Long-awaited final rules governing the tax treatment of nonqualified deferred compensation hold some good news for companies, but they must act quickly—and carefully—to take advantage of the added flexibility, experts say.
The final regulations under Section 409A, a complex set of rules that govern the tax treatment of nonqualified deferred compensation, span almost 400 pages and come more than two years after the section was added to the federal tax code by the October 2004 passage of the American Jobs Creation Act.
While companies should have plenty of time to make sure all of their affected arrangements are in compliance, experts say the tricky part for some companies may be verifying that they have identified all compensation deals that are subject to 409A.
Serota
“There are a lot of arrangements, which may not all be in writing, that need to be reviewed,” says Susan Serota, a partner in the law firm Pillsbury, Winthrop, Shaw & Pittman.
That’s because the rules extend well beyond traditional deferred compensation arrangements to apply to employment agreements, bonus programs, equity compensation plans, change-in-control agreements, excess benefit plans, certain severance arrangements and other plans.
As Compliance Week previously reported, the final regulations, issued April 10 by the Internal Revenue Service, preserve much of the guidance included in the proposed regulations and subsequent notices. They also maintain the requirement that plans be brought into documentary compliance by the end of this year. Plans must operate in “good faith” compliance until the Jan. 1, 2008, deadline for compliance with the final rules.
Once companies have determined which of their arrangements are subject to 409A, Serota says they should review the rules to see if compliance can be achieved without amending any plan documents. Otherwise, plan amendments and documents must be updated by the end of the year.
Stiff Penalties For Getting It Wrong
While seven months may seem like plenty of time to prepare for rules companies have long known were coming, experts warn that subtle compliance pitfalls abound, and the penalties for noncompliance are severe: an immediate income tax bill to the employee, as well as a 20 percent payment tax and an interest charge.
Capwell
Even worse, the mistakes may not be fixable. The IRS currently has no plans to implement a program to allow for correction of errors, says Jeffrey Capwell, a partner at the law firm McGuire Woods. He describes Section 409A as “more than just a trap for the unwary … It imposes a set of strict and unforgiving administrative requirements.”
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
Treasury Department (April 10, 2007)
For instance, Capwell says, many common types of errors in operating plans—such as paying too much or too little or making payments a year earlier or later than the year they should’ve been paid—could result in violations that won’t be correctible, resulting in adverse tax consequences for the affected employees. “These rules cry out for a need to implement internal controls that are specifically designed with Section 409A in mind,” he says.
Feldman
Charles Feldman, a partner in the law firm Gibson, Dunn & Crutcher, says companies should make certain the definitions used in their plan documents are consistent with those in the regulations. “Even a minor difference in the language used may result in your undoing,” he says.
Still, for those companies that have monitored the 409A guidance as it has evolved, the compliance deadline shouldn’t pose too much difficulty, Feldman stresses. And despite the potential for disaster among the unprepared, he and others do welcome the final rules as a dose of much-needed clarity.
“The final regs make giant strides toward answering many of the questions and providing guidance in a number of areas companies were concerned about under the proposed regs,” Feldman says.
Those areas of concern included changes to the rules on severance pay, relaxed requirements on stock option extensions, a broader definition of service recipient stock, and clarification of how reimbursement arrangements can comply with Section 409A, among other things.
Feldman notes that additional guidance is expected in some areas that weren’t addressed by the final rules, including the calculation and timing of income inclusion amounts, problems associated with foreign trusts, and issues related to partnerships.
Regardless, Serota says the final rules allow “more latitude than the proposed rules” in many respects. While some changes make certain aspects of the rules somewhat less flexible, she says, “Overall, there are far more pluses than minuses.”
Changes to severance pay rules
The final regulations clarify that under certain circumstances, termination for good reason can be treated as an “involuntary” termination for purposes of Section 409A. That would allow payments made to the employee after he was fired to be exempt from Section 409A if he were paid within 10 weeks following the year when the termination occurs, Capwell says.
Such a payment would avoid any adverse tax consequences under Section 409A and, if the employee is in the class of public company employee subject to the six-month delay rules, the payment wouldn’t have to be delayed, he says.
The regulations also clarify that a severance pay exception applies to amounts paid following an involuntary termination, so long as they don’t exceed a dollar limit based on two times the lesser of an IRS retirement plan limit or the employee’s compensation for the year before termination.
Under the proposed regulations, it was unclear whether this exception could apply if the total severance payable was over the dollar limit, Capwell says. The final regulations clarify that the exception can apply to any amounts up to that limit, allowing agreements that pay severance over a period of time to be exempt even though the total amount of severance exceeds the dollar limit, he says.
Stock Options
Capwell notes that the final regulations generally relax the requirements relating to stock option extensions. Under the final regulations, companies can extend the option exercise period to the earlier of the end of the original option term or 10 years from the date of grant. For example, options that would expire after 90 days following an employee’s termination of employment could be modified to allow for continuation of the exercise period to the end of the original term of the option, so long as that extension didn’t extend beyond 10 years from when the option was granted.
Reimbursement Arrangements.
The regulations clarify how reimbursement arrangements can comply with Section 409A, which Capwell says will be “particularly helpful” for agreements that provide for tax gross-up payments and other promises to reimburse expenses for a period that is longer than two years.
Definition of Service Recipient Stock
Feldman notes that a broader definition of the term “service recipient stock” makes it easier for options or stock appreciation rights to be exempt from Section 409A. The final regulations expand the definition of “service recipient stock” to include any class of common stock that doesn’t have preferential distribution rights. That includes the stock of any company in a chain of corporations that’s above the employer corporation if a controlling interest requirement is met.
Capwell cautions that “service recipient stock” doesn’t include stock of any subsidiary or sister corporation of the recipient’s employer, a restriction he says needs to be “carefully considered” when designing and granting stock options for employees of related entities.
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