Final Code Section 409A Regulations Require Prompt Attention To All Nonqualified Deferred Compensation Arrangements To Preserve Tax Benefits
On April 10, 2007, the IRS issued long-awaited final regulations under Internal Revenue Code Section 409A. This important development requires immediate attention by business owners and other employers to ensure that any nonqualified deferred compensation (NQDC) plans or arrangements maintained for the benefit of executives and other employees are in compliance with those regulations on or before December 31, 2007.
Code Section 409A generally imposes strict requirements on NQDC plans and arrangements. These requirements may apply to a wide range of deferred payment plans, including cash bonus plans, supplemental executive retirement plans, stock option plans and future payments under employment contracts for individual employees. These requirements have been in effect since 2005 but the IRS previously postponed the deadline for full written compliance until the end of 2007, while it worked on finalizing the proposed regulations that were originally issued in 2005.
The final regulations that the IRS has now issued are generally similar to the proposed regulations, but include significant new provisions that make compliance easier. The final regulations will take effect on January 1, 2008, and can be relied upon by taxpayers before that date. Now that the final regulations have been issued, prompt action must be taken to amend any non-complying NQDC plans or arrangements as no further extension beyond December 31, 2007 is expected.
The costs of noncompliance with Section 409A are steep. All amounts deferred under a noncompliant NQDC plan are included in the employee’s income. Interest is also imposed on that income at a rate one percentage point higher than the interest rate on tax underpayments. On top of that, a twenty percent (20%) penalty is imposed.
Identifying plans that are subject to Code Section 409A
In order to comply with Code Section 409A, NQDC plan sponsors should first examine all of their compensation plans and arrangements to determine whether they involve deferred compensation. A plan provides for deferral of compensation if the employee has a legally binding right to compensation that is payable in a later tax year.
Certain plans enjoy an exemption from the Code Section 409A requirements. Qualified retirement plans, tax-deferred annuities, simplified employee pensions (SEPs), and SIMPLE retirement accounts are not considered NQDC plans. Likewise, Code Section 409A does not apply to some welfare benefit plans, such as bona fide vacation leave, sick leave, compensatory time, disability pay, and death benefit plans. However, severance pay plans may be subject to Code Section 409A unless an exemption applies. For example, the final regulations extend the period in which taxable reimbursements of medical expenses may be provided under a severance pay plan, to cover the period during which the employee would be entitled to continuation coverage under COBRA.
There is also an exception for short-term deferrals, such as in the case of year-end bonuses. Under this rule, there is no deferral of compensation if the employee receives the compensation not later than 2 ½ months after the end of the tax year of the employer or employee, whichever is later, in which the right of the employee to the compensation has vested. For example, if a calendar-year employer awards a bonus on November 1, there is no deferral of compensation if the bonus is paid or made available to the employee by the following March 15.
Nonstatutory stock options (NSOs) and stock appreciation rights (SARs) tied to employer stock do not provide for deferral of compensation if the option or SAR is not “in the money” on the date of grant and there is no other feature of such plan that provides for a deferral of compensation. The final regulations provide rules for determining the fair market value of the stock.
Compliance with Section 409A
If Code Section 409A applies, the NQDC plan or arrangement must comply in writing with four general requirements that relate to: (1) the initial deferral election, (2) the timing of payments to the employee, (3) acceleration of payments, and (4) subsequent deferral elections. Each of these requirements must be specified in the plan document, and the plan must be operated in accordance with the document.
Initial deferral election
In general, an employee must make the initial election to defer compensation before the year in which the services are performed for which the compensation is earned. In an employee’s first year of eligibility under a NQDC plan or arrangement, he or she may make a deferral election in the first thirty (30) days of participation. However, such election may only apply to compensation earned after the election was made. Under another special provision, an election to defer performance-based compensation that is based on services performed over 12 months or more must be made no later than six months before the end of the performance period.
Timing of payments
Payments under a NQDC plan or arrangement must be made at a fixed date, under a fixed schedule, or upon any of these five events (as defined in the final regulations): (i) death, (ii) disability, (iii) separation from service, (iv) change in ownership or control of the corporation, or (v) unforeseeable emergency. If the timing of payment is based on a specified event, the plan must designate an objectively determinable date or year after the event on which payment is to be made.
With limited exceptions, payments under a NQDC plan or arrangement generally may not be accelerated. For example, accelerated payments that are necessary to comply with a domestic relations order or conflict-of-interest rules, and upon certain plan terminations, may be permitted.
Subsequent deferral elections
If a NQDC plan permits an employee to elect to delay or change the form of a payment, the following conditions must be met:
- the election may not take effect until at least 12 months after the date on which it was made;
- if the election relates to a payment that is not made on account of death, disability or unforeseeable emergency, the first payment for which the election is made must be deferred for at least five years; and
- any election related to a payment at a specified time or under a fixed schedule may not be made less than 12 months before the date of the first scheduled payment.
Temporary relief will soon expire
Code Section 409A generally applies for: (1) amounts deferred in tax years beginning after 2004; and (2) amounts deferred in tax years beginning before 2005 if the NQDC plan or arrangement is materially modified after October 3, 2004. However, the IRS had previously extended the deadline for written compliance with Section 409A until the end of 2007. Thus, a plan will not violate Code Section 409A before January 1, 2008 if: (1) it is operated through December 31, 2007 in reasonable, good-faith compliance with Code Section 409A and earlier IRS guidance, and (2) the plan or arrangement is amended in writing before January 1, 2008 to fully conform with Code Section 409A and the final regulations.
Action steps for the rest of 2007
In the short period of time that remains before the final Section 409A regulations take effect, businesses and their advisers must first determine whether they have any plans or arrangements providing NQDC. Those plans must be analyzed to determine whether they comply with Code Section 409A and the Final Regulations. Plans which require amendment must finalize any changes that are required to comply with Code Section 409A and make sure that those written changes are fully incorporated into the appropriate plan documents on or before December 31, 2007. In the interim, such NQDC plans and arrangements must be operated in good-faith compliance with the Code Section 409A requirements.
IRS Circular 230 Notice: To ensure compliance with certain regulations promulgated by the U.S. Internal Revenue Service, we inform you that any federal tax advice contained in this communication is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding tax-related penalties under the U.S. Internal Revenue Code, or (2) promoting, marketing or recommending to another party any tax-related matters addressed herein, unless expressly stated otherwise.