Ten Things Every Nonprofit Should
Know About Section 409A

John P. Beavers
Bricker & Eckler LLP
May 2007

The Internal Revenue Service recently released long-awaited final regulations concerning the application of section 409A of the Internal Revenue Code to nonqualified deferred compensation plans on April 10, 2007. Employers sponsoring such plans have until December 31, 2007 to bring their nonqualified plans into compliance with section 409A. The final regulations contain a number of significant changes impacting tax-exempt organizations. These changes are highlighted below.

Overview of Section 409A

Section 409A creates a complex set of new rules that apply to any nonqualified deferred compensation plan. For purposes of this section, a "nonqualified deferred compensation plan" is defined broadly to consist of any compensation that is or may become payable in any year later than it is earned, or that relates to services performed in an earlier year.

Deferred compensation can arise in a variety of common circumstances, including through salary or bonus deferrals, payments of bonuses or incentive compensation for services performed in prior years, provision of severance benefits, including through employment agreements, and promises of supplemental retirement or other post-employment benefits. As a result, employers should carefully scrutinize all of their compensation practices to ensure that they comply with the new rules.

Section 409A generally requires that all nonqualified deferred compensation plans:

• Be maintained in writing;

• Require participants to make deferral elections in advance;

• Provide for payments only upon one of six statutorily-defined permissible payment events; and

• Prohibit participants from accelerating their receipt of benefits.

Section 409A also includes numerous other technical rules and requirements that will necessitate that most existing plans be significantly modified.

Failure to Comply

There are substantial penalties imposed on the participant in any nonqualified deferred compensation plan failing to comply with section 409A. These penalties require that the participant include all prior deferrals in gross income retroactive to the date of deferral, pay taxes, interest and penalties on the amount so included, and pay an additional 20% penalty on the amount included. As a result, employers and employees should be certain that their plans do not violate section 409A.

Ten Tips for Dealing with 409A

The final regulations under section 409A are nearly 400 pages long -- a fact that underscores the complexity of these rules. Because tax-exempt employers are already subject to a special set of rules, section 409A simply increases the complexity and opportunity for error. The following is a list of the top-ten things that tax-exempt organizations should know about the new rules:

1. Be Aware of the Tax-Exempt Triple-Threat
   Deferred compensation plans of tax-exempt organizations are subject to as many as three separate tax regimes, each with its own special rules.

   • "Eligible" deferred compensation plans remain exempt from section 409A, but are subject to the special rules of section 457(b).

   • By contrast, all "ineligible" deferred compensation plans are subject to the special rules of section 457(f).

   • Finally, certain ineligible deferred compensation plans are also subject to the rules of section 409A.

   Deferred compensation remains a valuable -- and increasingly popular tool -- for tax-exempt organizations to compensate their executives. The increased complexity of the tax rules that make these plans possible, however, underscores the need for these plans to be reviewed by counsel expert in these special rules.

2. Don't Be a "Bad Boy", Make Sure You're At Risk
   Tax-exempt employers whose deferred compensation plans are subject to both section 409A and section 457(f) should be aware that section 409A contains its own definition of "substantial risk of forfeiture". Thus, "bad boy" clauses, non-compete covenants and "rolling vesting" provisions that may provide a substantial risk of forfeiture under section 457(f) do not satisfy the separate definition under section 409A. As a result, employers should review these plans provisions to ensure that they do not inadvertently violate section 409A.

3. Don't Feel Bad About Being Excluded
   The final regulations clarify that most qualified retirement plans, including 401(a), 401(k) and 403(b) plans are excluded from section 409A; likewise, plans that provide only for a short-term deferral are also excluded.

   A plan provides for a "short-term deferral" if it provides that payment will be made no later than 2-1/2 months after the end of the year in which it is earned (or, if later, when it is no longer subject to a substantial risk of forfeiture). If there is any possibility that a plan could provide for a payment after this period, it does not qualify for this exception. Tax-exempt employers should review their plans to take advantage of this exception when available.

4. Develop "Separation" Anxiety
   Certain separation pay plans are exempt from section 409A. A "separation pay" plan is one that provides for payments only upon involuntary termination and caps the total amount of severance that may be paid. Employers may also provide up to $15,500 (in 2007) in payments or other benefits to employees, including reimbursement of medical expenses and provision of certain other fringe and in-kind benefits under separation pay plans.

   The final regulations significantly relax the requirements to qualify as "separation pay". Employers should be certain to review their severance policies (including severance provisions in employment agreements) to take advantage of this exception; otherwise, these agreements will have to be amended to comply with section 409A.

5. Be Sure to Have "Good Reason"
   The final regulations permit certain "good reason" separations from service to be treated as involuntary, both for plan distributions and to take advantage of the separation pay exclusion from section 409A. Treating good reason separations as involuntarily gives tax-exempt employers additional flexibility in structuring their deferred compensation plans and removes a potential sticking point in negotiations with employees.

6. Put it in Writing, Stupid
   The final regulations clarify that all deferred compensation plans must be maintained in writing. The plan document must, at a minimum, include a benefit formula and provide a time and form of payment. If the plan permits deferral elections to be made, it must set forth the conditions under which such an election may be made. Tax-exempt employers should consider adopting universal plan documents and policies to ensure that they meet the plan requirements and satisfy the operational requirements of section 409A, such as for making elections.

7. Address Aggregation Aggravation
   The final regulations require tax-exempt employers to aggregate various types of "like" deferred compensation plans and treat them as single plans. The types of plans that must be aggregated include elective plans, non-elective plans and separation pay plans. The aggregation rules are significant because they impact the time that participants may make certain elections and, in some cases, a violation of section 409A may trigger a violation in all like plans.

   Tax-exempt employer should also maintain a list of all their deferred compensation plans, by category, an update this list annually to reflect terminations, changes in participation and other relevant events.

8. Look Before Terminating
   The final regulations expand the circumstances under which tax-exempt employers may terminate their deferred compensation plans to include dissolution and change in control. Tax-exempt employers may voluntarily terminate their deferred compensation plans; however, if a plan is voluntarily terminated, all like plans must be terminated and no replacement plans may be established for three years. No termination is permitted if it is " proximate to a downturn in the financial health" of the organization. As a result, tax-exempt employers should carefully consider the effect that a plan termination will have on all of its other deferred compensation arrangements before proceeding with the termination.

9. Remember, There's No "Savings" You
   The final regulations clarify that "savings" clauses striking plan provisions that are inconsistent with section 409A have no effect. As a result, tax-exempt employers whose plans include such provision should remove them and review their plans to ensure that the remaining provisions comply with the requirements of section 409A.

10. Be Aware of Elections
    Section 409A requires that participants in deferred compensation plans make certain elections at specific times. These include a blizzard of new rules governing "initial" elections, as well as limitations on making "subsequent" changes to those elections. Plans must be amended to permit participants to make these elections and limit changes after such elections have been made, preferably from inception, otherwise they risk violating section 409A. Tax-exempt employers should carefully review their plans to make sure that they include the appropriate elections.

11. Bonus Tip: Be Reasonable
    Tax-exempt employers must remember that they are limited to paying only "reasonable" compensation under the intermediate sanctions regulations and that deferred compensation must be considered when setting compensation. All tax-exempt organizations are encouraged to take advantage of the "rebuttable presumption" of reasonableness. Total compensation, including the value of deferred compensation arrangements, both in kind or in cash, must be taken into account.

Conclusions

Despite the changes made by section 409A, deferred compensation remains an invaluable tool for tax-exempt employers. Because the changes highlighted above will require that many organizations revisit their plans, this is an excellent opportunity to revisit your compensation policies and procedures to ensure that your deferred compensation plans are accomplishing your goals and to ensure that are paying your executives only reasonable compensation. It is easier to address these issues with counsel, rather than the IRS.

We have put much more information about deferred compensation plans, including section 409A, in our Executive Compensation Resource Center. For information on the effect of Section 409A on all organizations, see Ten Things Companies Should Know About Section 409A.