In a nonqualified plan, an employee defers the receipt of a portion of compensation earned in one year until the future. In exchange, the employee gets to defer taxation on
If an employee defers compensation and invests in a nonqualified plan, one of the first questions they are likely to ask is: when do I get my money? Unfortunately, as with most legal questions, it depends on the law and the specific rules of your plan.
The first issue to tackle is to determine the law related to distribution events.
Internal Revenue Code Section 409A
Internal Revenue Code Section 409A governs the “Inclusion in gross income of deferred compensation under nonqualified deferred compensation plans.” If a nonqualified plan is subject to IRC 409A, the plan must operate within the requirements of Section 409A. If not, the employee’s gross income will include the deferred compensation when it is first deferred. This would largely defeat the purpose of the plan. Therefore, it is critical that a plan’s legal document tracks these rules.
If a plan is not subject to Section 409A, the plan may have more liberal distribution events. Regardless, most plans follow common distribution events. This is done to achieve the goals of instituting the plan and to
Section 409A Distribution Rules
IRC Section 409A limits the times at which distributions may be made from nonqualified plans to the following events:
1. “Separation from service as defined by the Secretary”
An employee “separates from service” from an employer if the employee dies, retires, or otherwise has a termination of employment. There are also rules as it relates to defining the terms retirement and termination of employment.
Key Employees of publicly traded companies also have additional rules. Key Employees are officers making more than $175,000 in 2018 (indexed for inflation), 5 percent or greater owners, and 1 percent or greater owners making more than $150,000 (not indexed for inflation).
For this purpose, a participant is disabled if he or she (i) is unable to engage in any substantial gainful activity by reason of any medically determined physical or mental impairment that can be expected to result in death or can be expected to last for a continuous period of not less than 12 months, or (ii) is, by reason of any medically determined physical or mental impairment that can be expected to result in death or can be expected to last for a continuous period of not less than 12 months, receiving income replacement benefits for a period of not less than three months under an accident or health policy covering employees of the employer.
The one event that likely doesn’t need further explanation.
4. “A specified time specified under the plan at the date of the deferral of such compensation”
The legislative history and legal rulings on this issue make clear that the legislature intended an arbitrary date in the future (i.e. 5 years) and that distributions may not be based upon the occurrence of an event (i.e. my son’s 18th birthday).
In practice, the “specified time” referenced by this statute is a time period that alligns with the goals of the plan.
5. “A change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation”
In general, the term “control” means the holding of at least 50 percent (by vote or value) of the stock of the corporation. Treasury Regulations provide further technical guidance for determining if a change in control has occurred.
6. “The occurrence of an unforeseeable emergency”
In general, the term “unforeseeable emergency” means a severe financial hardship to the participant resulting from an illness or accident of the participant, the participant’s spouse, or a dependent (as defined in section 152(a)) of the participant, loss of the participant’s property due to casualty, or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant.
The distribution amount may not exceed the amount necessary to satisfy the emergency and pay taxes, after taking into account the extent to which the hardship is or may be relieved through reimbursement or compensation by insurance or by the liquidation of the participant assets.
Plans Not Subject to Code Section 409A
If for some reason a plan is not subject to the requirements of Code Section 409A, the following are common distribution events that keep in line with the goals of implementing a nonqualified plan:
- Involuntary termination of employment
- Hardship (as strictly defined for nonqualified plan purposes)
- Constructive discharge
- Change in control of the plan sponsor
- Voluntary termination of employment at any time
- Voluntary termination after a certain period of years of service or age
Vesting is a separate issue from distribution. Again, employers typically establish vesting schedules that serve the goals of the nonqualified plan. An employer may design the plan to vest largely based on what employees actually value as an incentive. Similarly, an employer might set performance goals. Vesting rules also allow an employer to add noncompete clauses for a specific period or geographic location after termination. Typically, most vesting schedules run from two to six years.
The plan’s legal document must follow the rules Code Section 409A or there are significant penalties. That being said, in practice, plan design typically follows the goals of the company designing the plan.
If the goal is only to offer key employees additional tax-deferred savings opportunities, employers are likely to design a plan that pays deferred amounts soon after the vesting date. The opposite is obviously designing a plan to pay deferred amounts only at the earliest of death, disability or separation from service with the company.
There is also the opportunity to use plans as mid-term or long-term incentives to retain and reward the employee without making the employee wait until separation from service. Typically, to achieve this goal, nonqualified plans might have distribution events after five or seven years.