The purpose of this article is to clarify some of the rules governing changes in the form of payment under a Section 409A Non-Qualified Deferred Compensation (NQDC) Plan, also known as Executive NQDC Plans.
Confusion on Section 409A(a)(4)(C)
Section 409A(a)(4)(C)’s subsection titled “Changes in Time and Form of Distribution” addresses the rules when someone wants to change from an annuity to a lump sum. Subparagraphs (i)-(iii) identify the requirements for making a change in the form of payment.
Subparagraph (i) requires the election to not be effective until 12 months after the election is made. For example, if an election were made on June 30, 2019, the election would not be effective until June 30, 2020.
Subparagraph (ii) requires that an election related to a payment based on separation from service be deferred for at least 5 years from the date the payment was supposed to take place. For example, if a payment was scheduled to be made on July 1, 2019, it would have to be postponed until July 1, 2024.
It should be noted that subparagraphs (i) and (ii) run simultaneously.
Subparagraph (iii) requires that the election to change the payment form be made at least one year before the date of the first scheduled payment. However, this subparagraph only applies to payments based on a fixed date under 409A(a)(2)(A)(iv); not payments based on separation from service under 409A(a)(2)(A)(i). As described above, payments based on separation from service are separate and distinct from payments based solely on the arrival of a specified date, and the Employment Agreement was intended to qualify as a plan payable on “separation from service.” In fact, the calculation of the benefit presumes separation from service with reference to “final average earnings,” which itself implies a separation from service.
The statute specifically says that the requirements are met if “the plan requires that any election related to a payment described in paragraph (2)(A)(iv) may not be made less than 12 months prior to the date of the first schedule payment under such paragraph.” That is the exact quote from the statute. That provision is limited to elections “related to a payment described in paragraph (2)(A)(iv),” which is for payments based on a specified date rather than a payment based on separation from service under (2)(A)(i).
Change in Form of Payment
Treas. Reg. § 1.409A-3(j) explains the general rule against acceleration of benefits. Converting to a lump-sum payment would be an acceleration of benefits prohibited by the statute itself under Section 409A(a)(3). However, Treas. Reg. § 1.409A-2(b)(5) explains that Treas. Reg. § 1.409A-2(b)(1) is exempt from the anti-acceleration rule.
Treas. Reg. § 1.409A-2(b) regulates “subsequent changes in time and form of payment” as covered in the statute under Section 409A(a)(4)(C). In other words, you can change the form of payment to a lump sum, but it has to be done in accordance with Treas. Reg. § 1.409A-2(b).
This regulation provision explains that a plan may permit or be amended to permit an irrevocable election to change the form of payment based on the same conditions outlined in the statute under Section 409A(a)(4)(C)(i)-(iii). This has already been discussed above. The first requirement is that the election is not effective for 12 months. The second is that the payment may not commence for 5 years from the original scheduled payment date. The third requirement only applies to non-separation pay plans. The first and second timeframes run concurrently.
Treasury Regulation 1.409A-2(b) permits a plan to allow a “subsequent election… [to make] a change in the form of payment… only if… such election becomes irrevocable under the terms of the plan… [and] the following conditions are met,” which then recites the 3 requirements extensively discussed above: election having 12 months of postponed effectiveness, 5 year deferral on payment, and the third requirement being inapplicable to a separation pay plan.
Regulations Limiting Change in Form of Payment Are Invalid Nevertheless
Our interpretation is entirely consistent with regulations promulgated by the U.S. Treasury. Nevertheless, assuming arguendo that our interpretation was inconsistent, it is important to explain that taking a position contrary to established regulations is not unheard of. In fact, there’s a specific form for it: IRS Form 8275-R. The instructions to that form specifically direct to “use this form only to disclose items or positions that are contrary to Treasury regulations.” It’s important to know that Treasury regulations are not indisputable. That’s why IRS Form 8275-R exists. Judicial deference to treasury regulations was severely weakened with 3 major cases in 2010 and 2012: Home Concrete, Intermountain, and Dominion.
The first decision from the United States Supreme Court held that Treasury regulations cannot stretch the plain meaning of a statute. The second decision from the United State Tax Court ruled that, if a statute is unambiguous and clear on its face, then it forecloses Treasury’s ability to promulgate regulations to “fill-in gaps.” The third decision from the United States Court of Appeals for the Federal Circuit held that regulations cannot exceed the intent of Congress.
That’s three serious limitations: plain meaning cannot be stretched, clarity forecloses interpretation, and scope is limited to congressional intent.
This is critical because Section 409A(a)(4)(C) is absolutely clear; there is zero ambiguity. The requirements are that a change in form of payment not be effective until one year later and that payments must be deferred 5 years; the third requirement is only applicable to specified date plans – not separation pay plans. Therefore, none of the regulatory complexity applies.
Everyone knows that a Life Annuity is a monthly payment for life. Despite this clear and simple statute passed by Congress, Treas. Reg. § 1.409A-2(b)(2)(ii) attempts to declare that a “life annuity is treated as the entitlement to a single payment,” which directly violates the U.S. Supreme Court’s Home Concrete “plain [dictionary] meaning” standard as well as the U.S. Tax Court’s Intermountain “unambiguous” standard. By virtue of Congress’ clarity in the statute, it is even further arguable that the U.S. Federal Circuit’s Dominion “congressional intent” standard is violated. Section 409A was a response to accounting abuses by Enron; it was not intended to entirely regulate deferred compensation plans that are non-abusive.
Lawsuit Settlements Permit Qualified Acceleration Qualifying under Section 409A
Treas. Reg. § 1.409A-3(j) explains the general rule against acceleration of benefits. It contains several exceptions, however, under subparagraph (j)(4). The fourteenth exception under (j)(4)(xiv) is for “Bona Fide Disputes as to a Right to a Payment.” Any acceleration of benefits pursuant to a lawsuit settlement are honored as qualifying under Section 409A.
Therefore, in some cases, pursuing litigation would actually be advantageous for all parties since any resulting settlement would be classified as a Qualified Accelerated Payment under Treas. Reg. § 1.409A(j)(4)(xiv).
If you’re in a situation where you need to make a change in the form of payment, but your company is saying it’s impermissible, you would benefit from contacting our firm. We can schedule a free consultation to discuss you’re the specifics of your situation.