|
Overview of
SERPs
Time and Form of Payment Elections
Payments in Coordination with Qualified Plans
Amount of Benefits
in Coordination with Qualified Plans
Grandfathered Benefits and Transition Rules
Administrative Issues
Future Alerts
On September 29, 2005, the Treasury
Department and IRS issued long-awaited proposed regulations regarding
deferred compensation agreements under Section 409A of the Internal
Revenue Code. This alert, the third in a series regarding Section 409A
compliance and the proposed 409A regulations, discusses the compliance
issues relating to non-account balance plans such as supplemental
executive retirement plans (SERPs) and nonqualified defined benefit
plans.
Overview of SERPs
In contrast to a deferral or account balance
plan, a SERP’s benefit is based on an accrual formula instead of
participant voluntary deferrals or contribution amounts. This benefit
is usually stated as a defined benefit payable in a specified amount for
a specified period upon the occurrence of an event, such as retirement.
SERPs also may be designed to coordinate with an employer’s qualified
retirement plans so that the SERP benefit is offset by or is in excess
of the qualified plan benefit.
Time and Form of
Payment Elections
Under Section 409A, if a SERP provides the
participant with the right to elect the time and form of payment, such
election must be made by the end of the taxable year preceding the year
in which the services giving rise to the deferred compensation will be
performed. Where the SERP does not allow the participant to elect the
time and form of payment, the plan must set the time and form of benefit
payments no later than the time the service provider obtains a legally
binding right to the compensation, meaning that the service recipient
cannot reduce or eliminate the benefit -- this time will vary based on
the terms of the SERP with regard to benefit accruals. Most SERPs will
need to be amended to comply with this new rule because most plans
currently allow participants to elect the time and form of payment
shortly before the commencement of benefit payments.
The SERP must provide that payments will be
made only upon (i) a fixed date or under a fixed schedule, (ii)
separation from service, (iii) death, (iv) disability, (v) change in
ownership or control, or (vi) unforeseeable emergency. Subsequent
elections to change the time and form of payment under a SERP are
subject to certain limitations under Section 409A. However, an election
to change the form of payment from one type of annuity to another type
of annuity is not considered a change in time and form of payment so
long as the annuities are actuarially equivalent based on reasonable
actuarial assumptions. For more detailed information on election
requirements, see the second alert of the series entitled “Section
409A Compliance: Voluntary Deferral and Account Balance Plans.”
[Top]
Payments in
Coordination with Qualified Plans
Many SERPs condition the time and form of
payment on the payment under a qualified plan. For example, if a SERP
participant elects to receive benefit payments from the qualified plan
in a lump sum on December 1, 2006, then payment from the SERP will be
made to the participant in the form of a lump sum on December 1, 2006 as
well.
Generally, the time and form of payment
election provisions under a qualified plan would not comply with Section
409A if such plan were subject to Section 409A. As a result, the
election provisions under a nonqualified plan that mirror or depend upon
the provisions of the qualified plan will not comply with Section 409A.
Transitional relief has been extended through December 31, 2006 to
provide that nonqualified plan payments linked to qualified plan
payments will not violate Section 409A so long as the determination of
the time and form of payment is made according to the terms of the
nonqualified plan as in effect on October 3, 2004. The preamble to the
proposed regulations indicates that a further extension is not
expected. Therefore, nonqualified plan payments cannot be linked to
qualified plan payments on and after January 1, 2007. Further guidance
pending, plan sponsors will need to amend their SERPs to remove any link
of payments to qualified plan payments beginning on and after January 1,
2007.
The following example illustrates the
application of the transition rule. Company A’s SERP as of October 3,
2004 provides that the time and form of payment to a participant will be
the same time and form of payment elected by such participant under
Company A’s qualified defined benefit plan. The SERP may make or
commence payments on or after January 1, 2005 and on or before December
31, 2006 pursuant to the participant’s election under the qualified
plan. Further guidance pending, Company A will need to amend the SERP
to provide that payments shall not be based on the participant’s
election under the qualified defined benefit plan on and after January
1, 2007.
[Top]
Amount of
Benefits in Coordination with Qualified Plans
In a SERP coordinated with a qualified plan,
benefits under the SERP may increase or decrease based on actions taken
or not taken under the accompanying qualified plan. In a pension offset
SERP, for example, the benefit formula is designed to replace a
percentage of the executive’s compensation, reduced by the retirement
benefit payable under the defined benefit qualified plan. If the plan
sponsor amends the defined benefit qualified plan to decrease the
retirement benefit, the benefit payable under the SERP is increased
because the offset from the qualified plan has been decreased. This
raises an issue of whether such action results in a deferral election
for Section 409A purposes.
Generally, an amendment of the qualified
plan to increase or decrease benefits thereunder or to cease future
accruals under the qualified plan is not treated as a deferral election
or an acceleration of payment under the SERP. For example, there is no
deferral election or acceleration of payment upon the occurrence of the
following:
-
The addition, removal, increase or
reduction of a subsidized benefit or ancillary benefit under the
qualified plan; or
-
A participant election with respect to a
subsidized benefit or ancillary benefit under the qualified plan.
[Top]
Grandfathered
Benefits and Transition Rules
Earned and vested amounts deferred before
January 1, 2005 are grandfathered and not subject to Section 409A so
long as the plan is not materially modified after October 3, 2004. For
a non-account balance plan, such as a defined benefit SERP, the
grandfathered amount is equal to the present value as of December 31,
2004 of the earned and vested benefit that would have been paid on such
date if the participant had separated from service without cause. The
present value is determined based on reasonable actuarial assumptions.
This grandfathered amount also includes any increase in the present
value of the December 31, 2004 benefit that the participant actually
becomes entitled to based on the terms of the plan on October 3, 2004,
without regard to any services rendered after December 31, 2004 or any
other events affecting the amount of or the entitlement to benefits.
For example:
Company B’s SERP offers an early retirement
subsidy for participants who attain age 55 and have at least 10 years of
service. As of December 31, 2004, Mitch is age 52 with 12 years of
service and has a grandfathered benefit under the plan. On July 1,
2007, Mitch attains age 55 and has at least 10 years of service, and
therefore becomes eligible for the early retirement subsidy. Mitch’s
grandfathered benefit under the plan will increase by the amount of the
subsidy based on his December 31, 2004 benefit, but not for
post-December 31, 2004 increases in compensation or service.
The time and form of payment election rule
under Section 409A described above does not apply to grandfathered
benefits determined as of December 31, 2004. However, plans must comply
with the rule with respect to (i) 2005 accruals under the plan, and (ii)
any former-grandfathered benefits that subsequently lose their
grandfathered status due to a material modification. Transitional
relief has been provided so that participants may change their time and
form of payment elections through December 31, 2006 with respect to
amounts subject to Section 409A but not payable in 2006 – any such
change will not result in an impermissible subsequent deferral or
prohibited acceleration under Section 409A. Participants cannot in 2006
change payment elections for payments that they would otherwise receive
in 2006 or to cause payments to be made in 2006.
[Top]
Administrative
Issues
A plan sponsor that maintains a defined
benefit SERP and seeks to retain the grandfathered status of such plan
is likely to face a major hurdle because going forward it will be
necessary to administer pre-2005 balances and post-2004 balances under
the same plan. In addition, plan sponsors must be cautious to avoid any
material modifications that may cause a plan to lose its grandfathered
status. Plan sponsors should consider carefully whether it would be
more feasible and less expensive to amend and operate the SERP so that
all of the benefits thereunder comply with Section 409A.
[Top]
Future
Alerts
Future
alerts on Section 409A compliance will cover in greater depth various
issues, including exclusions from Section 409A coverage (e.g. short-term
deferrals and severance and separation pay arrangements), employment
agreements, bonus and performance pay arrangements, equity compensation
and split dollar.
If you have any questions
regarding this alert or other Employee Benefits Law related issues, please
contact one of our Employee
Benefits attorneys.
[Top]
|
