December 31, 2008, Deadline to Bring Nonqualified Deferred Compensation Arrangements, Severance Pay Arrangements, Incentive Stock Options and Employment Agreements into Compliance with Section 409A and to Make Modifications to Time and Form of Payment
9/22/2008
Employers face a looming deadline to make sure that all plans, programs and arrangements that pay deferred compensation either comply with the final regulations under section 409A of the Internal Revenue Code or have been structured to be exempt from section 409A. By December 31, 2008, documentation of all plans, programs and arrangements must comply with the final regulations under section 409A.
Background
Section 409A was enacted in 2004 to regulate nonqualified deferred compensation plans. Section 409A operates by specifying the nonqualified deferred compensation arrangements that are subject to its rules and by setting out detailed rules that must be satisfied with respect to (1) the timing of elections to defer compensation and (2) the timing of payment of amounts that are deferred. The U.S. Treasury Department issued final regulations interpreting many of section 409A's provisions in April 2007, with a proposed effective date of January 1, 2008. A discussion of the final regulations can be found here. Responding to concerns that the January 1, 2008 deadline did not allow enough time for employees to modify existing plans or to negotiate revision to comply with the final regulations, the Treasury Department issued Notice 2007-86, which extended the effective date of the final regulations to January 1, 2009. For more information on the general extension provided by Notice 2007-86, please see our Employee Benefits Law Alert entitled "Extensive Transition Relief Under Internal Revenue Code Section 409A". No further extension of the effective date is likely.
Why Comply?
Section 409A operates by imposing harsh tax treatment on employers (and independent contractors) with deferred compensation that is not exempt from section 409A but fails to satisfy the requirements of section 409A. Tax consequences include:
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Immediate taxation of deferred compensation in the year the deferred compensation plan fails to comply with section 409A or the year noncompliant deferred compensation vests. |
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A 20 percent excise tax on vested deferred compensation. |
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An interest penalty based on the taxes that would have been paid in the year the compensation was deferred. |
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Other reasons to comply with section 409A include:
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Nonqualified deferred compensation is usually provided to key executives and directors whose unhappiness with tax penalties will be problematic. |
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Failure to comply may affect representations in corporate agreements and borrowing arrangements. |
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The cost of making adversely affected employees whole for any tax penalties can be substantial. |
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What Should Be Done Now
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Survey: Employees need to identify all arrangements that may be subject to section 409A. |
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Review: Determine whether arrangements are or can be made exempt from section 409A. Plans or arrangements that cannot be made exempt must be examined for changes needed to comply with section 409A. |
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Document: Any changes to arrangements, either to be exempt from section 409A or to comply with section 409A, must be documented. This may require negotiations with affected employees and approval by board of directors and, possibly, shareholders. |
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Comply: Human resources managers must establish procedures to administer and communicate revised plans. Payroll departments and third-party payroll services must revise withholding and reporting procedures to comply with the revised plans and the special rules for reporting deferred compensation to the Internal Revenue Service. |
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Compensation Arrangements That Should Be Reviewed
Nonqualified Deferred Compensation Plans
Traditional nonqualified deferred compensation plans are the most obvious and important types of plans to review before the end of the year. Employers with nonqualified deferred compensation plans should review them to ensure they either meet the requirements of section 409A or are exempt from the application of section 409A. In addition to any formal nonqualified deferred compensation plans, employers should also review any programs or arrangements that may defer payments to employees to a year after the year in which the payments are earned. For example, short-term incentive pay programs or quarterly commission payment programs may inadvertently violate the requirements of section 409A. Employers with plans, programs or arrangements that include a deferral of compensation to a later date (even if the deferral is short) should review the time and form of payments to ensure section 409A compliance.
Severance Pay
Severance pay arrangements, either through a formal severance pay plan or as part of an individually designed employment agreement, can run afoul of section 409A. Employers should review all severance pay arrangements and individually designed severance packages currently in effect to ensure compliance with section 409A.
Stock Options
Stock options issued with an exercise price below the fair market value on the date of the grant are subject to section 409A. Employers should review all stock option arrangements to verify that all grants have been made with an appropriate exercise price.
Employment Agreements
Individual employment agreements often have terms that inadvertently violate the requirements of section 409A. Due to the individual nature of these agreements, they are often overlooked or not considered when employers are reviewing for section 409A compliance. Because section 409A has a broad scope and often applies to provisions in employment agreements that at first glance would appear not to be subject to section 409A, it is important to review these agreements carefully.
Changes to the Time and Form of Payment of Nonqualified Deferred Compensation
Employers wishing to take advantage of transition rules to make changes to the time and form of payments under any nonqualified deferred compensation arrangements will need to do so by December 31, 2008. Employers may need to consult with employees who have individual employment agreements to determine if any adjustments should be made.
Note that the rules provide that a change in the time or form of payment made in 2008 cannot cause a payment otherwise due in 2008 to be paid in a different year or cause a payment otherwise due in a different year to be paid in 2008.
Conclusion
The deadline to bring nonqualified deferred compensation arrangements into compliance with section 409A and to make any changes to the time and form of payment provisions under nonqualified deferred compensation arrangements is quickly approaching. It is important that employers verify these arrangements are in compliance with section 409A before the end of the year. This review should not be delayed because any required revisions to nonqualified deferred compensation arrangements may take some time to implement.
This Client Alert is a brief summary of the year-end deadlines for section 409A. In the interest of brevity, many details and issues have been omitted. If you have any questions or would like more information, please contact one of the following attorneys:
Related Client Alerts:
Employee Benefits Law Alert: Extensive Transition Relief Under Internal Revenue Code Section 409A
Employee Benefits Law Alert: Limited Transition Relief Under Internal Revenue Code Section 409A
Employee Benefits Law Alert: Overview of Key Provisions of the Section 409A Final Regulations
Employee Benefits Law Alert: Treasury and IRS Issue Final Regulations Regarding Deferred Compensation Plans
IRS Circular 230 Notice: Any tax advice contained herein was not intended or written to be used, and cannot be used, by you or any other person (i) in promoting, marketing, or recommending any transaction, plan, or arrangement, or (ii) for the purpose of avoiding penalties that may be imposed under federal tax law.
Christopher Briggs, an associate in our Seattle office, and Richard Hopp, a member in our Seattle office, prepared this Client Alert.