It's a Trap! Beware the Anti-Toggle Rule under I.R.C. § 409A
By Stephen A. Beck on May 31, 2017
Companies often utilize deferred compensation arrangements to incentivize their workers to use their best efforts to grow the value of those companies. If a company provides a worker with a legally binding right to payment that will be received in a future year, that arrangement generally constitutes a nonqualified deferred compensation plan. As such, the plan must satisfy all of the requirements under I.R.C. § 409A in order to avoid potentially disastrous tax consequences to the worker. Noncompliance with I.R.C. § 409A causes the worker to include in gross income for the year of noncompliance all of the non-vested compensation that had previously been deferred under plan. See I.R.C. § 409A(a)(1)(A). Noncompliance also causes the worker’s tax liability for the year of noncompliance to increase by the sum of: (i) the amount of interest that would have accrued on the previously deferred amounts at the underpayment rate plus one percent; plus (ii) an additional amount equal to twenty percent (20%) of the compensation that is required to be included in income by reason of the I.R.C. § 409A noncompliance. See I.R.C. § 409A(a)(1)(B).
One requirement under I.R.C. § 409A is that the plan must provide that payments of deferred compensation can be made to the worker only upon the occurrence of certain qualifying events. See I.R.C. § 409A(a)(2); Treas. Reg. § 1.409A-3(a). These events (the “Payment Events”) include: (i) the worker’s separation from service with the company; (ii) the date the worker becomes disabled; (iii) the date of the worker’s death; (iv) a specified time (or fixed schedule) that is set forth under the plan no later than the date on which the compensation is first deferred; (v) a change in ownership or control of the service recipient corporation or a substantial portion of that corporation’s assets; and (vi) an unforeseen emergency. See I.R.C. § 409(a)(2)(A). The Treasury Regulations elaborate the standards that must be satisfied for each Payment Event. See Treas. Reg. § 1.409A-3.
If a plan provides for payment upon any of the Payment Events, the plan will generally comply with I.R.C. § 409A, as long as the plan provides that payment will be made on the actual date of the Payment Event or another payment date that is objectively determinable and nondiscretionary at the time the Payment Event occurs. See Treas. Reg. § 1.409A-3(b). In addition, the plan can generally provide that the payment will be made upon a schedule that is objectively determinable and nondiscretionary based on the date the Payment Event occurred, provided that the schedule is fixed at the time the Payment Event is designated. See id.
A client may review I.R.C. § 409A and incorrectly conclude that, as long as payments under the deferred compensation plan are triggered by a Payment Event, the client can provide alternative schedules for making payments following that event. For example, a company may wish to provide in its deferred compensation plan for the following alternative payment schedules following a separation for service: (i) if the company terminates the worker without cause, a payment of $150,000 would be made in a lump sum on the thirtieth day following the date of termination; and (ii) if the worker terminates for other than good reason, the payment would be made in equal installments of $50,000 on each of the three anniversaries of the date on which employment was terminated.
This hypothetical payment arrangement would generally violate I.R.C. § 409A. The Treasury Regulations provide that a deferred compensation plan generally must provide only one time and form of payment upon the occurrence of each Payment Event. See Treas. Reg. § 1.409A-3(c). This rule is commonly referred to as the “anti-toggle” rule; i.e., the company and worker generally cannot toggle the payment schedule that would apply in connection with any specific Payment Event.
There are certain exceptions to the “anti-toggle” rule that may be available in a particular situation. For example, a plan may provide for alternative payment schedules depending on whether separation from service occurs before or after a specified date, such as the worker attaining a specific age. See Treas. Reg. § 1.409A-3(c)(2). In addition, there are other exceptions from the “anti-toggle” rule that would permit alternative schedules for payments following separations from service. See Treas. Reg. § 1.409A-3(c). There are also other exceptions applying to payments triggered by other Payment Events. See id.
It is also important to note that the “anti-toggle” rule only prohibits alternative payment schedules based on a single Payment Event and does not prohibit a plan from providing that no payments will be made at all upon a certain subset of that event. See id. Thus, it may be possible to provide in the deferred compensation plan that the worker will generally be entitled to receive a payment on a specific date or subject to a fixed schedule following a separation of service, except that the worker will not be entitled to any payment whatsoever if that worker is terminated for cause.
Whether any of the exceptions to the “anti-toggle rule” would apply to permit a company to specify alternative payment schedules in its desired manner must be analyzed carefully. An inadvertent violation of the “anti-toggle” rule could lead to burdensome tax liability for the worker due to noncompliance with I.R.C. § 409A. Furthermore, if a deferred compensation plan contains provisions in violation of the “anti-toggle” rule, it may be possible to correct that plan prior to the date on which the problematic Payment Event occurs. See I.R.S. Notice 2010-6, 2010-3 I.R.C. 275. If anyone has any questions regarding how their clients might be able to structure their deferred compensation arrangements to achieve their business objectives without causing problems with the “anti-toggle” rule, please contact Stephen Beck at 214-749-2401.
The material contained within Meadows Collier Tax Blog - MC Talks Tax and any attached or referenced pages, has been written or gathered by Meadows, Collier, Reed, Cousins, Crouch & Ungerman, L.L.P., for information purposes only. It is not intended to be and is not considered to be legal advice. Transmission is not intended to create and receipt does not establish an attorney-client relationship. Legal advice of any nature should be sought from legal counsel.