Due to the economic and financial upheaval caused by the coronavirus (COVID-19) pandemic, many employees are asking their employers if they are able to cancel their deferral elections and/or receive accelerated payments from their nonqualified deferred compensation plan accounts to help offset financial difficulties they may be facing.
Generally, Internal Revenue Code Section 409A and the regulations promulgated thereunder do not allow for the alteration or cancellation of deferral elections or the acceleration of payments under plans subject to Section 409A. However, Section 409A does allow for the cancellation of a deferral election and/or acceleration of payments if an employee experiences an “unforeseeable emergency” within the meaning of Section 409A.
The standard for establishing an unforeseeable emergency under Section 409A is high, but the conditions created by COVID-19 may result in certain employees having situations that meet this threshold. Unlike the rules governing hardship distributions under 401(k) plans, there are no safe harbor rules that an employer may rely on when determining whether an employee has experienced an unforeseeable emergency. Whether an employee is experiencing an unforeseeable emergency under Section 409A is based on a facts and circumstances analysis.
At a minimum, for an event to constitute an unforeseeable emergency, the event must both arise from extraordinary and unforeseeable circumstances beyond the control of the employee and cause 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.
Events that might trigger an unforeseeable emergency include the following:
- An illness or accident of the employee or employee’s spouse, beneficiary, or dependent
- The loss of the employee’s property due to casualty
- The immediate foreclosure of or eviction from the employee’s primary residence
- The need to pay for medical expenses (including nonrefundable deductibles) or prescription drug medications
- The need to pay for funeral expenses of a spouse, beneficiary or dependent
- Other similar extraordinary and unforeseeable circumstances arising out of events beyond the control of the employee (Section 409A specifically provides that the need to purchase a home or to pay college tuition are not unforeseeable emergencies)
Cancellation of Deferral Elections Due to an Unforeseeable Emergency
A nonqualified deferred compensation plan that permits or requires deferrals by employees must provide that deferral elections be made in accordance with the applicable rules under Section 409A. Generally, an employee must make a deferral election in the calendar year before the year in which the applicable services are performed, and an election is not considered made until it is irrevocable. Any subsequent revocation or cancellation of the election, absent a specific exception, would result in a violation of Section 409A.
One such exception is that an employee’s deferral election may be cancelled if an employee experiences an unforeseeable emergency or takes a hardship distribution from the employer’s 401(k) plan. Under this exception, the deferral election must be cancelled and not merely postponed or otherwise delayed. The current statutory language does not allow for the cancellation of a deferral election due to a qualifying coronavirus distribution.
Acceleration of Payments Due to an Unforeseeable Emergency
Generally, Section 409A provides, subject to a number of limited and narrow exceptions, that a plan may not permit any acceleration of the payment of a deferred amount; however, if allowed pursuant to the terms of the plan, an employer may allow a limited payment of deferred compensation to an employee (or an employee’s beneficiary) if the employee (or an employee’s beneficiary) experiences an unforeseeable emergency. In addition, a plan may provide for the payment of deferred compensation upon certain types of unforeseeable emergencies without providing for payment upon all types of unforeseeable emergencies.
The amount of deferred compensation paid upon the occurrence of an unforeseeable emergency must be limited to the amount reasonably necessary to satisfy the emergency need. In determining the amount necessary to satisfy the emergency need, the employer must take into account the additional compensation that the employee could obtain by cancelling future deferral elections under all qualified and nonqualified deferred compensation plans.
Action Item for Employers
Employers should review their nonqualified deferred compensation plans to ensure that they include the provisions necessary to take advantage of the flexibility Section 409A allows in the event of an unforeseeable emergency occurring.