Code Section 409A Compliance: What To Do Before Year End
In 2004 Congress enacted Section 409A of the Internal Revenue Code, which sets forth a new tax regime for deferred compensation. Section 409A can apply to a wide variety of arrangements, including executive employment and severance agreements, as well as traditional deferred compensation plans. For the past three years employers have struggled to create new plans and timely revise existing ones in compliance with the new rules. Following various interim guidance, the IRS promulgated final regulations in April of this year. In response to an outcry over the January 1, 2008 effective date for the final regulations, the IRS issued Notice 2007-78, which offers limited relief for bringing plan documents into compliance.
Review of 409A
Before discussing the relief afforded in Notice 2007-78, a brief review of 409A requirements is in order.
Plans that are subject to 409A. Section 409A applies to all plans or other arrangements, with few exceptions, that provide for non-qualified deferred compensation (NQDC). In addition to arrangements generally recognized as NQDC plans, 409A also applies to deferred compensation features in employment agreements, change of control agreements, discounted stock option awards, bonus incentive agreements, severance agreements, and other plans which give employees a binding right to compensation in a future year. Moreover, NQDC arrangements with non-employees are also subject to 409A. For example, directors’ retirement plans, performance awards given to independent contractors, etc. are covered. A covered plan is either 409A-compliant or it is not. If it is not, then punitive taxation applies to the recipient of the deferred compensation.
Deferral of compensation. In general, compensation is considered to be deferred if it is not payable upon the termination of any “substantial risk of forfeiture,” or within the first 2½ months of the following year (the so-called “short-term deferral exception”). The final regulations interpret the phrase “substantial risk of forfeiture” to mean that the payment is conditioned either on the participant’s performance of future services for the plan sponsor or on the occurrence of a substantive event (such as meeting an earnings target) that is related to the purpose of the compensation.
Distribution requirements. In order for a plan to be 409A-compliant, vested deferred compensation may be paid to a participant only on account of permissible payment triggers: (i) a time or schedule specified in the plan document; (ii) the participant’s “separation from service,” death, or “disability,” (iii) a “change in control” of the sponsoring employer, or (iv) an “unforeseeable emergency.” All these terms are specifically defined in the final regulations, which in some instances, afford alternative definitions. Once the distribution event(s) have been established under the terms of the NQDC plan, distributions may not be accelerated for any reason.
Election requirements. If a participant in a NQDC plan is given an election to defer his compensation, or to specify the time or schedule of payments, such elections must be made not later than the close of the calendar year preceding the year in which the compensation is earned. There is an exception for the first year of a plan’s existence, when elections to defer may be made within the first 30 days of a person becoming a participant under the plan.
Penalties for noncompliance with 409A. If a plan is covered by Section 409A but does not comply with it, a participant will be subject to income tax as soon as the deferred compensation is vested, AND the participant will be liable for an additional 20% tax on the amount of the compensation. The employer is required to withhold with respect to such taxes if the participant is an employee.
Deferred compensation earned and vested before 2005 is not subject to Section 409A, provided the plan is not materially amended after October 3, 2004. Section 409A is effective for amounts deferred under existing or new plans after 2004, and such plans are required to contain provisions that conform to the statutory and regulatory requirements. However, given the complexities of the new rules and previously published guidance of the IRS, plan sponsors were given until December 31, 2007 to amend plans to meet the documentary requirements. The final Section 409A regulations become effective January 1, 2008. Until then, plans must be operated in good faith compliance with the final 409A regulations and IRS guidance regardless of the plan provisions.
Even the December 31 amendment deadline has proven to be burdensome for most plan sponsors on account of the myriad arrangements that must be reviewed for deferred compensation features. The IRS has now responded with Notice 2007-78, described below, and has suggested informally that further relief is being considered. (If further relief is granted by the IRS, information about it will be available on the CLM website.)
Transition Relief in Notice 2007-78
Written designations. This latest pronouncement by the IRS affords relief for documentary compliance for plans that do not presently meet all the Section 409A requirements. Non-complying NQDC plans will not have to be amended to reflect specific Section 409A requirements until December 31, 2008, provided certain actions are taken immediately. First, before January 1, 2008, a “written designation” must be adopted that provides for an objectively determinable time and form of payment of plan benefits that conform to Section 409A. If the designation is adopted, the IRS will disregard other nonconforming provisions of the NQDC plan for the time being.
The “designation” may take the form of a plan amendment or it may be a separate written instrument addressing a specific plan or providing a blanket time and form provision for all plans of an employer that are subject to Section 409A. The written designation may permit the payment of plan benefits only upon Section 409A permissible distribution events as described above.
The written designation is effective only if
- the amounts to which each designation applies are objectively determinable,
- the plan is administered in a manner that conforms to the requirements of Section 409A (that is, nonconforming provisions of the plan are not followed), and
- the plan is amended to provide compliant provisions on or before December 31, 2008.
Thus, if a written designation is made pursuant to the Notice, other plan defects can be cured next year. If no written designation is made, a plan will need to be brought into full formal compliance this year.
Six-month delay in distributions. Section 409A also requires that the distribution of NQDC to a “specified employee” of a public company, triggered by the employee’s separation from service, be postponed for six months. Notice 2007-78 waives the requirement that that rule be set forth in plan documents, provided that the distribution is actually delayed for the requisite six months, and during 2008, the plan document is retroactively amended to state the rule as of January 1, 2008.
Separations from service for “good reason.” There has been considerable confusion over payments made under a plan (including an employment agreement) on account of involuntary separation from service where the plan treats an employee’s separation from service for “good reason” as involuntary. If the plan is intended to comply with the exception from Section 409A for severance plans (that pay out not more than two times base pay over a distribution period of not more than two years), the plan definition of “good reason” must match the definition in the final Section 409A regulations.
Other arrangements, for example separation payments under a senior executive’s employment agreement, that do not comply with the severance plan exception, provide for deferred compensation unless their definitions of “good reason” satisfy the requirements of the final Section 409A regulations, by proper design or by adoption of the safe harbor definition afforded in the regulations. Arrangements that do not have a conforming definition of “good reason” cannot comply with the short-term deferral exception, so such separation payments must be paid only upon a Section 409A triggering event. If the company is a public company and the employee is a “specified employee,” the six-month delayed payment rule (see above) must be observed.
The Notice allows the definition of “good reason” in an existing employment agreement to be modified to conform to a satisfactory definition in the final 409A regulations before 2008, but only under limited circumstances. Every “good reason” definition in an employment agreement should, therefore, be analyzed this year to determine if a conforming amendment is permitted, and if so, an appropriate modification to the definition should be made. Modifications are not generally permitted after 2007.
Although the extent of the relief afforded by Notice 2007-78 is disappointing for many who had hoped the IRS would permit continued operational and documentary good faith compliance, no sponsor of a NQDC plan should disregard the opportunities presented by the Notice or the December 31, 2007 deadline.
Employers that have not already done so should, before year end, review all existing arrangements for features that are subject to Section 409A, identify the changes required to be made and either make conforming amendments to their plans or adopt a written designation. The timing of this will be especially compressed if board action is needed to adopt plan amendments or a written designation.
Questions regarding this client advisory may be directed to Patricia Matzye at (212-238-8730, firstname.lastname@example.org), Dan Pittman (212-238-8854, email@example.com) or Howard Barnet (212-238-8606, barnet @clm.com) of our New York Office.
Carter Ledyard & Milburn LLP uses Client Advisories to inform clients and other interested parties of noteworthy issues, decisions and legislation which may affect them or their businesses. A Client Advisory does not constitute legal advice or an opinion. This document was 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 transaction or matter addressed herein.
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