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Section 409A contains a very strict set of times when a NQDC plan can make distributions. They are:
(i) separation from service as determined by the Secretary (except as provided in subparagraph (B)(i)), (ii) the date the participant becomes disabled (within the meaning of subparagraph (C)), (iii) death, (iv) a specified time (or pursuant to a fixed schedule) specified under the plan at the date of the deferral of such compensation, (v) to the extent provided by the Secretary, 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, or (vi) the occurrence of an unforeseeable emergency. Death (iii) and a specified time (iv) are not legally debatable; they simply are. Like other key provisions of 409(A), disabled is specifically defining in the statute: (C) Disabled: For purposes of subparagraph (A)(ii), a participant shall be considered disabled if the participant-- (i) is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which 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 determinable physical or mental impairment which 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 3 months under an accident and health plan covering employees of the participant’s employer. This term is tightly written, offering lawyers little interpretational wiggle room. It’s obvious that a formal medical opinion (and probably a second) is required for the client file. Finally, there is the unforeseen emergency: 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 terminology strongly implies the “fortuity” element in an insurance contract, strongly hinting that the insured does not have the ability to take preventative measures to avoid the event. It’s also highly likely that a medical opinion will also be required. Next, we’ll discuss the “separation from service” requirement. Income for tax purposes is defined in the broadest possible terms. §61 states it as “income from whatever source derived.”[1] The case law adds further clarification and detail. Glenshaw Glass defined income as “undeniable accessions to wealth, clearly defined, and over which the taxpayers have complete dominion.”[2] The latter term is central to a properly structured non-qualified deferred compensation (NQDC) plan. If the taxpayer has any control over the plan’s income, he will have to include the total income in his annual income.
Therefore, all money in a NDQC plan must be subject to a substantial risk of forfeiture.[3] “[E]ntitlement to the amount [must be] conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial.” The future services must be performance based, and they cannot include “any amount or portion of any amount that will be paid either regardless of performance, or based upon a level of performance that is substantially certain to be met at the time the criteria is established.”[4] These two conditions further support the requirement that the NQDC contract must be in writing.[5] They also strongly allude to an employment law component in which the service recipient and provider agree on a basic compensation level and an additional layer, which will be paid for through the NQDC plan. Finally, the “substantial risk of forfeiture” element can’t be met if the service provider is the sole owner of the company. The underlying rationale is simple: he or she will not use their management position to not pay themselves – it’s simply not going to happen. The examples in the Treasury Regulations imply that a 20% ownership stake is the maximum amount the service provider can own of the company and still benefit from the NQDC plan. But this same section also says the ultimate determination is based on the “facts and circumstances.”[6] [1] 26 U.S.C. §61 [2] Comm’r v. Glenshaw Glass, 348 U.S. 426 (1955) [3] Treas. Reg. 1.409-1(a)(d)(1) [4] Treas. Reg. 1.409A-1(e)(1) [5] See also Treas. Reg. 1.409(A)-1(e)(“The term performance based compensation means compensation that amount of which, or the entitlement to which, is contingent on the satisfaction of preestablished organizational or individual performance criteria relating to a performance period of at least 12 consecutive months.”) [6] Treas. Reg. 1.409(A)-1(d)(3)In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program. He is the author of three books: U.S. Captive Insurance Law, Captive Insurance in Plain English and The Lifetime Income Security Solution. He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog. He is also an investment adviser with Thompson Creek Wealth Advisors. In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program. He is the author of three books: U.S. Captive Insurance Law, Captive Insurance in Plain English and The Lifetime Income Security Solution. He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog. He is also an investment adviser with Thompson Creek Wealth Advisors. This is cross-posted at the Wealth and Risk Management Blog
In this post, I’ll take a look at several more definitions related to non-qualified deferred compensation (NQDC) plans, beginning with the definition of “plan:” “The term plan includes any agreement, method, program or other arrangement, including an agreement, method, program or other arrangement that applies to one person or individual.”[1] Here, we see the Treasury using the standard definitional tactic of using several words that, while moderately different, convey the same idea. However, the commonplace definition of the word “plan” (“a method for achieving an end.”)[2] along with its synonyms[3] would have sufficed. The plan must be in writing. While not explicitly stated, it is strongly implied in the regulations. “…a plan is established on the latest of the date on which it is adopted, the date on which it is effective, and the date on which the material terms of the plan are set forth in writing. The material terms of the plan may be set forth in writing in one or more documents.”[4] In addition, because of the sheet complexity of NQDC, it’s best to have a governing document. (I googled the search term “NQDC sample plan and found several online examples, here, here and here). There are only six events that allow the plan to distribute assets:
[1] Treas. Ref. 1.409(A)(c)(1) [2] https://www.merriam-webster.com/dictionary/plan [3] Id (“arrangement, blueprint, design, game, game plan, ground plan, master plan, program, project, roadmap, scheme, strategy, system”) [4] Treas. Reg. §1.409(A)(3)(i): [5] 26 U.S.C. 409(A)(2)(i)-(vi) |
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