journal of spring 2016 volume 21, number deferred - aon · permitted under the plan) a payout of...

JOURNAL OFDEFERREDCOMPENSATIONNonqualified Plans andExecutive Compensation

Editor-in-Chief: Bruce J. McNeil, Esq.

To start your subscription toJournal of Deferred Compensation,call 1-800-638-8437

VOLUME 21, NUMBER 3 SPRING 2016

• EDITOR’S NOTE

Bruce J. McNeil ...................................iii

• NONQUALIFIED DEFERRED COMPENSATION AND DOMESTIC RELATIONS ORDERS

Hitz Burton, Elizabeth Groenewegen, and Lee Nunn .....................................1

• SETTLING DISPUTES WITH THE DEPARTMENT OF LABOR

John L. Utz .........................................18

1

Nonqualified Deferred Compensation and Domestic Relations Orders

HITZ BURTON, ELIZABETH GROENEWEGEN, AND LEE NUNNHitz Burton is a Partner and legal consultant in Aon Hewitt’s Legal Consulting & Compliance practice in Newport Beach, California. He may be reached at [email protected].

Elizabeth Groenewegen is an associate partner in Aon Hewitt’s Legal Consulting & Compliance practice in San Francisco, California. She may be reached at [email protected].

Lee Nunn is a senior vice president in Aon Hewitt’s Executive Benefits practice in Atlanta, Georgia. He may be reached at [email protected].

Copyright 2015 Aon plc

Retirement plan assets are often a significant part of marital assets in a divorce. For executives, the most substantial retirement asset is often benefits due under one or more nonqualified plans (rather than under their employer’s

broad-based qualified pension and 401(k) and retirement saving plans). Unlike qualified pensions and retirement savings benefits, however, nonqualified benefits may be so difficult to divide that transferring other nonretirement assets to the nonemployee spouse is ordinarily more practical. This difficulty stems from the fact that most tax and ERISA rules that apply to qualified plans do not apply to nonqualified plans. And divorcing couples cannot count on state domestic relations laws (and court orders issued pursuant to such laws) to force immediate payment of the retirement benefits due to uncertainty around the scope of ERISA preemption. Finally, some employers either refuse or resist paying nonqualified benefits to anyone but the executive during the executive’s lifetime. This article discusses issues what divorcing couples should consider in divid-ing marital assets that include nonqualified plan benefits and issues that employers should consider in establishing a consistent policy to address domestic relations orders (DROs) impacting nonqualified plan benefits.

2 / JOURNAL OF DEFERRED COMPENSATION

SIZE OF THE PIE

Regardless of the difficulty in dividing nonqualified plan benefits between divorcing spouses, nonqualified plan benefits are an important part of the marital estate. Property settlement agreements rarely give each ex-spouse an ownership interest in every asset. Instead, divorcing spouses determine the value of the marital estate and often give one spouse or the other full ownership of individual assets. Even when the nonemployee spouse will receive no direct interest in the nonqualified retirement assets, the value of these assets typically is marital property. Hence, it may be important to determine the value of the nonemployee spouse’s share of nonqualified plan benefits in order to determine the value of the marital estate.

In valuing nonqualified plan benefits in a divorce, the executive should obtain copies of all plan documents, communication materials, and benefits statements. The executive should confirm the employer’s policy on a distribution from its nonqualified plan(s) pursuant to a DRO. Measuring the value of a particular nonqualified plan benefit will depend on, among other things, whether the benefit is based on an account balance or nonaccount balance plan.

Account balance nonqualified plans are the easier of the two arrangements to measure and are more likely to be available as an immediate lump sum. Examples of account balance nonqualified plans include elective deferral arrangements and “defined contribution” sup-plemental executive retirement plans (DC SERPs). The pre-tax deferred amount is simply the account balance. Federal income taxes may reduce the gross value of the benefit substantially (depending upon the recipi-ent’s federal income tax bracket at the time of payment). FICA tax liability is simpler to determine. The executive could confirm whether all FICA taxes have been paid already. If the nonqualified plan benefit is to be received over a period of less than 10 years, or is not based solely on paying amounts in excess of a statutory limit, there may be state income tax (source tax) owed to the state in which the benefit was earned. Federal law limits state income tax to the recipient’s residence state (if applicable) when the benefit is received over a period of 10 or more years; certain other exceptions may apply.1 When payment under an account balance plan is not available as an immediate lump sum, the divorcing couple should consider the employer’s credit risk, any benefit of above-market interest rate credits that may continue to be available under the nonqualified plan, and potential changes in future tax rates.

Nonaccount balance plans are more difficult to value and are less likely to be available as an immediate lump sum. A traditional defined benefit SERP is a nonaccount balance plan. Converting a future benefit

NONQUALIFIED DEFERRED COMPENSATION AND DOMESTIC RELATIONS ORDERS / 3

paid as a life annuity to an actuarial present value generally requires the services of an accredited pension actuary who understands applicable state law on DROs and the requirements of Actuarial Standard of Practice No. 34, Actuarial Practice Concerning Retirement Plan Benefits in Domestic Relations Actions (ASOP No. 34). Among other require-ments, ASOP No. 34 describes specific factors the actuary should take into account in selecting reasonable assumptions for valuing retirement plan benefits subject to a DRO. Actuarial calculations for tax and accounting purposes generally do not meet the requirements of ASOP No. 34. Federal income taxes may also reduce the value of the benefit substantially for one or the other spouse depending upon their other sources of income (or agreement between the parties). FICA taxes (discussed later) have often not been paid on nonqualified nonaccount plan benefits. State income tax may be owed to the recipient’s residence state if the benefit is received as a life annuity. State income taxes vary from state to state and may be owed to the state in which the benefit was earned if the benefit is received as a lump sum.2 When a nonac-count balance plan is available as an immediate lump sum, consider any potential forfeiture of early retirement subsidies and the subsidy (or lack of subsidy) in converting an annuity payment into a lump sum. When a nonaccount balance plan is not available as a lump sum, the divorcing couple should consider the employer’s credit risk, the executive’s health, and potential changes in future tax rates. Consider a separate interest annuity on the life of the nonemployee spouse when available if a lump sum is not available and the executive is in poor health.

Nonvested retirement arrangements also can serve to increase the value of marital assets, but inclusion varies by state. Many states include in the marital estate all retirement benefits attributable to ser-vice performed during the marriage, regardless of whether the benefits are fully vested. Determination of the present value of those benefits, however, can be difficult and any nonvested benefit could be forfeited. Valuation of nonvested benefits is beyond the scope of this article.

DIVIDING NONQUALIFIED RETIREMENT ARRANGEMENTS

As stated above, account balance arrangements are more fre-quently available as immediate lump sums than nonaccount balance arrangements. When an immediate lump sum is available, immediate payout to the nonemployee spouse is often more practical than tracking separate balances for the executive and the nonemployee spouse. When the immediate lump sum includes both a balance subject to Internal Revenue Code (IRC) § 409A and a balance that is grandfathered (i.e.,


not subject to IRC § 409A), the executive should consider (to the extent permitted under the plan) a payout of the § 409A balance first to pre-serve the payout flexibility for the grandfathered balance. For example, a grandfathered balance may be available on demand subject to a 10 percent “haircut” penalty or at the scheduled payout date without the penalty. If an immediate lump sum is not available, consider the practical challenges in separating the executive’s account balance from the nonemployee spouse’s account balance when payouts begin. Some plan recordkeepers may be able to track executive and spouse balances separately, although sometimes at additional cost. Separate tracking can take the form of an entire phantom account or class year record-keeping. Absent separate recordkeeping, consider the effect of future deferrals, additional employer contributions, and rebalancing when multiple accounts are present.

Example 1: Adam participates in a nonqualified 401(k) restoration plan that allows elective deferrals and reflects employer matching contributions. During divorce nego-tiations, Adam learns that the recordkeeper refuses to track executive and former spouse balances separately. Nevertheless, Adam considers assigning 50 percent of his vested balance on the date of divorce to Angela, his soon-to-be-former spouse. After Adam considers the effect of additional deferrals, matching contributions, and rebalanc-ing, Adam is skeptical that he will be able to distinguish his balance from Angela’s balance. Instead, Adam consid-ers substituting another marital (nonretirement) asset for Angela’s share of the 401(k) restoration plan.

It may be possible to track balances separately, even when the plan recordkeeper is unable (or unwilling) to do so. An independent financial advisor may be able to use information from the recordkeeper’s Web site to track the value of investment units assigned to the nonemployee spouse, but dedicating a particular investment fund (or funds) to the nonemployee spouse may be more practical.

Example 2: Barbara participates in the same nonquali-fied 401(k) restoration plan as Adam and agrees to assign 50 percent of her vested balance on the date of divorce to Bill, her soon-to-be-former spouse. However, Barbara and Bill designate a target date retirement fund as the sole investment available to Bill. None of Barbara’s funds are invested in the target date retirement fund occupied


by Bill. Barbara continues to defer compensation into the plan; her employer continues to credit matching contribu-tions; and Barbara rebalances quarterly. When the employer begins to pay benefits, the distributions from the target date fund (or its successor) determine Bill’s share of the non-qualified 401(k) benefits.

Even when a divorcing couple succeeds in tracking separate bal-ances, the nonemployee spouse may be uncomfortable with not hav-ing direct access to the benefit information and control over when the executive can change investment allocations and the time and form of payments. Furthermore, the executive and the nonemployee spouse may disagree on particular asset allocation decisions and time and form of payment, even when direct access to plan information is available to the nonemployee spouse. Executives and their soon-to-be-former spouses should consider immediate lump sums (when available) or substituting other marital assets for account balance nonqualified plans when track-ing separate balances is not practical. Nonqualified benefit payments are not guaranteed, so the executive needs to understand that he or she may be giving up an existing asset for one that he or she may never end up receiving.

For nonaccount balance plans, the bad news is that immediate lump sums for DRO distributions are less frequently available, but the good news is that dividing scheduled benefit amounts is simpler. If an immediate lump sum is available from a nonaccount balance plan, a divorcing couple should analyze the value of the lump sum relative to the value of the scheduled benefits. For example, an immediate lump sum could cause a forfeiture of early retirement subsidies or the use of unfavorable assumptions regarding the discount rate and mortality. In other words, the availability of an accelerated lump sum doesn’t neces-sarily make it the most attractive option.

More frequently, a nonaccount balance plan offers a life annu-ity starting shortly after the executive’s separation from service. If the nonemployee spouse’s benefit is available as a separate interest, consider recalculation of the actuarially equivalent benefit based on the nonem-ployee spouse’s date of birth. Mortality assumptions are required to be unisex under federal civil rights employment law.3

Example 3: Charlie has a vested retirement benefit of $10,000 per month in a defined benefit SERP on the date his divorce is finalized. The divorce decree assigns $5,000 of the monthly benefit to Cindy, Charlie’s former spouse, who is concerned that monthly benefits will stop if


Charlie predeceases her. Charlie’s employer allows divorced spouses to have separate interests in the SERP benefits and recalculates an equivalent monthly benefit of $4,800 per month to reflect her younger age. The $4,800 monthly ben-efit begins on the same date that Charlie receives his first monthly SERP benefit and continues until Cindy’s death (even if Charlie predeceases her).

If the employer will not pay the nonemployee spouse directly, any alimony based on designated SERP benefits should be paid only if, as, and when received by the executive. This avoids the situation in which the executive relies on the monthly benefit to finance alimony payments and then continues to be obligated to make the alimony payments after the employer discontinues benefit payments upon bankruptcy. Likewise, a formal tie avoids the situation in which the employer settles the SERP benefit with a lump-sum payment while the executive continues to be obligated to pay monthly alimony payments. Alimony payments that are independent of the related SERP benefits run the risk that the lump sum will not be enough to fund the future alimony payments.

Example 4: Denise has a vested nonqualified retirement ben-efit of $10,000 per month in a defined benefit SERP on the date her divorce is finalized. The divorce decree assigns $5,000 of the monthly benefit to David, Denise’s former spouse, pay-able over Denise’s lifetime. Denise’s employer refuses to pay anyone but the participant during the participant’s lifetime under the SERP plan’s anti-alienation provision. Denise tentatively agrees to pay David $5,000 per month when she begins receiving the SERP benefits. However, Denise is wor-ried that her employer might eventually declare bankruptcy and default on the SERP benefits. Denise also worries that her employer might terminate and liquidate the SERP through a lump-sum settlement. Any lump sum is not guaranteed to be sufficient to fund future alimony payments. With these risks in mind, Denise agrees to pay David $5,000 per month if, as, and when she receives those SERP payments. If Denise’s employer settles the SERP in a lump sum, she will pay David a prorata share of the lump sum.

Even a plan with an anti-alienation provision ordinarily would allow payment in the event of the executive’s death. Nonemployee spouses need a well drafted DRO to protect any rights they may have to death benefits and survivor benefits.


Example 5: Edward, age 53, participates in a defined ben-efit SERP. He was divorced from his first wife, Elaine, two years ago and is approximately two years from the earliest date he could commence nonqualified plan benefits (i.e., later of age 55 or separation from service). Edward and Elaine were married for 25 years and were married when Edward joined his current employer. The terms of their divorce decree provide that all retirement benefits arising from Edward’s employment with his current employer are to be split 50/50. Edward is considering getting remarried and wants to understand what will happen to his SERP benefit should he die prior to commencing his SERP benefit. Edward has no plans to retire and envisions work-ing for several years past age 55. Should Edward actually die prior to benefit commencement, various parties may attempt to assert rights to a death benefit, including Elaine, Edward’s then-current spouse (if any) or, if Edward does not remarry, any children he may have. In order to protect both parties’ rights, and avoid a costly and painful battle between the survivors, a DRO should have been entered at the time of the divorce—or, at the very least, the divorce agreement should have clearly specified the extent to which Elaine is entitled to pre- or post-retirement death benefits. Among other matters, the DRO should specify the death benefit payable prior to when Edward commences a benefit and whether Edward will be obligated to elect a J&S ben-efit (at least with respect to the part of the accrued benefit earned during the marriage) and name Elaine as the survi-vor beneficiary on such J&S annuity.

THE DOMESTIC RELATIONS ORDER

When a divorcing couple agrees that dividing nonqualified retire-ment arrangements is a necessary part of the division of marital assets, the executive normally coordinates with the plan administrator. A plan administrator with an established procedure for handling DROs will specify the information required to be included in the DRO. A plan that includes a strict anti-alienation clause may prevent the plan administra-tor from paying anyone but the executive during the executive’s lifetime. A plan that allows DRO distributions (or gives the plan administrator the discretion to authorize such distributions) but has no established procedure requires careful communication with either the plan record-keeper or actuary as appropriate, and may require the intervention of


legal counsel to ensure the correct result is attained. The DRO should include at least the following information:

• Name of plan

• Nonemployee spouse’s full name

• Amount or percentage of benefits to be paid to nonemployee spouse

• Specific source of benefits if applicable (e.g., benefits subject to IRC § 409A, or from a particular notional investment fund)

• Time and form of payment, if applicable

The plan administrator also needs the nonemployee spouse’s date of birth (if life annuities are to be paid) and a W-9 for the Social Security Number, but this nonpublic information is included in a separate addendum provided to the plan administrator so that it is not filed with the Court as a public document.

EMPLOYERS

Just as every divorce is different, every employer is different. Employer approaches to DRO distributions from nonqualified plans are diverse, and DRO procedures can vary even from plan to plan within a single employer. On one end of the spectrum is the nonqualified plan that specifies complete forfeiture of benefits after any attempt to assign benefits (other than elective deferrals). At the other end of the spectrum is a concierge approach, which allows separate interests and acceleration of vested benefits under a DRO.

The specific approach used in any plan often reflects corporate cul-ture, but just as often reflects a deliberate balance between minimizing administrative complexity and meeting the needs of executives who get divorced. Some plans grant plan administrators discretion to interpret plan provisions in order to avoid trying to anticipate every possibility in the plan document. (This approach can lead to potential discrimination in plan administration, and thus must be carefully considered.) Other plans take a hard line with a strict anti-alienation provision that leaves no room for interpretation (or payment to an alternate payee during the executive’s lifetime). These plans rely on ERISA’s preemption of state laws that apply to benefit plans (discussed later). Some employers impose reasonable fees to cover administrative costs and to discourage


small divorce-related transactions. While the court decisions in this area may reach different conclusions depending on the court and jurisdic-tion, the absence of specific guidance on particular ERISA and tax issues suggests that a number of different approaches could be consid-ered reasonable.

Employers should not provide the present value of future defined benefits. As noted earlier, any such valuation generally should be done by an accredited retirement actuary who understands applicable state law on DROs and the requirements of ASOP No. 34. Actuarial calcula-tions for tax and accounting purposes generally do not meet the require-ments of ASOP No. 34.

ERISA ISSUES

Most ERISA rules and regulations that apply to qualified retire-ment plans and qualified domestic relations orders (QDROs) do not apply to nonqualified plans. Parts 2, 3, and 4 of Title I of ERISA, which cover participation and vesting,4 funding,5 and fiduciary respon-sibility6 respectively, do not apply to top-hat plans, which are unfunded and “maintained by an employer primarily for the purpose of provid-ing deferred compensation for a select group of management or highly compensated employees.” ERISA’s QDRO and anti-alienation provi-sions are included in Part 2 of Title I of ERISA.7 ERISA excess benefit plans,8 which are unfunded and which restore only benefits lost to IRC § 415 limits, are entirely exempt from ERISA but have become less common since Congress imposed a compensation limit9 on qualified plans beginning in 1998. Likewise, governmental plans are not subject to ERISA.10

Part 5 of Title I of ERISA, which covers administration and enforcement, does apply to top-hat plans. These rules include ERISA’s preemption of state laws that relate to benefits.11 Although a court might interpret ERISA preemption to preclude a plan from being forced to accelerate a benefit that is not otherwise payable under the terms of the plan, it is less clear that an employer could rely on preemp-tion to refuse to pay an alternate payee when the amount and timing of the payment of the benefit would not be changed from when such amount would have been paid to the executive. For example, a United States District Court12 determined that because ERISA’s enforcement provisions (Part 5 of Title I) apply to a top-hat plan, the QDRO excep-tion to the preemption provision13 also applies to the top-hat arrange-ment. Unfortunately, the Court did not address the fact that the QDRO provision in Part 5 cross-references the QDRO definition in Part 2, which does not apply to top-hat plans. More convincing logic appears


in a different court opinion involving garnishment of a SERP, where a United States District Court directed an employer to garnish an execu-tive’s SERP benefits to pay the executive’s creditors under Maryland law.14 Likewise, a SERP sponsored by an employer having executives residing in a community property state may be ordered to pay a former spouse under the rationale that payment of the community property interest does not interfere with administration of the plan. The reason-ing behind decisions to permit (or reject) the alienation of nonqualified plan benefits by courts (and employers) can vary significantly from state to state, and such courts (and employers) may reach very differ-ent conclusions notwithstanding substantially similar facts. For this reason, divorcing couples also should confirm the effect of state law on beneficiary designations after divorce, in the event that ERISA does not preempt state law in this context.

Anti-alienation provisions are not required of top hat plans by ERISA.15 Nonetheless, such provisions are common and some courts may choose to rely on such provisions in reaching a conclusion to deny the alienation of nonqualified benefits to a former spouse. Traditionally, these provisions help avoid premature taxation under the economic ben-efit doctrine. They are also designed many times to ensure that the execu-tive, rather than a third party, receives the benefits. Paying only executives also simplifies administration of the plan. When a plan includes a strict anti-alienation provision and no plan administrator discretion on interpretation of plan provisions, paying an alternate payee, such as a former spouse, may require a plan amendment and uniform adminis-tration for all similarly situated participants in the future. Amending a plan to permit payments to former spouses creates its own risks, such as the potential loss of grandfathering under IRC § 409A16 (to the extent a grandfathered provision was to be modified) and including former spouses as participants who, standing alone, may not meet the criteria for “top-hat” eligibility.17 Although it is not clear how the inclusion of a for-mer spouse as a recipient of a nonqualified plan benefit may impact the plan’s “top-hat” status, such issue should be considered in any assessment of the implications of paying former spouses under a nonqualified plan.

TAX ISSUES

IRC § 409AWhereas ERISA provides no specific guidance on DRO distribu-

tions from top-hat plans, the IRS has addressed many of the appli-cable federal income tax issues. Although Congress did not specifically address accelerations for DROs in IRC § 409A, the finalized Treasury Regulations include DROs in the exceptions18 to the general rule that


prohibits acceleration of nonqualified plan payments. Presumably the IRS recognized an analogy between DROs and the events of death, dis-ability, and unforeseen emergencies, which are all events assumed to be beyond the control of the executive and the employer. Although distri-butions for death, disability, and unforeseen emergencies are permitted by statute,19 whereas distributions for DROs are permitted under the regulations, the distinction may not be important. Treasury Regulation § 1.409A-3(j)(4)(ii) allows, but does not require, acceleration of pay-ments to comply with a DRO:

A plan may provide for acceleration of the time or schedule of a payment under the plan to an individual other than the service provider, or a payment under such plan may be made to an individual other than the service provider, to the extent necessary to fulfill a domestic relations order (as defined in § 414(p)(1)(B)).

Payments under a DRO are not subject to the six-month delay applicable to payments triggered by a specified employee’s separation from service from a public company.20 Likewise, the IRC § 409A rules on subsequent changes in time and form of payment do not apply to pay-ments to an alternate payee pursuant to a DRO.21 On the other hand, delaying payments to accommodate an executive in the process of nego-tiating a divorce settlement might conflict with IRC § 409A provisions that require timely payment and generally prohibit providing the service provider (executive) with direct or indirect control over the tax year the deferred compensation is received. Specifically, it is unclear how divorce would make calculation of the benefit not “administratively practi-cable”22 or how divorce would cause a “disputed payment”23 under IRC § 409A’s provisions for delayed payment.

When defining a DRO in the context of IRC § 409A, almost any directive issued by a domestic relations tribunal is likely to qualify, unlike a QDRO, which must meet additional specific criteria. The § 409A regulations24 cross-reference IRC § 414(p)(1)(B), which defines a DRO as follows:

Any judgment, decree, or order (including approval of a property settlement agreement) which relates to the pro-vision of child support, alimony payments, or marital property rights to a spouse, former spouse, child, or other dependent of a participant, and is made pursuant to a State domestic relations law (including a community prop-erty law).


A DRO does not have to meet requirements of IRC § 414(p)(2), “Order Must Clearly Specify Certain Facts,” or IRC § 414(p)(3), “Order May Not Alter Amount, Form, Etc., Of Benefits”, although it clearly may be in the best interests of the parties to do so. Consequently, all parties should consider the criteria in these sections to confirm impor-tant details of payment.

Example 6: Same facts as Example 5 except assume that Edward’s SERP consists of both a “grandfathered” and “nongrandfathered” nonqualified plan benefit. Payment under the part of the SERP that is not subject to IRC § 409A (i.e., the grandfathered benefit) is linked in time and form of payment to the qualified plan (which continues to be permissible under pre-409A law). The qualified pension plan provides a traditional final average pay benefit and benefits are only available as an annuity. While Edward will not be able to commence the “grandfathered” part of his SERP benefit until he separates and commences an annuity under the qualified pension plan, the plan sponsor may accept a DRO that provides Elaine with an earlier pay-ment based on the nongrandfathered portion of the SERP benefit, since payment pursuant to an approved DRO is an exception from the general rule prohibiting acceleration of payment under IRC § 409A.

Federal Income Taxation, Reporting, and WithholdingThe IRS provides additional guidance on federal income taxation

in Revenue Rulings 2002-22 and 2004-60. Both predate IRC § 409A and involve the same fact pattern, which involved both account bal-ance and nonaccount balance plans, with payment at termination of employment. Nonqualified deferred compensation benefits payable to an alternate payee are wages taxable to the alternate payee and subject to withholding under IRC § 3402, Income Tax Collected at Source. No Form W-4 is required for the alternate payee. Employers should treat payments as supplemental wages taxable to the alternate payee and subject to flat rate withholding, which is currently 25 percent on supplemental wages up to $1 million in a tax year, and presumably 39.6 percent on supplemental wages in excess of $1 million payable to the alternate payee. Employers report the payment to alternate payees on Form 1099-MISC, Box 3, with withholding on supplemental wages in Box 4. Form W-2 does not apply for income tax reporting because the alternate payee is not an employee. Instead of filing Form 941, employ-ers file Form 945, Annual Return of Withheld Federal Income Tax.


FICA TaxationThe IRS provides guidance on FICA taxation in Revenue Ruling

2004-60. Paying the nonqualified benefit to an alternate payee does not avoid FICA taxation. Because the fact pattern in Revenue Ruling 2004-60 involved no acceleration, the amount and timing of FICA taxes were the same as if the benefits were paid to the executive. FICA withhold-ing includes 1.45 percent Medicare tax on all FICA wages, 6.2 percent on FICA wages up to the Social Security wage base ($118,500 for 2015), and 0.9 percent on FICA wages in excess of $200,000. Because FICA income and withholding are reported on the executive’s W-2, even the reporting is the same. FICA’s special timing and nonduplica-tion rules apply, and the general timing rule applies where the special timing rule has not been used. The difference is that the alternate payee (transferee), rather than the executive, pays any remaining FICA tax due on the benefit, as stated in the following excerpt from Revenue Ruling 2004-60:

To the extent the distributed payments are FICA wages, the employee FICA tax is deducted from the payment made to the transferee. The amount includible in the gross income of the transferee is not reduced by any FICA withholding from the payments (including transfers of property) to the transferee.

In evaluating whether to accept a DRO that allocates unpaid FICA taxes on the alternate payee’s portion of the benefit to the executive, the employer should understand that such approach could be perceived to be inconsistent with Revenue Ruling 2004-60.

Deducting the remaining FICA tax from the payment to the trans-feree can be a problem when the FICA tax exceeds the amount payable to the transferee. This situation is common in nonaccount balance plans that include the present value of an annuity payout in FICA wages at the benefit commencement date.

Example 7: Charlie (from Example 3) has announced his retirement next month. His employer has agreed to pay Cindy $4,800 per month for the rest of her life pursuant to a DRO. The plan’s actuary calculates the present value of this benefit as $700,000. Charlie’s year-to-date FICA wages exceed $200,000, and Charlie’s employer adds the $700,000 to Box 5 of Charlie’s W-2, which increases the FICA tax in Box 6 by $16,450, or 2.35 percent of $700,000. The $4,800 monthly benefit (reportable and


taxable to Cindy) is subject to 25 percent federal income tax withholding on supplemental wages. Cindy now lives in Florida, which imposes no state income tax. The $1,200 in income tax withholding reduces her net monthly benefit to $3,600, which is insufficient to pay the $16,450 owed for FICA.

Paying the FICA is not optional, but the employer has several choices in handling this situation. The employer can request the short-fall in cash from Cindy. The employer can loan the shortfall to Cindy and withhold the $3,600 net monthly benefit until the loan is repaid. The employer can allow a distribution from the plan to pay the FICA tax and increase the distribution amount to reflect the 25 percent income tax withholding due on that distribution. If the employer allows the distribution, the plan actuary will calculate a lower monthly benefit to reflect the distribution. The DRO should address how the FICA taxes will be paid.

The employer could also insist on the general timing rule if the shortfall is not paid in cash. The employer is not obligated to loan the shortfall or allow an acceleration of the benefit. In fact, the following excerpt from Revenue Ruling 2004-60 specifically contemplates the use of the general timing rule:

Accordingly, the nonqualified deferred compensation paid or made available to the former spouse remains subject to the rules of § 3121, including § 3121(v)(2) and the regula-tions thereunder, to determine when and whether FICA tax is applicable. Thus, to the extent the amount deferred has been previously taken into account for FICA purposes, the distribution to the former spouse of the proceeds of the account balance plan would not be treated as wages for FICA tax purposes. However, to the extent the amount deferred has not been previously taken into account for FICA tax purposes, the distribution to the former spouse of the proceeds of the account balance plan would be wages of the employee for FICA tax purposes.

Note that the IRS attributes the wages to the executive only for the purpose of determining the amount and timing of FICA taxes rather than determining who will pay those taxes. The alternate payee pays any remaining FICA taxes due on benefits paid under a DRO.

The following example illustrates how paying the FICA taxes up front under the special timing rule is usually more attractive.


Example 8: Cindy from Example 7 refuses to pay the FICA tax shortfall and Charlie’s employer refuses to loan Cindy the shortfall or allow an acceleration to pay the FICA tax. Instead, Charlie’s employer uses FICA’s general timing rule to include $57,600 in FICA wages each year. Charlie has no other FICA wages after his retirement, and the FICA tax is 7.65 percent of $57,600, or $4,406.40 per year. Charlie’s employer reports the $57,600 in Boxes 3 and 5 of Charlie’s W-2, and withholds the $4,406.40 from Cindy’s benefit until either Cindy or Charlie dies. It would have been less expensive for Cindy to pay the $16,450 up front under the special timing rule than to pay $4,406.40 for the rest of her life (assuming that Cindy lives to receive at least four years of benefit payments).

Allowing Cindy to pay the $16,450 under FICA’s special timing rule would forestall any claim by Cindy that she suffered financial harm by being required to pay FICA tax each year under the general timing rule.

State Income TaxationState income taxes on nonqualified plans can be even more

costly than FICA taxes, but careful planning can sometimes reduce or eliminate these taxes. Federal law prohibits states from taxing for-mer residents on nonqualified benefits earned in that state when the benefits are received in the form of substantially equal payments for life or at least 10 years (or to the extent that benefits are based solely on amounts in excess of Internal Revenue Code limits).25 This means that an executive who earns nonqualified retirement benefits in New York can retire to Florida to avoid state income taxes altogether as long as the payments are protected from taxation by the nonresident state under federal law. Other executives benefit by retiring to a state with lower tax rates compared to their work state. The key to avoiding taxes otherwise payable to a nonresident state in which the benefits were earned is a benefit payout protected under federal law. Benefits paid after retirement and based solely on amounts in excess of Internal Revenue Code limits are protected from taxation by nonresident states regardless of the form of payout. State income tax laws differ by state, but nonemployee spouses who receive taxable nonqualified benefits under a DRO cannot assume that no state income taxes will be paid to the state in which a lump-sum benefit was earned. A state could claim the right to tax a nonresident nonemployee spouse on a lump sum the same way it would tax a former resident who earned nonqualified benefits in that state.


PLANNING TIPS FOR EXECUTIVES AND THEIR SPOUSES

Because managing the effect of divorce on nonqualified plans is complicated, a divorcing couple should hire a family law expert with experience in nonqualified plans. Most important, do not assume that a DRO distribution from a nonqualified plan works the same way as a QDRO from a qualified plan. Gather all information related to the plans, and communicate with the plan administrator. In particular, request a copy of the plan document and confirm corporate policy on accelerating benefits pursuant to a DRO, paying benefits directly to the nonemployee spouse, and tax issues with respect to FICA and state taxes. Confirm any fee charged for administering a DRO.

Consider the different nature of account balance plans from non-account balance plans. For account balance plans, determine how you might distinguish each spouse’s balance over time. If an immediate lump sum is not available, consider substituting other marital assets for these values. Nonqualified benefit payments are not guaranteed, so the employee spouse needs to understand that he may be giving up an exist-ing asset for one that he may never end up receiving. For nonaccount balance plans, determine whether acceleration (if available) causes a loss in value because of forfeiture of early retirement subsidies or if benefits are reduced by reason of an unfavorable lump-sum actuarial factor. Consider the health of the annuitants in making any payout elections that involve life contingencies. Regardless of the nature of the benefit, consider any contingencies such as corporate bankruptcy, claw-backs, or any other possible forfeitures or defaults. If both IRC § 409A and grandfathered benefits are available, consider how the distinction affects any division or acceleration of the benefits. Consider the effect of taxes, including federal income taxes, FICA, and state income taxes. Confirm applicable state law on including nonvested benefits in marital assets and the effect of divorce on beneficiaries.

PLANNING TIPS FOR EMPLOYERS

Because of the complexity of the ERISA and tax issues, employers should rely on the advice of tax and ERISA counsel with expertise in nonqualified plans. Employers should develop a consistent policy on pay-ing nonqualified benefits in the context of divorce and should communi-cate that policy to executives. Corporate policy may vary by plan. Include your payroll department, actuary, and plan recordkeeper as appropriate in the establishment of any policy. Finally, consider charging the executive or nonemployee spouse for reasonable costs of complying with a DRO.


ACKNOWLEDGEMENTS

Eric Keener, Aon Hewitt’s Chief Actuary, and Emily McBurney, Kegel McBurney LLC, helped to edit this article.

NOTES

1. Source Tax Act, 4 U.S.C. § 114.

2. Ibid.

3. 42 U.S.C. § 2000e-2(a). Also, Arizona Governing Committee for Tax Deferred Annuity and

Deferred Compensation Plans, etc., et al. v. Norris, etc., 103 S. Ct. 3492 (1983).

4. ERISA § 201(2), 29 U.S.C. § 1051(2).

5. ERISA § 301(a)(3), 29 U.S.C. § 1081(a)(3).

6. ERISA § 401(a)(1), 29 U.S.C. § 1101(a)(1).

7. ERISA § 206(d)(3), 29 U.S.C. § 1056(d)(3).

8. ERISA § 4(b)(5), 29 U.S.C. § 1003(b)(5).

9. IRC § 401(a)(17).

10. ERISA § 4(b)(1), 29 U.S.C. § 1003(b)(1).

11. ERISA § 514(a), 29 U.S.C. § 1144(a).

12. Bass v. Mid-America Co., Inc., 1995 U.S. Dist. LEXIS 15719, 1995 WL 622397 (N.D. Ill. 1995)

13. ERISA § 514(b)(7), 29 U.S.C. § 1144(b)(7)

14. Sposato v. First Mariner Bank, 2013 U.S. Dist. LEXIS 45806, 2013 WL 1308582

(D. Md. 2013).

15. ERISA’s anti-alienation requirement is ERISA § 206(d)(1), 29 U.S.C. § 1056(d)(1), which does

not apply to top-hat plans as stated in ERISA § 201(2), 29 U.S.C. § 1051(2).

16. Treas. Reg. § 1.409A-6(a)(4).

17. Demery v. Extebank Deferred Compensation Plan (B), 216 F.3d 283 (2d Cir. 2000).

18. Treas. Reg. § 1.409A-3(j)(4)(ii).

19. IRC § 409A(a)(2)(A).

20. Treas. Reg. § 1.409A-3(i)(2)(i).

21. Treas. Reg. § 1.409A-2(b)(4).

22. Treas. Reg. § 1.409A-3(d).

23. Treas. Reg. § 1.409A-3(g).

24. Treas. Reg. § 1.409A-3(j)(4)(ii).

25. Source Tax Act, 4 U.S.C. § 114.

journal of spring 2016 volume 21, number deferred - aon · permitted under the plan) a payout of...

Documents