Editor: Greg A. Fairbanks, J.D., LL.M.
Now that the transition relief under Sec. 409A has expired and the Sec. 409A final regulations have gone into effect, nonqualified deferred compensation must comply with a vast set of new rules for nonqualified plans. This may include the subsequent deferral election rules, which could bring unpleasant surprises for employers and employees. When the transition relief was in effect, employers and employees could change the time and form of payment under deferred compensation plans without complying with very restrictive rules. Now a change to the time and form of payment may be made only if the agreement allows for the change and the subsequent deferral election rules are followed.
Subsequent Deferral Election Rules in GeneralSubsequent deferral elections are changes made to the time and form of payment under a deferred compensation plan after the initial election. Employers often want to allow such changes to provide flexible payment alternatives. The new rules for nonqualified deferred compensation under Sec. 409A allow subsequent deferral elections, but the elections will have to meet rigid requirements under Regs. Sec. 1.409A-2(b).
A change in the time and form of payment would include, for example:
- A change from a lump-sum payment to an annuity payment;
- A change from a life annuity to a lumpsum payment;
- A change in the length or commencement date of an installment payment;
- The addition of a new payment trigger; and
- A change in the payment date of a lump-sum payment. The general rule under Regs. Sec. 1.409A-2(b)(1) provides that:
- The subsequent deferral election must be made at least 12 months before the originally scheduled payment date;
- The subsequent deferral election may not go into effect until at least 12 months after the election is made; and
- The new payment date must be at least five years after the originally scheduled payment date.
The five-year delay requirement does not apply if the employer or employee elects to add a payment trigger for death, disability, or an unforeseeable emergency. However, if made part of a subsequent deferral election, these payment dates may not be effective until at least 12 months after the election is made (Regs. Sec. 1.409A-2(a)(5)).
Installment PaymentsWhen the employee is initially scheduled to receive a series of installment payments, those payments are generally treated as one payment (Regs. Sec. 1.409A-2(b)(2)(iii)). Therefore, the subsequent election must be made at least one year before the first installment payment date, and all the installment payments must be deferred for at least an additional five years (Regs. Sec. 1.409A-2(b)(1)).
A plan may explicitly state from the plan's inception that each installment payment, other than an installment payment under a life annuity, is treated as a separate payment. In this case, the employer or employee could then subsequently elect to further defer a portion of the installment payments, rather than all of them. For example, consider a deferred compensation plan that provides for five equal annual installments beginning on the employee's normal retirement age of 60. The plan designates each installment payment as a separate payment. If the payments are made by age 59, the employee may elect to receive the first three installment payments annually beginning at age 65 and still receive the fourth and fifth installment payments at ages 63 and 64, respectively.
Special consideration must be given if the employer or employee wishes to change the form of payment from installments to a lump-sum payment, if the plan provides that each installment is treated as a separate payment. The lump-sum payment date must be at least five years after the final installment payment date. For example, consider a plan that provides for the payment of five equal annual amounts, each of which is designated as a separate payment. The first installment is scheduled for January 1, 2011, and the last is scheduled for January 1, 2015. The employee wishes to receive the payment in a lump sum. Provided the election is made on or before December 31, 2009, the earliest the employee may receive the lump-sum payment is January 1, 2020, which is five years after the last scheduled installment payment under the original election. If the plan did not provide that each installment payment was treated as a separate payment, the lump-sum payment could be made as early as January 1, 2016 (i.e., five years after the initial installment payment) (Regs. Sec. 1.409A-2(b)(9), Example (20)).
Life AnnuitiesSpecial rules apply to life annuities (Regs. Sec. 1.409A-2(b)(2)(ii)). Unlike installment payments, a plan may not provide that each individual annuity payment is a single payment. In all cases, the life annuity is treated as a single payment. Accordingly, a subsequent deferral election must be made at least 12 months prior to the first life annuity payment and must delay the payments at least five years from the originally scheduled commencement date of the life annuity. An employer or employee may change the form of the annuity payment from one life annuity to another life annuity before any annuity payments have been made without being subject to the subsequent deferral elections. The new life annuity must commence on the same date as the original annuity, and the life annuities must be actuarially equivalent. The regulations provide certain rules that apply when determining if the life annuities are actuarially equivalent.
Short-Term DeferralsThe subsequent deferral election rules may apply if an employer or employee elects to defer compensation that would otherwise be a short-term deferral under Regs. Sec. 1.409A-1(b)(4). A short-term deferral is a plan under which the payment will be made to the employee within 2½ months after the end of the tax year in which the employee's right to the compensation vests. Short-term deferrals are exempt from Sec. 409A. The employer or employee may elect to defer the shortterm deferral as long as the election meets the subsequent deferral election rules. This election would cause the deferred compensation to be subject to Sec. 409A. For this purpose, the date the compensation vests is treated as the originally scheduled payment date.
Consider a bonus plan entered into on January 1, 2010. Under the terms of the bonus, the employee vests on December 31, 2011, and the payment would otherwise be made on March 1, 2012. This would qualify as a short-term deferral, thus exempting the bonus from Sec. 409A. The employee decides in 2010 to receive the payment in a year beyond 2012. Provided that the election to defer is made before December 31, 2010, the employee may elect to receive the payment on or after December 31, 2016, which is five years after the date the employee vests in the bonus payment.
Multiple Payment TriggersIf multiple payment triggers are initially included in a plan, the subsequent deferral election rules apply separately to each payment trigger. For example, a deferred compensation plan could provide for a lump-sum payment upon the earlier of age 60 or the employee's separation from service. In this case, the employer or employee could change the age trigger to 65 or a later date without changing the payment date with respect to separation from service. As long as the subsequent deferral election was made prior to the employee's reaching age 59, the plan would not violate Sec. 409A.
Adding a trigger in a subsequent election, however, will affect other triggers. If a payment trigger is added, the general restrictions on subsequent deferral elections will apply to all the original payment triggers, and the payment must be made upon the latest of the payment triggers. For example, consider a plan that originally provided for a lump-sum payment upon separation from service. If the employee subsequently elects to add a specified age as a payment trigger, the plan must provide that the separation from service trigger is pushed back five years. Thus, the payment will be made at the later of five years after a separation from service or the specified age.
ConclusionThe subsequent deferral election rules under Sec. 409A can result in unexpected consequences if employers and employees are not prepared. For example, adding a new payment trigger to a plan after the initial election may result in an unanticipated delay in payment. To avoid this, employers and employees may wish to consider including all the permissible payment triggers (such as death, disability, separation from service, change in control, specified date, and unforeseeable emergency) in the initial deferral election. Employers and employees need to be aware of the rules so they do not encounter any unpleasant surprises now that the Sec. 409A final regulations are in effect.
Greg A. Fairbanks, J.D., LL.M., is a tax manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.