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Return to Section 409A: Major Changes For Deferred Compensation

Questions and Answers on Section 409A

This section provides a series of questions and answers providing a brief overview of section 409A, designed to correct perceived abuses in the use of deferred compensation arrangements. The questions and answers also highlights some significant developments in the final regulations and conclude with several recommendations on how employers sponsoring such plans should proceed.

What Arrangements are Subject to Section 409A?

Section 409A applies to any "nonqualified deferred compensation plan". In general, a nonqualified deferred compensation plan is any plan providing for the deferral of compensation.

A "plan" includes any arrangement covering employees, directors, board members, trustees and certain independent contractors (referred to as "service providers").

A plan provides for the "deferral of compensation" to the extent that it creates a legally binding right to have compensation earned by a service provider in one taxable year paid in a future taxable year.

The issue of whether a service provider has a "legally binding right" to receive compensation is made on a facts and circumstances basis, but generally to the extent that the plan creates an right to receive compensation that may be enforced contractually or by statute, it will have created a legally binding right. However, if the employer (referred to as the "service recipient") has unilateral discretion to reduce or eliminate payments, the plan does not create a legally binding right to receive compensation, unless the facts and circumstances indicate that it is unlikely that the service recipient will exercise this discretion.

What Specific Types of Plans Are Subject to Section 409A?

The final regulations make clear that section 409A potentially applies to any payment (to which a service provider has a legally binding right) that may be received in a future year, unless the payment qualifies for one of the exclusions from the application of section 409A.

Due to the breadth of this provision, section 409A potentially applies to all of the following types of arrangements:

  • Traditional salary and bonus deferral plans;

  • Severance arrangements (whether included in an employment agreement, severance agreement or severance plan);

  • Any bonus arrangement which is paid more than 2-1/2 months after the close of that year, and any multi-year performance plan;

  • Employment agreements with termination payments, retention bonuses, deferred bonuses or other deferred compensation;

  • Independent contractor agreements providing for deferred compensation;

  • Deferred director's fees;

  • Certain equity arrangements (restricted stock units ("RSUs"), below-market stock appreciation rights ("SARs"), below-market stock options, phantom stock plans and phantom SARs);

  • Section 457(f) plans maintained by tax-exempt entities;

  • Certain benefit replacement plans (i.e., supplemental executive retirement plans ("SERPs") and excess benefit plans); and

  • Certain incentive compensation plans.

What Plans are Excluded from Section 409A?

As a general rule, the following plans or arrangements are excluded from section 409A as not providing for a deferral of compensation:

  • "Short-term deferrals";

  • Qualified plans, including 401(a) plans, 403(a) annuity plans, 403(b) annuity contracts, SEP plans, SIMPLE-IRAs, and certain broad-based foreign retirement plans;

  • Section 457(b) plans of tax-exempt and governmental employers;

  • Bona fide vacation, sick leave, disability pay or death benefit plans;

  • Payments received after the end of taxable year under the service provider's customary payment timing arrangements;

  • Certain "stock rights", including fair-market value stock options and fair market value stock appreciation rights;

  • Grants of incentive stock awards ("ISOs") and grants made under employee stock purchase plans ("ESPPs");

  • The provision of substantially non-vested property (whether or not the service provider makes an elected under section 83(b) of the Code);

  • Certain "separation pay" plans, reimbursement arrangements, in-kind payments and other limited payments occurring after a separation from service;

  • Indemnification and liability insurance plans;

  • Legal settlements; and

  • Educational benefit plans.

Are Independent Contractors and Directors Subject to Section 409A?

Section 409A does not apply to arrangements between service recipients and independent contractors if, during the taxable year, the independent contractor provides significant services to two or more unrelated service recipients. The final regulations clarify the situations under which an independent contractor is deemed to provide significant services to two or more service recipients, and also creates a safe harbor.

Directors – even directors who are independent contractors with respect to multiple unrelated corporations – are not eligible to take advantage of the independent contractor exception.

What is a Short-Term Deferral?

One significant additional exclusion from section 409A applies to plans providing for a "short-term deferral."

Under the exclusion for short-term deferrals, a plan does not provide for the deferral of compensation to the extent the service provider receives a payment at the later of 2-1/2 months from: (a) the end of the service provider's taxable year (generally, March 15) or; (b) the date on which it is no longer subject to a substantial risk of forfeiture.

A stock plan provides for the deferral of compensation to the extent that the service provider can exercise a stock right after the applicable 2-1/2 month period.

The final regulations clarify that a plan does not provide for deferred compensation, even if payment occurs after the short-term deferral period, if it is administratively impracticable to make the payment, making the payment would jeopardize the service recipient's ability to continue as a going concern, or making the payment would trigger the application of section 162(m) of the Code.

What is a Substantial Risk of Forfeiture?

Under section 409A, a "substantial risk of forfeiture" requires that the entitlement to payment be conditioned on the performance of substantial future services or the occurrence of an event, and the possibility of forfeiture is substantial.

The final regulations clarify that payment that is conditioned upon an involuntary separation from service, without cause, is substantial, but that a covenant not to complete is not substantial.

The additions to, or extension of, a risk of forfeiture after the legally binding right to compensation has arisen, is disregarded. As a result, section 409A no longer permit rolling vesting and similar arrangements.

How Are Stock Plans Treated Under Section 409A?

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.

When Does a Stock Right Provide a Feature for the Deferral of Compensation?

A stock right containing a feature for the deferral of compensation is subject to section 409A. A stock right includes a "feature for the deferral of compensation" if the:

  • Amount required to purchase the stock is or could become less than the fair market value of the stock on the date of the grant, or compensation payable under the appreciation right is or could be greater than the difference between the stock value on the date of grant and the value on the date of exercise;

  • Stock right permits the recipient to receive compensation other than cash or stock of the service recipient on the date of exercise and such additional rights allow for the deferral of compensation; or

  • Stock right permits the recipient to receive an amount equal to all or part of the dividend declared and paid on the underlying stock upon exercise.

Stock plans are addressed in more detail under the For-Profit Employers section of this web resource.

Grants of Stock under ISOs and ESPPs

Generally, grants of stock under ISOs and ESPPs do not provide for a deferral of compensation. However, a modification, extension or renewal of the option treated as the grant of a new option that is not a statutory option may be subject to section 409A if the new option provides a feature for the deferral of compensation.

Are Grants of Partnership Interests Subject to Section 409A?

The final regulations have reserved guidance on the application of section 409A to grants of partnership interests. Until such time as guidance is issued, taxpayers may rely on the interim guidance in Notice 2005-1, Q&A-7 and the explanation in the preamble to the proposed regulations regarding the application of section 409A to guaranteed payments for services described in section 707(c) of the Code.

Are Split-Dollar Arrangements Subject to Section 409A?

Split-dollar life insurance arrangements may provide deferred compensation subject to section 409A. The IRS issued Notice 2007-34 at the same time as the final regulations describing how section 409A would apply to split-dollar life insurance.

How are Severance Agreements Treated?

Severance pay is deemed to provide for deferred compensation unless it falls within a specific exception for separation pay.

"Separation pay" is provided only upon an actual involuntary separation from service or pursuant to a window program and is either:

  • Collectively bargained; or

  • Paid no later than two years following the year of separation and limits the amount of separation pay to the lesser of two times: (a) the service provider's annualized compensation; or (b) the section 401(a)(17) limit for the year ($225,000 in 2007).

Whether a separation from service is involuntary is based on all of the facts and circumstances, but the characterization by the service provider and service recipient is presumed to be correct. The final regulations permit good reason separation from service to be treated as involuntary. For these purposes, a "good reason" separation from service requires that the service recipient cause a material negative change in the employment relationship.

"Separation from service" includes death, retirement or "termination of employment". Separation from service does not include military leave, sick leave, or a bona fide leave of absence of less than six months, or longer, if re-employment is guaranteed by statute or contract.

A "window program" is any program that provides separation pay for employees who leave during a limited period of time (no greater than one year) or under certain circumstances.

What is Separation Pay?

Separation pay includes arrangements providing for:

  • Reimbursement of certain deductible business expenses, as well as for outplacement and moving expenses for a limited period of time;

  • Reimbursements of medical expenses paid and incurred by a person other than the service recipient and deductible under section 213 of the Code;

  • Provision of certain in-kind benefits; and

  • Certain limited payments that do not exceed the 402(g)(1)(B) limit ($15,5000 in 2007).

The final regulations make clear that the separation pay components may be used in combination. There are a number of other special rules relating to the time and ability to take advantage of the separation pay rules. These are discussed more detail under Special Problems of Severance Pay.

What Changes Does Section 409A Require to My Plans?

Section 409A requires employers to make several significant changes to their deferred compensation plans. These changes require that:

  • Employers maintain their plans in writing;

  • Participants make timely deferral elections to defer performance based and non-performance based compensation;

  • Distributions from plans be made only upon the occurrence of one of the six specified permissible payment events described in the statute;

  • Distributions to certain key employees of public companies be delayed by six months; and

  • Plans prohibit participants from accelerating their receipt of benefits.

In addition, section 409A prohibits employers from using certain "offshore" trusts to hold plan assets or trust documents containing "financial health" triggers.

What is the "Plan" Requirement?

Under section 409A, 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. In the case of a plan of a service provider that is required to delay payments for certain specified employees, the plan must contain a provision to this effect before any service provider becomes a specified employee, as well as list of specified employees.

When Must Initial Deferral Elections Be Made?

Section 409A requires service providers to make an "initial deferral election" to defer compensation. The time that an initial deferral election must be made depends on whether the compensation being deferred is performance-based or non-performance based compensation.

Service providers must make an initial deferral election to defer non-performance based compensation no later than the earlier of the time that the service provider first has a legally binding right to compensation (generally December 31 of the preceding year); however, service providers may make later initial deferral elections for:

  • The first year of eligibility;

  • Short-term deferral subject to a substantial risk of forfeiture;

  • Forfeitable rights;

  • Excess benefit plans;

  • Separation pay; and

  • Commissions.

Service providers must make an initial deferral election to defer performance-based compensation at least six-months before the end of the performance period or, if later, the date that the performance-based compensation has become readily ascertainable. For these purposes, "performance-based compensation" is compensation that is contingent on the satisfaction of pre-established performance criteria over a performance period of at least 12 months.

When May Subsequent Deferral Elections be Made?

Section 409A permits service providers to make "subsequent deferral elections" to change the time and form of payment under a plan under certain circumstances.

Generally, a service provider may make a subsequent deferral election only if:

  • The election will not be effective until at least 12 months after it is made;

  • Payment is deferred for at least five years; and

  • The election is made at least 12 months before payments were scheduled to be made.

The final regulations grant service recipient some flexibility to delay making payments beyond the Event of Distribution selected by the service provider that will not be considered subsequent deferral elections. These exceptions relate to payment that would be subject to section 162(m) of the Code or violate Federal securities laws or other applicable laws, or changes made to satisfy USERRA.

What Are the Six Permissible Payment Events?

Section 409A substantially restricts the timing of distributions from a deferred compensation plan. The new distribution rules eliminate many currently popular distribution events. Under these new rules, only the following constitute a "permissible payment event":

  • Separation from Service;

  • Death;

  • Disability;

  • A specified time or pursuant to a fixed schedule (this cannot be an event);

  • Change in Control; or

  • Unforeseeable Emergency.

Each of these terms is specifically defined in the regulations to section 409A. As a result, even plans limiting distributions to one of these permissible payment events may still have to be amended to conform their definitions.

In addition, many plans use payment events that are not permissible under section 409A. Thus, plans permitting payments in the event that the plan is terminated, upon a change in the financial condition of the employer, for certain "life" events (e.g., payment of tuition), or to pay taxes do not comply with section 409A and must be amended accordingly.

When Must Payment Be Made After an Event of Distribution?

The final regulations provide that payment will be treated as made upon a permissible payment event so long as it is made upon the occurrence of such event, within the same taxable year of the service provider, or within 2-1/2 months following the end of the taxable year in which the permissible payment event occurs.

In addition, the final regulations also permit payment to be made up to 30 days before the permissible payment event.

Are There Any Special Rules for Public Companies?

Specified employees of publicly traded corporations may not receive a distribution from a deferred compensation plan until at least six months after termination of employment (or, if earlier, death). A "specified employee" is defined by reference to section 416(i) of the Internal Revenue Code.

In addition to section 409A, the SEC recently revised and updated its compensation disclosure rules. These rules are discussed here: SEC Impose New Reporting Requirements on Public Companies.

What Does it Mean to Prohibit the "Acceleration" of Benefits?

The Act generally prohibits any acceleration of benefits under a deferred compensation plan. The prohibition on the acceleration of benefits is intended primarily to discourage perceived abuse of the constructive receipt doctrine. Under the new rules, many popular features of deferred compensation plans that provide for the acceleration of benefits would be prohibited.

These features include:

  • "Haircut" provisions, which typically impose a penalty for early payment of vested benefits;

  • One-year advance distribution elections, which permit participants to receive early payment of vested benefits upon giving of at least twelve months advance notice; and

  • Provisions allowing participants to change their form of payment to accelerate the receipt of benefits, such as by switching from an annuity to a lump-sum payment.

When is Acceleration Permitted?

The final regulations do permit service recipients to add death, disability or an unforeseeable emergency as a potentially earlier permissible payment event to any plan without the addition causing a prohibited acceleration.

In addition, a plan may provide for accelerated payments to:

  • Comply with a qualified domestic relations order;

  • Comply with ethic agreements or conflicts of interest laws;

  • Pay taxes upon vesting in a 457(f) plans, or to pay state, local or foreign taxes;

  • Provide for limited cashouts;

  • Pay employment taxes;

  • Pay taxes arising from a violation of section 409A;

  • Avoid a nonallocation year under section 409(p);

  • Satisfy a debt to the service recipient (as an offset); or

  • Upon a plan termination of liquidation.

In addition, a plan may permit a service provider to cancel deferrals in the event of an unforeseeable emergency or due to disability.

What Are the Penalties for Not Complying with the New Rules?

If a plan violates the rules discussed above, section 409A imposes substantial penalties against the participant. As a result, service providers have a significant vested interest in ensuring that their employers comply with section 409A.

The failure of a plan to comply with section 409A requires that the participant include all previously deferred amounts under the plan in gross income and pay on this amount: (1) income taxes, (2) employment (Social Security and Medicare) taxes; and (3) a 20% penalty tax. In addition, the participant will also be responsible for interest and penalties on this amount at the underpayment rate plus 1% and any underpayment penalties that may be imposed.

What if I Violate Section 409A but Correct the Violation?

Section 409A does not provide an exception from these penalties for good faith plan drafting errors or operational failures that are fully and promptly corrected upon discovery.

How Are Multiple Plans Treated?

Under section 409A, all similar nonqualified deferred compensation plans of a service recipient in which a service provider participates are aggregated. This means that an operational failure with respect to any single plan is deemed to trigger an operational failure in all other plans of that service recipient in which the service provider participates.

When Does Section 409A Take Effect?

Section 409A applies to: (1) any amount deferred on or after January 1, 2005; or (2) any plan that was "materially modified" after October 3, 2004.

An amount will be treated as deferred before 2005 (and, as a result, exempt from these new rules) so long as the service provider has a legally binding right to receive the amount, and the amount is both earned and vested. For this purpose, an amount is earned and vested only if not subject to either a substantial risk of forfeiture or a requirement to perform further services.

A plan is "materially modified" if it is amended to add a benefit, right or feature to the plan or accelerates vesting of pre-section 409A deferrals.

When Should I Amend My Plans?

The Internal Revenue Service has granted generous transition relief to permit employers to amend their plans to comply with section 409A.

Although employers were originally supposed to comply with section 409A beginning on January 1, 2005, due to delays in developing proposed and final regulations, employers now have until December 31, 2007 to amend their plans, so long as they are operated in good faith compliance section 409A until such time.

What Is "Good Faith Compliance" with Section 409A?

Plans will be operated in "good faith compliance" with section 409A so long as they operated in accordance with the principles in Notice 2005-1, the proposed regulations or the final regulations.

Note: The exercise of discretion by the service recipient or provider in a manner that causes a plan to violate section 409A will not be considered good faith compliance. However, such actions will not cause the plan to fail to be operated in good faith compliance with respect to the other participants.

What Should I Do about My Existing Plans?

The actions that employers should take in response to section 409A depend on the type of deferred compensation plans maintained.

Fully Vested Plans

Generally, section 409A is not applicable to deferred amounts that were fully earned and vested by December 31, 2004. This means that all services for accrual and vesting of all benefits under the plan have been performed. Thus, fully earned and vested plans are grandfathered under the old law. As a result, an employer should take no action with respect to an existing deferred compensation plan that no longer accepts deferrals and all previously deferred amounts under which are fully vested.

Existing Plans Still Accepting Deferrals

An employer maintaining an existing deferred compensation plan still accepting deferrals that were not vested by December 31, 2004 should consider freezing this plan with respect to previously deferred amounts that were fully vested as of December 31, 2004 to preserve the prior, more favorable, tax treatment of the plan. Employers must be careful not to "materially modify" the plan, otherwise they risk jeopardizing the plan's grandfathered status.

The employer may permit participants to continue making deferrals into the existing plan, as employers have until December 31, 2007 to amend their plans.

Under this transition rule, the existing plan will be deemed to comply with section 409A so long as: (a) deferral elections for 2005 were made by March 15, 2005; (b) deferral elections for 2006 are made by December 31, 2005; (c) the plan is amended to conform to section 409A by December 31, 2007; and (d) the plan is operated in good-faith compliance with section 409A and Notice 2005-1, the proposed regulations or final regulations until such time.

Can I Just Terminate My Plans and Avoid Section 409A?

Yes. However, due to the plan aggregation rules, the termination of a plan may require that the service recipient terminate all similar plans. In addition, the service recipient will be prohibited from establishing new plans for a period of thee years. As a result, employers should proceed very carefully before terminating any existing plan.

Does Section 409A Change My Tax Reporting?

Yes. This topic is addressed in more detail under Tax Reporting.

Are There Other Limitations on Deferred Compensation Plans?

Yes. For example, the Pension Protection Act of 2006 restricted the ability of employers with under-funded pension plans to fund the nonqualified deferred compensation plans of their executives.

Similarly, tax-exempt employers are subject to both the rules of section 457(f) and section 409A.