Jun 18, 2021
Section 409A of the Internal Revenue Code of 1986, as amended (the “Code”) requires deferred compensation to be paid under written agreements specifying both the time when payments commence and the form of payment. Section 409A prohibits earlier payments under an “anti-acceleration” rule.
The statutory language does not provide an exception to the anti-acceleration rule for plan terminations. The omission was intentional. The Enron hearings revealed that the officer-directors who also were participants in the plan had the power to effectively pay themselves on a discretionary basis without regard to their deferral agreements by terminating the plan.
Treasury regulations issued under Code § 409A carve out narrow exceptions under which plans may be terminated and liquidated. These include:
- termination in connection with a corporate dissolution or reorganization under federal bankruptcy laws;
- termination in connection with a change in control as defined in the § 409A regulations; and
- discretionary terminations under specified conditions that attempt to reduce the conflict of interest between the employer and the executives who participate in the plan.
Liquidation or Bankruptcy Terminations
If there is a corporate dissolution taxed under § 331 of the Code or approved by a bankruptcy court pursuant to 11 U.S.C. § 503(b)(1)(A), the employer may terminate and liquidate the plan within 12 months of the corporate dissolution.
Payment is made and taxed to the participants in the calendar year of plan termination, unless doing so is not administratively practical (such as termination of the plan near the end of the calendar year). If deferrals remain subject to a vesting schedule, the amounts are taxable as they vest if vesting occurs at a later date (this is not common).
Change in Control Terminations
The employer may terminate and liquidate a nonqualified deferred compensation plan in the event of a “change in control event” as defined in the final regulations under § 409A. The conditions for plan termination and liquidation in the event of a change in control include:
- The employer that is primarily liable for the payment of plan benefits immediately after the transaction must adopt an irrevocable resolution to terminate the plan during a period that begins 30 days prior to closing and ends 12 months after closing. The buyer or seller may be “primarily liable”, depending on how the transaction is structured. The sale of a subsidiary, for example, commonly transfers the subsidiary’s liability to the buyer, with the subsidiary as the entity primarily liable. The sale of assets on the other hand could result in retention of primary liabilities by the seller, in which case the seller would be the party authorized to terminate the plan.
- The plan must be liquidated within 12 months after the irrevocable resolution is adopted.
- The termination and liquidation applies only to the portion of the plan that benefits participants affected by the change in control.
- All of the non-qualified plans of a similar type in which the affected employees participate must be terminated as well.
Issues Related to Change in Control Terminations
- Following termination, all normally scheduled payments, including scheduled lump sum payments upon a change in control, must be made as elected prior to final liquidation.
The change in control termination and liquidation rules are an exception to the general rule under § 409A that payments cannot be made earlier than the elected scheduled payment date or event. This means a plan termination payment may accelerate the participants’ scheduled payments, but it cannot extend the payment beyond the scheduled payment date or event.
- Payroll deductions may stop after the termination resolution is adopted.
- Participants scheduled to receive payments under their elections in the year the terminating resolution is adopted must continue to receive their scheduled payments if the plan liquidation date is expected to occur in the next year.
Example: Plan terminates July 1, Year 1 following a change in control on June 30, Year 1. Employer with primary liability adopts an irrevocable resolution to terminate the plan on July 1 and intends to liquidate the plan on March 1, Year 2. Participant P elected to receive all of his accounts within 90 days following a change in control. Participant P must receive his change in control lump sum within 90 days. The employer cannot wait until Year 2 to pay P.
- After the change in control, participants may not re-enroll as “newly eligible” participants under the successor employer’s non-qualified plan unless certain conditions are met.
These conditions include:
All liquidation payments under the terminated plan must be made first; and
- The affected employees must not be eligible to participate under the terminated plan or the successor employer’s plan at the time the final payment is made, or
- Regardless of the final termination payment date, affected participants must not have been eligible to enroll under the terminated plan for 24 months prior to becoming eligible under the successor employer’s plan.
- Post-termination deferral election planning is limited.
It is common for participants to seek some deferral alternative to offset some of the taxable income received from the terminating plan. Making an immediate termination payment followed by enrollment in the successor employer’s plan, as described above, (i) may not be viable because of the conditions that must be met and (ii) even if viable, offsetting deferrals are limited to compensation earned during the remainder of the calendar year, which may be insufficient to provide a meaningful offset.
Under § 409A, the determination of the payment year cannot be made or influenced by the participants. However, for employers that seek to provide some choice to their employees, it may be advisable to continue the current year deferrals as elected and pay the liquidation amounts in the calendar year following the transaction. This may mean delaying the termination resolution until the following calendar year (employer has 12 months after closing to terminate and 12 additional months to pay). This approach may allow employees to obtain a full year’s deferrals under the successor employer’s plan.
- About annual bonuses.
The annual bonus, often payable in Q1 of the calendar year following termination of the plan, may be subject to a deferral election under the terminating plan. Plan termination typically results in a cancellation of the bonus deferral. However, it may be possible for a participant to file a new deferral election after the change in control if the participant in the terminating plan becomes a participant in the successor employer’s plan and the successor employer’s plan permits deferral of performance-based bonus. Assuming the bonus is performance-based as defined in § 409A, and not ascertainable, the bonus election may be filed up to six months before the end of the performance period.
The final regulations also permit the plan sponsor to elect, in its discretion, to terminate and liquidate the plan. The requirements are:
- Financial Health. The irrevocable resolution to terminate and liquidate the plan must not occur “proximate to a downturn in the financial health of the service recipient”. This is apparently a facts and circumstances test. This requirement is a direct result of Congress’s Enron investigation so it would be safe to assume that similar circumstances would preclude a plan termination.
- All Plans of Similar Type Must Terminate. The employer, including its controlled group affiliates, must terminate and liquidate all other nonqualified plans of a similar type. For example, if the plan being terminated is a 401(k)-style elective deferral plan with matching contributions, then all deferred compensation plans offered by the employer and its affiliates that provide for (i) elective deferrals and (ii) company contributions must terminate. This may mean terminating supplemental profit sharing and account-based SERP plans as well, which are all forms of company contribution plans. Formula based plans such as traditional final average pay supplemental defined benefit plans would not be affected by a decision to terminate the account-based plans.
- The terminating resolution should provide for cessation of deferrals under the Plan.
- Liquidation Payments Delayed 12 Months, Completed in 24 Months. No payments in liquidation of the plan can be made within 12 months of the plan’s termination, other than payments that are payable under the normal provisions of the plan, and all payments must be made within 24 months of the plan’s termination.
- No Replacement Plans for Three Years. The controlled group may not adopt a new nonqualified plan of the same type (e.g. of a type that would be aggregated with the terminated plan under the IRC 409A regulations) for at least three years following the date of the plan’s termination.
Issues Related to Discretionary Terminations
- All payments completed from the first anniversary of the termination resolution date to the day before the second anniversary. Payments need not be made in a lump sum, but must be completed during the period. Participants may not elect or otherwise influence the calendar year in which payment is made.
- Grantor (“rabbi”) trust distributions and termination. If the plan is “informally funded” utilizing a rabbi trust, arrangements must be made with the Trustee regarding making distributions from the trust, reimbursing the plan sponsor for distributions to participants (if authorized in the trust agreement or otherwise by the Trustee), and terminating the trust when all benefits under the plan or plans informally funded by the trust have been made.
- Employer-owned life insurance may be used as funding source or re-purposed. If life insurance on plan participants has been utilized as an “informal funding” vehicle (owned by the corporation or a rabbi trust), decisions regarding accessing cash value through policy surrenders or partial surrenders or policy loans need to be made and communicated with insurance providers. There normally are tax and other financial considerations that come into play when deciding whether to access policy cash values.
- Participant communications. Participant communications are vital when terminating a plan. Communication materials explain the suspension of deferrals and future enrollments as well as the form and timing of distributions of promised benefits according to the plan. Because termination shortens investment horizons, the termination communications to participants should remind them to re-allocate investments to reflect the expected termination payment dates.
- SEC requirements include proxy disclosures, de-registration of a registered plan under state and federal law. For publicly traded companies, appropriate proxy disclosure of plan termination and the amount of distributions to named executive officers is likely required. If the plan is registered with the SEC on Form S-8, the plan will need to be de-registered. State law de-registration requirements may also need to be met.
Termination v. Freezing the Plan
Termination and liquidation of a plan is distinguished from discontinuing deferrals in future years. Employers who wish to stop future deferrals may do so by suspending annual enrollments. Board of director resolutions normally are not required. However, if deferral elections renew automatically each year, the sponsor will need to at least notify the participants of the suspension of deferrals and may also need to amend the plan to stop the renewals. All such employer actions should occur consistent with the § 409A election timing rules.
Amounts deferred and vested prior to January 1, 2005 may be “grandfathered” under pre-409A versions of plan documents. These plans may be terminated in accordance with their terms, without regard to the conditions that apply to plans that are subject to Code Section 409A.
Terminating a non-qualified plan is an exceptional event under § 409A, which generally prohibits any discretionary acceleration of the participant-elected time and form of payment. The § 409A conditions for termination must be satisfied and the “downstream” administrative consequences must be addressed. Termination ideally should take into account the impact a termination payment may have on the employer’s other employee benefit plans, and how the lump sum payment will be received by shareholders when reported on the employer’s annual proxy. Terminating related trusts and employer owned life insurance may have additional financial consequences that should be considered well in advance of the final plan liquidation date.
Newport’s non-qualified plan consultants have assisted a number of private and publicly-held employers in connection with termination planning, in a variety of business contexts. We welcome the opportunity to work with you and your advisers in developing a plan suited to your objectives. Contact your Newport representative for more information.
This material has been prepared for informational purposes only, and is not intended to provide, nor should be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before making any decisions. Newport Group, Inc. and its affiliates provide recordkeeping, plan administration, trust and custody, consulting, fiduciary consulting, insurance and brokerage services.