• Section 409A Subsequent Changes in Elections -- Installment No. 8
  • June 15, 2007
  • Law Firm: McGuireWoods LLP - Richmond Office
  • See the previous installments of our Section 409A commentary (1, 2, 3, 4, 5, 6 and 7).

    The seventh installment of this series dealt with initial elections to defer compensation and initial elections as to the time and form of payment of deferred compensation. This installment covers Section 409A’s specific requirements concerning subsequent changes in those initial elections.

    Changes to Deferral Elections

    An election to defer compensation must be irrevocable before the beginning of the taxable year in which the services connected with the compensation are to be performed. That will generally be December 31 of the preceding year. If a deferral election provides that the election remains in effect from year to year until modified, the election should provide that it becomes irrevocable as of December 31 for compensation earned during the next year. Any modification of the election could not take effect until the year that begins after the year in which the modification is made.

    Example: Employee elects to defer 5% of her annual bonus under an elective deferral feature in her employer’s short-term incentive plan. The election is made in December 2007 and is to remain in effect until Employee changes it. On December 31, 2007, the election becomes irrevocable for the bonus which she earns for services performed in 2008. If Employee increases or decreases the deferral percentage with a new election during 2008, that change cannot take effect until January 1, 2009.

    Changes to Distribution Elections

    An initial distribution election as to the time or form in which benefits will be paid generally must be made when the deferral election becomes effective. That initial distribution election may later be changed (called a “subsequent election”) if the plan requires that:

    • No subsequent election may take effect until at least 12 months after the date on which the subsequent election is made.
       
    • For an election related to a payment not on account of disability, death or unforeseeable emergency, the payment must be deferred for an additional period of not less than five years from the date the payment would otherwise have been paid.
       
    • For an election related to a payment at a specified time or pursuant to a fixed schedule, the election may not be made less than 12 months prior to the date the payment is scheduled to be paid.

    In the case of a life annuity or installment payments treated as a single payment, the five-year delay and 12-month advance election requirements apply from the date the first amount was scheduled to be paid.

    A change that does not comply with the subsequent deferral election rules may result in either an impermissible acceleration of a payment or a noncompliant deferral of compensation, either of which would trigger adverse tax consequences under Section 409A.

    The rules on subsequent deferral elections apply both to unilateral elections by an employee, unilateral changes by the employer and to changes that are agreed to on a bilateral basis by both the employer and the employee.

    Five-year deferral

    As noted above, Section 409A provides that subsequent distribution election changes generally must delay the employee’s receipt of the payment by at least five years. This requirement does not apply to any change that is related to payment on account of death, disability or unforeseeable emergency. Accordingly, each other change to the initial distribution election pushes the payment date back another five years.

    Example: Employee’s employment contract pays deferred compensation on a specified date, December 31, 2012. In 2008, the parties amend the agreement to provide that payment will be made on December 31, 2017, and to add a provision that will allow her to access a portion of her deferred compensation in the event of an unforeseeable emergency. This change does not violate the subsequent election change rules because the change is made at least 12 months before the payment was first scheduled to be paid and the payment date is delayed for at least five years. Furthermore, adding the unforeseeable emergency is not subject to the five-year payment delay rule.

    Meaning of “Payments”

    The regulations define “payment” as each separately identified amount (by means of an objective determination) to which a service provider is entitled to payment of under a plan on a determinable date. A life annuity is treated as the entitlement to a single payment. A series of installment payments that are not a life annuity are treated as the entitlement to a single payment, unless the plan provides at all times that the right is to a series of separate payments. These rules are significant because they determine the matter in which the 12-month advance election and five-year delay requirements are to be applied.

    Example: Employee participates in an arrangement that pays deferred compensation in installments commencing on a specified date. The arrangement also specifically provides that the installment payments are treated as the right to a series of separate payments. Employee has elected to receive his deferred compensation in five equal annual installment payments, commencing January 1, 2015. Employee later decides to postpone retirement until 2017 and therefore wants to postpone receipt of his deferred compensation until 2017. Because the plan provides that each installment payment will be treated as a separate payment, Employee may defer the payments that would otherwise be due in 2015 and 2016 until 2021 and 2022, respectively, if all other elements of the subsequent election rules are met. The payments scheduled for 2017-2020 would not be changed. If the plan did not provide that each installment would be treated as separate payments, the five-year deferral rule would require Employee to postpone the entire series of installments by at least five years so that the entire series of installment payments could not begin to be paid until 2020 at the earliest, and Employee would not have the flexibility to receive payments coincident with his new retirement date.

    Life annuities

    Many plans allow an employee to choose between various types of life annuities at any time before the first annuity payment is made. Generally, this choice does not violate the election requirements so long as the life annuities are actuarially equivalent. If they are actuarially equivalent, two life annuities are considered a single form of payment.

    An annuity is treated as a life annuity under this rule even if it contains a term certain feature, pop-up provision, cash refund feature, Social Security or Railroad Retirement leveling features, or features applying a permissible cost of living index. In addition, the regulations treat a subsidized joint and survivor annuity as actuarially equivalent to a single life annuity if neither the annual lifetime benefit nor the annual survivor benefit under the subsidized joint and survivor annuity is greater than the annual lifetime benefit under the single life annuity.

    The actuarial assumptions used to evaluate the annuities must be reasonable. When determining whether two annuities are actuarially equivalent, the same assumptions must be used to value each annuity. The assumptions used can vary from year to year and can be different from those used in an employer’s qualified retirement plan.

    Practice Tip: Nonqualified deferred compensation plans that offer annuities, such as SERPs, need to be carefully examined to determine whether they meet the special requirements that allow for elections among different annuity forms. For example, the plan’s prescribed interest rate and mortality assumptions for determining actuarial equivalence should be reviewed to determine whether they are reasonable. In addition, any special features in the various annuity forms should be evaluated to confirm that they satisfy the requirements of Section 409A.

    Multiple Payment Events

    If a plan permits a payment upon each of a number of potential permissible payment events, such as the earlier of a fixed date or separation from service, the regulations provide that the subsequent election requirements must be applied separately to each payment event.

    Example: A plan provides for payments at the earlier of the employee’s separation from service or attainment of age 60. The employee initially elects to receive payments in both cases as installments over 10 years. The employee later changes the payment election for separation from service to a lump sum. The lump sum payment election will be given effect for a separation from service but does not have to be applied to distribution made on attainment of age 60. However, the lump sum could not be paid until five years after the separation from service, and the employee’s election change could not be given effect for at least 12 months. If the employee separates from service less than one year after requesting the lump sum form of payment, the election change must be ignored and payment must be made in installments.

    Addition or deletion of payment events

    Generally, the final regulations forbid the addition or deletion of payment events after the initial deferral election deadline. However, death, disability, or unforeseen emergency can be added as payment events, unless the result of the change is that the payment can be made at a later date. The Internal Revenue Service has indicated that those three additions will be considered permissible, even though they could result in the acceleration of a payment, because they are not likely to result in abuse.

    Example: Employee and his employer enter into an individual deferred compensation agreement on January 1, 2008. The agreement requires by its terms that all deferred compensation is to be paid on July 1, 2010. On January 1, 2009, the parties amend the agreement to allow payment upon the later of July 1, 2010 or Employee’s death. This change violates the election requirements because the payment was not pushed back at least 5 years from 2010. The change would have complied with Section 409A if it had allowed payment on the earlier of July 1, 2010 or Employee’s death.

    Domestic relations orders

    The final regulations contain an exception to Section 409A’s subsequent election requirements for domestic relations orders. However, this exception only extends to the elections by the alternate payee and does not apply to any subsequent election by the employee. Thus, a domestic relations order will not violate Section 409A if it gives the alternate payee discretion to elect the time or form of payment of deferred compensation so long as the domestic relations order does not alter the time or form of payment of deferred compensation with respect to the employee.

    Permissible delays in payments

    In limited circumstances, payment may be delayed beyond the designated payment date without having to comply with the subsequent election rules, if the employer delays all payments to similarly situated employees on a reasonably consistent basis. Delays do not violate the subsequent election requirements to the extent the delay is effected to avoid either a violation of Internal Revenue Code Section 162(m) or federal securities law.

    Additionally, certain “transaction-based compensation” that is paid as a result of certain types of Section 409A change in control events will comply with the subsequent election rules if it is paid on the same schedule and under the same terms and conditions that apply to payments to shareholders generally with respect to those change in control events. “Transaction-based compensation” includes compensation related to a change in the ownership of a corporation, or a change in the ownership of a substantial portion of a corporation’s assets, if payment of the compensation: (i) occurs because an employer purchases its stock held by the employee, (ii) occurs because the employer or a third party purchases a stock right held by an employee, or (iii) is calculated by reference to the value of the employer’s stock.