Advanced Designs. Pocket Guide. Questions & Answers Regarding IRC Section 409A and the Final IRC Section 409A Regulations

Transcription

1 Advanced Designs Pocket Guide Questions & Answers Regarding IRC Section 409A and the Final IRC Section 409A Regulations Applications for Using Life Insurance AD-OC-792A

2 This material is not intended to be used, nor can it be used by any taxpayer, for the purpose of avoiding U.S. federal, state or local tax penalties. This material is written to support the promotion or marketing of the transaction(s) or matter(s) addressed by this material. Pacific Life, its distributors and their respective representatives do not provide tax, accounting or legal advice. Any taxpayer should seek advice based on the taxpayer s particular circumstances from an independent tax advisor. Investment and Insurance Products: Not a Deposit Not FDIC Insured Not Insured by any Federal Government Agency No Bank Guarantee May Lose Value

3 Table of Contents Does IRC Section 409A restrict the use of corporateowned life insurance (COLI) in nonqualified deferred compensation (NQDC) plans? What is the effective date for IRC Section 409A? 1 What is the purpose of the NQDC reform? 1 What type of NQDC plans does IRC Section 409A affect? What is considered a deferral of compensation under IRC Section 409A? Is a plan that requires distributions within two and a half months of vesting outside the scope of IRC Section 409A? When is compensation considered earned and vested under IRC Section 409A? What is the definition of a substantial risk of forfeiture under the final regulations? Is it possible for a business owner to have a substantial risk of forfeiture for the purposes of IRC Section 409A? How does IRC Section 409A impact supplemental executive retirement plans (SERPs)? Are split-dollar life insurance arrangements considered deferred compensation plans under IRC Section 409A? Does IRC Section 409A affect past deferrals or only future deferrals? How can the parties determine how much has been deferred prior to January 1, 2004? What is considered a material modification of an NQDC plan?

4 Can a change to a plan document that would be considered a material modification be rescinded? What are the consequences for an NQDC plan that does not meet the new requirements set forth by IRC Section 409A? Under IRC Section 409A, do deferred compensation plans require a written document? What are the consequences if the document for an NQDC plan fails to meet the requirements of IRC Section 409A? What are the rules for correcting a document failure that involves the use of an ambiguous plan term? What are the rules for correcting a document failure that involves the use of an impermissible definition of an otherwise permissible payment event? Is there any relief provided for corrections made on a timely basis? What are the allowable distribution triggers for NQDC plans? Is it permissible for a plan to have distributions upon the occurrence of multiple events? What is considered separation of service under IRC Section 409A and the regulations? Can NQDC benefits be immediately distributed to all employees upon separation of service? What is considered an unforeseeable emergency and is there a limit to the amount that may be distributed from the NQDC plan in case an unforeseeable emergency does occur? What is a change of control event for the purposes of IRC Section 409A? Does the change of control event have to relate to the company sponsoring the plan?

5 Is the acceleration of NQDC plan payments allowed? Can a plan be terminated and the deferrals distributed to the participant without the termination being considered an acceleration of benefits? Can a plan be terminated if the employer declares bankruptcy? Can a plan be terminated if there is a change of control for the employer? Is the shortening of a vesting period considered an acceleration? When must deferral elections be made? 21 What are the requirements for a benefit to be considered performance-based compensation? Can an offshore trust be used to hold NQDC assets? 21 Can a company provide distribution triggers for NQDC plans that are tied to its financial health? What is the penalty for NQDC plans that place assets in an offshore trust or provide a distribution trigger tied to the company s financial health? Can an NQDC plan allow for an installment payout for distributions at a specified date and a lump sum upon the executive s separation of service? What are the requirements for a change in the time or form of payment of amounts from an NQDC plan? Are all the payments in an installment payout considered a single payment or a series of separate payments? If installment payments are treated as separate payments, can the executive change the timing or form of each individual payment?

6 What is the difference between an installment payout and a life annuity? Can a participant receive a lump sum payout if his or her plan was originally structured to provide an installment or life annuity payout? Can a company delay a payout if its income tax deduction for the payout is limited by the maximum reasonable compensation for executives of publicly traded companies under IRC Section 162(m)? Do the regulations require IRC Section 409A compliance for severance plans? Are all severance plans subject to IRC Section 409A? Are arrangements between a business and an independent contractor governed by IRC Section 409A?

7 Non-qualified deferred compensation (NQDC) plans have long been a staple of executive benefits planning. In 2004, Internal Revenue Code (IRC) Section 409A became law as part of the American Jobs Creation Act. Prior to 2004, there was not a standard set of rules that provided guidelines for NQDC plans. The Department of the Treasury issued final regulations on IRC Section 409A in Together, IRC Section 409A and the final regulations provide a strict set of guidelines that must be followed by employers with NQDC plans. This pocket guide identifies and examines several of the key provisions of IRC Section 409A and the final regulations. Does IRC Section 409A restrict the use of corporate-owned life insurance (COLI) in nonqualified deferred compensation (NQDC) plans? No, IRC Section 409A does not contain any provisions that would restrict the use of COLI in NQDC plans. What is the effective date for IRC Section 409A? IRC Section 409A applies to all deferrals made into an NQDC plan after December 31, For the purposes of IRC Section 409A, an amount is considered deferred before January 1, 2005 if the amount is earned and vested before such date. What is the purpose of the NQDC reform? NQDC was perceived as a source of potential abuse by many lawmakers because of the major corporate scandals in the early 2000s. The purpose of IRC Section 409A and its final regulations is to eliminate these perceived abuses. Specifically, the key features of IRC Section 409A are the limitations on distributions from NQDC plans and the standardization of deferral elections. 1 Treas. Reg. Sec A-6(a)(1)(i). Page 1 of 27

8 What type of NQDC plans does IRC Section 409A affect? IRC Section 409A affects any employer-sponsored plan that provides for the deferral of compensation. If an arrangement meets the definition of deferred compensation under IRC Section 409A and contains amounts that were earned or vested after December 31, 2004, that plan must meet IRC Section 409A s requirements whether the plan was funded by employer contributions or executive deferrals of salary. Some common NQDC arrangements that may require IRC Section 409A compliance include: Voluntary deferral plans Supplemental executive retirement plans (SERPs) 401(k) mirror voluntary deferral plans 457(f) plans Equity split-dollar arrangements Under the final regulations, the following arrangements are not considered plans subject to IRC Section 409A s requirements: An employer-sponsored qualified plan o Any plan that is described in IRC Section 401(a) and is either a trust exempt from tax under IRC Section 501(a) or described in IRC Section 402(d) o Any annuity plan described in IRC Section 403(a) o Any annuity contract described in IRC Section 403(b) o Any simplified employee pension (within the meaning of IRC Section 408(k)) o Any simple retirement account (within the meaning of IRC Section 408(p)) o Any plan under which an active participant makes deductible contributions to a trust described in IRC Section 501(c)(18) o Any eligible deferred compensation plan (within the meaning of IRC Section 457(b)) o Any plan described in IRC Section 415(m) Page 2 of 27

9 o Any plan described in Section 1022(i)(2) of the Employee Retirement Income Security Act of 1974, Public Law (88 Stat. 829, 942) (Sept. 2, 1974) (ERISA) o Any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan 2 IRC Section 409A is not intended to affect stock options that are granted at fair market value. It may, however, affect stock options granted at a price below fair market value. Additionally, IRC Section 409A is not intended to affect annual bonuses or annual compensation paid within two and a half months after the close of the taxable year, incentive stock options granted under IRC Section 422, or Employee Stock Ownership Plans under IRC Section 423. What is considered a deferral of compensation under IRC Section 409A? According to the final regulations, a plan provides for the deferral of compensation if the executive has a legally binding right during a taxable year to compensation that, pursuant to the terms of the plan, is or may be payable to the executive in a later tax year. 3 A deferral of compensation does not occur if the plan sponsor has the ability to unilaterally reduce or eliminate the compensation before it is paid to the participant. 4 Is a plan that requires distributions within two and a half months of vesting outside the scope of IRC Section 409A? Yes. Plans that require that compensation be received by an executive within two and a half months of the lapse of a substantial risk of forfeiture or within two and a half months of the end of the executive s first year in which the amount vested are not 2 Treas. Reg. Sec A-1(a)(2). 3 Treas. Reg. Sec A-1(b)(1). 4 Id. Page 3 of 27

10 considered NQDC plans for the purposes of IRC Section 409A. 5 For example, a plan that requires that all executive plan balances be distributed by March 15 of the first year following an executive s vesting in the compensation is not considered an NQDC plan for the purposes of IRC Section 409A. When is compensation considered earned and vested under IRC Section 409A? Compensation is considered earned and vested if the compensation is not subject to a substantial risk of forfeiture or a requirement to perform future services. 6 In other words, if an executive has earned compensation but the right is subject to a substantial risk of forfeiture or a requirement to perform further services, the compensation is not considered vested. What is the definition of a substantial risk of forfeiture under the final regulations? Compensation is subject to a substantial risk of forfeiture if entitlement to the compensation is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. 7 Under the final regulations, executives cannot add or extend a substantial risk of forfeiture after the executive has a legally binding right to the compensation (i.e. after the executive vests). Is it possible for a business owner to have a substantial risk of forfeiture for the purposes of IRC Section 409A? It is unlikely that a majority owner of a business can have a substantial risk of forfeiture in an NQDC plan under the final regulations. Several factors are to be considered when determining 5 Treas. Reg. Sec A.1(b)(4). 6 Treas. Reg. Sec (a)(2). 7 Treas. Reg. Sec A-1(d). Page 4 of 27

11 whether a majority owner of a business has a substantial risk of forfeiture. These factors include the following: The executive s relationship to the other shareholders The position of the executive in the employer s organizational structure and the extent that the executive is subordinate to other executives The executive s relationship to the officers and directors of the employer 8 Please note that the absence of a substantial risk of forfeiture does not necessarily mean that a business owner cannot participate in an NQDC plan. As long as the NQDC plan in which the business owner participates meets the requirements of IRC Section 409A, the business owner may be able to defer compensation. A business owner s ability to use short-term deferrals to avoid compliance with IRC Section 409A (i.e. distributions which occur with two and a half months of a lapse of a substantial risk of forfeiture) is eliminated if they do not have a substantial risk of forfeiture. How does IRC Section 409A impact supplemental executive retirement plans (SERPs)? Even though a SERP does not consist of executive salary deferrals, most SERPs must comply with the requirements of IRC Section 409A. Under the final regulations, a deferral of compensation occurs if the executive has a legally binding right during a taxable year to compensation that, pursuant to the terms of the plan, is or may be payable to the executive in a later tax year. 9 A SERP plan, once vested, gives the participant a legally binding right to compensation in the year vested that may be payable in a future year, thus, many SERPs meet the definition provided by the final regulations and must abide by the requirements of IRC Section 409A. 8 Treas. Reg. Sec.1.409A-1(d)(3)(i). 9 Treas. Reg. Sec A-1(b)(1). Page 5 of 27

12 One possible exception is for SERPs that are immediately payable to the participant upon the date of vesting. Under the final regulations, a deferral of compensation does not occur if the compensation is received by the later of (1) the date that is two and a half months from the end of the executive s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture or (2) the date that is two and a half months from the end of the employer s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture. 10 Are split-dollar life insurance arrangements considered deferred compensation plans under IRC Section 409A? Some split-dollar arrangements are considered deferred compensation plans under IRC Section 409A. At the same time the Treasury released the final regulations, Notice was released, which provided guidance regarding which split-dollar arrangements are considered deferred compensation plans subject to IRC Section 409A. 11 Under Notice , the following types of split-dollar arrangements are considered deferred compensation arrangements subject to IRC Section 409A: Equity split-dollar arrangements entered into after September 17, 2003 Equity split-dollar arrangements entered into prior to September 17, 2003 with premiums paid after December 31, loan arrangements that provide forgiveness of the loan Notice provides information on how a split-dollar arrangement that is subject to IRC Section 409A requirements can be amended to comply with IRC Section 409A without that 10 Treas. Reg. Sec A-1(b)(4)(A). 11 Please note that Notice only affects employer/executive split dollar arrangements. Private split dollar arrangements (i.e. arrangements between an individual and an irrevocable life insurance trust) are not affected by Notice Page 6 of 27

13 amendment being considered a material modification for the purposes of the final split-dollar regulations. Does IRC Section 409A affect past deferrals or only future deferrals? IRC Section 409A generally only affects deferrals (and earnings) that are vested after December 31, There is a provision in the final regulations, however, which states that if a plan is materially modified after October 3, 2004, all deferrals (and earnings) that are vested under the plan prior to January 1, 2005 will be treated as amounts deferred under IRC Section 409A. 12 How can the parties determine how much has been deferred prior to January 1, 2004? IRC Section 409A applies to all deferrals (and earnings) that are vested on or after January 1, Under the final regulations, the amount of compensation deferred prior to that date is determined by the type of plan implemented: Non-account balance plans (e.g. defined benefit SERP plans). The amount deferred under a non-account balance plan is the present value, as of December 31, 2004, of the amount the participant would be entitled to if he or she voluntarily terminated services on that date and received a full payment of benefits. 13 Account balance plans (e.g. voluntary deferral plans). The amount deferred is determined by the participant s account balance as of December 31, Equity-based compensation plans (e.g. phantom stock plans). The amount deferred is determined by the amount available to the participant on December 31, Treas. Reg. Sec A-6(a)(4). 13 Treas. Reg. Sec A-6(a)(3)(i). 14 Treas. Reg. Sec A-6(a)(3)(ii). 15 Treas. Reg. Sec A-6(a)(3)(iii). Page 7 of 27

14 What is considered a material modification of an NQDC plan? A grandfathered NQDC plan is considered materially modified and thus subject to IRC Section 409A if a benefit or right existing as of October 3, 2004 is enhanced or a new benefit or right is added and such material enhancement or addition affects amounts earned and vested before January 1, According to final regulations, the following events are not considered a material modification: A participant s exercise of discretion over the time and manner of payment of a benefit to the extent such discretion is provided under the terms of the plan as of October 3, A participant s exercise of a right permitted under the plan as in effect on October 3, The amendment of a plan to bring the plan into compliance with the provisions of IRC Section 409A 19 The establishment of or contributions to a trust (e.g. a rabbi trust) or other arrangement from which benefits under the plan are to be paid as long as the contribution to the trust or other arrangement would not otherwise cause an amount to be includible in the executive s gross income 20 The reduction of an existing benefit (e.g. the removal of a haircut provision) 21 The change of the investment measure for an account balance plan 22 Please note that adding a right or enhancing a benefit, even if that right or benefit is allowable under IRC Section 409A, is considered a material modification. For example, adding a provision to an 16 Treas. Reg. Sec A-6(a)(4). 17 Treas. Reg. Sec A-6(a)(4)(i). 18 Id. 19 Id. 20 Treas. Reg. Sec A-6(a)(4)(i)(A). 21 Treas. Reg. Sec A-6(a)(4)(i). 22 Treas. Reg. Sec A-6(a)(4)(iv). Page 8 of 27

15 existing NQDC plan, which would allow for a distribution upon the occurrence of an unforeseeable emergency, would be considered a material modification of that plan. Can a change to a plan document that would be considered a material modification be rescinded? A change to a plan that would be considered a material modification can be rescinded as long as the rescission takes place by the earlier of the new right or enhancement being exercised or the last day of the calendar year during which the material modification occurred. 23 What are the consequences for an NQDC plan that does not meet the new requirements set forth by IRC Section 409A? If an NQDC plan fails to meet the requirements of IRC Section 409A, all compensation deferred under the plan for the current tax year and all preceding tax years is includible in the executive s income in the current tax year to the extent that the amounts are vested and not previously included in gross income. 24 Additionally, if there is a tax imposed because the plan failed to meet the requirements of IRC Section 409A, the tax imposed includes interest and a 20 percent penalty. 25 The interest charged will be, the amount of interest at the underpayment rate plus one percentage point on the underpayments that would have occurred had the deferred compensation been includible in gross income for the taxable year in which first deferred or, if later, the first taxable year in which such deferred compensation is not subject to a substantial risk of forfeiture. An example may help to illustrate this point: Executive defers $20,000 in 2015 into a non-compliant plan. For this example, no growth on the deferral is taken into consideration. 23 Treas. Reg. Sec A-6(a)(4)(vi) 24 IRC Sec. 409A(a)(1)(A)(i). 25 IRC Sec. 409A(a)(1)(B)(i). Page 9 of 27

16 Executive is forced to include the $20,000 in his or her taxable income in Assumptions: Executive Income Tax Bracket 40% (combined state and federal) Tax Penalty 20% Underpayment Interest Rate Charged 7% Underpayment Interest Plus 1% 8% Results: Income Taxes Dues on Deferral $20,000 * 40% = $8,000 Tax Penalty $20,000 * 20% = $4,000 Underpayment Interest Charged $8,000 * 32% (7% + 1% for each of the 4 years) = $2,560 Total Taxes, Penalties and Interest Due $14,560 Executive Is Left With $5,440 It is important to note that these provisions only apply to the participants of a plan that have NQDC agreements that fail to comply with IRC Section 409A, and not to all participants of the plan. Under IRC Section 409A, do deferred compensation plans require a written document? Under the final regulations, a deferred compensation plan must be in writing to meet IRC Section 409A s requirements Treas. Reg. Sec A-1(c)(3)(vii). Page 10 of 27

17 What are the consequences if the document for an NQDC plan fails to meet the requirements of IRC Section 409A? In Notice , the IRS provided guidance concerning the correction of certain plan document failures under IRC Section 409A. Most notably the notice addressed the correction of certain ambiguous plan terms, and the correction of impermissible definitions of otherwise permissible payment events. Depending on the nature of the document failure and the timing of its correction, the consequences for the failure can range from no penalty to the full inclusion of plan funds in the participant s taxable income including penalty taxes under IRC Section 409A. What are the rules for correcting a document failure that involves the use of an ambiguous plan term? If a plan document contains a provision that could simultaneously be interpreted to be both compliant and non-compliant with IRC Section 409A, it will not cause the plan agreement to fail so long as the employer in practice is compliant with the terms of IRC Section 409A. For example, if a plan document contains the term termination of employment rather than the allowable distribution trigger of Separation of Service, this will not cause the plan agreement to fail so long as the employer only makes distributions on the occurrence of an actual Separation of Service as allowed under IRC Section 409A. The plan document may be amended at any time to provide either 1) that the plan provision must be interpreted to comply with the requirements of IRC Section 409A, or 2) an explicit definition of termination of employment that qualifies as a Separation of Service under IRC Section 409A. What are the rules for correcting a document failure that involves the use of an impermissible definition of an otherwise permissible payment event? If a plan document contains an impermissible definition of an otherwise permissible payment event, it must be amended immediately to provide for a payment event that satisfies the Page 11 of 27

18 requirements of IRC Section 409A. For example, in the case where there is an impermissible definition for Separation of Service, the plan document must be amended before the occurrence of either a true Separation of Service under IRC Section 409A or an event that would have improperly triggered a distribution under the unamended document. Failure to amend the plan document before the occurrence of either of these events will result in the participant having to include all deferrals made into the plan as taxable income and pay any penalty taxes under IRC Section 409A. Even in the case where the plan document is amended successfully, the occurrence of either a true Separation of Service or an event that would have improperly triggered a distribution under the unamended document within a year of the amendment will result in the participant having to include 50% of deferrals made into the plan in their taxable income in addition to paying penalty taxes. Is there any relief provided for corrections made on a timely basis? Plan documents corrected pursuant to Notice (document failures) on or before December 31, 2010, may be treated as having been corrected on January 1, As a result, any requirement of an inclusion of income under Notice will not apply. What are the allowable distribution triggers for NQDC plans? A key focus for IRC Section 409A is to limit the distribution triggers available to NQDC participants. Under IRC Section 409A, the following are allowable distribution triggers: Separation of service Disability Death A specified time (or pursuant to a fixed schedule) stated in the plan at the date of deferral of such compensation Page 12 of 27

19 A change in ownership or effective control of the business, or in the ownership of a substantial portion of the assets of the corporation An unforeseeable emergency Is it permissible for a plan to have distributions upon the occurrence of multiple events? Yes. It is permissible to have distributions upon the occurrence of multiple events. The regulations state that as long as a distribution event is permissible under IRC Section 409A (e.g. separation of service, disability or death), a plan may provide for payment upon the earliest, or latest of more than one event. 27 What is considered separation of service under IRC Section 409A and the regulations? The regulations provide that an executive separates service with an employer for the purposes of IRC Section 409A if he or she dies, retires or otherwise terminates employment with the employer unless the executive is on a bona fide leave of absence (e.g. military leave or sick leave) and that leave does not exceed six months (unless the executive s right to re-employment with the employer is provided by either statute or contract). 28 Can NQDC benefits be immediately distributed to all employees upon separation of service? No. Distributions for separation of service cannot be made to specified employees until six months after their separation of service. 29 Specified employees for the purposes of this requirement are key employees (as defined in IRC Section 416(i)) of a corporation that is publicly traded on an established stock market Treas. Reg. Sec A-3(b). 28 Treas. Reg. Sec A-1(h)(i). 29 Treas. Reg. Sec A-3(i)(2)(i). 30 IRC Sec. 409A(a)(2)(B)(i). Page 13 of 27

20 What is considered an unforeseeable emergency and is there a limit to the amount that may be distributed from the NQDC plan in case an unforeseeable emergency does occur? IRC Section 409A defines an unforeseeable emergency as a severe financial hardship to the participant resulting from one of the following events: An illness or accident of the participant, the participant s spouse, or a dependent of the participant Loss of the participant s property due to casualty Other similar extraordinary and unforeseeable circumstances as a result of events beyond the control of the participant 31 The final regulations provide some examples of events that may be considered an unforeseeable emergency: The need to rebuild a home following damage to a home not otherwise covered by insurance, for example, not as a result of a natural disaster The imminent foreclosure of or eviction from the executive's primary residence The need to pay for medical expenses, including nonrefundable deductibles, as well as for the costs of prescription drug medication The need to pay for the funeral expenses of a spouse, a beneficiary, or a dependent 32 The amount that may be distributed is limited to amounts necessary to compensate for the emergency plus amounts that are sufficient to pay the taxes generated by the distribution. Please note that amounts received by the participant from insurance or liquidation of other assets (to the extent the liquidation does not 31 IRC Sec. 409A(a)(2)(B)(ii)(I) 32 Treas. Reg. Sec A-3(i)(3) Page 14 of 27

21 cause additional financial hardship) must be taken into consideration when determining the amount that may be distributed for an unforeseeable emergency. 33 What is a change of control event for the purposes of IRC Section 409A? A distribution from an NQDC plan can be made upon a change of control of the company. Under IRC Section 409A and the final regulations, the following are permissible change of control events: A change in the ownership of the company. A change in the ownership of the company occurs on the date that any one person or more than one person acting as a group acquires ownership of stock of the company that, together with stock held by such person or group, constitutes more that 50 percent of the total fair market value or total voting power of the stock of the company. 34 A change in effective control of the company. A change in the effective control of the company occurs on the date that either (1) Any one person, or more than one person acting as a group acquires (or has acquired during the 12 month period ending on the date of the most recent acquisition by such person or persons) ownership of stock of the company possessing 30 percent or more of the total voting power of the stock of the company; or (2) a majority of members of the company s board of directors is replaced during any 12 month period by directors whose appointment or election is not endorsed by a majority of the members of the company s board of directors prior to the date of the appointment or election. 35 A change in the ownership of a substantial portion of the assets of the company. A change in the ownership of a 33 IRC Sec. 409A(a)(2)(B)(ii)(II) 34 Treas. Reg. Sec A-3(i)(5)(v)(A). 35 Treas. Reg. Sec A-3(i)(5)(vi)(A). Page 15 of 27

22 substantial portion of the company s assets occurs on the date that any one person, or more than one person acting as a group, acquires (or has acquired during the 12-month period ending on the date of the most recent acquisition by such person or persons) assets from the company that have a total gross fair market value equal to or more than 40 percent of the total gross fair market value of all of the assets of the company immediately prior to such acquisition or acquisitions. For this purpose, gross fair market value means the value of the assets of the company, or the value of the assets being disposed of, determined without regard to any liabilities associated with such assets. 36 An NQDC plan may provide for distributions upon the occurrence of any, none, or all of these changes of control events. Does the change of control event have to relate to the company sponsoring the plan? Not necessarily. Under the final regulations, a change of control event must relate to one of the following entities: The corporation for whom the participant is performing services at the time of the change in control event 37 The corporation that is liable for the payment of the deferred compensation (or all corporations liable for the payment if more than one corporation is liable) but only if either the deferred compensation is attributable to the performance of service by the executive for such corporation (or corporations) or there is a bona fide business purpose for such corporation or corporations to be liable for such payment and, in either case, no significant purpose of making such corporation or 36 Treas. Reg. Sec A-3(i)(5)(vii)(A). 37 Treas. Reg. Sec A-3(i)(5)(11(A)(1). Page 16 of 27

23 corporations liable for such payment is the avoidance of federal income tax 38 A corporation that is a majority shareholder of a corporation identified in the first two bullets above or any corporation in a chain of corporations in which each corporation is a majority shareholder of another corporation in the chain, ending in a corporation identified in the first two bullets above 39 An example from the final regulations illustrates this last bullet point. Assume Corporation A is a majority shareholder of Corporation B, which is a majority shareholder of Corporation C. A change in ownership of Corporation B will constitute a change in control event to plan participants performing services for Corporation B or Corporation C, and to plan participants for which Corporation B or Corporation C is solely liable for payments under the plan (for example, former employees), but will not constitute a change in control event as to Corporation A or any other corporation of which Corporation A is a majority shareholder. Notwithstanding the foregoing, a sale of Corporation B may constitute an independent change in control event for Corporation A, Corporation B and Corporation C if the sale constitutes a change in the ownership of a substantial portion of Corporation A s assets Treas. Reg. Sec A-3(i)(5)(11(A)(2). 39 Treas. Reg. Sec A-3(i)(5)(11(A)(3). 40 Treas. Reg. Sec A-3(i)(5)(11(C). Page 17 of 27

24 Is the acceleration of NQDC plan payments allowed? Generally no. A plan will not meet the requirements of IRC Section 409A if it allows for the acceleration of the time or schedule of any payments. However, the final regulations provided a list of acceptable permissible accelerations of the payment of NQDC benefits. 41 The following are some of the permissible acceleration events under the final regulations: A payment to an individual other than the plan participant to fulfill a domestic relations order 42 A distribution to a participant to pay income taxes due upon a vesting event subject to IRC Section 457(f) provided that the amount of the payment is not more than is needed to pay the taxes 43 A distribution upon termination and liquidation of the NQDC plan 44 Can a plan be terminated and the deferrals distributed to the participant without the termination being considered an acceleration of benefits? In some cases, yes, a plan may be terminated without that termination being considered an acceleration of benefits. The termination, however, must follow the parameters established for plan termination in the final regulations. Under the final regulations, a deferred compensation plan may be terminated if the following requirements are met: The termination and liquidation does not occur proximate to a downturn in the financial health of the employer. The employer terminates and liquidates all agreements, methods, programs, and other arrangements sponsored by 41 Please see Treas. Reg. Sec (j)(4) for the full list of permissible acceleration events under the final regulations. 42 Treas. Reg. Sec A-3(j)(4)(ii). 43 Treas. Reg. Sec A-3(j)(4)(iv). 44 Treas. Reg. Sec A-3(j)(4)(ix). Page 18 of 27

25 the service recipient that would be aggregated with any terminated and liquidated agreements, methods, programs, and other arrangements under Treas. Reg. Sec A-1(c) if the same executive had deferrals of compensation under all of the agreements, methods, programs, and other arrangements that are terminated and liquidated. No payments in liquidation of the plan are made within 12 months of the date the employer takes all necessary action to irrevocably terminate and liquidate the plan other than payments that would be payable under the terms of the plan if the action to terminate and liquidate the plan had not occurred. All payments are made within 24 months of the date the employer takes all necessary action to irrevocably terminate and liquidate the plan. The employer does not adopt a new plan that would be aggregated with any terminated and liquidated plan under Treas. Reg. Sec A-1(c) if the same executive participated in both plans, at any time within three years following the date the employer takes all necessary action to irrevocably terminate and liquidate the plan. 45 Can a plan be terminated if the employer declares bankruptcy? Possibly. The final regulations allow for a termination of a plan upon dissolution of an employer if that dissolution is taxed under IRC Section 331, or, upon approval of the bankruptcy court. In either case, the income must be included in the executive s income at the latest of the following: The calendar year in which the plan termination and liquidation occurs The first calendar year in which the amount is no longer subject to a substantial risk of forfeiture 45 Treas. Reg. Sec A-3(j)(4)(ix)(C). Page 19 of 27

26 The first calendar year in which the payment is administratively practicable 46 Please note that this provision does not provide creditor protection for participants of NQDC plans. All amounts deferred into an NQDC plan are subject to the claims of the employer s creditors at all times. Can a plan be terminated if there is a change of control for the employer? Yes. An employer may irrevocably elect to terminate a plan in the 30 days preceding or 12 months following a change of control event. If the employer does elect to terminate a plan upon the occurrence of a change of control event, the employer must essentially terminate all NQDC plans that would be aggregated under IRC Section 409A, and the executives must receive all amounts deferred into those plans within 12 months of the date that the employer takes all necessary actions to terminate the arrangements. 47 Is the shortening of a vesting period considered an acceleration? No, under final regulations, the shorting of a vesting period is not considered an acceleration of the time or schedule of payments under a plan. 48 For example, if a nonqualified deferred compensation plan provides for a lump sum payment of the vested benefit upon separation from service, and the benefit vests under the plan only after 10 years of service, it is not a violation of the requirements of IRC Section 409A if the company reduces the vesting requirement to 5 years of service, even if a participant becomes vested as a result and qualifies for a payment in connection with a separation from service. 46 Treas. Reg. Sec A-3(j)(4)(ix)(A). 47 Treas. Reg. Sec A-3(j)(4)(ix)(B). 48 Treas. Reg. Sec A-3(j). Page 20 of 27

27 When must deferral elections be made? The required timing of an election to defer compensation differs depending on the situation. Generally, the deferral election must be made prior to the close of the tax year preceding the year in which the compensation is to be deferred. If a participant is new to a plan, the election must be made within 30 days after the date the participant becomes eligible to participate. In the case of performance-based compensation for services performed over a period of at least 12 months (such as an annual bonus), the election must be made no later than 6 months before the end of the period. What are the requirements for a benefit to be considered performance-based compensation? The term performance-based compensation means compensation the amount of which, or the entitlement to which, is contingent on the satisfaction of pre-established organizational or individual performance criteria relating to a performance period of at least 12 consecutive months. 49 Performance-based compensation does not include any amount or portion of any amount that will be paid either regardless of performance, or based upon a level of performance that is substantially certain to be met at the time the criteria is established. Can an offshore trust be used to hold NQDC assets? No. Property transferred to an offshore trust for the purposes of paying NQDC benefits will be treated as property transferred in connection with the performance of services under IRC Section 83 and immediately taxed to the participant and subject to penalties. This is the case even if the assets are available to satisfy the claim of an employer s general creditors. This provision does not apply to assets located in a foreign country if substantially all the services to which the NQDC relates are performed in that country. Please note that IRC Section 409A does not provide any grandfathering for arrangements with assets in offshore trusts Treas. Reg. Sec A-1(e)(1). 50 Notice Page 21 of 27

28 Can a company provide distribution triggers for NQDC plans that are tied to its financial health? No. The elimination of these types of provisions, which are commonly known as insolvency triggers, was a major focus of IRC Section 409A. One key element of NQDC plans is the fact that the funds must be within the reach of corporate creditors. By tying the distribution of NQDC plan assets to the company s financial health, the participants would be violating this element by taking the money out of the company when it appears as though the company may be undergoing financial difficulty. Under IRC Section 409A, if a plan provides that its assets will be restricted to the payment of NQDC benefits upon a change in the employer s financial health, those funds will be treated as property transferred in connection with the performance of services under IRC Section 83 and immediately be taxed to the participant and be subject to penalties. Please note that IRC Section 409A does not provide any grandfathering for arrangements with distribution triggers based on the employer s financial health. 51 What is the penalty for NQDC plans that place assets in an offshore trust or provide a distribution trigger tied to the company s financial health? In both instances, participants must currently recognize contributions to NQDC plans as taxable income, and there are additional penalties associated with these types of plans: Any increase in value in assets in these types of plans will be considered an additional transfer of property under IRC Section 83. Interest at the IRS underpayment rate plus one percent and a 20 percent penalty will be assessed on those amounts which must be included in gross income. 51 Id. Page 22 of 27

29 Can an NQDC plan allow for an installment payout for distributions at a specified date and a lump sum upon the executive s separation of service? Yes. According to the final regulations, a plan may provide for a different form of payment depending upon the payment event. 52 For example, a plan could require an installment payout if the executive s distributions start when the executive reaches age 65 or a lump sum distribution if the executive separates from service prior to age 65. What are the requirements for a change in the time or form of payment of amounts from an NQDC plan? Under the final regulations, elections to change the timing or form of payment of compensation from an NQDC are permitted under the following conditions: The election to change the time or form of payment does not take effect until at least 12 months after the date of the election. 53 The payment is deferred for a period of at least 5 years after the election to change the timing or form. 54 If the payment was scheduled to be made on a specified date, the election to change the timing or form of payment must be made at least 12 months prior to that specified date. 55 If the above requirements (informally known as the one and five rule ) are met, the participant can re-defer their payments for a receipt at a later date or change the form of their payment. 52 Treas. Reg. Sec A-3(c). 53 Treas. Reg. Sec A-2(b)(1)(i). 54 Treas. Reg. Sec A-2(b)(1)(ii). 55 Treas. Reg. Sec A-2(b)(1)(iii). Page 23 of 27

30 Are all the payments in an installment payout considered a single payment or a series of separate payments? Under the final regulations, an installment payout can be defined in the plan document as either a single payment or a series of separate payments. 56 If the plan document does not specify whether the payments are considered a single payment or a series of separate payments, the final regulations stipulate that the default will be a single payment. 57 If installment payments are treated as separate payments, can the executive change the timing or form of each individual payment? Yes. If the installment payments are considered a series of separate payments, the executive may elect to change the timing or form of payment for each installment. What is the difference between an installment payout and a life annuity? A life annuity is a series of substantially equal periodic payments, payable not less frequently than annually, for the life (or life expectancy) of the executive or a series of substantially equal periodic payments, payable not less frequently than annually, for the life (or life expectancy) of the executive, followed upon the death (or end of the life expectancy) of the executive by a series of substantially equal periodic payments, payable not less frequently then annually, for the life (or life expectancy) of the executive s designated beneficiary (if any). 58 The key difference between a life annuity and an installment payout is the fact that a life annuity is seen as a single payment, meaning that the timing and form of each individual payment cannot be changed; only the timing or form of the entire life annuity can be changed. Conversely, as discussed above, an installment payout can be viewed as a series of 56 Treas. Reg. Sec A-2(b)(2)(iii). 57 Id. 58 Treas. Reg. Sec A-2(b)(2)(ii). Page 24 of 27

31 individual payments, meaning the timing or form of each payment can be changed if the participant meets the requirements to change the timing or form of payments set forth in the regulations. Can a participant receive a lump sum payout if his or her plan was originally structured to provide an installment or life annuity payout? Yes, if the original distributions are considered one single payment made over a period of years (a life annuity or installment payments considered a single payment) and the requirements to change the timing or form of payment set forth in the regulations are met. 59 For example, if an executive is scheduled to receive a life annuity distribution starting in 2016, he or she may elect instead to take a lump sum distribution if he or she elects to change the timing and form of payment at least one year prior to the first scheduled distribution, and the lump sum distribution is not made until at least 2021 (five years after the original distribution date). Can a company delay a payout if its income tax deduction for the payout is limited by the maximum reasonable compensation for executives of publicly traded companies under IRC Section 162(m)? Yes, under the final regulations, an employer may delay the payment of NQDC benefits if it is reasonably anticipated that the employer s income tax deduction, with respect to that payment, would be limited or eliminated by IRC Section 162(m). 60 Please note, however, that for this exclusion to apply, the terms of the arrangement must require that the payment to be made either at the earliest date at which the employer reasonably anticipates that the deduction of the payment of the amount will not be limited or eliminated by application of Section 162(m) or the calendar year that the executive separates from service. 59 Treas. Reg. Sec A-2(b)(5). 60 Treas. Reg. Sec A-1(b)(4)(ii). Under IRC Sec. 162(m) a publicly held company cannot deduct more that $1,000,000 of salary apiece for the chief executive officer and the next four highest paid officers in any given year. Page 25 of 27

32 Do the regulations require IRC Section 409A compliance for severance plans? Yes. According to the regulations, many severance plans (i.e. plans that only provide compensation upon a separation of service) are considered NQDC plans and are subject to IRC Section 409A. 61 Are all severance plans subject to IRC Section 409A? No. The regulations did carve out an exception for some traditional severance plans, making them exempt from IRC Section 409A. Under the regulations, a severance plan is not considered a deferral of compensation if the following conditions are met: The payment from the severance plan is only made upon an actual involuntary separation from service. The separation pay does not exceed two times the lesser of the following: o Two times the executive s salary in the year prior to separation of service o The maximum amount or compensation that may be taken into account under a qualified plan 62 The payments must be completed by December 31 of the second calendar year following the calendar year in which the separation occurs Treas. Reg. Sec A-1(b)(9). 62 Under IRC Sec. 401(a)(17), the total amount that can be taken into account for a qualified plan in 2015 is $260, Treas. Reg. Sec (b)(9)(iii)(A). Page 26 of 27

33 Are arrangements between a business and an independent contractor governed by IRC Section 409A? IRC Section 409A does not govern arrangements between a business and an independent contractor as long as the following conditions are met: The independent contractor is actively engaged in the trade or business of providing services, other than as an employee or director of a corporation. The independent contractor provides significant services to two or more businesses to which the independent contractor is not related 64 and that are not related to one another. An independent contractor is considered providing significant services for two or more businesses if the independent contractor does not receive more than 70% of their total revenue for providing those services from any business or group of related businesses. 65 The independent contractor is not related to the business The regulations provide a definition for when an independent contractor is considered related. Specifically, the regulations adopt the related persons rules that are set for in IRC Secs. 267(b) or 707(b)(1). For more information, please see the Treas. Reg. Sec A- 1(f)(3)(ii). 65 Treas. Reg. Sec A-1(f)(2)(iii). 66 Treas. Reg. Sec (f)(2)(iii). Page 27 of 27