This set of FAQs is part of a series dealing with the impact of COVID-19 on businesses. Government-mandated protocols and social distancing directives as a result of the COVID-19 pandemic have led to significant business interruptions and tremendous financial strain on employers. These measures may continue to disrupt businesses and the economy for the foreseeable future. As a result, employers are faced with difficult choices regarding their employees–including how to keep them working during this unprecedented time and for many employers, possibly reducing employees’ hours, furloughing employees, or terminations–all of which can directly affect retirement plans and other types of employee benefit plans. In addition, a wave of new federal legislation affecting employee benefit plans, much of which is intended to provide relief to employees, is being rolled out. This set of Q&As addresses some of the most common deferred compensation and executive agreement questions that arise as employers make business and staffing decisions in response to COVID-19. Other Q&As addressing workforce reduction options, what to do when an employee is diagnosed with COVID-19, health coverage and other welfare benefit plan issues, and retirement plans in light of COVID-19 are available. We will continue to update these and other topics as continued legislation and guidance are issued.
We have placed employees on furlough. Does a furlough constitute a “Separation from Service” under Section 409A, which could result in a payment event under our deferred compensation plan?
In our experience, clients that are considering furloughing employees intend to recall the employees once the cloud of economic uncertainty lifts and business conditions stabilize. If this is your intent, then such a furlough should not be treated as a “separation from service” for purposes of Section 409A of the Internal Revenue Code (409A). This is because a “separation from service” under 409A does not include a “bona fide” leave of absence, which is defined as a leave of absence where there is a reasonable expectation that the employee will return to perform services for the employer and either of the following apply:
- The leave of absence will not exceed six months.
- The leave of absence exceeds six months and the employee has either a contractual or statutory right to re-employment.
Based on this definition, 409A would likely treat most furloughs as a leave of absence since the employer reasonably expects to recall employees within six months. Employers, of course, may terminate an employee during such time (subject to any other allocable legal restrictions), and such termination would be a separation from service.
Additionally, if a furlough exceeds six months, a separation from service will be deemed to occur after the six months unless there is a right to re-employment, such as pursuant to an employment agreement or statutory right. Note that FMLA leave is an example of a statutory right that qualifies under 409A, although we are unaware of any other relevant circumstances in which the right to re-employment under the FMLA extends beyond six months.
It is important to remember, however, that placing individuals on furlough or reduced schedules can create a separation from service in certain circumstances. A 409A separation of service occurs on the date that the employer and employee reasonably anticipate that the level of bona fide services the employee would perform after a certain date would permanently decrease to no more than 20% of the average level of bona fide services performed over the immediately preceding 36-month period. If an employee’s hours drop below the 20% threshold for an extended period, the IRS may deem the employee to have separated from service. Because the determination of whether a furlough or hours reduction is a separation from service is a fact-specific determination, employers should carefully review their deferred compensation arrangements and employment agreements with their counsel to establish what payments may become due to employees in the case of a layoff or an extended furlough, as these payments could have a significant impact on the employer’s cash flow.
We’re considering making some changes that will impact our executive team in light of economic circumstances. What should we be thinking about?
Companies should take stock of their executive employment agreements, offer letters, equity awards, and deferred compensation plans to determine the impact on their cash flow if they decide to terminate executives, restructure their executive team, or institute temporary salary reductions, as these actions could trigger payments under such arrangements. An often-overlooked concern is arrangements that contain benefits that become due upon termination by the employee as a result of a “good reason” event (e.g., a reduction in compensation or a change in an employee’s duties, responsibilities, title, or direct report). It is possible that salary reductions, reduced schedules, or furloughing of employees could trigger these definitional prongs, which could lead to an immediate payment obligation if the executive terminates employment.
In addition, some employers are considering whether certain executive benefits—such as executive medical or employer contributions to nonqualified plans—can be scaled back or eliminated to control costs. You should review your plan’s governing documents to determine whether either a scale back or elimination is permitted. If the benefits are purely discretionary and/or subject to amendment or termination at any time, then you may be able to make changes.
Employees have asked to cancel their deferral elections under our deferred compensation plan or receive a distribution to help offset financial difficulties. Can we allow them to do so?
Unlike 401(k) plans or other retirement plans, deferral elections under a deferred compensation plan generally may not be altered or canceled under 409A, nor are accelerated distributions permitted. Section 409A does contain one notable exception in both instances. If an employee experiences an unforeseeable emergency, 409A allows an employee to cancel a deferral election for the remainder of the year and/or request a distribution. Additionally, some plans are written so that deferral elections are automatically canceled for a period of time in the event distributions are received on account of an unforeseeable emergency.
409A defines an unforeseeable emergency as extraordinary and unforeseeable circumstances beyond the control of the employee that causes the employee severe financial hardship. Specific examples of unforeseeable emergencies include:
- The employee’s (or the employee’s spouse’s, beneficiary’s or dependent’s) illness or accident.
- Imminent foreclosure or eviction of the employee’s primary residence.
- The need to pay medical expenses (including nonrefundable deductibles) or prescription drug medications.
- Other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the employee which cannot be relieved through the employee’s other resources.
While normally the threshold for establishing an unforeseeable emergency is high, the circumstances caused by the COVID-19 pandemic may be a situation that meets this threshold. Given the complexity around these rules, it is recommended that employers consult with counsel before allowing an employee to cancel deferral elections or receive early distributions.
Given economic conditions, can we terminate our deferred compensation plan and distribute account balances to participants?
While 409A permits an employer to terminate a deferred compensation plan and distribute the assets to participants, there are strict limits on such terminations. For instance, the plan, and all similar plans, must be terminated for all participants, not just those who request a payment; no payments from the plan may be made for 12 months; and the employer cannot offer a new deferred compensation plan for three years.
A plan may also not be terminated if the employer is experiencing a financial downturn. Because of these limitations, plan terminations are not likely a feasible alternative. We suggest that employers discuss this option with their counsel to avoid any unintended consequences.
We have substantial payment obligations due under our deferred compensation plan that we cannot afford to pay. Can we agree with the executive to defer payment under 409A?
409A requires payment of deferred compensation on permissible payment dates outlined in the plan document, such as a termination of employment, death, disability, a fixed date in the future or a change in control. Failure to pay the deferred compensation on the dates outlined in your plan document would be treated as an impermissible delay in payment and a violation. 409A does provide some relief, however, if the payment is made before the end of the year in which it is due. For instance, if a payment is due under a plan on July 1, 2020, then as long as the payment is made by December 31, 2020, a 409A violation should not occur. Additionally, a payment under a deferred compensation plan may be delayed if making the payment would jeopardize the company’s ability to continue as a going concern, provided that the payment is made as soon as practicable once the company’s financial health is no longer an issue. We caution that the 409A going concern exception is a very high bar to meet and little guidance is available from the IRS regarding the circumstances when this exception is available. Employers are advised to consult with counsel before delaying any payments under the going concern exception or otherwise.
We use a rabbi trust to fund certain of our payment obligations under our deferred compensation plan. Can we use rabbi trust assets for other corporate needs in light of COVID-19?
No. Once money is contributed to a rabbi trust, it may only be used to pay benefits due under the plan. The only exception to this rule is in bankruptcy, where the assets are subject to the claims of general creditors of the company, including the plan participants. Employers, however, can decide to no longer fund future contributions to a rabbi trust if permitted by the plan document and trust agreement.
What are the consequences of a violation of the 409A regulations?
Immediate taxation of the deferred compensation amounts, including interest penalties to the date of the violation and an additional 20% penalty tax, all of which are imposed on the employee. As a result, careful consideration should be given to any actions taken with regard to your deferred compensation arrangements to avoid these substantial penalties.
Could the COVID-19 disruptions affect elections for “performance-based” compensation in 2020?
UPDATED (April 1, 2020): Yes. Companies that offer “performance-based” compensation, for instance, annual bonus programs, often allow employees to defer such compensation under a nonqualified deferred compensation plan. While 409A generally requires deferral elections to occur prior to the year in which the compensation is earned (e.g., 12/31/2019 for 2020 compensation), there is an exception for performance-based compensation. This exception allows the election for such compensation to be made on or before the date that is six months prior to the end of the performance period. For an annual calendar-year bonus program, this means that a deferral election could be made, or altered, as late as June 30. In order to meet this exception, however, 409A requires, among other things, that the performance goals that must be reached to earn the annual bonus must be established in writing no later than 90 days after the commencement of the period of service to which the criteria relates. Due to the uncertainty caused by COVID-19, many companies have not set or will alter the performance goals to be utilized for 2020 outside of this 90-day window. As a result, the “performance-based election” may not be available this year. Companies should review their election procedures to ensure that the requirements necessary to make performance-based elections are met for 2020 to avoid inadvertent late elections under Section 409A.
As further COVID-19 legislation is passed and as agencies provide further advice on how to operate benefit plans, we will continue to provide guidance for plan sponsors. If you have any questions about the information in these Q&As, please contact any of our employee benefits attorneys.