Sapers & Wallack
Bulletins: AALU Washington Reports
“Funding” Rabbi Trusts — Impact of the Financial Crisis
December 10, 2008
Section 409A(b)(3) of the Internal Revenue Code, added by the Pension
Protection Act of 2006 (see our Bulletin No. 06-99), imposes restrictions on “funding”
rabbi trusts that provide deferred compensation benefits when the employer has a
qualified defined benefit pension plan that is considered to be “at-risk.” With the
tremendous drop in asset values in recent months, many employers with defined benefit
pension plans that were not previously at-risk are now facing the possibility that their
plans may fall into that category. In addition to the numerous problems that this
creates for the pension plan, it may also trigger a freeze on funding the nonqualified
deferred compensation plan. Given this possibility, this Bulletin addresses whether
employers should consider transferring assets to their rabbi trusts before the end of this
year.
Overview of Nonqualified Plan Funding Restrictions
In general, during any “restricted period” (discussed below), if an employer (or a member of the
controlled group that includes the employer) maintains both a qualified defined benefit pension plan and a
nonqualified deferred compensation arrangement, the ability of the employer to set aside or transfer funds
to rabbi trusts or “other arrangements” to fund the nonqualified plan will be restricted. Any such set-aside
or transfer to such a trust for the nonqualified plan during this restricted period will trigger adverse taxation
to certain executives covered by the plan.
For purposes of these rules, the term “restricted period” (i.e., the period during which these
restrictions apply) covers any of three periods:
- the time when the qualified defined benefit plan sponsor is a debtor in bankruptcy;
- six months before or after the date that an underfunded defined benefit plan is terminated; or
- any period during which a qualified defined benefit plan is “at-risk.” under section 430(i).
At-Risk Rules
A qualified defined benefit plan will be at-risk for a particular plan year if, for the preceding plan
year, its assets were both (i) less than 80% of its funding target (subject to phase-ins) using its actuarial
assumptions and (ii) less than 70% of its funding target using certain special actuarial assumptions.
For purposes of the 80% threshold, there is a transition rule which provides that the applicable
funding threshold for determining at-risk status is 65% for 2008, 70% for 2009 and 75% for 2010.
The funding percentage (referred to as the funding target attainment percentage, or FTAP) for a
plan year is the ratio, expressed as a percentage, that the value of the plan’s assets (reduced by any credit
balance carryovers from prior years) bears to the plan’s funding target for the year. A plan’s funding target
for a plan year is the present value of all benefits accrued or earned under the plan as of the beginning of
the plan year. The funding percentage, or FTAP, is generally determined by the qualified plan’s actuary as
of the beginning of a plan year.
Small Plan Exception
The at-risk rules generally do not apply to small qualified plans, which are defined as qualified
plans that, on each day during the preceding plan year, have 500 or fewer participants. For purposes of this
exception, all qualified defined benefit plans (other than multiemployer plans) maintained by the same
employer (or any member of the employer’s controlled group) will be treated as 1 plan. Thus, based on the
language of the new rules, a qualified plan that qualifies as a small plan for a particular plan year should
not be considered to be at-risk for purposes of the nonqualified plan funding restrictions for that plan year.
However, guidance under these new rules has not yet been issued and none is expected in the near future.
Until such guidance is issued, employers will have to operate under a reasonable, good faith interpretation
of the statutory provisions and legislative history (which is minimal).
Covered Employees
The funding restrictions apply to any “applicable covered employee.” This term means an
individual described in section 162(m)(3) or an individual subject to the requirements of section 16(a) of
the Securities Exchange Act of 1934. Under section 162(m)(3), the term “covered employee” applies to
the chief executive officer (or an individual acting in that capacity) or to an employee whose total
compensation is required to be reported to shareholders under the Securities Exchange Act of 1934 by
reason of the employee being among the four highest compensated officers for the taxable year (not
counting the CEO).
These definitions raise an interesting question. Since the definitions refer to employees to whom
the Securities Exchange Act of 1934 applies (other than the reference to the chief executive officer), read
literally, this would suggest that the funding restrictions would apply to the CEO, but would only apply to
other employees if the company is a publicly traded company subject to the Securities Exchange Act of
1934. (Generally, only public companies are subject to the Securities Exchange Act of 1934).
Although guidance has not yet been issued and none is expected in the near future, AALU counsel
understands that, at least until guidance is issued by the IRS, this more narrow reading of these definitions
is likely to be considered reasonable by the IRS. As such, these provisions may currently only apply to the
CEO unless the company is publicly traded.
Nonqualified Plan Funding Restrictions
The nonqualified plan funding restrictions restrict assets being “set aside or reserved (directly or
indirectly) in a trust (or other arrangement as determined by the Secretary) or transferred to such trust or
other arrangement” in order to pay nonqualified deferred compensation. These restrictions also apply if a
nonqualified deferred compensation plan provides that assets will become restricted to the provision of
benefits under the plan in connection with the restricted period with respect to the qualified defined benefit
plan or if the assets are, in fact, so restricted. Although no guidance has been issued under this provision
and none is expected in the near future, from the wording of the statute and its legislative history, the new
rules would appear to effectively freeze the nonqualified plan funding with respect to the covered
employees from the time at which the employer’s qualified defined benefit plan (or the qualified defined
benefit plan of any member of the controlled group that includes the employer) becomes at-risk, as
discussed above.
If a transfer is made to a rabbi trust or other funding vehicle during this restricted period, then the
amounts transferred are treated as a transfer of property under section 83 (regardless of whether the
amounts are available to satisfy the claims of general creditors) and therefore would be subject to taxation
(if vested). The amounts so included would also be subject to an additional 20% tax and interest at the IRS
underpayment rate plus one percent from the date of the initial deferral or vesting under section 409A.
Furthermore, any tax gross-up payments to the executive to ameliorate these adverse tax consequences
would also be subject to the same adverse tax treatment (i.e., immediate income inclusion, additional 20%
tax and interest at an increased rate). Any such payments would also be nondeductible by the employer.
Impact of Financial Crisis
For companies that maintain (somewhere in their controlled group) a qualified defined benefit plan
whose assets have declined sharply this year and that also maintain nonqualified deferred compensation
plans for their CEO or other executives, the potential impact of these restrictions should be carefully
considered. Because the nonqualified funding restrictions only apply during the restricted period, if the
company anticipates that as of January 1, 2009, the assets in its defined benefit plan may cause the funding
percentage to be 70% or less, consideration should be given to whether the company wishes to set aside
money in a rabbi trust or other similar arrangement for the covered executives in order to avoid the impact
of these restrictions, and if so, when does the company need to make that transfer.
Planning Considerations
The answer to this question is complex, especially in light of the absence of any definitive guidance
in this area. A number of companies are considering transferring assets to rabbi trusts before the end of
2008 with the intention of avoiding these restrictions. However, based on the wording of the statutory
language, such accelerated rabbi trust funding may not be necessary until the end of 2009 because of the
one-year lag in determining at-risk status under the new rules.
A qualified plan generally is considered at-risk for a plan year only if the funding percentages for
the preceding plan year fall below the applicable thresholds (i.e., 70% in 2009). In addition, the funding
percentages generally are determined as of the beginning of a plan year. Thus, if a qualified plan was not
at-risk as of January 1, 2008, the at-risk funding restrictions would not apply for the 2009 plan year. If,
because of the significant decline in the stock market in 2008, the qualified plan becomes at risk as of
January 1, 2009, the qualified plan would be considered at risk beginning with the 2010 plan year and the
at-risk funding restrictions would not apply to the nonqualified plan until the beginning of the 2010 plan
year.
A second factor to be considered is the exemption for small plans. If the employer’s qualified
defined benefit plan (as aggregated with any other qualified pension plan within the employer’s controlled
group) covers fewer than 500 participants, the employer should not be subject to the at-risk rules at all. If
that is the case, the language of the new rules indicates that the at-risk funding restrictions should also not
apply.
A third factor to be considered is the fact that the restrictions only apply to transfers or set-asides to
a trust or other similar arrangement. The funding restrictions do not appear to restrict accruals of
nonqualified benefits — only set-asides and transfers (or plan provisions that restrict benefits). Thus, it
would appear that the employer could continue to accrue benefits under the nonqualified plan, even if the
qualified plan is at-risk, although it could not “fund” those benefits with respect to covered employees. It
should be kept in mind, however, that the exact meaning of the terms “set aside,” “transfer” and “other
arrangement” have not been defined at this point and may not be defined by IRS guidance for another year
or two (at the very least). Consequently, any action based on an interpretation of these provisions needs to
be carefully weighed given the numerous uncertainties outlined above.
Because the applicability of the at-risk funding restrictions depends on the qualified plan’s funding
status, companies that may be subject to the funding restrictions should discuss the qualified plan’s current
funding status and future funding strategies with the qualified plan’s actuary before the beginning of 2009.
Qualified Plan Benefit Restrictions Contrasted With At-Risk Rules
Under a separate but related series of rules in section 436, a qualified plan that is substantially
underfunded (generally 60% or less) will be subjected to various restrictions on the benefits it can provide.
These can include a prohibition against any increases in benefits and a prohibition against lump sums and
other accelerated payments from the qualified plan. The rules in section 436, however, are separate from
the at-risk rules in section 430 and the applicable percentages for determining a qualified plan’s funding
deficiencies and measurement period are different. To illustrate, a qualified plan can be at-risk under
section 430 (for example, because its FTAP is below 70%) but not be subject to the benefit restrictions in
section 436 because its funding percentage is not as low as required under that section (generally 60%).
In addition, sections 430 and 436 differ concerning when the restrictions apply. For purposes of the
benefit restrictions in section 436, the funding percentages are determined on a current plan year basis
based on the assets at the beginning of that plan year. By contrast, from the wording of section 430(i), at-risk
status is determined on the basis of a one-year lag; that is, a defined benefit plan will be at-risk in a
particular plan year if for the preceding plan year its funding percentage fell below the applicable
threshold. For example, if a qualified plan were 90% funded on January 1, 2008 and 68% funded on
January 1, 2009 (due to the recent market decline), it appears that the qualified plan would not be at-risk
under section 430(i) until 2010 even though some of the benefit restrictions in section 436 might apply to
the qualified plan in 2009.
A company that is anticipating a significant reduction in its qualified pension plan’s funded status as
of January 1, 2009 because of the financial crisis may also want to consider whether it should make
additional contributions to the qualified plan in order to avoid at-risk status under section 430 for the 2010
plan year and/or to avoid the benefit restrictions under section 436 for the 2009 plan year. Such companies
should discuss the funding strategies with their plan actuaries before the beginning of 2009.
Any AALU member who wishes to obtain a copy of Internal Revenue Code sections 409A(b)(3),
430(i) and 436 may do so through the following means: (1) use hyperlink above next to “Major References,”
(2) log onto the AALU website at www.aalu.org and enter the Member Portal with your social security
number and select Current Washington Report for linkage to source material or (3) email Ray Harmon at
harmon@aalu.org and include a reference to this Washington Report.
In order to comply with requirements imposed by the IRS which may apply to the Washington Report as
distributed or as re-circulated by our members, please be advised of the following:
THE ABOVE ADVICE WAS NOT INTENDED OR WRITTEN TO BE USED, AND IT CANNOT
BE USED, BY YOU FOR THE PURPOSES OF AVOIDING ANY PENALTY THAT MAY BE
IMPOSED BY THE INTERNAL REVENUE SERVICE.
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of the IRS guidance, then, as required by the IRS, please be further advised of the following:
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ADVICE, AND, BASED ON THE PARTICULAR CIRCUMSTANCES, YOU SHOULD SEEK
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