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On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004, which added to the Internal Revenue Code of 1986, as amended, a new section 409A. Enacted in response to perceived abuses by Enron executives, Code Section 409A makes fundamental changes to the tax treatment of “nonqualified deferred compensation” and imposes severe penalties for noncompliance. Code Section 409A overhauls the rules governing nonqualified deferred compensation in much the same way as ERISA overhauled the rules governing traditional pension plans. Although the statute itself is only about 3 pages long, the IRS and the Treasury Department issued nearly 400 pages of regulations on April 10, 2007. The final regulations present countless traps for the unwary and a nightmare of complexity for practitioners.
Definition of Deferred Compensation
For purposes of Code Section 409A, an individual has deferred compensation if there is a legally binding right during a taxable year to payment of compensation in a subsequent taxable year. Deferred compensation exists even if the right is subject to a risk of forfeiture (i.e., even if the right is not “vested”) and even if the right is subject to a condition that may never be fulfilled. Although Code Section 409A was enacted to curb abuses by executives, it applies to all deferred compensation, whether or not the recipient of the compensation is an executive.
As you may expect, Code Section 409A potentially applies to a number of compensation arrangements typically granted to executives, including:
However, as a result of the broad definition of deferred compensation, Code Section 409A potentially applies to many other compensation arrangements, which may affect rank and file employees as well as executives, such as:
Code Section 409A Requirements
When applicable to a compensation arrangement, Code Section 409A:
Initial Deferral Elections: Elections to defer compensation must be made in the year prior to the year in which the compensation is earned. Code Section 409A provides 2 important exceptions to this rule. First, new hires may make an election to defer compensation within 30 days of becoming eligible to defer compensation. Second, elections to defer certain types of performance-based compensation may be made during the year in which the compensation is earned as long the election is made at least 6 months prior to the end of the period over which performance is measured.
Subsequent Deferral Elections: Once an election to defer compensation has been made, that election generally is irrevocable. However, elections may be changed only if the subsequent election is made at least 12 months before a scheduled distribution, the subsequent election does not take effect for at least 12 months, and the subsequent election defers the distribution for a period of at least 5 years. Under transitional guidance from the IRS, participants in nonqualified deferred compensation plans may make elections to change the time and form of payments through December 31, 2008, provided that any such election applies to amounts that otherwise would not be payable during the year of the transitional election, and does not cause an amount to be paid in the year of the transitional election that otherwise would not be paid during such year.
Permissible Payment Events: Under Code Section 409A, payment of deferred compensation is permissible only upon the occurrence of one of the following six events:
Anti-Acceleration Rules: Code Section 409A generally prohibits acceleration of payments. Therefore, nonqualified deferred compensation plans may no longer contain “haircut” provisions, which enable a participant to accelerate a distribution by forfeiting a small percentage of the amount deferred. Code Section 409A provides limited exceptions to this rule for de minimis amounts, payments to satisfy a participant’s obligations under a qualified domestic relations order, and payments for taxes.
Documentary Compliance: Code Section 409A establishes a written plan requirement. Therefore, arrangements providing for deferred compensation must meet the documentation requirements of Code Section 409A in addition to complying with the rules in operation. A documentary compliance failure will cause an immediate violation under Code Section 409A. Plan documents must contain material terms, such as the conditions under which compensation may be deferred, and the time and form of payment of deferred compensation. In addition, plans to which the 6-month rule applies must specifically state the 6-month rule.
Code Section 409A Exceptions
Numerous arrangements are excepted from the application of Code Section 409A, such as:
Short-Term Deferrals: Under the short-term deferral exception, Code Section 409A does not apply to payments actually or constructively received no later than 2 ½ months after the end of the year in which the right to the payment becomes vested if the arrangement does not contain any provisions that would allow payment to be made at a later date.
Equity Compensation: Stock options and stock appreciation rights may be excepted from the application of Code Section 409A if the exercise price of the stock option or stock appreciation right is not less than the fair market value of the underlying stock on the date of the grant, the stock option or stock appreciation right does not have any additional feature that would defer taxation, and the underlying stock meets certain requirements.
Separation Pay Arrangements: Separation pay may be structured to fit within the short-term deferral rule. Otherwise, Code Section 409A will apply to arrangements providing for separation payments beyond the date which is 2 ½ months after the year in which the right to payment became vested (such as a salary continuation arrangement), unless certain requirements are met. Specifically, separation payments may be made only on account of involuntary separation from service (or “good reason” terminations under the Code Section 409A final regulations). Also, the amount of separation pay may not exceed the lesser of 2 times annual compensation or the Internal Revenue Code Section 401(a)(17) limit (which is $230,000 in 2008). Finally, the separation pay must be made no later than the last day of the 2nd taxable year following the year of the separation from service. Separation pay arrangements that do not comply with the above rules are subject to Code Section 409A and must satisfy the operational and documentary requirements of Code Section 409A, including the 6-month rule.
Penalties for Noncompliance
Code Section 409A imposes some of the most severe penalties under the Internal Revenue Code. It is important to understand that the penalties under Code Section 409A apply to the recipient of the deferred compensation, not the business entity paying the deferred compensation. If Code Section 409A is violated, the recipient of the deferred compensation is subject to current income taxation on all compensation deferred under the arrangement as soon as it is not subject to a substantial risk of forfeiture (even if the deferred compensation is not actually paid), a 20% additional tax penalty, and interest on all deferred compensation taxed as a result of the failure of the arrangement to comply with Code Section 409A at the IRS underpayment interest rate plus 1%.
The final regulations under Code Section 409A become effective January 1, 2008. Complete operational compliance with the final regulations is not required until January 1, 2009; however, good faith operational compliance is currently required and will be required throughout 2008. Full documentary compliance is required by December 31, 2008.
The critical first step to dealing with Code Section 409A is to identify arrangements that are subject to Code Section 409A. The IRS has indicated that it may offer a voluntary compliance program to correct limited operational failures, such as an inadvertent payment acceleration that is corrected within the same taxable year. However, the IRS has not indicated that correction procedures will be available for documentary failures. Think Code Section 409A if there is any possibility of payment (in cash or in the form of any economic right or benefit) in any future taxable year, to or for the benefit of an employee or independent contractor (or anyone designated by such employee or independent contractor), that is based in whole or in part on the employee’s or independent contractor’s services in the current taxable year or any earlier taxable year. After identifying arrangements subject to Code Section 409A, revise documents to satisfy the documentary compliance requirements on or before December 31, 2008. Consider transitional elections to change the time and form of payment. Finally, assist clients in developing procedures to ensure operational compliance. Clients should understand that Code Section 409A compliance requires a team effort involving personnel from human resources, finance, legal, payroll and IT.
About the Author
C. John Wentzell, Jr. is an associate with Ogletree, Deakins, Nash, Smoak & Stewart, P.C. in Greenville, South Carolina, where he practices employee benefits law.