Avoiding unintended consequences under IRC section 409A: emerging nonqualified deferred compensation plan design issues.

EXECUTIVE SUMMARY

Internal Revenue Code (IRC) [section] 409A and its associated guidance and regulations provide much needed clarity and flexibility regarding the compliant design and operation of nonqualified deferred compensation plans (DCPs). The proposed regulations require plan documents to be amended to comply with the new law by December 31, 2006. This documentary compliance deadline will be the impetus for many plan sponsors to examine the available design options for their deferred compensation arrangements on a going-forward basis. However, some design options may have unanticipated negative consequences to participants and plan sponsors alike. This article provides an overview of some design issues to consider during the [section] 409A compliance process. For convenience, the table below summarizes a few potentially problematic rules and the author's related suggestions, as further described in the article.

Although IRC [section] 409A has been in effect since January 1, 2005, plan sponsors have delayed making long-term plan design decisions regarding their nonqualified deferred compensation arrangements until more information became available. On September 29, 2005, this long awaited guidance was released in the form of proposed Treasury regulations. These proposed regulations, which will not become effective until January 1, 2007, provide that plan sponsors have until December 31, 2006, to bring their plan documents into documentary compliance with the requirements of IRC [section] 409A and related regulations. Further, the guidance provides a roadmap for amending existing nonqualified plans without fear of adversely affecting the "grandfathered" status of amounts that were deferred and vested by December 31, 2004 (and, therefore, would not be subject to the requirements of IRC [section] 409A in the absence of a "material modification"). Without question, executive benefit practitioners and plan sponsors will need to convene during 2006 to make informed design decisions with respect to their nonqualified benefit plans.

As members of the benefits community and their clients work through the implications of the recently released proposed regulations for IRC [section] 409A, new "best practices" will emerge. In many ways, new and revised plan designs that comply with [section] 409A may allow for more flexibility than the designs they replace. In an attempt to avoid some potentially unintended consequences of a poor plan design, the following is an analysis of several design issues associated with amending or designing a [section] 409A-compliant nonqualified deferred compensation plan. It is hoped that this discussion will help plan sponsors and their advisors avoid future headaches.

THE SIX-MONTH DELAY FOR KEY EMPLOYEES

Rule

IRC [section] 409A requires that, in general, non-qualified benefit payments to be made upon the separation from service of a "specified employee" of a public company must be delayed for a period of at least six months following the participant's separation from service.

Considerations

The "specified employees" of public companies for whom the delay in payment applies are determined based on the definition of "key employee" provided in IRC [section] 416(i). The broadest category of "key employees" under that definition will be any officers with annual compensation of at least $140,000 (for 2006)--capped at 50 individuals.

The proposed regulations for [section] 409A include guidance on how this rule must operate in practice. Plan sponsors are to identify their "specified employees" on an annual basis based upon an identification date (December 31 is the default if the plan document does not specify another date). An employee that is determined to be a "specified employee" on the identification date would be subject to a six-month delay in commencement of benefit payments (but only payments triggered by his or her separation from service) if he or she experiences a separation at any time during the 12-month period beginning on the first day of the fourth month following the identification date. For example, if December 31, 2006, is the identification date, the …