Employers that sponsor nonqualified deferred compensation plans are no doubt aware of the strict requirements in providing these plans. Failure to adhere to these requirements can lead to penalties as well as tax consequences for both the employer and the participating employee. In light of the unprecedented business and market conditions as well as employee needs that have arisen as the result of the COVID-19 pandemic, employers would be wise to consider any actions taken in the current environment with their nonqualified plans to ensure compliance with the strict requirements of IRC § 409A.
Unintentional 409A arrangement
The COVID-19 pandemic has caused many employers to impose temporary wage reductions for their employees. Employers that promise to make up for those reductions in the future may unintentionally create a nonqualified deferred compensation arrangement subject to 409A. Factors affecting whether such an arrangement is subject to 409A include:
- Whether the promise of a future payment is subject to an employee’s continuous employment;
- The exact timing of the future payment; and
- Whether the employee participates in a deferred compensation plan maintained by the employer.
It is a requirement under 409A that an election to defer salary under a nonqualified plan be made prior to the start of the service year. Generally, there can be no mid-year change to an election. The one exception is if the employee experiences an “unforeseeable emergency,” defined as:
- Severe financial hardship resulting from an illness or accident affecting the employee or the employee’s spouse, dependent, or beneficiary;
- Casualty loss to an employee’s property; or
- Events beyond the employee’s control that cause similar extraordinary and unforeseeable circumstances.
Depending upon how an employee is impacted, the COVID-19 pandemic may or may not be classified as an unforeseeable emergency. Employers should not assume that the tax-qualified rules under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) automatically apply to nonqualified plans, including the power to cease deferrals. In addition, employers should bear in mind that when a deferral election is cancelled due to an unforeseeable emergency, the cancellation must apply for the entire year.
With limited exceptions, the timing of nonqualified deferred compensation payments under 409A cannot be accelerated from the original scheduled payment date. An unforeseeable emergency qualifies as one of the exceptions that would permit early payment of nonqualified deferred compensation. However, the emergency cannot be relieved through:
- Reimbursement or compensation from insurance or other sources;
- Liquidating the employee’s assets; or
- Ceasing deferrals under the plan.
Again, employers should not assume that the tax-qualified rules under the CARES Act automatically apply to the early payment of nonqualified deferred compensation. The employee must have suffered an unforeseeable emergency to qualify.
Payments triggered by a separation from service
Most nonqualified plans stipulate payment upon a separation from service. Layoffs, leaves, furloughs, or reductions in hours may not qualify as a separation from service. Under 409A, an employment relationship remains intact if:
- A leave of absence is less than six months or, if it is longer, the employee retains his or her right to reemployment under a contract or applicable statute; or
- There is a reasonable expectation that the employee will return to work following leave.
Determining what constitutes a separation from service depends on facts and circumstances that show both employer and employee reasonably believed that the employee’s services would end on a certain date or that any services the employee would perform after that date would be permanently decreased to 20 percent or less of their average level of services over the past 36 months. Therefore, a furlough would typically not be considered a separation of service that would trigger a nonqualified plan payment – nor would a termination of employment (in lieu of a furlough) in which both employer and employee expect that the employee will be rehired.
Deferring payment upon separation from service
A change in the timing of payment is prohibited under 409A unless the employee’s election to delay payment will not take place until at least 12 months after the change date. In addition, payment must be delayed by at least five years from the date on which the payment otherwise would have been made. Therefore, an employee that has separated from service cannot further defer payment in hopes of receiving a bigger payment due to improved market conditions. There are additional requirements for public companies, including a six-month delay in making payments to certain employees separated from service.
Temporarily delaying payment
The COVID-19 pandemic has put an enormous strain on the financial resources of many employers, and 409A does provide some flexibility to temporarily delay payment with one important caveat: A delay is only possible if making the payment as specified in the plan would jeopardize the ability of the employer to continue as a going concern.
If a company’s financial need rises to that level, payment may be delayed until the first taxable (to the employee) year in which making the payment will not have such effect.
Hall Benefits Law helps organizations set up the benefits plans that are right for their members, put processes in place to ensure regulatory compliance, and keep those benefit plans updated based on changes in the law. To learn more about the services we offer, call 678-439-6236 today.