The IRS’s guidance on the Coronavirus Aid, Relief and Economic Security (CARES) Act and COVID-19 has largely been focused on tax qualified plans and individual retirement accounts (IRAs), but sponsors of nonqualified deferred compensation (NQDC) plans need to deal with some of the same issues as qualified plan sponsors. These include understanding the current financial needs of participants, the impact of furloughs and leaves, and their own financial difficulties.
In the absence of COVID-19 guidance, plan sponsors need to navigate the complexities of regulations under Internal Revenue Code Section 409A to determine what is permissible. Here are some important issues.
Canceling Deferral Elections
Participants in financial difficulty may want to suspend their deferral elections. However, deferral elections to nonqualified plans are generally irrevocable during the year.
Section 409A provides some exceptions for canceling an option in cases of an unforeseeable emergency or the receipt of a hardship distribution from a 401(k) plan, but the application depends on specific facts and circumstances.
The IRS issued helpful relief in the form of a clear rule in recent Notice 2020-50. Under this relief, all participants who have received coronavirus-related distributions (CRDs) may cancel their deferred compensation elections for the rest of 2020. This relief permits complete cancellation of elections but not changes to elections merely to delay deferrals or reduce the level of elected deferrals. If a deferral election is canceled, new elections may not be effective earlier than 2021.
Has There Been a Separation From Service?
Nonqualified deferred compensation plans must permit distributions only on defined events, and many deferred compensation plans provide for payment when a participant has a separation from service. Factual issues will arise as to whether a distribution will be permitted in the case of furloughs and leaves of absence.
Under the regulations, a furlough or leave of absence usually will not constitute a payment event, as there is a reasonable expectation that the participants will return to work. However, if the leave exceeds six months and the participant has not returned to work, there will be a separation from service on the first date after the end of the six-month period unless the participant has a legal right to re-employment.
Participants with reduced work schedules will not usually qualify to receive a distribution on separation from service. A participant is presumed to have separated from service only if the participant will continue to perform services at a level that is no greater than 20% of the level over the preceding 36-month period. A participant is presumed to be still employed if the level of reduced services is 50% or more of the level over the preceding 36-month period, and it is a facts and circumstances determination if the reduced level of services is between 20% and 50% of the prior level.
Deferred compensation plans may not usually accelerate payments, but, if the plan permits, a distribution of the amount needed to alleviate the hardship may be made to a participant who has an unforeseeable emergency. There must be a severe financial hardship of the participant, the participant’s spouse, beneficiary or dependent, such as hardship resulting from accident, illness, a casualty loss of property or similar extraordinary circumstances beyond the participant’s control. Examples of other qualifying emergencies are the need to pay medical expenses, imminent foreclosure or eviction, and a spouse’s funeral.
These distributions will not be available to everyone who is eligible for a CRD from a qualified plan, as CRDs do not require a proof of hardship. If plans do not permit distributions for an unforeseeable emergency, they may be amended now to add the provision.
Plan sponsors in financial difficulty may want to delay scheduled payments that are coming from corporate assets. There is a “going concern” exception to the payment timing rules permitting a delay in payment if making the deferred compensation payment would jeopardize the employer’s ability to continue as a going concern. The payments are treated as having been timely made if they are paid during the first tax year in which the viability of the company is no longer in jeopardy. This exception applies also to short-term deferrals intended to be exempt from Section 409A. However, there is a lack of guidance on what constitutes financial jeopardy.
Terminating Deferred Compensation Plans
Plan sponsors may be considering terminating their deferred compensation plans in order to pay everyone out. However, there are special restrictions on terminating these plans that may make this option unattractive or unavailable.
Under the general provisions applicable to terminations—where the sponsor is not in dissolution or had a change in control—a difficulty is that the termination can’t be proximate to a downturn in the plan sponsor’s financial health. This requirement may be difficult for many plan sponsors to satisfy during the pandemic. If a plan sponsor can pass this hurdle, participants are not permitted to be paid out for 12 months and must be paid within 24 months. In addition, all plans of the same type must be terminated at the same time. A further restriction is that new plans of the same type may not be adopted for three years following all necessary employer action to terminate and liquidate the plan.
Plan sponsors in financial difficulty might consider freezing nonelective or matching contributions as an alternative to plan termination. It is recommended that counsel be consulted regarding any restrictions on these alternatives, such as requirements for participant consent.
Plan sponsors are also considering whether performance goals in plans will need to be changed and how to address underwater equity awards. If the IRS does not issue further COVID-19 guidance targeted to nonqualified deferred compensation plans, plan sponsors will need to make judgment calls regarding the issues discussed here. Due to the penalties for violating Code Section 409A and the complexity of the regulations, plan sponsors would be well-advised to consult legal counsel before taking action.
Carol Buckmann is a co-founding partner of Cohen & Buckmann P.C. As a highly regarded employee benefits and ERISA [Employee Retirement Income Security Act] attorney, Buckmann deals with the foremost issues in ERISA, including pension plan compliance, fiduciary responsibilities and investment fund formation.
She has 40 years of practice in this area of the law and a depth of experience on complex pension law and fiduciary problems. She regularly shares her thoughts on new developments in the benefits industry on Insights, Cohen & Buckmann’s blog, and writes and speaks on ERISA topics. Buckmann has been recognized by Martindale-Hubbell as an AV Pre-eminent Rated Lawyer, was selected for inclusion in the Best Lawyers in America and was named one of the Super Lawyers in Employee Benefits.This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of Institutional Shareholder Services or its affiliates.
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