Identifying Specified Employees Under Sec. 409A

By G. Edgar Adkins, Jr., CPA, Washington, DC, and Jeffrey A. Martin, CPA, Washington, DC

Editor: Greg A. Fairbanks, J.D., LL.M.

Due to the new nonqualified deferred compensation (NQDC) rules under Sec. 409A, corporate executives may be surprised if they expect to receive distributions from their NQDC plans immediately after they terminate employment. When Congress enacted Sec. 409A, it placed strict rules on NQDC plans that must be followed in order for employees to avoid harsh consequences (i.e., immediate taxation, a 20% penalty, and interest). One of these rules is typically referred to as “the six-month delay rule.” This rule generally provides that NQDC plan distributions on account of a separation from service to a “specified employee” (as defined in detail below) may not be made before the date that is six months after the date the specified employee separates from service (Regs. Sec. 1.409A-3(i)(2)). This rule applies only to corporations with stock that is publicly traded on an established securities market (including foreign securities markets).

Employers must understand how to determine whether an employee is a specified employee so that the plan is operated in accordance with Sec. 409A. This can be accomplished using a three-step process, as discussed below.

Step 1: Select the Specified Employee Identification Date

The first step an employer should take to identify its specified employees is to select the specified employee identification date (identification date). In general, this is the only date during the year on which the specified employees will be identified. Under Regs. Sec. 1.409A-1(i)(3), the default identification date is December 31. However, an employer may designate an alternative identification date. The same identification date must be used for all of the employer’s NQDC plans. The identification date may be changed in the future, but the change cannot be effective until at least 12 months after the decision to change the date has been made.

Step 2: Select the Specified Employee Effective Date

The second step an employer should take is to select the specified employee effective date (effective date). This is the date that the specified employees who have been identified under step 1 will become specified employees for purposes of applying the six-month delay rule. Under Regs. Sec. 1.409A-1(i)(4), the default effective date is the first day of the fourth month following the identification date. Thus, for an employer who chooses to use the default identification date of December 31, the default effective date is the following April 1. The employer may choose an alternative effective date as long as that date is not later than the default effective date (i.e., first day of the fourth month following the identification date). Thus, for an employer who uses an identification date of December 31, the effective date can be any date prior to the following April 1. For example, suppose an em ployer chooses to use an alternative identification date of October 31 because that date coincides with the employer’s tax year end. The default effective date would be the following February 1. However, the employer might want to choose an alternative effective date of January 1 in order to coincide with the calendar year. Because the alternative effective date (January 1) does not ex tend past the default effective date (February 1), the alternative effective date is acceptable.

The same effective date must apply to all of the employer’s NQDC plans. As with the identification date, the employer may change the effective date after it has been initially established. However, the change cannot go into effect until 12 months after the decision to change the effective date has been made.

Step 3: Determine Whether an Employee Is a Specified Employee

Once an employer has established an identification date and an effective date, the final step is to determine which employees are specified employees. An employee is a specified employee if he or she is a key employee on the date of his or her separation from service. The term “key employee” is defined under Sec. 416(i) as follows:

  • Any officer with annual compensation greater than $150,000 (as in dexed for inflation in 2008);
  • A 5% owner of the employer; or
  • A 1% owner of the employer with annual compensation greater than $150,000 (not indexed for inflation).

The number of officers under the first category who must be included is limited to 10% of all employees. However, for companies with fewer than 30 employees, the maximum number of officers that can be included is three, and for companies with more than 500 employees the maximum is 50.

The six-month delay rule applies only if an employee is a specified em ployee on the date he or she separates from service. Thus, the remainder of this step involves determining whether an employee is a specified employee when he or she separates from service.

In order to determine whether an employee is a specified employee on separation, it is necessary to work backwards, starting with the date that the employee separates from service. After determining the separation date, the employer should identify the effective date (as described in step 2) that falls on, or immediately precedes, the separation from service date. Next, the employer should determine the identification date (as described in step 1) that immediately precedes the effective date. Finally, the employer should determine whether the employee was a key employee at any time during the 12-month period ending on the identification date.

If an employee was a key employee during that 12-month period, the em ployee is treated as a specified employee on the date of his or her separation from service. Accordingly, the employee is a specified employee for whom the six-month delay must be applied for distri butions made on account of separation from service.

Example: As of December 31, 2007, Company A had 350 employees. J is an officer of A. Her 2007 annual compensation was $165,000, and she was the sixth-highest compensated employee in 2007. She participates in A’s supplemental executive retirement plan (the plan). The plan provides that a distribution will be made on separation from service and that specified employees will not receive a distribution until six months after the separation from service date. A has decided to use the default identification date and effective date for purposes of applying the six-month delay rule. On April 15, 2008, J terminates her employment with A. The effective date immediately preceding J’s separation from service was April 1, 2008, and the identification date immediately preceding the effective date was December 31, 2007. Therefore, A must determine if J was a key employee at any time during the 12-month period ending on December 31, 2007. Because J’s annual compensation was greater than $145,000 (the indexed amount for 2007) and she was among the top 35 compensated officers (10% of 350 employees), J was a key employee during the 12-month period ending on December 31, 2007. Therefore, J is considered a specified employee when she separated from service, so she will not be able to receive a distribution from the plan until October 15, 2008.

Alternative Method

To avoid the process above for identifying specified employees, an NQDC plan may provide for an alternative method to identify specified employees. The final Sec. 409A regulations do not specify any alternative methods. Thus, it is the employer’s responsibility to develop such a method. However, Regs. Sec. 1.409A-1(i)(5) provides certain conditions that the alternative method must meet. The alternative method must be reasonably designed to include all specified employees, and it must be an objectively determinable standard providing no direct or indirect election to any employee regarding its application. In addition, the alternative method must result in the six-month delay being applied to all employees or, if the method does not result in all employees being subject to the six-month delay, the method must result in no more than 200 employees being subject to the six-month delay. Based on these guidelines, an employer would choose to treat all employees as specified employees. While such an approach has the disadvantage of imposing the six-month distribution delay on all employees, it has the advantage of avoiding the complex process of identifying specified employees.

Impact of Corporate Transactions on the Identification of Specified Employees

Certain corporate transactions may have an impact on how an employer determines which employees are specified employees. These transactions in clude mergers and acquisitions of public and private companies, spinoffs, public offerings, and other corporate transactions that result in the employer’s stock being publicly traded. The final regulations address the impact of these transactions on the identification of specified employees. A discussion of these rules is beyond the scope of this item.

Conclusion

The six-month delay rule applies only to a public corporation’s NQDC plans that provide for a distribution on separation from service. The process of identifying specified employees can be complex. The above steps will help employers identify their specified em ployees. The correct application of these steps is of paramount importance: If the rules are not followed correctly so that distributions on separation from service are delayed for specified employees, the specified employees will be subject to significant tax penalties.


EditorNotes

Greg A. Fairbanks, J.D., LL.M., works for Grant Thornton LLPWashington, DC

Unless otherwise indicated, contributors are members of or associated with Grant Thornton LLP.

If you would like additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or greg.fairbanks@gt.com.

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