This blog is part of a 12-part series entitled The nonqualified deferred compensation plan (NDCP) dirty dozen: An administrative guide to avoiding 12 traps.

The process of deferring a portion of a participant's pay under a nonqualified deferred compensation plan (NDCP) can, at first glance, appear quite similar to how such deferral would be handled under a 401(k) plan. Participants designate a specified dollar amount or percentage of their pay they wish to defer under the plan. The plan sponsor then arranges for such amounts to be deducted from the participants pay and allocated to an account maintained on their behalf under the plan. However, upon delving deeper, we see stark differences that must be observed by NDCP participants and sponsors in order to comply with Internal Revenue Code Section 409A. As with many of 409A's rules, the restrictions on deferral elections require tight timing. This blog will highlight the differences between permissible 401(k) and NDCP deferral elections while also describing some of the plan design options available to provide participants with at least some flexibility when making their NDCP deferral elections with respect to salary and bonuses. While 409A also contains specific rules governing other types of deferrals (e.g., short-term deferrals, commission, etc.), analysis of such rules is beyond the scope of this series.

NDCP deferrals: Generally Election Day comes just once a year
Typically, 401(k) plans permit participants to make deferral elections as soon as their first payroll periods coincident with or next following the date on which they meet the plan's eligibility requirements. If any participant fails to defer when first eligible, a 401(k) plan could allow them to begin deferring as of any subsequent payroll period. Similarly, a 401(k) plan can generally permit participants to increase, decrease, or discontinue their rates of deferrals as of any subsequent payroll period. In contrast, while a participant's initial deferral opportunities under an NDCP are somewhat similar to the 401(k) plan, once the first deferral chance passes, there is considerably less flexibility.

Under an NDCP, in the case of the first year in which a participant becomes eligible to participate in the plan (whether it is a brand new plan or an existing plan for which the individual has just become eligible), participants have until 30 days after they first become eligible to make their salary deferral elections. Such elections must only apply to compensation (whether in the form of salary or bonus) paid for services to be performed beginning with the first payroll period after the election. If participants pass on this initial deferral option, they will not have another deferral opportunity until January 1 of the next calendar year. Similarly, for those participants who do elect to defer a portion of their salaries when first eligible, no changes to such initial elections can be made until January 1 of the next calendar year.

Because all NDCP deferral elections (including elections not to defer) are locked in for the calendar year in which they are made, plan sponsors need to be sure that their corporate cultures and populations are the right fit and that they have effectively provided the appropriate caveats before deciding to offer participants evergreen elections. Under such elections participants have the ability to make an NDCP deferral election and then have that election automatically roll over from year to year unless they specify otherwise before the applicable January 1. Without such a fit and/or without any proactive measures in place, such a design runs the risk of participants forgetting to get decrease or discontinuance requests to sponsors on time and then being stuck for the coming year with deferral rates that they do not want, or worse, may not be able to afford, given their anticipated cash flow and expenses for such year. In order to prevent this predicament, the NDCP sponsor can instead require that the participants reenroll each year by making a new salary election prior to January 1 of each year. This design is particularly effective in decreasing potential participant complaints if combined with a strong annual communications campaign during an open enrollment period that begins as early as October and ends on whichever day in December is the last day that the plan administrator is able to accept the election in order to process it for the first payroll period in January, during which the participant earns pay attributable to services performed in the new year. (Note: any carry-over pay from the previous year, i.e., pay earned in the previous year but not payable until January of the current year, will be subject to the previous year's deferral rate.)

Taking the onus out of bonus deferrals
Because of the various Internal Revenue Service (IRS) restrictions that limit the amount that highly compensated employees can defer into a 401(k) plan in any given year, wide fluctuations in their bonus amounts from year to year will probably have little, if any, effect on their allowable 401(k) deferral amounts. Whether it is due to nondiscrimination testing cutbacks, the maximum annual dollar limit ($18,000 in 2016), or the annual limit on the amount of compensation that can be taken into account ($265,000 for 2016), chances are that applying the elected deferral rate of these participants to just their salaries will bump up against one of these limits even before factoring in any bonuses.

Because no such limits apply to NDCP deferrals, plan sponsors need to take the possibility of bonus fluctuations into account when designing their NDCPs. There are two basic ways to address this issue.

(1) No bonus deferrals allowed: The simplest method is to avoid the issue entirely by structuring the plan so that participants may only defer a portion of their regular salaries (i.e., bonuses will be specifically excluded from the plan's compensation definition for this purpose). This option may also be preferable for those plan sponsors who, for tax reasons, wish to limit the total amount that participants may defer, because the more dollars that are deferred under the NDCP, the less current deduction the plan sponsor gets to take.

(2) Allow separate deferral elections for regular salary and bonus pay: A typical example of this would be a provision under which participants could defer up to 50% of their regular salaries and up to 75% of their bonuses.

For sponsors who opt for the latter method, there is still the matter of dealing with the potential uncertainty of the bonus amount. This is a problem because of the previously discussed requirement that deferral elections be made prior to the beginning of the calendar year of reference. While participants typically are comfortable with locking in a particular deferral rate on their salaries (which, absent unexpected midyear salary hikes, they already know), they may have some qualms about doing so with their bonuses, whose amounts may vary based on circumstances that occur after the year begins (e.g., company financials, their individual performances).

Fortunately, the 409A rules do provide some relief in this area for participants. There is an exception to the normal deferral election timing requirements for performance-based compensation, which 409A generally defines as compensation the amount of which, or the entitlement to which, is contingent on the satisfaction of pre-established organizational or individual performance criteria relating to a performance period of at least 12 consecutive months.

If the compensation in question meets the 409A standard of performance-based compensation, the participant's deferral election may be made with respect to such performance-based compensation on or before the date that is six months before the end of the performance period. As a result, in the case of an NDCP maintained by plan sponsor with a calendar year fiscal year, while the annual salary deferral elections would have to be made prior to January 1 of each year, participants would have until June 30 to make their bonus deferral elections, assuming the performance period is the fiscal year. This six-month delay is available provided the following conditions are met:

(1) The participant performs services continuously from the later of (a) the beginning of the performance period, or (b) the date the performance criteria are established through the date an election is made.

(2) In no event may an election to defer performance-based compensation be made after such compensation has become readily ascertainable. For this purpose, when the amount is considered readily ascertainable depends upon whether or not the performance-based compensation is a specified or calculable amount. If it is, the compensation is readily ascertainable if and when the amount is first substantially certain to be paid. If it is not (for example, because the amount may vary based upon the level of performance), the compensation, or any portion of the compensation, is readily ascertainable when the amount is first both calculable and substantially certain to be paid. The rules provide that the performance-based compensation is bifurcated between the portion that is readily ascertainable and the amount that is not readily ascertainable. Accordingly, in general, any minimum amount that is both calculable and substantially certain to be paid will be treated as readily ascertainable.

Because the determination of whether or not a particular bonus qualifies as performance-based pay under 409A can be complex, the plan sponsor should be sure to meet with its employee benefit consultant and ERISA counsel prior to designing a plan to permit participants to make these midyear deferral elections. In the event that the bonus payments do not satisfy the 409A standard for performance-based pay, but the sponsor still wants to offer the participants the option of making separate bonus deferral elections, such election must be made at the same time as the salary deferral elections, assuming that the plan sponsor has a calendar year fiscal year and/or bases the bonus on a calendar year performance period. If the sponsor has a non-calendar-year fiscal year, pays the bonus based on performance during such period, and the bonus does not meet the above-reference standard, then the bonus deferral election would have to be made prior to the beginning of the fiscal year. However, in either case, even though the bonus deferral election does not qualify for the six-month delay, it can be structured in such a way as to provide participants with at least some protection against such early election causing the participant to either defer significantly more or less than they intend because of an unexpected extreme increase or decrease in the bonus amount. For example, the NDCP could offer some type of multi-tiered bonus election under which participants have the ability to limit their bonus deferral election to only that portion of such bonus either above or up to a specified threshold. The selection of the method should be based on the organization's bonus history as well as the anticipated future cash flow needs of the participants. Accordingly, NDCP sponsors interested in pursuing such options should contact their employee benefit consultants and ERISA counsel for assistance with implementing a plan design that is the best fit for their participants and organization.