As we have previously reported, in order to avoid significant penalties, most “deferred compensation arrangements” (e.g., employment, severance, bonus, commission, change-in-control, split-dollar, excess benefit, stock option, phantom stock, etc.) for employees and other service providers (such as independent contractors or directors) must either be brought into compliance with, or meet one of the exemptions from, the new Section 409A of the Internal Revenue Code (“409A”).
Deadline Extended to 2008
The Treasury Department and IRS recently issued Notice 2007-78, extending the deadline to December 31, 2008 to bring most deferred compensation arrangements into compliance with 409A. In general, this means that a deferred compensation arrangement will not violate the requirements of 409A on or before December 31, 2008, so long as the plan is operated at all times after January 1, 2005 in good faith compliance with 409A and the plan document is amended on or before December 31, 2008 to comply with 409A retroactively to January 1, 2008.
Action Still Required in 2007
While the deadline to amend the written provisions of a plan for 409A has been extended, keep in mind that many important decisions regarding the payment structures of these arrangements still must be made and documented by the end of 2007:
- Good faith operational compliance with 409A is required at all times on and after January 1, 2005.
If a compliant time or form of payment is not currently elected by a service provider under an existing arrangement, his or her election must be made by December 31, 2007. - If an existing arrangement (whether written or oral) does not currently provide for a compliant time and form of payment, or if a new choice needs to be added, you must designate these items in writing by December 31, 2007.
- If you want an existing arrangement to fit within the short-term deferral exception from 409A (this is the exception that allows a payment made within 2 ½ months following the close of the taxable year in which the payment is no longer subject to a substantial risk of forfeiture to be excluded from the definition “deferred compensation”), it must do so by December 31, 2007.
- For purposes of determining service providers’ abilities to modify payment dates, if you want installment payments provided under an existing arrangement to be treated as a right to a series of separate payments (rather than a single payment), you must designate this treatment in writing by December 31, 2007.
- If an existing arrangement provides for payments upon separation from service for “good reason”, you must conform your “good reason” definition to the safe harbor definition by December 31, 2007 to take advantage of the involuntary separation from service exception from 409A.
- If you have existing arrangements linked to qualified plans (generally, SERPs and excess benefit plans), these must be de-linked and new elections made by participants by December 31, 2007.
- If your arrangement provides for discounted stock options, by December 31, 2007 you must either bring the arrangement into compliance with 409A or exclude it from 409A by raising the exercise price up to fair market value as of the date of grant.
- No offshore trusts may be used to fund an arrangement, and no funding of arrangements is permitted while the company’s defined benefit plan remains at certain levels of underfunding, after December 31, 2007.
We Recommend That, Prior To December 31, 2007, You Take The Following Actions:
- Review all potential deferred compensation arrangements (whether oral or written) and take steps to identify what updates need to be adopted before December 31, 2007;
- Take all actions necessary to comply with the above-listed 2007 items; and
- Make sure your Board of Directors or other governing body takes formal action in a separate written document to approve a default payment date and method for all deferred compensation arrangements that have not been identified or are not otherwise in compliance with 409A.
Violations of 409A will result in significant penalties to the individual service provider (e.g., an employee or independent contractor). If a deferred compensation arrangement violates 409A (in form or operation), the individual may be immediately taxed on the total value of the deferred compensation and all similar deferred compensation arrangements in which he or she participates (even though the payment under the noncompliant arrangement may not yet be payable to the individual), plus a 20% penalty tax, plus interest. Companies will be liable for timely withholding and payment of income and employment taxes. Although to our knowledge a cause of action has not yet been recognized, it is possible that courts may in the future recognize causes of action against companies for failure to make sure their deferred compensation arrangements comply with 409A.