With a nonqualified plan, a Key Employee defers receipt of a portion of compensation earned in one year into the future. In exchange, the employee gets to defer paying taxes on the compensation. Additionally, the deferred compensation grows tax-free until the Key Employee actually receives it.
If a Key Employee defers compensation and invests in a nonqualified plan, one of the first questions they are likely to ask is: when do I get my money? Unfortunately, as with most legal questions, it depends on the law and the specific rules of your plan.
The first issue to tackle is the law related to distribution events.
Internal Revenue Code Section 409A
Internal Revenue Code Section 409A governs the “inclusion in gross income of deferred compensation under nonqualified deferred compensation plans.” If a nonqualified plan is subject to IRC 409A, the plan must operate within the requirements of Section 409A. If not, the Key Employee’s gross income will include the deferred compensation when it is first deferred. This would largely defeat the purpose of the plan. Therefore, it is critical that a plan’s legal document tracks these rules.
If a plan is not subject to Section 409A, the plan may have more liberal distribution events. Regardless, most plans follow common distribution events. This is done to achieve the goals of instituting the plan and to ensure plan compliance.
Section 409A Distribution Rules
IRC Section 409A limits the times at which distributions may be made from nonqualified plans to the following events:
1. “Separation from service as defined by the Secretary”
A Key Employee “separates from service” from an employer if the Key Employee dies, retires, or otherwise has a termination of employment. There are also rules as it relates to defining the terms retirement and termination of employment.
Key Employees of publicly traded companies also have additional rules. Key Employees are defined as officers making more than $175,000 in 2018 (indexed for inflation), 5 percent or greater owners, and 1 percent or greater owners making more than $150,000 (not indexed for inflation).
2. Disability
For this purpose, a participant is disabled if he or she (i) is unable to engage in any substantial gainful activity by reason of any medically determined physical or mental impairment that 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 determined physical or mental impairment that 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 three months under an accident or health policy covering employees of the employer.
3. Death
This is the one distribution event that likely doesn’t need further explanation.
4. “A specified time specified under the plan at the date of the deferral of such compensation”
The legislative history and legal rulings on this issue make clear that the legislature intended an arbitrary date in the future (i.e. 5 years) and that distributions may not be based upon the occurrence of an event (i.e. my son’s 18th birthday).
In practice, the “specified time” referenced by this statute is a time period that alligns with the goals of the plan.
5. “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”
In general, the term “control” means holding of at least 50 percent (by vote or value) of the stock of the corporation. Treasury Regulations provide further technical guidance for determining if a change in control has occurred.
6. “The occurrence of an unforeseeable emergency”
In general, 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 distribution amount may not exceed the amount necessary to satisfy the emergency and pay taxes, after taking into account the extent to which the hardship is or may be relieved through reimbursement or compensation by insurance or by the liquidation of the participant assets.
Plans Not Subject to Code Section 409A
If for some reason a plan is not subject to the requirements of Code Section 409A, the following are common distribution events that keep in line with the goals of implementing a nonqualified plan:
Death
Disability
Involuntary termination of employment
Hardship (as strictly defined for nonqualified plan purposes)
Constructive discharge
Change in control of the plan sponsor
Voluntary termination of employment at any time
Voluntary termination after a certain period of years of service or age
Vesting
Vesting is a separate issue from distribution. Again, employers typically establish vesting schedules that serve the goals of the nonqualified plan. An employer may design the plan to vest largely based on what Key Employees actually value as an incentive. Similarly, an employer might set performance goals. Vesting rules also allow an employer to add noncompete clauses for a specific period or geographic location after termination. Typically, most vesting schedules run from two to six years.
Plan Design
The plan’s legal document must follow the rules Code Section 409A or there are significant penalties for both the employer and Key Employee. That being said, in practice, plan design typically follows the goals of the company designing the plan.
If the goal is only to offer key employees additional tax-deferred savings opportunities, employers are likely to design a plan that pays deferred amounts soon after the vesting date. Where there are other considerations, employers can design a plan to pay deferred amounts only at the earliest of death, disability, or separation from service with the company.
There is also the opportunity to use plans as mid-term or long-term incentives to retain and reward the employee without making the employee wait until separation from service. Typically, to achieve this goal, nonqualified plans might have distribution events after five or seven years.
Across the board, nonqualified plan designs look very different based on each individual company’s goals. Therefore, it is necessary to have administrators and lawyers who understand your company’s unique issues.
Chasen Cohan, Esq. is the founder of Cohan PLLC. Mr. Cohan is a licensed attorney who also possesses FINRA Series 7 (Registered Representative) and Series 63 (Uniform State Representative) licenses, state insurance licenses, and State Securities Registrations in Nevada, Missouri, and North Carolina. Mr. Cohan is admitted to practice law before the Nevada Bar, all Nevada State and Federal Courts, and the United States Court of Appeals for the Ninth Circuit.
Mr. Cohan’s representative clients have included: Wal-Mart Stores, Inc., Sam’s West, Inc., MGM Grand Resorts International, New York-New York Hotel & Casino, Mandalay Corp., The Treasure Island Hotel and Casino, The Cosmopolitan of Las Vegas, The Mirage Casino-Hotel, South Point Hotel & Casino, American Express, Barclays, US Bank, Wells Fargo, Citibank, and various life insurance companies and service providers.
Mr. Cohan is a Las Vegas native who graduated with honors from UCLA with a Bachelor of Arts degree in Political Science. Mr. Cohan received his Juris Doctorate from the University of Texas School of Law. During law school, Mr. Cohan served as a clerk for the Office of the Texas Attorney General and a Judicial Extern for United States District Court Judge James R. Nowlin.
Clients from global brands and middle-market companies to innovative startups and individuals trust Cohan PLLC to resolve their trickiest legal disputes. Whether that’s litigation in state or federal trial and appellate courts in Nevada; investigations and enforcement actions before government agencies; or mediation, arbitration, and regulatory agency proceedings. Cohan PLLC has litigated hundreds of millions in dollars of claims on behalf of corporate litigants. As a result of this experience, Cohan PLLC has been afforded the opportunity to selectively act as Plaintiff’s counsel on complex, personal injury matters.