Ten Things Every Company 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 that are highlighted below.

Overview of Section 409A

Section 409A creates a complex set of new rules that apply to any nonqualified deferred compensation plan. Essentially, section 409A treats any payment that could be made in another tax year as "nonqualified deferred compensation" unless it falls within a specific exception. As a result, the following common circumstances may give rise to deferred compensation: salary and bonus deferrals, bonus and incentive compensation plans, severance agreements, supplemental or other post-employment benefits, and certain types of equity arrangements (such as restricted stock units, stock options, stock appreciation rights and most shadow or phantom equity). 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 and increases the opportunity for error. The following is a list of the top-ten things that all employers should know about the new rules:

1. Don't Feel Bad About Being Excluded; Try and Be a "Short-Term"-er
   The final regulations clarify that qualified retirement plans, including 401(a), 401(k) and similar 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. Employers should review their plans to take advantage of this exception when available.

2. Develop "Separation" Anxiety
   Severance pay is presumptively deferred compensation; certain separation pay plans, however, 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. Under a separation pay plan, employers may also reimburse their employees medical expenses or premiums, provide fringe and in-kind benefits, as well as outplacement services and moving expenses, and make limited additional payments (not to exceed $15,500 in 2007) to their employees. The final regulations significantly relax the requirements necessary 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.

3. Pay Attention to "Permissible Payment Events"
   Section 409A provides that distributions from nonqualified deferred compensation plans be made only upon the occurrence of one of six permissible payment events. A "permissible payment event" includes only death, disability, separation from service, unforeseeable emergency, change in control, or a specified time or pursuant to a fixed schedule. Most of these terms are also specifically defined in section 409A, meaning that all plans should be reviewed to ensure that their distributions comply with these definitions.

   Employers should also be aware that certain "specified employees" of publicly-traded companies must also wait an additional six-months after a permissible payment event to receive their distributions.

4. 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 discussed above). Treating good reason separation as involuntarily gives employers additional flexibility in structuring their deferred compensation plans and removes a potential sticking point in negotiations with employees.

5. 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. 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.

6. Address Aggregation Aggravation
   The final regulations require that employers 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, stock 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.

   Employers should maintain a list of all their deferred compensation plans, by category, and update this list annually to reflect terminations, changes in participation and other relevant events.

7. 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.

8. 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 provisions should remove them and review their plans to ensure that the remaining provisions comply with the requirements of section 409A.

9. 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. Employers should carefully review their plans to make sure that they include the appropriate elections.

10. Take "Stock" of Your Plans
    Fair market value stock rights are not subject to section 409A, unless the stock rights provide a feature for the deferral of compensation. For these purposes, "stock rights" include both stock options and stock appreciation rights with respect to service recipient stock.

    "Service recipient stock" includes only common stock of an eligible issuer of service recipient stock, and does not include any stock with preferences as to distributions, except for shares with liquidation preferences. An "eligible issuer of service recipient stock" is limited to the corporation for which the service provider provides direct services on the date of grant and any corporation (or chain of corporations) in which each corporation has a controlling interest (determined by applying the affiliated company and common control definitions in Treasury Regulation § 1.414(c)-2(b)(2)(i) and using a 50% ownership test, or 20%, if legitimate business criteria exist).

    The final regulations include an extensive discussion on determining the fair market value of stock rights, for both publicly traded and non-publicly traded corporations. Generally, any "reasonable" valuation method is acceptable, but the final regulations also create safe harbors for valuations based on appraisal, repurchase formulas containing non-lapse restrictions, and certain written estimates for illiquid start-up corporations. Each of these safe-harbor formulas has significant drawbacks.

What Should I Do?

Employers should immediately inventory their deferred compensation arrangements and meet with counsel to create a schedule for amending their plans and obtaining the necessary board and committee approvals. Employers should also carefully review their executive employment agreements to look for "secret" deferred compensation in severance provisions. Remember: plans must be amended by year end. The final regulations no longer do not differentiate between document and operational failures – all failures result in severe penalties being imposed on executives.

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 review 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 now, rather than the IRS later.

We have put much more information about deferred compensation plans, including section 409A, in our Executive Compensation Resource Center. For a more detailed discussion of Section 409A on nonprofit organizations, see Ten Things Every Nonprofit Should Know About Section 409A.