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Internal Revenue Code Section 409A introduced new rules governing non-qualified retirement plans and other deferred compensation arrangements. In this series of articles, we take an in-depth look at selected issues under Section 409A.
This article examines the interrelationship between disability and the rules of Section 409A and discusses potential pitfalls that may be avoided with proper examination and drafting of a plan's disability definitions and procedures.
Internal Revenue Code Section 409A allows "disability" to be a payment trigger for deferred compensation, with disability defined under stringent standards set forth in the final regulations under Section 409A. Even if disability is not a payment trigger as such, the occurrence of a disability may impact the timing of payments made under a separation from service trigger. Additionally, a disability may affect vesting or other aspects of the operation of a deferred compensation arrangement, which may have implications under Section 409A.
As employers are reexamining their deferred compensation arrangements with a goal toward having arrangements compliant in form and operation by the end of 2008, it is important to consider the interrelationship of disability and the rules of Section 409A. Depending on how a disability impacts the deferred compensation arrangement, very different considerations come into play under Section 409A.
DISABILITY AS A VESTING EVENT
Disability may serve as a vesting event under a deferred compensation arrangement. A simple and common example is a supplemental retirement plan that provides for 100 percent vesting in the event of disability.
If disability results in full vesting, but does not otherwise affect the benefit payable under a deferred compensation arrangement—that is, it does not serve as a payment trigger or toggle—then the definition of disability need not comply with any particular standard set forth in Section 409A. The disability definition can be whatever is deemed appropriate for plan purposes.
It is important to keep in mind that accelerated vesting itself may convert an arrangement that is not subject to Section 409A into one that is subject to Section 409A. For example, let's take a simple restricted stock unit arrangement that provides for full vesting and immediate payment after three years of continuous substantial service. This arrangement is not subject to Section 409A because payments are made within the short-term deferral period following the vesting event—the vesting event in this case being the completion of three years of continuous service.
However, if there is full vesting on disability (but no accelerated payment), in the case of an employee who becomes disabled in the first year of the three-year service vesting period, for example, the payment will not be made within the short-term deferral period. Thus, as to that employee, the restricted stock unit is subject to Section 409A.
But if the arrangement had provided for payment at the time of disability vesting (rather than deferred payment at the normal vesting date), then it may escape Section 409A under the short-term deferral rule.
Further, because it is possible for the arrangement to be deferred compensation with respect to any employee—any employee could become disabled—it may be that the arrangement is subject to Section 409A with respect to all employees. While the arrangement may comply with Section 409A because it provides for a fixed payment date, nonetheless, the full range of potential tax consequences associated with Section 409A becomes applicable to the arrangement and it will be necessary to ensure proper tax reporting of the deferred compensation, avoid accelerations and substitutions, and otherwise remain sensitive to the impact of Section 409A.
DISABILITY AS A FORFEITURE EVENT
Disability may serve as a form of forfeiture event under a deferred compensation arrangement. Consider this hypothetical scenario: A severance arrangement that is deferred compensation pays benefits in the event of any termination of employment other than an involuntary termination for cause, a voluntary termination for good reason, a death or a disability. In this case, a disability results in benefits not being paid under the arrangement.
If a separation from service is the payment trigger for deferred compensation, but disability is an exception that causes benefits not to be paid, then the definition of disability need not comply with any standard set forth in Section 409A.
In some cases, use of a Section 409A definition of disability in a context where it is not necessary may be awkward from a design standpoint. For example, take a severance arrangement that pays benefits in the event of any termination of employment other than an involuntary termination for cause, a voluntary termination for good reason, or death or disability. Regardless of whether this arrangement is or is not subject to Section 409A, the definition of disability need not comply with any standard in Section 409A because disability is not a payment trigger. If the Section 409A "any occupation" definition is used to define disability, then a fact pattern may arise where a lesser disability qualifying under an "own occupation" standard results in an entitlement to a severance benefit, when a more severe disability would disqualify the individual from benefits.
Each arrangement must be analyzed on its own. It is important to bear in mind, however, that blind adoption of a Section 409A definition of disability under circumstances where it is not necessary may result in bad plan design.
COORDINATION OF DISABILITY WITH SEPARATION FROM SERVICE
Section 409A recognizes the following as separate and distinct events that can trigger payment of deferred compensation:
"Separation from service" and "disability" are defined terms under Section 409A. As a result, plan definitions of those terms must comply with Section 409A. However, even if disability is not a payment trigger, a disability must be properly handled in determining whether a separation from service has occurred for payments that are triggered by separation from service.
Section 409A defines a separation from service as having occurred as of the date that the employer and employee reasonably anticipate that no future services will be performed or that future services will permanently be at a level that is 20 percent or less of the average service level over the past 36 months (or the period of employment if less than 36 months).
The relevant factor in determining whether a separation from service has occurred is not the individual's status as an "employee" from a payroll standpoint, but whether the service level (as an employee or contractor) is expected to drop below the applicable 20 percent threshold.
The occurrence of disability may mean that the parties expect that no future services will be rendered, but that does not necessarily result in an immediate separation from service. Section 409A regulations have a special rule for disability absences. If an employee is on disability leave, the "separation from service" date may be extended for up to 29 months of such leave. A disability for this purpose is defined as:
An "own occupation" standard is used for this purpose, not the more stringent "any occupation" standard used elsewhere under Section 409A. An earlier termination of employment will end the disability extension—that is, the special disability extension applies only for so long as the individual is an employee under the company's employment policies, or 29 months if shorter. At the earlier of those two dates, a separation from service occurs which then must serve as the trigger for payment of deferred compensation amounts payable upon separation from service. Recognizing any other date as the separation date for purposes of separation-based deferred compensation may violate Section 409A. Thus, in defining "separation from service" with respect to any deferred compensation arrangement that has separation from service as a payment trigger, the disability leave extension provided under the Section 409A regulations must be carefully considered and integrated into the terms and processes of the arrangement.
Unfortunately, the Section 409A regulations leave many unanswered questions. For example, it is not clear whether use of the extended disability leave rule is optional or mandatory. While the regulations themselves state that "a 29-month period of absence may be substituted for" the normal six-month rule, the preamble to the regulations states that "[w]ith respect to disability leave, the employment relationship will be treated as continuing for a period of up to 29 months, unless otherwise terminated by the employer or employee, regardless of whether the employee retains a contractual right to reemployment" (emphasis added).
It also is not clear whether changes in employment policies, or discretion applied under the employment policies, could be viewed as an impermissible acceleration or subsequent deferral. For example, if the formal disability policy of an employer provides that termination of employment occurs 12 months after a disability leave starts, a modification of that policy necessarily will affect when deferred compensation is paid if separation from service is the payment trigger. Presumably, a change that applies to all employees uniformly and that is not made to cause an acceleration or deferral of the benefit payable to any given employee should not be problematic—but that is not certain under the regulations.
DISABILITY AS A PAYMENT TRIGGER
Section 409A defines "becoming disabled" as a payment event separate and distinct from separation from service, and thus it can be used as such under a deferred compensation arrangement. For example, a supplemental profit sharing plan may provide for a lump-sum payment in the event that a participant is disabled, but regardless of whether the participant has experienced a separation from service.
The Section 409A regulations require the use of one of two alternative definitions of disability when disability is a payment trigger:
The first of the definitions is the definition of disability used by the Social Security Administration. The second is similar, but it substitutes a standard requiring that disability payments be made for three months for the failure to engage in "any occupation" standard.
A plan may "deem" that a disability determination made by Social Security automatically satisfies the disability standard used in the plan. A plan may also "deem" a disability determination made by a disability plan administrator to satisfy the disability standard used in the plan, but only where the disability standards in the underlying disability plan comply with Section 409A.
What Is the Date of a Disability?
If disability is a payment trigger, the regulations contemplate—indeed, require—that the payment date be "objectively determinable and nondiscretionary at the time the event occurs." It thus is necessary to be able to determine the date the employee became disabled and, as a practical matter, that determination must be made before the arrangement calls for distribution to be made.
The date of disability generally is determined by the medical condition of the employee within the disability standard set by the plan terms consistent with Section 409A. If disability is the payment trigger, the payment date must be identifiable by reference to, and as of, the disability date. In other words, it does not appear to be appropriate under Section 409A to define the payment by reference to the date on which the decision maker determines that the employee is disabled. That would allow the decision maker to control the payment date by manipulating the determination date.
Let's say a deferred compensation plan provides for a payment as of the first day of the month following the date of disability. Determining whether an employee is disabled will take some time, and, in many cases, it would be totally unrealistic to expect that a determination can be made by the first day of the next month. In this regard, the regulations generally allow a payment made by the 15th day of the third calendar month following the scheduled payment date to "relate back" to the scheduled payment date and thus not be considered late. Any payment made in the same calendar year as the scheduled payment also can relate back. This allows some administrative processing time, but that still may not be enough. A better approach may be to define the payment date in the context of a disability to be sufficiently far in the future as to allow for appropriate processing—for example, payment will be made 90 days after the date of disability.
Who Determines Disability?
The next question is: Who is to decide whether a disability has occurred? And how? And what are the consequences of an "incorrect" determination?
Section 409A does not dictate who the decision-maker is on disability, or how the determination is to be made. However, a plan clearly must designate a decision maker and have a decision-making process in place. Due to the nature of the standard, professional medical input will almost certainly be required in most cases.
The regulations do allow a determination of disability by the Social Security Administration to be "deemed" to be a disability determination for plan purposes. However, this does not mean that it is advisable to include a plan provision that defines disability as having occurred by reference to a determination by the Social Security Administration. It is not possible to know when the Social Security Administration will make a determination of disability, especially since the timing of such a determination may depend to a large degree on the actions of the participant.
As a result, the Section 409A requirement that the payment date be objectively determinable probably is not met. Use of the Social Security Administration "deemed" disability provisions in the regulations thus are of limited utility, except with respect to those arrangements where payments are deferred to a later date following the occurrence of the disability which would allow for processing by the Social Security Administration.
A plan decision maker and decision-making process thus are necessary. Presumably, a good faith determination made using a prudent process is all that is required. However, if a payment is made under a disability payment provision under circumstances where the existence of a disability is highly questionable, that may result in taxation and penalties for the participant under Section 409A.
Impact on the Six-Month Delayed Payment Rule
In the case of a payment made to a "specified employee" of a public company that is on account of separation from service, Section 409A requires that such payment be delayed for six months following the separation from service. This six-month delayed payment rule does not apply in the case of a payment that is triggered by the participant's disability. It is perfectly acceptable, therefore, to have a plan provide for delayed payments in the event of any separation from service, but to have immediate payment in the event of a disability trigger.
It is important to properly identify (and draft) the payment triggering event in order to avoid a potential finding by the IRS that payment was an impermissible acceleration upon a separation from service rather than a permissible payment upon the occurrence of a disability.
DISABILITY AS A PAYMENT FORM TOGGLE
A deferred compensation plan may provide a form of payment in the event of disability that is different than the form of payment that applies in the event of another payment trigger. For example, a plan may provide that a lump sum will be paid in the event of disability, while installments will be paid in the case of a separation from service. Disability thus serves as a type of payment form toggle.
A deferred compensation plan generally may be designed to include a separate payment form for each permissible payment event. Thus, the form of payment in the event of a disability can be different than the form of payment in the event of a separation from service.
HANDLE DISABILITY CAREFULLY
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