Executives often participate in various nonqualified deferred compensation plans designed to reward upper management.  These can be simple plan designs such as electively deferring a portion of their salary or bonus until a later year.  Or the plan can be more complicated such as awards of phantom stock or stock appreciation rights that will pay compensation to the Executive at a future date based on the value of the employer where the number of units awarded depend on the Executive meeting certain performance goals.  These deferred compensation arrangements generally must comply with Internal Revenue Code section 409A unless exempted.  Failing to comply causes the Executive to be subject to income tax on the deferred compensation as soon as the right to receive it is non-forfeitable.   Such taxable amount is also subject to an additional 20% federal tax and California imposes its own 5% additional tax.

Ceasing Deferrals.  An Executive experiencing financial difficulties as a result of the Covid-19 Pandemic (Pandemic), may desire to stop any elective deferrals of compensation into a deferred compensation plan in order to have more “take home” pay.  However, Code section 409A has strict rules regarding making deferrals and changing them.  First, an elective deferral must generally be made before the end of the year prior to the year in which the compensation is earned.  Additionally, unlike elective deferrals into a 401(k) plan which can be stopped at any time, a deferral of compensation into a plan subject to Code section 409A generally cannot be altered once made for the year.  Thus, had an Executive elected to defer 10% of 2020 salary in an election made prior to the end of 2019, the Executive cannot cancel such deferral in 2020 without violating Code section 409A.  The exception to this rule is if the plan permits deferral elections to be cancelled as the result of an unforeseeable emergency discussed further below.

Unforeseeable Emergency Distributions.  An Executive may also wish to access compensation previously deferred to relieve financial stress caused by the Pandemic or medical expenses resulting from COVID-19.  Code section 409A governs what events may give rise to a distribution under a deferred compensation arrangement.  These are: separation from service, death, disability, a specified date, a change in control, and an unforeseeable emergency.  The triggering events permitted by the plan must be set forth in the written plan document.  Code section 409A also contains a prohibition against accelerating payment of deferred compensation even if it means the Executive receives less than deferred by taking a “haircut” penalty.  This is prohibited due to several highly publicized corporate abuses involving haircuts before Code section 409A was enacted.

Circumstances caused by the Pandemic might be eligible as an unforeseeable emergency If that triggering event is permitted under the plan document.  If the deferred compensation plan does not already provide for such a triggering event, it may be amended to add it.  A distribution on account of an unforeseeable emergency is different than hardship distributions permitted in a 401(k) plan.  Additionally, the CARES Act permitted 401(k), and other types of qualified plans, to specifically permit distributions to participants affected by COVID-19.  However, deferred compensation plans for Executives are not permitted to allow COVID-19 specific distributions and unlike hardship distributions from 401(k) plans, there are no safe harbor rules that an employer may rely on, when determining whether an Executive  experienced an unforeseeable emergency.  Whether this has occurred is based on the facts and circumstances.

Code section 409A defines an unforeseeable emergency as extraordinary and unforeseeable circumstances beyond the control of the employee that causes the employee severe financial hardship that cannot be alleviated by (1) compensation or reimbursement received from insurance companies or otherwise, (2) liquidation of the employee’s assets, or (3) ceasing future deferrals of compensation.  Specific examples of unforeseeable emergencies include:

  1. The employee’s (or the employee’s spouse’s, beneficiary’s or dependent’s) illness or accident.
  2. Imminent foreclosure or eviction of the employee’s primary residence.
  3. The need to pay medical expenses (including nonrefundable deductibles) or prescription drug medications.
  4. 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.

Clearly the Pandemic is an event out of the control of an Executive.  However, to permit a distribution, the deferred compensation must be needed because the Executive has no other resources to use such as savings or ceasing elective deferrals into the deferred compensation plan or a 401(k) plan.  Therefore, it will likely be difficult for an Executive to meet this burden, and get a distribution, especially if there is money available under a 401(k) plan or the emergency can be met by ceasing deferrals to the 401(k) plan and the deferred compensation plan.

Plan Termination.  Another way that Executives could receive their deferred compensation early without a triggering event would be for the employer to terminate and liquidate the plan (and all like it).  However, this would not likely help an Executive that is feeling financial stress due to the Pandemic because of the requirements of the termination.  First, the employer cannot terminate the plan proximate to the employer experiencing a financial downturn.  Thus, this option is likely not available if the employer is suffering economically as a result of the Pandemic.  Second, once terminated, the plan may not make liquidating distributions to participants for 12 months but must make all distributions within 24 months of the termination date.  Additionally, the employer cannot adopt a replacement plan for 3 years.

Conclusion.  Code section 409A limits the ability of Executives to use deferred compensation plans to alleviate financial hardships derived from the Pandemic.  Given the potential tax consequences, Executives and employer-administrators should be very careful about requests to access deferred compensation due to the Pandemic.