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October 11, 2007
Section 409A Deferred Compensation Rules:
The Deadline for Compliance
By William N. Anspach, Jr.
In late 2004, Congress added Section 409A to the Internal Revenue Code to more tightly regulate deferred compensation programs. Final regulations, which are quite lengthy and complex, were issued in April 2007. While all nonqualified deferred compensation plans must be operated in compliance with the final regulations by January 1 2008, the IRS recently extended the deadline for bringing the actual plan documents into compliance until December 31, 2008.
The good news for both employers and employees is that deferred compensation plans can easily be amended to meet the new requirements of Section 409A. The key to compliance is to identify the affected plans and arrangements, review the documents and arrangements, and amend these programs in a timely manner. Since operational compliance is required by January 1, 2008, it is imperative that employers review their deferred compensation plans and arrangements before this date.
What follows is an explanation of the facts essential to proper compliance. For starters, nonqualified deferred compensation generally includes any compensation earned one year but paid in a subsequent year. It is also important to understand that many arrangements that employers may not normally consider deferred compensation can be covered by Section 409A, including severance plans, bonus arrangements and employment agreements.
Common Compliance Issues
Plan Documents. All nonqualified deferred compensation plans must be in writing. With that requirement in mind, employers should identify and document any informal practices that provide for deferred compensation in order to avoid penalties. While deferred compensation plans must operate in compliance with Section 409A as of January 1, 2008, the deadline for written compliance of plan documents is December 31, 2008.
Timing of Payments. The timing of payments must be established when the deferral election is made or the right to deferred compensation is granted. Furthermore, distributions must be either pursuant to a fixed time and schedule or triggered by one of the following events: death, disability, change of control, separation from service or unforeseeable emergency. Any changes to the payment date must be made at least one year before the originally scheduled payment and delayed for at least five years after that date.
Acceleration of Payments. Because Section 409A prohibits the acceleration of payments, employers should remove this type of provision from their deferred compensation plans. There are, however, certain exceptions to this prohibition, such as an event in which a change of control occurs.
Form of Payments. An employee may no longer select from among various distribution options, such as a lump sum or installment payments, at the time of distribution. Therefore, in order to comply with Section 409A, deferred compensation agreements must specify the form of payment.
Severance Agreements. Employers often fail to realize that many severance agreements are considered deferred compensation and, therefore, are covered by Section 409A. When an employee is terminated involuntarily, the severance agreement may be exempt from Section 409A, but only if the individual is paid in full by December 31 of the second year following the year of termination and the amount of severance pay does not exceed the lesser of (1) twice the employee's annual compensation for the prior calendar year; or (2) twice the annual compensation limit for the qualified plans ($225,000 in 2007).
Bonus Arrangements. In order to stay outside the reach of Section 409A, all bonuses earned in one year and paid the following year must be distributed no later than two-and-a-half months after the end of the year in which the bonus was earned.
Important Transition Rule Expires December 31, 2007
Employers should be aware that a very important transition rule will expire on December 31, 2007. On or before that date, a plan may be amended to provide for new payment elections with respect to both the time and form of payment. In other words, if the plan provides for installment payments, the form of payment may be changed to a lump sum without that revision being treated as an impermissible acceleration of payments. Similarly, the timing of payment may be changed so long as elections made in 2007 do not apply to payments that otherwise would have been made in 2007.
Consequences of Noncompliance
If your nonqualified deferred compensation plan fails to meet the requirements of Section 409A, the tax consequences for your affected employees can be severe. The employee covered by the plan will be subject to immediate tax, as well as penalties and interest. Specifically, the recipient must claim the compensation as income upon the later of (1) the date the compensation is deferred; or (2) the time at which the compensation is no longer subject to a substantial risk of forfeiture. In addition, the employee could be assessed a penalty totaling 20% of the deferred compensation, plus interest.
Given the severity of the penalties, compliance is of vital importance to you—and your employees. If you have questions regarding the application of Section 409A to your nonqualified deferred compensation arrangements, please contact William N. Anspach, Jr., or any Much Shelist attorney.
William N. Anspach, Jr., a Principal in the firm's Business & Finance and Labor & Employment practice groups, heads the Employee Benefits department. He has extensive experience in virtually all areas of employee benefits, including designing and implementing qualified plans, health and welfare plans, executive compensation plans and other deferred compensation programs. Bill can be reached at 312.521.2406 or wanspach@muchshelist.com.
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