According to §401(a)(4), a deferred compensation plan cannot discriminate in favor of highly compensated employees (HCEs), which is a person who either owned 5% of the business at any time during the year or made more than $80,000 (inflation-adjusted) during the preceding year.
The regulations provide two safe-harbor tests for defined contribution plans (which comprise the vast bulk of 401ks). The first is a "unified allocation formula," which requires all plan contributions to be allocated in one of three ways:
While the rules do allow a C-Suite executive to benefit from the plan based on their status within the company, it doesn't allow them to benefit more than their status would allow.
The second method uses a "uniform points method" which are determined by summing "the employee's points for age, service, and units of plan year compensation for the plan year."
The main point that advisers should take from these rules is that the regulations contain very rigid, mechanical rules that prevent the top of the employee ranks from rigging the retirement plan to their benefit at the expense of the rank-and-file.
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 order for a deferred compensation trust to the “qualified,” it must comply with all of §401's specific requirements. Complete compliance creates tax-deferred status. §501 states (emphasis mine), “An organization described in subsection (c) or (d) or section 401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under section 502 or 503.”
One of 401s most important requirements is that funds can only be used for the benefit of the employees. §401(a)(2) states in relevant part,
“(2) if under the trust instrument it is impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be (within the taxable year or thereafter) used for, or diverted to, purposes other than for the exclusive benefit of his employees or their beneficiaries…”
To borrow language from contract law, this section contains a condition precedent, which is, “... an event which must take place before a party to a contract must perform or do their part.” The following hypothetical illustrates: Company A owes a significant amount of money and also has a large, well-funded retirement plan. 401(a)(2) prevents the company from raiding the retirement fund until every possible obligation of the trust is paid.
The Treasury Regulations add additional color:
(2) As used in section 401(a)(2), the phrase “if under the trust instrument it is impossible” means that the trust instrument must definitely and affirmatively make it impossible for the nonexempt diversion or use to occur, whether by operation or natural termination of the trust, by power of revocation or amendment, by the happening of a contingency, by collateral arrangement, or by any other means. Although it is not essential that the employer relinquish all power to modify or terminate the rights of certain employees covered by the trust, it must be impossible for the trust funds to be used or diverted for purposes other than for the exclusive benefit of his employees or their beneficiaries.
The phrasing is unambiguous, providing no legal “wiggle-room.”
In my introductory post on the topic, I specifically noted this code section uses trust language, placing a fiduciary duty and obligation on the sponsoring company. This section furthers that observation.
29 U.S.C. Chapter 18 contains ERISA -- the Employee Retirement Income Security Act, which was passed in 1974. Its purpose is to protect employee benefit plans from employer malfeasance, such as using employee plans to fund corporate operations or pay corporate debts.
Like the deferred compensation section of the tax code, ERISA itself its own legal specialty. A complete discussion would be the subject of an entire course in law school. For our purposes, the following points are salient:
1.) The statute gives federal courts jurisdiction over a large number of causes of action related to ERISA: ("Except for actions under subsection (a)(1)(B) of this section, the district courts of the United States shall have exclusive jurisdiction of civil actions under this subchapter brought by the Secretary or by a participant, beneficiary, fiduciary, or any person referred to in section 1021(f)(1) of this title. State courts of competent jurisdiction and district courts of the United States shall have concurrent jurisdiction of actions under paragraphs (1)(B) and (7) of subsection (a) of this section.). This greatly increases the weight of potential litigation.
2.) The statute creates a complex compliance burden. Here is a list of the sections contained in 29 U.S.C. Part I: Reporting and Disclosure:
This is yet another reason why an entire industry exists to service deferred compensation plans.
Certain sections of the tax code (such as §1031 like-kind exchanges and §482 transfer pricing) have become their own mini-specialty. §401-§420 (deferred compensation) is another such area of the code. In the following posts, I’ll go over the “high points” of these code provisions, starting with today’s general introduction to the topic.
The opening sentence of §401 contains a large amount of important information:
A trust created or organized in the United States and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries shall constitute a qualified trust under this section—
Here are that sentence’s key provisions:
 In Re Rothko, 43 N.Y. 2d 305 (I have reversed the order of the quotes for the sake of clarity).
Revenue Procedure 92-64 contains model language for a “Rabbit Trust,” which is a trust a company can establish to set-aside funds for a NQDC plan. Companies routinely use these structures to allay employee concerns about actually receiving NQDC payments.
You can read the entire Procedure at this link on the Legal Bit Stream website.
This is cross-posted on the Wealth and Risk Management Blog
As I noted in my previous post, the NQDC statute specifically states there are six events when a NQDC plan can make a distribution, one of which is when the service provider “separates from service,” which is defined in the Treasury Regulations as:
An employee separates from service with the employer if the employee dies, retires, or otherwise has a termination of employment with the employer.
As with other aspects of this statute, there is little room for a liberal legal interpretation of the definition.
The statute further defines “termination of employment” as,
Whether a termination of employment has occurred is determined based on whether the facts and circumstances indicate that the employer and employee reasonably anticipated that no further services would be performed after a certain date or that the level of bona fide services the employee would perform after such date (whether as an employee or as an independent contractor) would permanently decrease to no more than 20 percent of the average level of bona fide services performed (whether as an employee or an independent contractor) over the immediately preceding 36-month period (or the full period of services to the employer if the employee has been providing services to the employer less than 36 months).
The statute provides 2 tests. Either there is a complete termination of employment or an 80% reduction in the amount of work performed (as compared to the preceding three years) by the service provider. This is one of the few areas where a bit of definitional “play” exists in the statute.
Finally, the statute provides the following, non-exclusive set of factors to use in a “facts and circumstances” determination as to whether termination has in fact occurred:
1.) Whether the employee continues to be treated as an employee for other purposes (such as continuation of salary and participation in employee benefit programs),
2.) Whether similarly situated service providers have been treated consistently, and
3.) Whether the employee is permitted, and realistically available, to perform services for other service recipients in the same line of business.
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)),
(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.” 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.” 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. “[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.” These two conditions further support the requirement that the NQDC contract must be in writing. 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.”
 26 U.S.C. §61
 Comm’r v. Glenshaw Glass, 348 U.S. 426 (1955)
 Treas. Reg. 1.409-1(a)(d)(1)
 Treas. Reg. 1.409A-1(e)(1)
 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.”)
 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.”
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.”) along with its synonyms 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.”
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:
 Treas. Ref. 1.409(A)(c)(1)
 Id (“arrangement, blueprint, design, game, game plan, ground plan, master plan, program, project, roadmap, scheme, strategy, system”)
 Treas. Reg. §1.409(A)(3)(i):
 26 U.S.C. 409(A)(2)(i)-(vi)
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