare Regs. §1.409A-1(e)(1)-(2) and Regs. §1.162-27(e)(2). For instance, approval of the board compensation committee is not required for §409A “performance-based compensation.” “Equity-based performance-based compensation” is discussed in Regs. §1.409A-1(e)(3). Commissions are discussed in Regs. §1.409A-2(a)(12) and broken into two categories: sales commissions and investment commissions.
7 §409A(a)(4)(B)(iii); Regs. §1.409A-2(a)(8). See also the Preamble to Final 409A Regulations, VI.C.. Unfortunately, there are no specific examples in the regulations covering deferral elections of a performance-based compensation bonus deferral.
8 Regs. §1.409A-2(a)(7).
9 See the Preamble to Proposed 409A Regulations, IX.B., which indicates that the deposit from nonqualified plan to qualified plan is not a prohibited §409A acceleration. See also PLR 9530338 (and subsequent following PLRs) concerning the IRS final approved “401(k) wrap plan” design structure (defer into the nonqualified plan first and then transfer to the qualified plan once allowable amount is known).
10 See generally DOL Reg. §29 CFR 2510.3-102; Proposed Amended Reg. §29 CFR 2510 (2/29/08) concerning safe harbor contributions transfer deadline for small plans under 100. The basic question is whether a “401(k) wrap plan” design meets the requirements of the DOL plan asset regulations governing timeliness of employee contributions? Timeliness of employer deposits to 401(k) plans has been a growing issue at the DOL since 1996. See, e.g., Fyi, Buck Consultants, Vol. 31, Issue 22, Mar. 19, 2008.
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