Until now, the big compliance challenges for companies surrounding the rules that govern deferred compensation have been sorting out the effect of those complex rules and determining which pay arrangements will be subject to them.
Now that final regulations have been issued—clocking in at nearly 400 pages—companies face a much tougher hurdle: getting, and staying, compliant. Plan to get started sooner rather than later.
Glover
“Now that final regs have been issued and there’s a clear year-end deadline to bring plans into documentary compliance, all plans subject to the rules need to be identified and if necessary, amended,” says Marjorie Glover, partner-in-charge of executive compensation in the New York office of Chadbourne & Parke. “Many boards hold their final meetings in late summer or early fall, so that needs to be done in the next few months.”
The rules apply to Section 409A of the federal tax code, although they arrived in April more than two years after Section 409A was established by the American Jobs Creation Act. Since the rules are strict in many ways, and the tax consequences to employees even for minor errors are steep, companies must rigorously examine the administrative processes they have in place, says Jeff Capwell, a partner in the law firm McGuireWoods.
For example, Glover says, companies must ensure that payroll and IT departments are tracking deferrals and benefits accruals properly. “Changes to those systems may be needed around how amounts subject to 409A will be reported,” she says. Companies must also coordinate with third-party administrators for compensation packages that might be linked to underlying qualified plans, such as supplemental savings or supplemental pension plans.
Louis Marett, a partner with the law firm Choate, Hall & Stewart, suggests companies start by conducting a “409A audit.”
“The compliance issues will vary by the size and practices of the company,” he says. “Companies need to identify who’s in charge of each and every arrangement or function that might have 409A consequences and get them educated on how the rules can impact what they do.”
Marett
Marett says 409A is “a tough compliance problem, because 409A touches so many different things that in most companies won’t all be under the same roof,” such as stock option issuance, employment agreements, severance arrangements, and expense reimbursement. While larger companies may have a team comprised of several people from human resources, legal, and finance to oversee compliance, Marett suggests a designated “409A czar to monitor it all.” Smaller companies without the internal resources could also seek help from outside counsel.
From Compliance Policy To Effective Control
Since most companies have been ramping up for 409A for more than a year, those who work with nonqualified deferred compensation plans regularly, like human resources executives and corporate attorneys, will probably be fairly familiar with the rules and should be able to get those plans into compliance with some coordinated effort, experts say. But amending those plans subject to the rules to bring them into compliance isn’t enough. The task now is for those in the know to educate others in the organization who will be touched by the new rules.
The hard part: that can include nearly everyone.
Michael Melbinger, of the law firm Winston & Strawn, says groups likely to need extra help include compensation committee members, who make decisions about many of the arrangements that may be subject to the final rules; any executives with the power to dole out stock options or negotiate severance; and all of the employees who participate in any of the plans subject to the rules.
RULE EXCERPT
Below is a portion of the Treasury Department’s new rules for taxation of deferred compensation agreements.
The final regulations provide that a nonqualified deferred compensation plan is a plan that provides for the deferral of compensation. The final regulations further provide that a plan generally provides for the deferral of compensation if, under its terms and the relevant facts and circumstances, a service provider has a legally binding right during a taxable year to compensation that, pursuant to its terms, is or may be payable to (or on behalf of) the service provider in a later year. For this purpose, an amount generally is payable at the time the service provider has a right to currently receive a transfer of cash or property, including a transfer of property includible in income under section 83, the economic benefit doctrine or section 402(b). Accordingly, a taxable transfer of an annuity contract is treated as a payment for purposes of section 409A.
The definition of deferral of compensation in the final regulations excludes the condition that the amount not be actually or constructively received and included in income during the taxable year, because that language might cause confusion with respect to the applicable rules governing deferral elections and the prohibition on the acceleration of payments For example, if a service provider has made an irrevocable election to defer an amount of his or her salary to a future year, that amount is treated as deferred compensation regardless of whether the service recipient actually pays such amount to the service provider during the year in which the services are performed. Any early payment of the deferred compensation (or any right to receive such an early payment) generally would constitute an impermissible acceleration of the payment of the deferred amount.
For this purpose, a plan will be treated as providing for a payment to be made in a subsequent year whether the plan explicitly so provides (including through a service provider election) or the deferral condition is inherent in the terms of the contract. Where the parties have agreed that a payment will be made upon an event that could occur after the year in which the legally binding right to the payment arises, the plan generally will provide for a deferral of compensation (unless otherwise excluded under a specific exception, such as the short-term deferral rule).
For example, if a plan provides a service provider a right to a payment upon separation from service, the plan generally will result in a deferral of compensation regardless of whether the service provider separates from service and receives the payment in the same year as the grant, because under the plan the payment is conditioned upon an event that may occur after the year in which the legally binding right to the payment arises. Similarly, if an arrangement such as a stock option or stock appreciation right not otherwise excluded from coverage under section 409A provides a right to a payment for a term of years where the payment could be received during the short-term deferral period or a subsequent period but is not otherwise includible in income until paid, the arrangement will provide for deferred compensation even though the service provider could receive the payment during the short-term deferral period (for example, by exercising the stock option or stock appreciation right). However, where a plan does not specify a payment date, payment event or term of years, (or specifies a date or event certain to occur during the year in which the services are performed), the plan generally will not provide for the deferral of compensation if the service provider actually or constructively receives the payment within the short-term deferral period.
The proposed regulations provided that earnings on deferred amounts are generally treated as deferred compensation for purposes of section 409A. Under the final regulations, whether a deferred amount constitutes earnings on an amount deferred, or actual or notional income attributable to an amount deferred, is determined under the principles defining income attributable to the amount taken into account under §31.3121(v)(2)-1(d)(2).
Source
IRS Final Regulation: Application Of Section 409A To Nonqualified Deferred Compensation Plans (Department of the Treasury; April 10, 2007)
Melbinger
“While most companies by now have identified all the plans they have that are subject to the rules, that knowledge hasn’t made it all the way up to the compensation committee and senior executives,” Melbinger says. “For those folks not accustomed to working with 409A, it’s not intuitive that it applies to things like employment agreements.”
Along those lines, Melbinger warns that to prevent a 409A compliance disaster, nobody at any level in the company should amend any agreement, plan, or policy regarding deferred compensation “without checking with someone who knows 409A and its impact.”
Glover agrees. “There needs to be coordination between departments to make sure anything that gets promised doesn’t run afoul of 409A and bring adverse tax consequences to the employee,” she says. In particular, she notes, the rules around separation pay arrangements are “very strict.”
Just as important as getting staff educated, Melbinger says, is getting plan participants up to speed on the impact of their elections. Distribution elections alone can pose a potential nightmare, because under the final rules, any election changes will postpone a distribution by at least five years beyond whatever was elected. For example, a participant who is 60 and previously elected a lump-sum distribution at age 65 now can choose to take installment payments, but those installments won’t begin until the participant turns 70.
“Participants need to be advised carefully about the consequences of certain elections and counseled as to how to make their elections to best preserve flexibility for themselves,” Melbinger says.
Other Probable Perils
Melbinger also contends that equity awards can spell trouble. He lists five potential pitfalls: making an award below fair market value; amending or modifying an award; giving an award in something other than the company’s stock; extending the time for exercising options beyond what’s allowed under the exception period; and allowing an additional deferral feature.
In addition, Marett cautions companies to make sure employees don’t have the ability to shift expense reimbursements from year to year and to watch out for disputed payments related to compensation. “Whenever there’s a disputed payment related to compensation, there will be a potential 409A issue,” he says.
Capwell
On top of making sure they’re compliant by year-end and that the appropriate executives and employees are educated on the rules, companies must take caution to ensure that they don’t create future 409A violations. Capwell says companies need to have “some sort of controls or system in place to review whether any new compensation arrangements are subject to 409A.”
“It isn’t just about getting your current plans amended by the end of the year,” he explains. “It’s also about making sure you’re in compliance going forward, when you put a new arrangement in place or someone makes changes to an existing arrangement.”
For those that are subject to the rules, “They need to make sure the way the new plans are designed complies or figure out what needs to be changed,” he says. All new arrangements must also be documented in writing before they become effective.
Experts stress that compliance will be an ongoing effort. “There are dozens and possibly hundreds of possible footfalls in the rules,” Marett says. “It’s a 365-day-a-year proposition to keep everybody on one side.”
Melbinger expects it to be “like qualified plans all over again.” His prediction: “I think Congress is likely to amend 409A nearly every year.”
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