In corporate transactions, it is often not clear whether nonqualified deferred compensation (NQDC) can be or must be distributed to employees, especially when the NQDC plan requires payments upon a participant’s separation from service. Whether such a separation takes place under Internal Revenue Code section 409A, which governs the tax treatment of NQDC, depends on the nature of the transaction:

  • Asset sales: A sale of assets of a business constitutes a separation from service for employees who go to work for the buyer (although the seller and the buyer can negotiate a different outcome).
  • Spin-offs and stock sales: A corporate transaction that involves a sale or spin-off of stock generally does not create a separation from service for employees of the entity whose stock is sold or spun off.
  • Initial public offerings (IPOs): An IPO does not cause a separation for employees of the corporation whose shares have been sold to the public.
  • Change in control (CIC): A transaction that is not a separation may be a CIC under section 409A. In a CIC, the plan sponsor may provide for accelerated payment of the deferred compensation to affected employees.

Separation from service

Under many NQDC plans, payments are made upon a participant’s separation from service as defined under section 409A. So in a corporate sale or similar transaction, sponsors must determine whether such a separation has occurred. These corporate transactions include a sale of stock or of corporate assets, a spin-off by a parent of shares in a subsidiary to the parent’s shareholders and an IPO.

Under section 409A, a separation from service generally occurs when an individual terminates employment with the employer, and it is reasonably expected that the employee will either stop working for the employer altogether or will not work enough hours to meet the required threshold set forth under the applicable regulations.

Identifying the “employer” is key. The employer is the legal entity or person for whom services are performed, and if the entity or person is part of a controlled group, it is all entities in the group. Entities are generally considered in the same controlled group when they can trace at least 50% ownership to a common parent entity. An example of a controlled group under the basic standard is a parent corporation, its 100% owned first-tier subsidiary and an entity owned at least 50% by that subsidiary. Transferring from one of these entities to another does not constitute a separation from service.

The following examples illustrate a sale of assets, sale of stock, tax-free spin-off and IPO.

Example 1: Sale of assets

A corporation with several distinct business units — none separately incorporated — sells all assets used by one such business unit to an unrelated buyer. All employees of that business unit stop working for the selling corporation and start working for the buyer.

Under section 409A, when one entity sells substantial assets to another unrelated entity, employees of the selling entity who go to work for the buyer generally have incurred a separation from service. However, the parties may specify that these transferring employees will not be treated as having a separation from service until they separate from service with the buyer, as long as certain conditions are met. (Note that separation status does not depend on whether the buyer or the seller assumes responsibility for the nonqualified benefits after the sale.)

Example 2: Sale of stock

A parent corporation sells all the stock of a subsidiary to an unrelated buyer, and all the subsidiary’s employees remain employed by the subsidiary. When stock in a corporation is acquired by an unrelated buyer, the regulations do not directly address the separation-from-service issue. Where the transaction is in the form of a spin-off of a subsidiary, the regulations indicate that the spin-off generally does not create a separation from service for employees who continue working for the subsidiary. That outcome seems to rest on the fact that the subsidiary is the same distinct corporate entity both before and after the spin-off. We think the same result arises in a sale of stock for the same reason.

As in an asset sale, the outcome should not depend on which entity — i.e., the corporation whose stock was sold, the seller of that stock or the buyer of that stock — assumes responsibility for the NQDC benefits. In contrast to the rules for asset sales, however, parties to the transaction cannot alter this outcome.

Example 3: Tax-free spin-off

A publicly traded parent owns 100% of the stock of a subsidiary. The parent spins off the shares of the subsidiary to the parent’s shareholders in the same proportion that those parent shareholders own parent stock. After the transaction, the parent no longer owns any stock in the former subsidiary.

As noted above, the regulations indicate that a spin-off generally does not cause a separation from service for employees who remain with the spun-off entity. There is no separation from service for those who were employed by the spun-off subsidiary before the spin-off if they are employed by the now-separate company after the spin-off. This outcome does not depend on whether the subsidiary assumes the liability to pay these employees’ deferred compensation after the spin-off.

Example 4: IPO

A privately owned corporation sells more than 50% of its stock in an IPO. Whether an IPO creates a separation from service is determined the same way it would be for any other sale of a corporation’s stock. The only thing that changes is the identity of the employer’s shareholders, and employees generally work for the same entity before and after the transaction. Accordingly, there is no separation from service.

Change in control

If a transaction constitutes a CIC under section 409A, and the NQDC plan requires payment upon such a CIC (or at the earlier of a separation from service or a CIC), the NQDC must be paid.

If the deferred compensation plan does not already provide for CIC payments, plan sponsors may elect to terminate the plan at a CIC and pay out all benefits to affected workers. Technically, only the entity that is primarily liable for the deferred compensation after the CIC can terminate and liquidate under this exception, although the parties involved in the transaction generally agree whether to do so as part of the deal.

A section 409A CIC can occur in several ways:

  • An organization or a group acting together acquires more than 50% of the (vote or value of) stock in a target.
  • An organization or a group acting together acquires at least 30% of the stock (vote, not value) in a target within a 12-month period.
  • A majority of the board is replaced in a 12-month period by directors who were not endorsed by a majority of the prior board.
  • An organization or a group acting together acquires at least 40% of the assets of the target (based on total, gross fair-market value) within a 12-month period.

Based on these alternative definitions:

  • An asset sale (satisfying the threshold above) qualifies as a CIC.
  • A stock sale (satisfying the threshold above) qualifies as a CIC.
  • A tax-free spin-off to shareholders of a public company is not a CIC because the acquiring shareholders did not join together to acquire the shares as a group, so the total shares are not aggregated to apply the above thresholds.
  • An IPO will not qualify as a CIC, again because the purchasers have not purchased their shares as a group.

As indicated above, accelerated payments upon a section 409A CIC may be made only to those who “experience” the CIC event, which include the following employees:

  • Those performing services for the corporation that directly undergoes the CIC, such as employees of a wholly owned subsidiary whose stock is sold by the parent company to an unrelated buyer.
  • Employees of a corporation or corporations responsible for paying the deferred compensation when such entity or entities are the ones that directly undergo the CIC. However, this applies only where there is a bona fide business purpose for the corporation to be liable for the deferred compensation.
  • Subsidiary employees if the CIC relates directly to an upstream majority shareholder of either the workers’ employer or the corporation liable to pay the deferred compensation described above. For example, employees of a wholly owned subsidiary whose parent corporation is acquired by an unrelated buyer experience the CIC (as do employees of the parent corporation, based on the first alternative above).

Post-CIC plan sponsorship

Where a transaction neither creates a separation from service nor permits the plan to be terminated under a section 409A CIC, the sponsor of a plan that provides for payments upon separation from service must continue to monitor the employment status of the employees working for the corporation involved in the transaction. When plan participants separate from the affected entity, the sponsor will need to make payments (assuming the plan requires it).

When employees continue working for a divested business, the preferred approach is transferring the obligation for the deferred compensation from the current sponsor to the buyer, so the divested business makes the NQDC payments when its employees separate, which it can easily monitor. When a parent company sells a subsidiary to an unrelated buyer but retains responsibility for NQDC payments for employees of the former subsidiary, the parent must be aware of future separations from service so it can pay separating workers as required. In such cases, the parent might want to negotiate a commitment from the buyer to keep the sponsor so informed. Even then, however, the ongoing need to monitor employment status may be burdensome and often creates problems in complying with section 409A.

Summary

In a corporate transaction, a sponsor of a NQDC plan that pays benefits upon a separation from service needs to determine whether affected participants incur a separation that will necessitate payment. In a CIC, the sponsor should also determine whether the transaction constitutes a CIC under section 409A, which might trigger payouts of deferrals under preexisting plan terms or could be used by the sponsor to accelerate payment of the deferrals for employees affected by the CIC, in at least some types of transactions.

If deferred compensation benefits cannot be paid upon the corporate transaction to employees who will work for the entity that is sold, the seller should consider seeking to have the buyer assume the obligation for the deferred compensation. Alternatively, the seller might obtain a commitment from the buyer to inform the seller when the buyer’s employee-participants separate, so the seller can pay its deferred compensation as required.

This article does not constitute consulting, legal, tax or any other type of professional advice, and should be used only in conjunction with the services of a Towers Watson consultant or another professional advisor with full knowledge of the user’s situation.