The Ticktock of the Section 409A Clock

For more than 25 years, the rules governing nonqualified deferred compensation arrangements remained relatively unchanged. In the Revenue Act of 1978, Congress directed that amounts deferred under a nonqualified deferred compensation plan were required to be taken into income as provided by applicable law in effect on February 1, 1978. Both businesses and tax practitioners knew and understood the rules (and in some cases, how to work around them). Peace and stability prevailed in the land of nonqualified deferred compensation.

For more than 25 years, the rules governing nonqualified deferred compensation arrangements remained relatively unchanged. In the Revenue Act of 1978, Congress directed that amounts deferred under a nonqualified deferred compensation plan were required to be taken into income as provided by applicable law in effect on February 1, 1978. Both businesses and tax practitioners knew and understood the rules (and in some cases, how to work around them). Peace and stability prevailed in the land of nonqualified deferred compensation.

Then, in October 2004, a new Section 409A (“409A”) was added to the Internal Revenue Code of 1986 (the “Code”) by the American Jobs Creation Act of 2004. Since then, the rules have been the subject of many questions and much uncertainty, and the land of nonqualified deferred compensation has known neither peace nor stability.

New 409A was, at least in part, a congressional response to abuses by executives of Enron, Worldcom and others who cashed out their deferred compensation accounts before the walls came tumbling down, leaving rank-and-file employees with empty promises of future payments from bankrupt companies. However, instead of focusing on perceived abuses and the senior executives in a position to benefit from them, 409A employs a broad-brush approach that applies to all participants in almost every form of arrangement under which some type of deferred compensation might be payable.

Because of the breadth of its application and the draconian consequences suffered by participants in the event that its terms are violated, 409A effectively resulted in a requirement that every “nonqualified deferred compensation plan” (within the broad meaning of 409A and the related IRS guidance) in effect on or after January 1, 2005 be reviewed and, in most cases, revised. The initial IRS guidance, issued in December 2004 in the form of Notice 2005-1, answered some of the myriad questions about the proper interpretation of the new statutory language and set December 31, 2005 as the date by which plan documents must be brought into compliance with the new requirements. However, Notice 2005-1 left unanswered more questions than it addressed, and the next round of IRS guidance on 409A issues did not appear until the issuance of proposed regulations on September 29, 2005 (the “Proposed Regs”). Because of the delay in issuing that additional guidance and the number of questions that still remain unanswered, the date by which plan documents must be brought into compliance with the requirements of 409A has been extended to December 31, 2006.

What Arrangements Are Subject To 409A?

409A applies to the deferral of compensation, and arrangements permitting that deferral, in tax years beginning after December 31, 2004 as well as earlier unvested deferrals. Compensation deferred in a tax year beginning before January 1, 2005, and that was earned and vested before that date, generally is not subject to the reach of 409A, and the same “grandfather” protection applies to the investment returns or earnings on those deferrals. However, that grandfather protection will be lost, and the pre-2005 deferrals and related investment earnings subjected to the requirements of 409A, if the plan or arrangement permitting the deferral is materially modified after October 3, 2004. A “material modification” would include the addition to the plan or arrangement of any right or feature that provided a new benefit to the employee or other service provider, but not the exercise or reduction of an existing right or feature (such as the elimination of a provision allowing an in-service distribution subject to a “haircut”) or changes necessary to effect compliance with 409A.

For purposes of 409A, an arrangement provides for the deferral of compensation, and thus is subject to 409A’s requirements, if an employee or independent contractor (referred to in the 409A provisions and guidance as the “service provider”) has a legally binding right to compensation during one taxable year; that compensation is not actually received (or treated as constructively received) by the service provider during that year; and the arrangement provides that the compensation is payable in a later year. Interpretive guidance issued by the IRS in Notice 2005-1 and the Proposed Regs creates a significant exception to that general rule for “short-term deferrals”: an amount is not considered to be deferred compensation (and therefore is not subject to the rules of 409A) if the amount is required by the arrangement to be paid by the later of the date that is two and one-half months after the end of the service provider’s first taxable year in which the compensation is no longer subject to a substantial risk of forfeiture, or the date that is two and one-half months after the end of the first taxable year of the employer or other entity receiving the service (referred to in the 409A provisions and guidance as the “service recipient”) in which the compensation is no longer subject to a substantial risk of forfeiture (the “Short-Term Deferral Exception”).

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Arrangements that are within the scope of 409A are by no means limited to those formally titled “nonqualified deferred compensation plan.” Qualified employer plans, such as 401(k) plans and plans qualified under Code Section 401(a), are expressly excluded from 409A’s coverage, as are bona fide vacation leave, sick leave, compensatory time, disability pay and death benefit plans. However, almost any other type of agreement that provides for the payment of compensation is potentially subject to the requirements of 409A, including agreements or arrangements that apply to only one person (for the sake of simplicity, this article will refer to any such arrangement as a “plan,” without regard to the form the arrangement actually takes). Even nonqualified stock options, not traditionally thought of as deferred compensation, will be subject to 409A if the exercise price is or may be less than the fair market value of the stock on the date of grant or if there is a deferral feature other than the option holder’s ability to control the timing of the exercise of the option. Although the provisions of 409A are not intended to change the tax treatment of incentive stock options under Code Section 422 or options granted under a Code Section 423 employee stock purchase plan, the Proposed Regs provide that certain modifications to the terms of incentive stock options may result in those options being subject to, and in violation of, 409A, in some cases as of the option’s original grant date. For a listing of the types of plans and arrangements that can raise 409A issues, see the chart on page 24.

What Does 409A Require?

409A imposes restrictions on both the timing and substance of deferral elections under covered plans, the circumstances in which distributions are permitted as well as the timing of certain distributions, and the manner in which the rights of service providers may be protected through funding mechanisms.

Initial Deferral Elections. 409A generally requires that an elective deferral of compensation be made prior to the end of the calendar year preceding the year in which the related services are performed. For example, in the case of a bonus to be earned by performing services in 2006, to defer the bonus in compliance with 409A a proper deferral election generally must have been made before the end of 2005, even if the bonus would not otherwise be payable until 2007. However, if the deferral relates to performance-based compensation tied to services performed over a period of at least 12 months, the election will comply with 409A if made no later than six months before the end of the performance period. Another exception to the general rule applies to a service provider’s first year of eligibility in the service recipient’s covered plans: the election will be treated as timely for 409A purposes if made within 30 days after the date the service provider first becomes eligible to participate in any plan of the service recipient covered by 409A, but the election is effective only with respect to compensation attributable to services performed after the election is made. Thus, for example, if an employee is hired on June 15, he has until July 14 to make his deferral election. If he makes his election on June 30, it can apply only to compensation earned on or after July 1.

In addition to meeting the timing requirements described above, an initial deferral election must also set forth the date or permitted circumstances that will trigger the commencement of distributions under the plan, as well as the form that those distributions will take — i.e., installments or a lump-sum payment.

Subsequent Deferral Elections. If a plan permits subsequent elections by the service provider or service recipient to change the distribution commencement date or to change the form of payments, the new election cannot become effective for at least 12 months after it is made. Similarly, an election to further delay the commencement of payments or to change the form of a distribution to be made on a date certain or pursuant to a fixed schedule must be made at least 12 months in advance of the first scheduled payment. If the subsequent election relates to a payment to be made on separation from service, on a date certain or pursuant to a fixed schedule, or upon a change of control, the additional deferral period must be at least five years from the date the payment would otherwise have been made. In no event may a subsequent election have the effect of accelerating payments to the service provider. The Proposed Regs provided some much-needed clarification regarding the application of these rules by allowing a plan to specify whether a series of payments constitutes a single payment or multiple payments. For example, a plan could provide that all installments in a series of installment payments constitute a single payment. In that case, an initial election establishing a series of five annual installments commencing July 1, 2010 could be changed to provide for a lump-sum payment on July 1, 2015 without violating the five-year delay rule. If, instead, the plan treated those five installments as separate payments, a change in the initial election to a lump-sum payment on July 1, 2015 would violate 409A because the installments originally scheduled for 2011 through 2014 would not have been delayed for the required five years. As a result, the initial election could not properly be changed to reflect a lump-sum payment date earlier than July 1, 2019.

Many nonqualified deferred compensation plans (such as supplemental executive retirement plans, or SERPs) have deferral and payment provisions that are tied to qualified plans. For example, an amount contributed to a SERP may be determined by reference to the amount that, but for a statutory limitation, would have been contributed by the employer to a qualified plan for the participant’s benefit. As a result, there was considerable uncertainty whether changes to the related qualified plans, which are not themselves subject to 409A, would be considered to result in impermissible deferrals or accelerations under the affected nonqualified deferred compensation plans. The Proposed Regs addressed that uncertainty by providing that changes to the terms of a qualified plan, or the exercise or failure to exercise a benefit or right added to such a plan, are not considered to cause a deferral or acceleration under a related nonqualified deferred compensation plan so long as the amount deferred for the year under the nonqualified deferred compensation plan does not exceed statutory annual limits and the change to the qualified plan does not affect the time or form of payment under the nonqualified deferred compensation plan. Of course, that clarification provided by the Proposed Regs does not mean that all links to qualified plans are permitted by Section 409A. For example, linking the payment provisions of a nonqualified deferred compensation plan to those in a qualified plan may result in distributions that run afoul of 409A’s restrictions.

Distribution Restrictions. To comply with the requirements of 409A, a plan may not permit the distribution of compensation deferred under the plan earlier than one of the following:

(i) Separation from service. To prevent service providers and service recipients from gaming the system, the Proposed Regs include operating rules under which, regardless of characterization of the employment relationship by the two parties, a service provider will be treated as having separated from service if he or she no longer continues to provide more than a stated minimum level of services and, conversely, will be treated as not having separated from service if the service provider continues to provide more than a stated maximum level of services. A special rule (discussed in more detail below) applies in the case of certain senior executives of public companies.

(ii) Disability. A service provider is considered “disabled” for purposes of 409A if (a) he or she is unable to engage in any substantial gainful activity because of a medically determinable physical or mental impairment that can be expected to result in death or to last for a continuous period of at least 12 months; or (b) he or she has been receiving income replacement benefits for at least three months under an accident and health plan of the service recipient as the result of a medically determinable physical or mental impairment that can be expected to result in death or to last for a continuous period of at least 12 months. This definition of disability is consistent with the definition of that term used in the Code in other contexts.

(iii) Death of the service provider.

(iv) Specified time (or pursuant to a fixed schedule). The specified time or schedule must be set forth in the original deferral election or delayed pursuant to a proper subsequent election. Providing for a payment upon the occurrence of a specified event (such as the purchase of a house or the enrollment of a child in college) does not meet 409A’s requirements.

(v) Unforeseeable emergency. For these purposes, “unforeseeable emergency” means a severe financial hardship resulting from an illness or accident of the service provider (or his or her spouse or dependent), loss of property due to casualty or some other extraordinary and unforeseeable circumstance beyond the control of the service provider. This provision must be applied on a mandatory rather than discretionary basis if included in the plan, and the amount of the distribution must not be greater than the amount necessary to meet the emergency, plus taxes on the distribution, after taking into account insurance and the liquidation of other assets (to the extent that the liquidation of those other assets would not itself cause severe financial hardship).

(vi) Change of control of the service recipient (including the sale of substantially all of its assets). Although it is similar, 409A’s definition of “change of control” is not the same as the definition of that term used for purposes of the golden parachute provisions of Code Section 280G.

No acceleration of the timing of distributions is permitted, except in very limited circumstances, such as to comply with a domestic relations order, to comply with certain conflict of interest rules, to provide for the payment of applicable employment taxes, and to provide for the payment of amounts that must be included in income due to a violation of the 409A requirements.

In the case of an employer that is a publicly traded corporation, a distribution made with respect to separation from service by a “specified employee” cannot be made earlier than six months after the date of separation from service or, if earlier, the date of the specified employee’s death. A “specified employee” is an employee who (1) is an officer of the corporation with annual compensation of more than $140,000 generally (for identification dates in 2006), (2) is a five-percent owner of the corporation, or (3) is a one-percent owner of the corporation with annual compensation of more than $150,000. The Proposed Regs set out a procedure for an annual determination of the specified employees for the next 12-month period and also provide alternative ways to implement the required six-month payment delay: each scheduled payment to the specified employee can be delayed for six months, or in the alternative, all payments that otherwise would have been made during the delay period can be aggregated and paid six months after the specified employee’s separation from service. The delayed payment requirement appears to be the most direct response of 409A to the perceived abuses of the executives of Enron, Worldcom and others who received early payouts of their deferred compensation accounts before their companies foundered. However, this mandated delay in payment is at odds with the Short-Term Deferral Exception that excludes from the definition of deferred compensation (and, therefore, the scope of the 409A restrictions and penalties) amounts that must be paid within two and one-half months after the end of the participant’s tax year in which the right to the payment vests. It would appear that if payments are structured so they are made immediately (within the Short-Term Deferral Exception period), they would avoid being treated as a “deferral of compensation” and therefore would not be subject to 409A’s required delay for payments to specified employees. However, that result does not appear to have been intended, and we expect that additional interpretive guidance will close that loophole.

Funding Restrictions. 409A changes in some cases the rules applicable to the tax treatment of rabbi trusts. If assets are set aside in, or transferred to, a trust outside the United States, the assets are now required to be treated as transferred to the applicable service provider in connection with the performance of services (i.e., the value of the assets will be taxable to the service provider under Code Section 83), whether or not the assets are available to satisfy the claims of general creditors.

If the plan provides that the employer must contribute assets to a domestic rabbi trust upon a change in the financial health of the employer, the assets are now to be treated as transferred to the participant for purposes of Code Section 83 as of the earlier of the date the assets are transferred to the trust or the date the plan provides for the required funding of the trust due to the change in the employer’s financial health. This rule would not prevent a requirement that assets be contributed to a trust upon the occurrence of a change of control without regard to the financial condition of the employer.

What Are the Consequences Of Violating 409A?

If a plan fails to meet the requirements of 409A concerning deferral elections and distributions, including the limitation on accelerated distributions, with respect to a participant, that participant will be required to include currently in income all amounts deferred under the plan in that year and all prior years (other than pre-2005 deferrals for which grandfather protection remains available) to the extent not currently subject to a substantial risk of forfeiture and not previously included in income. In addition, the same current income inclusion will be required for amounts deferred under similar plans of the employer that 409A requires to be aggregated — e.g., 409A treats as a single plan all plans under which a participant’s payment rights are measured by an account balance. The participant’s resulting tax liability is increased by an amount equal to 20 percent of the includible income (producing a potentially applicable 55 percent federal income tax rate on the amount included in income) and an interest component (computed at one percent above the underpayment rate) with respect to the period commencing with the initial deferral date or, if later, the date the deferred amount ceased to be subject to a substantial risk of forfeiture.

If a plan fails to meet the funding requirements for an offshore trust or a domestic rabbi trust due to changes in the financial health of the employer, the participant’s resulting tax liability is increased by an amount equal to 20 percent of the amount required to be included in income and an interest component computed at one percent above the underpayment rate. In addition, for each taxable year that the assets remain set aside in such a trust, any increase in the value of the property in the trust and any earnings with respect to the property in the trust will be treated as additional transfers of property subject to taxation under Section 83, to the extent not previously included in income.

Other than income reporting and tax withholding obligations (and potential employee relations issues and voluntary contractual obligations), a violation of the requirements of 409A results in no adverse consequences for the employer maintaining the plan. The draconian consequences of a violation are borne entirely by the participant, whether or not the participant was in a position to influence the employer’s actions or to affect the administration of the plan or its compliance with 409A.

What to Do to Comply, and When?

To avoid the adverse effects on participants that result from a violation of 409A, any arrangement that falls within that provision’s broad definition of “nonqualified deferred compensation plan” should be reviewed for compliance with the applicable requirements and, if necessary, amended accordingly before December 31, 2006. In the interim, “good faith” compliance with the provisions of 409A is required. Delaying the plan review and related corrective action until the end of the year is not advisable, as continuing to operate a plan in accordance with existing terms that conflict with 409A would not be considered good faith compliance. The plan review required for 409A compliance may also present a good opportunity for an employer to conduct a broader audit of its overall executive compensation arrangements and practices to ensure that they appropriately address other issues of particular concern to the IRS. For additional information on such an executive compensation audit, see “The IRS Eyes Executive Compensation,” Trust The Leaders, Issue 10 (Winter 2004).