RCG Magazine - 2nd Quarter 2005 | Table of Contents | Printable Version

Plan Administration

The Key to Complying with IRC Section 409A

With the passage of Internal Revenue Code Section 409A as part of the America Jobs Creation Act of 2004, plan sponsors of Nonqualified Deferred Compensation (NQDC) Plans have to amend their plan documents by December 31, 2005. For the moment most companies are taking advantage of “treasury transition relief” which allows the grandfathering of pre-2005 deferrals and to operate the plans in "good faith compliance" (IRC Section 409A and IRS Notice 2005-1).

The Major Provisions of 409A

The major impact of Section 409A on traditional deferred compensation can be summarized as impacting plans in four major areas. The first three areas are generally viewed as more restrictive than before, while the fourth is considered a liberalization of the rules:

1. Deferral Elections. With limited exceptions for performance-based compensation, deferrals must be made in the year prior to the year in which the compensation is earned.

2. Distribution Elections. The time and form of distribution must be determined at the time of deferral.

3. No Acceleration of Benefits. Except for very limited exceptions, there can be no acceleration of the time or schedule of distribution.

4. Rules Governing "Re-deferrals". The time and form of distribution may be delayed (“re-deferred”) as long as the re-deferral election is made at least 12 months before the scheduled distribution, and the subsequent distribution must be for at least an additional 5 years. Significantly, there is no limit placed on the number of re-deferrals a participant can make.

Administration System Capabilities Required to Comply with 409A

Amending the plan document is only the first, and the easy, part of complying with 409A. Administering or operating the plans in "good faith compliance" is the difficult part. Plan sponsors will need to work with their plan providers to ensure that their record- keeping systems are able to administer the amended plan. Whether a Plan Sponsor has an existing plan or wants to implement a new plan in 2005, it should require the following from their Plan Services Providers:

1. The record-keeping system must have the capability to record contributions by class year, i.e., each contribution year should be recorded as a separate account. This capability is critical for the following reasons:


• Plan sponsors with existing plans who wish to clearly freeze existing accounts as of December 31, 2004 must distinguish between Pre-2005 and 2005 contributions, benchmark earnings, and balances.
• Plan participants must make distribution elections at the time of deferral, and therefore must have a separate record for each deferral year.

2. The record-keeping system must have the capability to distinguish vested and unvested balances of pre-2005 deferrals. Pre-2005 deferrals that are unvested as of 12/31/2004 are considered 2005 contributions and are subject to 409A.

3. The record-keeping system must have the capability to provide participants and plan sponsors the same interface for pre-2005 and post-2005 deferral balances.

4. The record-keeping system must have the capability to generate cross-plan reporting to help plan sponsors account for pre-2005 and 2005 deferrals separately.

5. The record-keeping system must have the capability to provide all distribution records on the web or benefit statements. With the 409A restrictions on modifying distribution elections, this systems feature is most critical to remind plan participants of pending In-Service or Short-Term distributions. In addition, it will remind participants of their distribution schedules upon retirement, termination, etc.

Conclusion

Most plan providers claim to have updated their systems to assist plan sponsors in complying with 409A. In reality, not all plan providers have equally robust systems. Plan sponsors should conduct a "Due Diligence" evaluation by reviewing their provider’s systems during an onsite visit, by conducting interviews with other clients, and by gathering information from other sources such as independent consultants. Plan sponsors have the obligation to bring their NQDC plan document into compliance as early as possible. Even more importantly, plan sponsors have the obligation to make sure that their plan provider is knowledgeable of 409A requirements and that they have updated their systems. If the plan provider does not have the plan administration system capabilities described above, the plan sponsor runs the risk of not complying with 409A. Failure to comply with 409A will result in: (1) a tax on all deferrals (2) a penalty interest on all amounts deferred and (3) an additional 20% penalty.

The information provided is general information for reference purposes only, and should not be construed as advice in any respect. Please consult with your legal counsel or tax advisor in order to assure thorough and proper application of the complex rules that are highlighted here.

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