Modifying or terminating nonqualified deferred compensation plans.

• Author: Altieri, Mark P.

Most tax practitioners are aware of the general provisions of Sec. 409A as they are applied to nonqualified deferred compensation arrangements (NQDC plans).(1) With the downturn in the economy and increasing rates of bankruptcy and insolvency, both employers and employees have given second thought to the wisdom and future viability of existing NQDC plans. This article reminds readers of Sec. 409A's general parameters and provides specific guidance on modifying or terminating existing NQDC plans.

Comprehending the effect of Sec. 409A is made difficult by the required multistep, three-pronged analysis. The first step is to determine whether an arrangement to defer compensation is an NQDC plan as defined under Sec. 409A. If so, the second prong of the test determines whether NQDC plan benefits are subject. to a substantial risk of forfeiture. When the arrangement is no longer subject to a substantial risk of forfeiture, the third inquiry is whether the NQDC plan inherently suffers from a "plan failure."

If these three events occur, Sec. 409A imposes income acceleration and penalties: Amounts deferred under the NQDC plan for current and preceding tax years are includible in gross income and are subject to an additional 20% penalty. Interest is also added at the underpayment rate plus 1% from the year that such amounts were deferred. (2)

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The rude awakening for tax advisers when Sec. 409A was enacted in 2004 was that virtually any contractual deferral of compensation other than under a qualified retirement plan or a vacation, sick leave, compensatory time, disability pay, or death benefit plan was potentially subject to the new law. (3) Thus, not only were traditional nonqualified deferred compensation arrangements subject to Sec. 409A scrutiny, but employment agreements providing for a deferred bonus, severance pay, and/or equity compensation were potentially subject to it as well. The regulations issued under Sec. 409A (4) specifically noted the potential application of the new law regardless of whether the arrangement constituted a pension plan under the Employee Retirement Income Security Act of 1974 (ERISA) or an individual contract to defer compensation income. (5)

The General Parameters of Sec. 409A

The First Prong

All that is required for a deferral arrangement to constitute an NQDC plan is that the service provider (typically a common-law employee) (6) has a legally binding right to deferred compensation to be paid in a year after that in which it was earned. If the employer may unilaterally reduce or eliminate that right to compensation, the employee has no legally binding right to it. If an employer would be unlikely to reduce or eliminate the deferred compensation, the employee would be deemed to have a legally binding right to it. (7)

This is the case even if the deferred compensation is subject to a substantial risk of forfeiture. For example, an NQDC plan would exist if a newly hired professional employee and the employer enter into an agreement to pay a deferred compensation benefit 10 years in the future, but only if the employee is still a full-time employee at that time. Even though the right to the deferred payments would be subject to a substantial risk of forfeiture for 10 years, the deferred compensation plan is an NQDC plan from its inception.

Apart from the exempted deferred compensation plans noted in footnote 3, there are a few other deferrals that are exempt from Sec. 409A. Most common is the short-term deferral exception. If deferred compensation is paid out in full within 2 1/2 months after the year of vesting, the arrangement is deemed never to have constituted an NQDC plan. (8) This exception is frequently used to avoid Sec. 409A NQDC plan status for annual nondiscretionary bonus arrangements based on a productivity factor, as well as long-term deferrals where the payout occurs in a lump sum shortly after the deferred benefit vests. Also excluded from Sec. 409A and NQDC plan characterization are limited categories of separation pay arrangements. (9) Moreover, if reasonable valuation methodologies are employed, nonquali-fied stock option and stock appreciation right arrangements will avoid being characterized as NQDC plans. (10)

In general, NQDC plans of the same class are aggregated and treated as one plan for testing purposes under Sec. 409A. (11) In other words, so-called account balance plans (defined contribution plans) are generally aggregated and treated as one plan. Similarly, all non-account balances (defined benefit plans) are aggregated as well as other possible categories of plans such as nonexempt equity-based arrangements and severance-pay arrangements noted above. A nonexempted separation-pay plan may, therefore, provide a different amount and form of benefit to a given employee from that payable to the same employee from a regular account-balance plan structured for benefit payments on separation from service to the same employer.

The Second Prong

If a deferral arrangement constitutes an NQDC plan, the next inquiry is whether it is contractually subject to a substantial risk of forfeiture, which is similar to the definition in Sec. 83(c)(1) for transfers of property in connection with the performance of services. (12) A substantial risk of forfeiture requires that the deferred compensation be conditional on the future performance of substantial services by the employee.

Moreover, the substantial...