Feb 15, 2018
Under Code Section 409A, an annual salary deferral election generally applies to all salary earned during the calendar year. If this concept were to apply to salary earned during the last payroll period of the year that crosses into the next year, human resources would need to (i) identify the salary earned on or before December 31 and the salary earned after December 31,
(ii) apply the appropriate deferral elections to each portion, (iii) communicate the two components of deferred compensation to the plan’s record keeper in order to assign the appropriate payment schedule to each portion and then (iv) communicate the combined deferral amount to payroll for processing.
Fortunately, this cumbersome process is not required. The 409A regulations provide that the compensation earned in the final payroll period that includes December 31 of Year 1 and paid in January of the following Year 2 is deemed to be earned entirely in Year 2. The salary deferral election in effect for Year 2 will apply to that payroll.
Example
Participant P files his annual election to defer 10% of his salary earned in the next calendar year (“Year 1”). In November, Year 1, P files an election to defer 15% of his salary to be earned in the
next calendar year (“Year 2”). The elections in this example are applied in the following pay periods:
Weekly or Bi-weekly Payroll
Employer pays bi-weekly, one week in arrears. Employer’s last payroll period in Year 1 runs from December 24, Year 1 through January 4, Year 2. P is paid January 11, Year 2.
Question: Does the Year 1 or Year 2 election apply?
Answer: The Year 2 (15%) election applies.
Semi-monthly Payroll
Employer’s payroll period is semi-monthly, with payment made the next business day after the 15th and last day of the month. The last payroll period in Year 1 runs from December 17 through December 31. P is paid January 2, Year 2.
Question: Does the Year 1 or Year 2 election apply?
Answer: The Year 2 (15%) election applies, even though all of the services were performed in Year 1. The “straddle rule” applies if the last payroll period for the calendar year includes the last day of the year.
Application to Bonuses
The “straddle rule” described above allows a plan participant to file an election as late as December 31 to defer salary already earned and that could be paid as early as a day or two later. IRS is willing to suspend the constructive receipt principles in this limited circumstance for the sake of administrative convenience.
If the straddle rule were to apply to Year 1 quarterly or annual bonus the participant would be able to defer the bonus as late as December 31 of Year 1 and have the election apply to the bonus paid a few days later in Year 2. The regulations address this potential loophole by providing that compensation earned outside of the regular payroll cycle is not eligible for the straddle rule.
From a payroll perspective, it is important to apply the correct deferral election. For example, if P in the semi-monthly example above had filed an election to defer 25% of his bonus earned in calendar quarters in Year 1 and 50% of his quarterly bonus in Year 2, P’s Year 1 election (25%) applies to the bonus and his Year 2 election (15%) applies to the salary, even though the earnings period for both salary and bonus end on December 31 of Year 1.
Pointers for Plan Design and Administration
The straddle rule applies unless the plan or participant elections provide for a different treatment. There may be valid reasons for doing so. Under the straddle rule, plans that end their enrollments in late December have a very short time to process and communicate the Year 2 deferral elections in time for the first payroll in January.
Rather than being driven by the strict timetables under 409A’s default rules, HR could tailor the earnings periods that are subject to salary deferral elections. Elections could be designed to state when deferrals commence (for example, the first payroll in February) and when they end (last payroll in the following January). If this approach is taken, any subsequent change to payroll practices would need to take the terms of the elections into account in order to avoid the potential for a “late election” under 409A.
There are tradeoffs to be considered whenever an existing plan design is changed. Your Newport Group representative is available to discuss any questions you may have about the straddle rule and alternatives that may be helpful to your organization.
Newport Group, Inc. and its affiliated companies do not render tax or legal advice and the material contained within should not be interpreted or relied upon as constituting tax or legal advice. You should consult your tax or legal advisors with respect to specific tax or legal decisions.