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The Key Employee Six-Month Rule and its Application to Public Company Sponsors of NQDC Plans

Aug 4, 2017

Public companies sponsoring non-qualified deferred compensation ,plans are subject to a special rule that requires payments to certain employees (called “specified employees” in IRC 409A) to be delayed for six-months following a separation from service. This summary is intended to assist sponsors in developing administrative procedures for compliance with this special rule. While plan documents typically utilize the term “specified employee” when referring to these individuals, most people know them as “key employees” and refer to the rule as the “key employee six-month delay rule.” This summary will refer to them as “key employees.”

Summary of the Key Employee Six-Month Rule
The Basic Rule
Key employees who receive payments from a non-qualified deferred compensation plan due to separation from service may not receive (or begin receiving) payments for at least six-months after the date of their termination of employment.

Employees Subject to the Rule
“Key employees” for purposes of the rule are the same as those employees who are identified to determine whether a qualified plan is “top heavy.” They are identified in Code Section 416(i) (disregarding sub-section 5 concerning beneficiaries). Essentially, these employees are officers of the company having an annual compensation in excess of a defined amount which is indexed (see below), 5-percent owners, or 1-percent owners having annual compensation in excess of $150,000 (which is not indexed).

Sponsors Subject to the Rule
Only “public companies” are subject to the rule. A public company is a corporation the stock of which is traded on an established securities market.
  • A U.S. subsidiary of a foreign parent with stock trading on a foreign exchange is subject to the six-month rule, even if the subsidiary has no publicly traded stock of its own.
  • Partnerships, trusts, privately held corporations and other non-public, non-corporate entities are not subject to the rule.
Accounts Subject to the Rule
The rule applies only to the 409A portion of a deferred compensation plan; any payments from pre-409A accounts (sometimes called “grandfathered accounts”) should be paid under the terms of the grandfathered plan.
  • The six-month rule potentially applies to a variety of deferred compensation arrangements,including, for example, (i) defined benefit SERPs and (ii) severance arrangements that do not qualify for an exemption from the rules of 409A.
Payments Subject to the Rule
The six-month delay applies only to termination payments. Payments to “key employees” occasioned by other payment events permitted under the Code, such as specified date payments, payments due to death, disability, or unforeseeable emergency, and payments due to a change in control, are not subject to the six-month delay. Note that payments subject to a “double trigger” should be examined closely to determine whether they are, in fact, occasioned by a separation from service. An example is a “change in control” provision that is common in many plans—if a separation from service occurs within a specified period following a change in control then payment is made in a lump sum. Such a payment is occasioned by a separation from service, not the change in control, and thus would be subject to the rule.

Identifying Key Employees
A sponsor wishing to identify individual employees subject to a six-month delay for a given year must first understand the identification process. This begins with an understanding of the “identification date” and the “effective date.”

The Identification Date
An employee is a “key employee” for purposes of the rule if such employee met the requirements of Code Section 416(i) at any time during the 12 month period ending on the identification date. The most frequently utilized identification date (and the default date provided in the final regulations) is December 31 of each year. Thus, for plans using a December 31 identification date, key employee status will be based on the employee’s compensation and ownership interests during the calendar year ending on December 31. Note that a plan may provide for a different identification date, if properly elected and documented.

The Effective Date
This is the date as of which the list of key employees takes effect. Employees who are determined to be key employees on the identification date must incur a six-month delay in payment if they become entitled to receive a distribution due to a separation from service during the twelve-month period beginning on the effective date. The most frequently utilized effective date (and the default date provided in the final regulations) is April 1 of the year immediately following the identification date. For such plans, the 12-month “effective period” is April 1 through March 31. This permits identification processes to occur after the identification date, with ample time to identify “key employees” prior to the beginning of the effective period. However, use of an April 1 effective date does require careful application. For example, an employee who separates from service during January, February, or March would not be subject to the six-month payment delay unless he or she was a key employee on the identification date preceding the most recent identification date. Note that a planmay provide for an earlier effective date that is not more than four months following the key employee identification date if properly elected and documented.

Identification of Key Employees
Officers
Officers of the company are key employees if, during the twelve months ending on the identification date, they had annual compensation in excess of the Code Section 416(i) limit for that year. The limit is indexed for cost of living increases and is determined each
year by the IRS. The limit is $170,000 for 2015.
  • Only employees may be “key employees” (e.g. no independent contractors such as outside directors will qualify).
  • Except for owners defined below, only OFFICERS of the company may be “key employees.” Status as an “officer” of the company depends not simply upon title, but upon actual roles and responsibilities; it typically requires authority over a major division or function of the company.
  • For purposes of the rule, if the employer has more than 50 officers who meet the compensation threshold, only the top 50 by compensation need be included as “key employees.”
  • “Compensation” means compensation as defined in the non-qualified plan for purposes of identifying key employees. If no definition is specified, compensation includes all amounts paid for personal services that are includible in gross income during the identification period.
  • Note that companies who are members of a “controlled group of corporations” need to consider the officers of all companies in the controlled group in determining the top 50. This may mean that none (or few) of the top 50 officers by compensation actually participate in the plan. The key employee determination—particularly in cases involving foreign parent companies—may be difficult. For this reason, the final regulations permit alternative methods of compliance with the key employee six-month delay rule.
    • Identification of a larger group is permissible, provided the alternative is reasonably designed to include all key employees, does not permit direct or indirect elections (discretion) by the company, and either identifies all participants or no more than 200 participants.
    • The regulations also permit a plan design where all participants’ payments that are occasioned by a separation from service are paid no earlier than six-months after the date of termination (see “Planning Considerations”, below).
Owners
An employee who, during the twelvemonth period ending on the identification date, was either (i )a 5% owner of the company or (ii) a 1% owner of the company who earned more than $150,000 is also considered a key employee. Ownership percentages are based on stock owned (i) directly by the participant and (ii) indirectly through family attribution including family trusts. For example, public corporations that are “founder controlled” may have such employees who, although not officers of the company, are subject to the six-month rule.
  • The “family attribution” rules can be complex. Consult legal or tax counsel if you should have any questions as to family ownership of stock.
Send the list of identified employees to Newport Group prior to the start of the effective period each year. Newport Group’s system will flag the accounts of identified key employees and reporting of payments to the identified individuals will be delayed when appropriate. Sponsors may upload their key employee census information to newportgroup.com through the census update feature.

Planning Considerations
Given the potential complexities and annual administration of the key employee list, sponsors may wish to consider establishing simplified procedures for identifying key employees. Alternatively, sponsors
could consider using a uniform payment date for all participants beginning on the first day of the seventh month following a separation from service. A uniform six-month delay potentially benefits the participants
as well, for example, by deferring taxable income to a subsequent year. The downside of adopting alternative procedures is the application of the six-month rule to a broader group of employees than what is required under the Code.

Special Situation: Mergers, Acquisitions, Spin-offs
A merger, acquisition or spinoff that results in a company becoming, or ceasing to be, a public company (or becoming, or ceasing to be, part of a controlled group that includes a public company) are subject to specific transition rules described in final regulations. Consult your legal counsel if transactions of this nature are contemplated.

Conclusion
Sponsors should, on an annual basis, identify and communicate to Newport Group the list of employees subject to the six-month rule, and should adopt formalized procedures for identifying those employees. The six-month rule is an important part of the administration of non-qualified plans subject to 409A. Please consult your legal counsel if you have questions about the application of the rule to your plans.










The information contained in this summary is provided for information purposes only and does not constitute legal or tax advice; readers are encouraged to consult their own legal and tax counsel. This paper is a high-level summary of a complex subject that is intended for Newport Group’s clients and intermediary partners and should not be understood as providing a comprehensive discussion of all issues or requirements under the regulations or as a guide to compliance. This document may not be reproduced or transmitted in any form or by any means without Newport Group’s written permission. For financial professional and plan sponsor use only. Not intended for distribution to the public.








 

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Newport Group, Inc. and its affiliates provide recordkeeping, plan administration, trust and custody, consulting, fiduciary consulting, insurance and brokerage services. Fiduciary consulting services are provided through Newport Group Securities, Inc., an SEC-registered investment adviser and FINRA-registered broker-dealer, and InterServ, LLC, an SEC-registered investment adviser. Newport Group Securities, Inc. and InterServ, LLC are affiliates of Newport Group, Inc. All securities transactions are provided through Newport Group Securities, Inc., in its role as broker-dealer. All fiduciary consulting services are provided through the registered investment adviser. when offering variable insurance products, Newport Group Securities, Inc. acts solely in its capacity as a broker-dealer.
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