In response to the unprecedented worldwide COVID-19 pandemic, businesses are turning to cash flow issues resulting from the abrupt economic downturn.  Companies are looking to reduce operating costs and employees are considering how they can increase their take home pay.  At a time of declining revenues, instead of reducing executives’ base salaries or other short-term cash compensation, some of our clients are asking if they can suspend company contributions to their nonqualified deferred compensation plans, and/or permit executives who made elections to defer compensation the ability to revoke their 2020 deferral elections. 

If an employer contribution to a nonqualified deferred compensation plan is discretionary, the employer may be able to suspend its contribution in accordance with its terms.  A plan amendment may be necessary, but once amended, employer contributions can be prospectively suspended.  While the Internal Revenue Code (Code) Section 409A rules governing deferred compensation plans provide some flexibility in plan design, plan sponsors must closely review governing plan documents to determine whether midyear changes in design are permitted.  Companies should also carefully review relevant employment agreements and related compensation documents to determine if such reductions are permitted.

Code Section 409A does not permit employer discretion to cancel deferral elections (by plan amendment or otherwise).  However, if the participant has made an election to defer performance-based compensation, the Code provides that deferral elections can be changed or cancelled as long as that change occurs with at least six months remaining in the performance period.  Whether the plan can permit an election change in this circumstance depends on plan terms and whether the compensation being deferred is “performance based”.   To be “performance-based” compensation under Code Section 409A, the relevant performance goals must be established no later than the first 90 days of the performance period.  Companies that change performance goals after March 2020 may not permit a performance-based compensation deferral election.  Because of the complexities of these rules, companies should review the plan’s deferral election procedures as well as the relevant performance compensation metrics.

Additionally, if a nonqualified deferred compensation plan so provides, it may permit a deferral election cancellation on account of an unforeseeable emergency.  An unforeseeable emergency is generally defined in Code Section 409A as a severe financial hardship to the participant resulting from an illness or accident to the participant, the participant’s spouse, or a dependent of the participant, a loss of the participant’s property due to casualty or similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the service provider.  If the plan document does not permit distributions on account of an unforeseeable emergency, the plan sponsor can amend its document to add unforeseeable emergency distributions prospectively.

Although the threshold for allowing cancellation of a deferral election is high, the circumstances caused by the COVID-19 pandemic might result in an unforeseeable emergency.  Plan sponsors may not, however, simply cancel a deferral election because of the crisis.  They should also be cautious in approving unforeseeable emergency distributions.  In order to support a deferral election suspension, the facts must clearly support a determination that an unforeseeable emergency existed.  If an unforeseeable emergency distribution is approved that is not supported by the facts, the distribution could trigger Section 409A penalties.  These penalties impose significant adverse tax consequences for the employee taking the distribution, including a 20% tax on the amount of the improper distribution.