This Executive Alert describes the rules governing when compensation deferred under an arrangement that is subject to Section 409A of the Internal Revenue Code (the “Code”) may be paid. In particular, this Alert highlights the changes that the final regulations published on April 10, 2007 made to the distribution rules set forth in the prior guidance published by the U.S. Department of the Treasury and Internal Revenue Service.
Distribution Rules Applicable to Deferred Compensation
Time and Form of Payment. Payments may generally be made from an arrangement that is subject to Code Section 409A only upon the occurrence of one of the following six (6) events:
1. Separation from service
4. A specified (fixed) time or pursuant to a fixed schedule stated in the plan
5. Change in control
6. Unforeseeable emergency
A deferred compensation arrangement must designate which of the events listed above will trigger a distribution. However, an arrangement may provide for distribution upon the earlier of, or the later of, two or more permissible payment events. For example, a deferred compensation arrangement could provide that distribution will be made upon the occurrence of the earliest (or latest) to occur of separation from service, disability or death of the employee or independent contractor (referred to as a “worker” for purposes of this Alert).
An arrangement must also designate when payment will be made. If the time of payment is based on the occurrence of a separation from service, death, disability, change in control, or unforeseeable emergency, the arrangements must: (1) state the date of the event as the payment date; (2) designate a payment date that is objectively determinable and nondiscretionary at the time the event occurs (for example, payment will be made three (3) months following the date of initial disability); (3) state that a payment (including a payment that is part of a schedule) will be made during a designated taxable year that is objectively determinable and nondiscretionary at the time the event occurs (for example, three (3) substantially equal payments to be made during the three (3) calendar years following the year of death); (4) provide that a payment will be made in accordance with a fixed schedule that is objectively determinable and nondiscretionary based on the date the event occurs (if the schedule is fixed at the time the permissible payment event is designated); or (5) state that a payment (including a payment that is part of a schedule) will be made during a designated period objectively determinable and nondiscretionary at the time the payment event occurs, if the designated period begins and ends within one taxable year of the worker or is not more than 90 days and the worker does not have a right to designate the taxable year of the payment. For example, a payment scheduled to be made within 180 days of a separation from service generally will not provide a specified time and form of payment under the final regulations because it does not specify either the worker’s taxable year in which the payment must be made following the separation from service or a period of 90 days or less following the separation from service in which the payment must be made. However, a provision requiring payment “as soon as administratively feasible” after a payment event will be treated as providing for a specified payment date only if the potential payment period is expressly restricted to one taxable year or is no longer than 90 days and the worker is not permitted to elect the taxable year of payment.
An amount is payable at a specified time or pursuant to a fixed schedule if specifically identified amounts (or amounts that may be determined at the time payment is due pursuant to an objective, nondiscretionary formula specified when the amount is deferred) are payable at a date or dates that are nondiscretionary and objectively determinable at the time the amount is deferred. If the arrangement provides for payment in accordance with a fixed schedule, the schedule must be fixed at the time the payment event is designated. Any subsequent change in the fixed schedule is considered a change in the time and form of payment under Code Section 409A.
The proposed regulations provided that a payment will be treated as made on a fixed date or fixed schedule if payment or payments are made by the end of the calendar year (or the worker’s tax year if different) in which a specified fixed payment date, or due date of a payment under a fixed schedule occurs or, if later, the fifteenth day of the third month following such fixed date or due date. The final regulations clarify that this same flexibility applies to making a payment on account of a separation from service, death, disability, change in control, or unforeseeable emergency. Thus, a payment is treated as made upon the occurrence of the event specified in the plan if the payment is made by the later of: (1) the last day of the calendar year (or the worker’s tax year, if different) containing the event date; or (2) the fifteenth day of the third calendar month following the date specified in the plan.
The final regulations continue to provide that an arrangement may designate a worker’s entire taxable year, rather than a specified date, as the payment date. If the arrangement provides only for the taxable year of the payment, the payment may be made at any time during the year. If the plan does not provide for payment on a specific date within a taxable year, the payment date is deemed to be January 1 for purposes of the subsequent deferral election rules. Further, the final regulations provide that a payment will be deemed to have been made upon the date specified in the arrangement (and not treated as an accelerated payment) if payment is made within the 30-day period before the scheduled date and the worker is not permitted to elect the taxable year of payment.
A specified time or fixed schedule also includes the designation of a defined period (e.g., January 1 through July 1 of a specified year) or periods within a worker’s taxable year or years that are objectively determinable, so long as no such defined period begins within one taxable year and ends within another taxable year (and the payment date is deemed to be the first day of the period in which the payment will be made for purposes of the subsequent deferral election rules).
Generally, an arrangement may designate only one time and form of payment upon the occurrence of a separation from service, death, disability, change in control, or unforeseeable emergency. For example, an arrangement cannot specify one payment date if an event occurs on a Monday but another payment date if the event occurs on any other day of the week. However, if the event triggering distribution is death, disability, change in control, or unforeseeable emergency, a plan may allow an alternative payment schedule if the event occurs on or before one (but not more than one) specified date. For example, a plan may provide that a worker will receive a lump sum payment of his entire benefit on the first day of the month following a change in control event that occurs before he attains age 55 but will receive 5 substantially equal annual payments beginning on the first day of the month following a change in control event that occurs on or after he attains age 55.
The final regulations also allow an arrangement to designate a different time and form of payment with respect to a separation from service under each of the following conditions: (1) a separation during a period of time not to exceed two (2) years following a change in control event; (2) a separation before or after a specified date; (3) a separation from service before or after a combination of a specified date and a specified period of service; and (4) a separation from service that is not described in (1), (2) or (3). The final regulations do not permit a different time or form of payment based on whether the separation from service is voluntary or involuntary.
Separation from Service.
Termination of Employment.
The proposed regulations provided that a separation from service for an employee occurred upon the employee’s death, retirement or other termination of employment with the employer. Whether a termination of employment had occurred would be determined based on the facts and circumstances. Under the proposed regulations, where the facts and circumstances indicated that the employer and employee did not intend for the employee to provide more than insignificant future services, the employee would be treated as having a separation from service. For this purpose, an employer and employee would not be presumed to have intended only insignificant services be provided if the employee continued providing services at a rate equal to at least 20% of the rate of the previous three (3) years. Where an employee continued providing services in another capacity (e.g., as an independent contractor), the employee would be deemed not to have a separation from service if he continued providing services at a rate equal to at least 50% of the services provided during the previous three (3) years.
The final regulations continue to provide that a separation from service for an employee occurs upon the employee’s death, retirement or other termination of employment with the employer (including all entities that would be treated as part of the employer’s controlled group under Code Sections 414(b) or (c) substituting a 50% ownership level for the 80% ownership level). However, in response to comments received, the final regulations provide a simplified standard for determining whether an employee has experienced a termination of employment. The simplified standard applies whether an employee continues to provide services as an employee or independent contractor.
Under the final regulations, the general standard for determining whether the employee has terminated employment with the employer is based on whether the facts and circumstances indicate that the employer and employee reasonably anticipated either that no further services would be performed after a certain date or that the level of bona fide services the employee would perform aftersuch date (whether as an employee or independent contractor) would permanently decrease to no more than 20% of the average level of bona fide services performed over the immediately preceding 36-month period (or the full period in which the employee provided services to the employer, whether as an employee or independent contractor, if the employee has been providing services for less than 36 months). Facts and circumstances to be considered in making this determination include whether the employee continues to be treated as an employee for other purposes (e.g., continuation of salary and participation in employee benefit programs), whether similarly situated workers have been treated consistently, and whether the employee is eligible to perform services for, and realistically available to perform services for, other employers in the same line of business.
In order to assist in applying the general standard regarding termination of employment, the final regulations set forth the following rebuttable presumptions: (1) an employee generally will be presumed to have separated from service where the level of bona fide services performed changes to a level equal to 20% or less of the average level of services provided during the previous 36 months; (2) an employee will be presumed not to have separated from service where the level of bona fide services rendered continues at a level that is 50% or more of the average level of services provided during the previous 36 months; and (3) no presumption applies to a change to a level of services between 20% and 50% of the average level of services provided during the previous 36 months. These presumptions are rebuttable by demonstrating that the employer and employee reasonably anticipated that, as of a certain date, the level of bona fide services would be reduced (or would not be reduced) permanently to a level less than or equal to 20% of the average level of services provided during the immediately preceding 36-month period (or the full period in which the employee has provided services if the employee has been providing services to the employer for a period of less than 36 months).
In addition to the above, the final regulations provide that, rather than treating a separation from service as requiring an anticipated permanent reduction in the level of bona fide services to 20% or less, an arrangement may treat another level of anticipated permanent reduction in the level of bona fide services as a separation from service if the level of permanent reduction required is set forth in the arrangement as a specific percentage that is greater than 20% but less than 50% of the average level of bona fide services provided in the immediately preceding 36 months. The arrangement must specify the definition of separation from service on or before the date at which a separation from service is designated in the arrangement as a time of payment of an amount deferred. Further, once designated, a change to the definition of separation from service with respect to an amount deferred is subject to the rules regarding subsequent deferrals and accelerations of payment.
Leaves of Absence.
An employee does not experience a separation from service while on military leave, sick leave or a bona fide leave of absence unless the period of leave extends beyond six (6) months, or if longer, the period for which the right to reemployment is protected by statute or contract. For purposes of determining whether an employee has separated from service, a bona fide leave of absence is a leave of absence where there is a reasonable expectation that the employee will return to service with the employer. Further, under the final regulations, with respect to disability leave, the employment relationship is treated as continuing for a period of up to 29 months, unless otherwise terminated by the employer or employee even if the employee does not have a contractual right to reemployment. The final regulations do not recognize extensions of leave or salary and benefits as a means of delaying the date of separation from service for purposes of Code Section 409A. Further, terminal leave with no intent to return generally is not treated as bona fide leave.
With respect to mergers and acquisitions, the final regulations adopt a rule providing that, where as part of a sale of assets by one employer to an unrelated employer, a worker of the seller would otherwise experience a separation from service with the seller, the seller and buyer may specify whether a worker providing services to the seller immediately before the asset sale transaction and providing services to the buyer after and in connection with the asset sale transaction has experienced a separation from service provided: (1) the transaction results from bona fide, arm’s length negotiations; (2) all workers providing services to the seller immediately before the asset sale transaction and providing services to the buyer after and in connection with the asset purchase transaction are treated consistently for purposes of applying the provisions of any nonqualified deferred compensation plan; and (3) such treatment is specified no later than the closing date of the asset sale transaction.
If a worker is an independent contractor, a separation from service will generally occur at the expiration of the contract under which services are performed if the expiration is a good-faith and complete termination of the contractual relationship. If a worker provides services to an employer as both an employee and independent contractor, the worker must separate from service both as an employee and independent contractor to be treated as having separated from service. However, if a worker provides services as both an employee and member of the board of directors, the services provided as a director are not taken into account for purposes of determining whether the worker has a separation from service as an employee for purposes of a nonqualified deferred compensation plan in which the worker participates in his or her capacity as an employee that is not aggregated with any plan in which the worker participates as a director. If a non-employee director is also providing services to an employer as an independent contractor, he does not have a separation from service for purposes of Code Section 409A until he has separated from service as both a director and independent contractor.
While a deferred compensation arrangement may permit a distribution to be made upon a worker’s separation from service, payments cannot be made for at least six (6) months after the date of the separation from service (or the worker’s death, if earlier), if the worker is a “specified employee” of a corporation whose stock is publicly traded on an established securities market (or of any entity within the public company’s controlled group of entities). An employee is a specified employee if the employee is a “key employee” within the meaning of Code Section 416(i). Key employees generally include certain shareholder employees, highly paid employees and designated officers. However, a non-employee director is generally not considered a key employee. Under the proposed regulations, the identification of key employees was based on a twelve (12)-month look back period ending on a date designated in the deferred compensation arrangement.
The final regulations include a number of additions and clarification to the specified employee provisions including the following: (1) the 6- month delay for payment to specified employees applies to an entity whose stock (or the stock of any of the entity’s controlled group members) is traded on a foreign exchange or is traded on a U.S. exchange only as American depositary receipts or American depositary shares; (2) any Code Section 415 definition of compensation may be used in determining specified employees; (3) a plan may be overinclusive in identifying specified employees (e.g., a plan may use an alternative, objective method of identifying specified employees so long as no more than 200 employees are identified as subject to the 6- month delay as of any date or a plan could provide that all employees are subject to the 6- month delay); (4) the default specified employee identification date is December 31; (5) the first day of the fourth month following the specified employee identification date will be the effective date for a new list of specified employees, but an employer may elect an earlier date following the specified employee identification date upon which the new list of specified employees will become effective as long as such date is not later than the first day of the fourth month following the specified employee identification date; (6) the 6-month delay requirement applies only where the worker is a specified employee as of the date of separation from service; and (7) additional clarification is provided for determining specified employees following a corporate transaction (e.g., mergers, acquisitions and spin-off transactions and IPOs).
Disability. The final regulations generally retain the provisions of the proposed regulations regarding payments due to disability.
A Specified Time or Pursuant to a Fixed Schedule Stated in the Arrangement.
Reimbursements and In-Kind Benefits.
The final regulations provide that a right to reimbursements (e.g., a right to reimbursement of membership fees) or in-kind benefits (a right to use a corporate vehicle or aircraft) satisfies the requirements of a fixed date or fixed schedule of payments if the following conditions are satisfied: (1) the arrangement provides an objectively determinable nondiscretionary definition of the expenses eligible for reimbursement or the in-kind benefits to be provided; (2) the arrangement provides for the reimbursement of expenses incurred or provision of in-kind benefits during an objectively and specifically prescribed period; (3) the amount of reimbursable expenses incurred or in-kind benefits available in one taxable year of the worker cannot affect the amount of reimbursable expenses or inkind benefits available in a different taxable year (except with respect to certain medical reimbursement arrangements); (4) the reimbursement of an eligible expense must be made before the last day of the worker’s taxable year following the taxable year in which the expense is incurred; and (5) the right to reimbursement or in-kind benefits may not be subject to liquidation or exchange for another benefit.
A payment schedule with a fixed or objective formula limitation on the amount that may be paid to an individual during a particular period will not fail to be a fixed schedule of payments if: (1) the limitation is established on or before the date the time and form of payment is otherwise required to be set; (2) the limitation is based on a fixed or objective nondiscretionary formula on the amount that may be paid in a particular period where all the factors relevant to the determination of the limit are not under the worker’s effective control and not subject to any exercise of discretion by the employer; and (3) the arrangement specifies the time and form of payment of any additional amount due in excess of the fixed or formula limitation amount. A change in the limits or allocation method for the payment of the unpaid excess amounts that will be paid after the original due dates due to application of the limit may constitute a subsequent deferral election or acceleration of a payment.
If an arrangement with multiple participants limits the total amount payable during a specified period, the time and form of payment requirements may be met if the arrangement specifies, from the date the time and form of payment is otherwise required to be established: (1) a fixed or nondiscretionary, objectively determinable limit on the amount that may be paid in a particular period so that none of the factors relevant to the determination of such limit is in the worker’s effective control or subject to the exercise of any discretion by the employer; (2) where there is an overall limitation on the aggregate amount that may be paid to a group of workers during a specified period, a nondiscretionary, objectively determinable method to allocate the payments that can be made in accordance with the limitation among the workers participating in the plan over which the worker does not have effective control and the employer does not have discretion; and (3) the time and form of payment of any amount that will be paid after its original due date because of the limitation. A change in the limits or a change in the allocation method may constitute a subsequent deferral election or acceleration of a payment.
Employer’s Business Performance.
A payment schedule may also be conditioned on a formula limitation related to business performance (e.g., a specified percentage of cash flow for a period) if: (1) the formula limitation is specified at the time the schedule of payments is otherwise required to be set; (2) the limitation is nondiscretionary and objectively determinable based on the employer’s business performance; and (3) the worker retains no control over the determination or application of the formula limitation. For this purpose, a formula limitation based on profit or other indicia of general business performance is not treated as discretionary or in the employer’s control. For example, a plan providing that the maximum payment during a year will equal no more than a set percentage of the employer’s cash flow for the previous year generally satisfies the requirement of a fixed time and form of payment. However, a change in the formula limitation may constitute a subsequent deferral election or an acceleration of a payment.
Tax Gross-Up Payments.
The final regulations provide that a right to a tax gross-up payment is a right to deferred compensation that satisfies the requirement of a specified time or fixed schedule of payments if the plan provides that the tax gross-up payment will be made, and the payment is actually made, by the end of the worker’s taxable year next following the worker’s taxable year in which the related taxes are remitted.
Customer Payments to the Employer.
The final regulations generally provide that a payment schedule based upon the timing of payments to the employer is not a fixed schedule of payments. However, a plan may qualify as having a fixed date or schedule of payments if the following requirements are satisfied: (1) if the employer is comprised of more than one entity, the payments must be due from a person that is not one of such entities; (2) the payments stem from bona fide and routine transactions in the employer’s ordinary course of business; (3) the worker must not have effective control of the employer, the person from whom the payments to the employer are due, or the collection of the payments; (4) the payment schedule provides for an objective, nondiscretionary method of identifying the payments to the employer from which the amount of the payment is determined; (5) the payment schedule provides a nondiscretionary, objective schedule under which payments of the nonqualified deferred compensation will be made; and (6) the sales to which the payment relates must be of a type that the employer is in the trade or business of making and makes frequently and either all such sales must be taken into account or there must be a legitimate, non-tax business reason for limiting the sales taken into account.
Change in Control Events. Payment may be made upon a change in ownership or effective control of a corporate employer. Under the final regulations, a change in effective control 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 twelve (12)-month period ending on the date of the most recent acquisition by such person or persons) ownership of stock of the corporation possessing 30% (35% in the proposed regulations) or more of the total voting power of the stock of such corporation; or (2) a majority of the members of the corporation’s board of directors is replaced during any twelve (12)-month period by directors whose appointment or election is not endorsed by a majority of the members of the corporation’s board of directors prior to the date of the appointment or election. Until further guidance is issued, a non-stock, non-profit corporation may apply the change in effective control rules by analogy to changes in the composition of its board of directors, trustees or other governing body.
The final regulations retain the rule that an IPO does not constitute a change in control event for purposes of Code Section 409A.
An arrangement must designate how an amount will be paid upon a change in control event and the final regulations clarify that an arrangement generally cannot provide one time and form of payment upon a particular type of change in control event and another time and form of payment upon another type of change in control event.
Unforeseeable Emergency. The final regulations generally retain the provisions of the proposed regulations regarding unforeseeable emergency. However, pursuant to the Pension Protection Act of 2006, under the final regulations, if an event would constitute a hardship under an arrangement if it occurred with respect to a worker’s spouse or dependent, the event will, to the extent permitted under an arrangement, constitute a hardship if it occurs with respect to a person who is a beneficiary under the arrangement with respect to the service provider.
Documents must be amended to comply with Code Section 409A by December 31, 2007. Before January 1, 2008, sponsors must be in good faith compliance with Code Section 409A, including limiting the timing of distributions to permissible payment events and avoiding the prohibited acceleration of payments with respect to compensation deferred after December 31, 2004. In order to be in good faith compliance, plan sponsors may rely on Notice 2005-1 or the proposed regulations and/or the final regulations. Either way, sponsors need to ensure that distributions of compensation deferred after December 31, 2004 do not violate Code Section 409A. Thus, sponsors need to determine which permissible payment events will entitle workers to distributions and which, if any, of the exceptions to the anti-acceleration rules they wish to adopt.