Identifying “Specified Employees”




The nonqualified deferred compensation (NQDC) rules may surprise employees who expect to receive distributions from their NQDC plans immediately after they terminate employment. Code § 409A contains strict rules NQDC plans must follow to avoid harsh consequences to the employee (that is, immediate taxation, 20% penalty, and interest). Under “the six-month delay rule,” NQDC plan distributions on account of separation from service may not be made until six months after a “specified employee” separates from service. This rule applies only to corporations with publicly traded stock.

Employers can use a three-step process to determine who is a specified employee.

Step 1: Select the Specified Employee Identification Date
An employer must select the specified employee identification date—the only date during the year when specified employees will be identified. The default date is Dec. 31, but an employer may designate an alternative date.

Step 2: Select the Specified Employee Effective Date
An employer must select the specified employee effective date—the date employees who have been identified under step 1 become specified employees under the six-month delay rule. The default date is the first day of the fourth month following the identification date. The employer may choose an alternative effective date that is not later than the default effective date.

Step 3: Determine Whether an Employee Is a Specified Employee
The final step determines which employees are specified employees. A specified employee is a “key employee” on the date of his or her separation from service. Key employees are:

Officers with annual compensation greater than $150,000;

5% owners of the employer; or

1% owners of the employer with annual compensation greater than $150,000.

No more than 10% of all employees (up to a maximum of 50) can be included in the first category.

To determine whether an employee is a specified employee on separation, start with the date the employee separates from service. Identify the effective date that falls on, or immediately precedes, the separation from service. Next, determine the identification date that immediately precedes the effective date. Finally, determine whether the employee was a key employee at any time during the 12-month period ending on the identification date. A key employee during that 12-month period is treated as a specified employee on the date of separation from service, and the six-month delay must be applied for distributions made to that employee.

An NQDC plan may avoid the above process by using an alternative method to identify specified employees. The regulations do not specify alternative methods, so employers must develop their own. Any alternative method must be reasonably designed to include all specified employees, and it must be objectively determinable, providing no direct or indirect election to any employee regarding its application. The alternative method must result in the six-month delay being applied to all employees, or it must result in no more than 200 employees being subject to the six-month delay.

Based on these guidelines, an employer may want to choose to treat all employees as specified employees. While this has the disadvantage of imposing the six-month distribution delay on all employees, it avoids the complex process of identifying specified employees.

For a detailed discussion of the issues in this area, see “Identifying Specified Employees Under Sec. 409A,” by G. Edgar Adkins Jr., CPA, and Jeffrey A. Martin, CPA, in the February 2008 issue of The Tax Adviser.

—Alistair M. Nevius, editor-in-chief
The Tax Adviser

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