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Understanding Non-qualified Deferred Compensation Plans And Compliance Under Section 409A Regulations
On April 10, 2007, final regulations on nonqualified deferred compensation plans (“NQDC plan”), defined under Internal Revenue Code Section 409A, were issued. There remains a great deal of confusion regarding implementation of these plans and issues continue to be topics of discussion among members of the American Bar Association and IRS officials at the highest levels. The purpose of this article is to raise the awareness of physician groups that have adopted such plans and those who are considering such plans as a component of physician compensation packages.
Why Adopt a Plan?
In an effort to attract and retain the most qualified physicians, medical groups frequently focus on a variety of ways to increase offers of income either through higher salaries, bonuses, or a combination of incentives. Physicians, however, are not only focused on current income but on the accumulation of retirement income under favorable taxation rules. The NQDC plan is different from other deferral-type of benefit plans such as qualified employer plans (e.g. 401(k)). For instance, participants in the NQDC plan may be limited to a group of highly compensated employees, such as physicians, without including other employees in the plan. Any plan adopted by an employer must be in writing and include the key provisions discussed below.
Plans Subject to Section 409A
A NQDC plan is any agreement, method, program or other arrangement that provides for deferred compensation. The final regulations make clear that Section 409A potentially applies to any payment to which a service provider has a legally binding right that may be received in a future year. It is likely, for instance, that Section 409A would apply to salary and bonus deferrals, severance payments, employment agreements with termination payments, certain equity arrangements and certain incentive compensation plans. Section 409A is very broad and is important that physician groups understand their plans and have them reviewed by experienced professionals to determine whether they comply with the regulation.
With heightened scrutiny by the IRS, compliance with the regulations has become more important than ever. Failure to comply with Section 409A can have the result of making all amounts deferred under the NQDC plan includable in the gross income of the participants, even if all accounts are not actually paid to the participant, unless such amounts are subject to a substantial risk of forfeiture. Additionally, such deferred amounts are subject to an additional 20 percent federal income tax, interest and penalties. Certain states have also adopted similar provisions in their statutes. The consequences for a non-compliant NQDC plan can potentially be very costly.
Key Provisions of the NQDC Plan
- Eligibility: The NQDC plan allows the organization to be selective in its eligibility criteria. Section 409A does not require that every employee be eligible to participate in the plan. In addition, the plan documents should enable the Board of Directors to determine eligibility and when a participant is no longer eligible.
- Vesting: A promised payment of deferred compensation is not vested under Section 409A until a substantial risk of forfeiture no longer exists, or if a person’s rights to the deferred amounts are conditioned upon the participant’s provision of substantial services to the organization. Careful drafting of the vesting and substantial risk of forfeiture provisions is necessary to avoid the severe penalties the IRS will impose if, upon audit, it is determined that the right to payment was not conditional.
- Events of Distribution: The NQDC plan is in compliance with Section 409A if distributions to participants are permitted in only the following events:
- Separation of service, including retirement(there will be a waiting period for key employees of public companies);
- Specified time or in accordance with a fixed schedule;
- Change of ownership or control; and
- Unforeseeable emergency.
The employer is not required to make distributions in all of these permissible events and can, for instance, limit events of distribution to separation from service, death and disability.
It is very important that the drafting attorney set forth a plan for payment of deferred compensation. Changes to the timing or form of payment may be made; however, implementation of the changes may be delayed, and will not be effective for the participant who has begun to receive the deferred compensation.
- Calculation of the Deferred Compensation Amount: The NQDC plan should be clear on how the deferred compensation amount is calculated to avoid disputes. The employer is free to determine a reasonable amount and criteria upon which to base that determination. The net amount of deferred compensation should take into account taxes owed by the employer, any amounts owed to the employer by the participant, any salary continuation payments that have taken place, accounts receivable, costs of collection and any other factors that might either add to or reduce the amount of the deferred compensation.
- Claims Procedure and Dispute Resolution. In addition to the key components of a NQDC plan, it is very important that both the employer and the participant have a clear road map to follow when claims are made. Participants, or their survivors, should know the steps they must follow to receive payment and how long it will take to receive the payments. In addition, a well-drafted plan will provide for a mechanism by which the employer and the participant can settle disputes without the need to engage in expensive litigation.
- Termination of the Plan: Absent from the list of permissible distribution events is the termination of the plan in its entirety. Section 409A provides limited options for terminating a plan as follows:
- Termination and liquidation of a plan within 12 months of a corporate dissolution, or with the approval of a bankruptcy court;
- Termination and liquidation of a plan following a change in control event (as defined by Section 409A); and
- Termination that Satisfies certain criteria, such as the requirement that termination of the plan does not occur due to a downturn in the financial health of the organization; the employer terminates all plans under the plan aggregation rules; no payments are made within 12 months of termination and all payments are made within 24 months of termination, and; the employer does not adopt another plan of the same type within 3 years of the termination.
The termination and liquidation rules are complex and no plan should be terminated without the advice of an experience professional.
Coordination with Other Employment Documents
Employers must be mindful that when drafting the NQDC plan, special care must be taken to coordinate the plan documentation with other employment agreements that may either exist or will come into existence. The terms of an employment agreement, for instance will generally address events of termination and the term “disability”, as a cause for termination is likely to differ from the term as defined by the IRS for 409A purposes. To avoid an impermissible accelerated distribution, it is important that all employment documents, including a general employee manual should be reviewed with an eye to the language in the NQDC plan.
Employers who have a NQDC plan in place, or who are contemplating such a deferred compensation arrangement, are well-advised to seek professional advice for review of their plan for Section 409A compliance, or preparation of a plan that meets the needs of the organization and complies with IRS rules and regulations.
This article was originally prepared for McKesson Corporation, Revenue Management Solutions.