Employers have been living with Section 409A—the complex tax rules governing nonqualified deferred compensation—since January 1, 2005. Repeated deadline extensions and various transition rules and have helped ease the burden of Section 409A. However, absent a last-minute reprieve by the IRS, the last and final compliance deadline is rapidly approaching. Full compliance with Section 409A—including
documentary compliance—is required by
December 31, 2008. Furthermore, transition rules have afforded employers and employees some flexibility
expire on
December 31, 2008.
This alert briefly outlines steps employers should consider to come into full compliance with Section 409A, and briefly outlines a final opportunity to take advantage of a transition rule under Section 409A.
Even though the deadline for full compliance is the end of 2008, good-faith compliance with Section 409A has been required since 2005, and continues to be required.
Section 409A is not limited to employers. It may apply to any "service recipient," including partnerships and entities receiving services from certain independent contractors. However, to make this Client Alert more readable, we refer to "employers" instead of "service recipients."
Full Compliance
Section 409A imposes requirements on a broad range of nonqualified deferred compensation plans and arrangements, and provides stiff penalties for noncompliance. Employers must comply with Section 409A in operation, and must have written documents for all arrangements subject to Section 409A.
Inventory. Section 409A reaches far beyond traditional deferred compensation plans, and employers are often surprised at the wide variety of arrangements covered by Section 409A. Employers that have not yet done so should promptly take an inventory of all arrangements that are potentially subject to Section 409A.
Section 409A covers any "nonqualified deferred compensation plan" as very broadly defined by regulations. Generally, this includes any arrangement under which an employee can be paid in a year after the year in which the employee obtains a legally binding right to the payment. This can include plans covering groups of employees as well as individual contracts and arrangements.
Below are general categories of arrangements that may constitute nonqualified deferred compensation plans under Section 409A, and specific examples of such arrangements.
- Employment, Bonus, and Severance Arrangements. These can include employment agreements, severance plans and agreements, change in control arrangements, earn-outs, separation arrangements, retention arrangements, bonus arrangements, and offer letters. Any agreement to provide benefits (whether in cash or
in-kind) post-employment should also be considered as potentially covered by Section 409A.
- Nonqualified Deferred Compensation Plans. Traditional deferred compensation plans, supplemental retirement plans, retirement enhancement plans, 401(k) excess plans, bonus plans, account balance plans, non-account balance plans, and annuity contracts should all be considered.
- Payment and Expense Reimbursement Programs. Payment reimbursement programs (for example, club/membership dues, tax gross-ups, and relocation expenses) may be subject to Section 409A. Even business expense reimbursements can come under Section 409A if not structured appropriately.
- Equity-Based Compensation. Equity awards are often exempt from Section 409A, but not always. Equity awards should be reviewed regardless of whether they are settled in securities or cash.
- Split-Dollar Life Insurance Arrangements. These need to be reviewed in conjunction with IRS Notice 2007-34, which provides guidance for determining whether Section 409A applies.
- Foreign Plans. Foreign plans should be examined to see if they qualify for Section 409A's foreign-plan exclusion.
- Partnership Arrangements. Arrangements between partners, partnership interests, profits interests, or options to acquire partnership interests granted in connection with the performance of services should be evaluated.
- Independent Contractor Arrangements. While the final regulations provide a safe harbor for some arrangements with independent contractors, such arrangements should be reviewed for compliance with the safe harbor.
After The Inventory. Regulations provide numerous exceptions to Section 409A coverage, so some of the arrangements listed in your initial inventory may later be crossed off. An analysis of each arrangement is normally needed because the exceptions can be technical and detailed.
Arrangements that are subject to Section 409A must come into written compliance by December 31, 2008. Regulations provide that merely adding a "savings clause" is not sufficient. Some of the arrangements included in your inventory might not currently have a written document, in which case a document must be created.
Given the breadth of Section 409A, the specific changes needed to comply are too numerous to be cataloged here. In general, plans subject to Section 409A must comply with detailed restrictions covering the timing of elections to defer compensation, the events which may trigger payment, and the timing of payments. In many instances, changes may be needed to avoid being subject to Section 409A. As just two examples of the many changes that may be needed by December 31, 2008:
- Payments or benefits (such as equity vesting) triggered upon a termination of employment for “good reason” can be subject to Section 409A. If an employer wishes to comply with Section 409A by revising the definition of "good reason," the revisions must be made on or before December 31, 2008.
- Stock options and stock appreciation rights ("SARs") granted at no more than fair market value are not subject to Section 409A, but discounted options and SARs are subject to Section 409A. The deadline to comply with Section 409A by substituting a non-discounted option or SAR for a discounted option or SAR is generally December 31, 2008 (although in some instances the deadline expired at the end of 2006).
The logistics of adopting or amending plans and agreements should be considered. For example, if action by a Board of Directors or Compensation Committee is needed, the amendment may need to be completed well in advance to ensure time for the Board or Committee to act before December 31.
Revisions to ancillary documents may be needed to reflect Section 409A amendments, such as plan summaries, Q&As, S-8 prospectuses, and other communications to employees.
Final Opportunity to Change Payment Elections Section 409A places strict restrictions on the ability to change the time of benefit payments and the form of benefit payments (such as lump sum versus installments). However, the full impact of these restrictions has been delayed by transition rules that have allowed some changes to the time and form of benefit payments. The last of these transition rules expires December 31, 2008. Under the last transition rule, there is a final opportunity to change the timing or form of payments that will be received in 2009 or later. However:
- If an employee is scheduled to receive a payment in 2008, changes to the timing or form of that payment are not permitted.
- If an employee is not currently scheduled to receive payments in 2008 but wants to change his or her election to receive payments in 2008, the change is not permitted.
The extent to which an employer wishes to use the transition rule is generally up to the employer (subject to any restrictions provided in a plan or contract). Thus, employers are not required to permit employees to make new elections under these transition rules. Furthermore, if permitted by a plan or contract, the employer may itself exercise the right to change a payment election under the transition rule.
IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any matters addressed herein.