In April 2007, the IRS issued final regulations under section 409A pertaining to nonqualified deferred compensation (NQDC) plans. The regulations represent a culmination of efforts to bring uniformity to a field that Congress perceived was too prone to abuse of income timing, especially by executives and other highly compensated individuals.
But despite reams of guidance so far, those efforts in Washington are far from over, and many affected companies may be just beginning to comply, as transition relief has extended the effective date of most provisions. CPAs and others administering employee benefits must therefore master this voluminous new body of regulations and help companies and individuals achieve and monitor compliance. Failure to satisfy the regulations’ requirements by Dec. 31, 2008, (extended from one year earlier, but note caveats under “Plethora of IRS Guidance”) can result in severe consequences.
WHAT NQDC IS AND IS NOT
IRC § 409A, enacted in 2004, and related regulations govern the timing of elections, distributions and funding to avoid inclusion by the “service provider” of deferred income at vesting. It establishes rules for constructive receipt of income deferred under a nonqualified plan. If the plan fails to meet certain requirements or is not operated according to them, then all income deferred under the plan “to the extent not subject to a substantial risk of forfeiture” becomes includible in gross income in the year of the failure. An additional excise tax of 20% of the amount of compensation required to be included may be imposed, plus any interest. “Service provider” most often means an employee, but can also mean a corporate entity. Payments to independent contractors with multiple clients usually will not be subject to section 409A, under rules of Treas. Reg. § 1.409A-1(f). NQDC doesn’t include qualified employer plans, such as a 401(k) retirement plan, or any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan.
An NQDC plan has three main requirements:
Distributions. The plan must provide that compensation deferred under it may not be distributed earlier than (1) separation from service (with special rules for certain “specified” key employees); (2) the date a participant becomes disabled; (3) death; (4) a time specified under the plan; (5) to the extent provided in the regulations—see Treas. Reg. § 1.409A-3(i)(5)—a change in the ownership or effective control of the organization; or (6) an illness, accident, casualty loss or other unforeseeable emergency that creates a financial hardship for the participant.
Generally, the plan may designate only one time and form of payment upon the occurrence of each event described above in (1), (2), (3), (5) or (6), or a date related to it, such as four years after death. Treas. Reg. § 1.409A-3(c) does, however, allow an alternate payment schedule for qualifying events (2), (3), (5) or (6) occurring before or after one (but not more than one) designated date. For example, a service provider may be paid an entire benefit lump sum for a change of control that occurs before he or she reaches a certain age, but annual payments if it occurs on or after that age.
Acceleration of benefits. Under IRC § 409A(a)(3), the plan may not permit the time or schedule of any payment to be accelerated except under specified circumstances listed in Treas. Reg. § 1.409A3(j)(4)—for example, to comply with a domestic relations order. Such exceptions, however, must be beyond the discretion of the service provider. The regulations provide guidance on payments that may be regarded as disguised accelerations of deferred compensation.
Elections. Compensation may be deferred at the participant’s election only if the election is made not later than the close of the taxable year preceding the taxable year in which the services were performed or at such other time as provided in the regulations. Within 30 days of becoming eligible to participate in the plan, a service provider may elect to defer compensation for subsequent services. There are special deferral election rules for performance-based compensation. Subsequent elections to delay or change the form of a distribution may not take effect until at least 12 months after the election. For an election related to a payment that is not made upon disability or death or due to an unforeseeable emergency, the plan must require the payment to be deferred for at least five years. Any election related to a payment made under a fixed schedule may not be made sooner than 12 months before the first scheduled payment.
The new rules apply to many common plans, including SERPs (supplemental executive retirement plans); certain SARs (stock appreciation rights); certain stock options; certain bonus and incentive deferral arrangements; certain severance arrangements; executive employment agreements that contain a deferral provision; certain split dollar life insurance; arrangements covering nonemployees such as directors; 457(f) plans; and other arrangements providing for the payment of compensation in the future. Some plans covered may not previously have been regarded as deferred compensation.
According to Jack Meola, a tax officer in the Bridgewater, N.J., office of Amper, Politziner & Mattia, “the [deferred compensation] situation can come about in all sorts of scenarios. For example, a buy-sell agreement where there is a payout over time, especially in a professional service company, is effectively a deferred comp plan.”
The new rules do not apply to “short-term” deferrals. Under the final regulations, there is no deferral of compensation if the payment is actually or constructively received no later than the 15th day of the third month following the end of the year in which the service provider becomes vested in the right to the payment or the service recipient’s taxable year, whichever ends later (subject to certain extensions for unforeseeable events), and the plan doesn’t allow later payment. See Treas. Reg. § 1.409A-1(b)(4).
They also don’t apply to qualified retirement plans, including certain plans with a foreign-situs trust covered by section 402(d); certain tax deferred annuities; SEPs; SIMPLE retirement accounts; 457(b) plans; 415(m) plans; incentive stock options; certain fair market value stock appreciation rights and nonqualified stock options; certain restricted stock plans; certain separation pay arrangements; certain split dollar life insurance; any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan or certain medical expense reimbursement arrangements; and any arrangement under which an active participant makes deductible contributions to a section 501(c)(18) trust.
PLETHORA OF IRS GUIDANCE
Congress passed section 409A as part of the American Jobs Creation Act of 2004, and it has been in effect since the beginning of 2005. Deferrals of compensation earned and vested before 2005 are subject to prior law (grandfathered) unless the plan is materially modified after Oct. 3, 2004. Amounts deferred after 2004 have to comply “in good faith” with section 409A as provided in ongoing guidance. This transitional compliance period will end once the final regulations become effective.
Proposed regulations and Notice 2005-1 were issued in 2005. Other guidance has been periodically issued since then through Notice 2007-100 (see sidebar, “Nascent Voluntary Correction Program”)
In October 2007, the IRS issued Notice 2007-86, which extended the effective date of the final regulations through the end of 2008. Notice 2007-86 indicates, however, that taxpayers are required to operate any nonqualified deferred compensation plan in compliance with the plan’s terms “to the extent consistent with section 409A and the applicable guidance (including Notice 2005-1).” For plans adopted on or before Dec. 31, 2008, this also includes the requirement that such plans be amended on or before Dec. 31, 2008, to conform to section 409A and its final regulations. Transition relief from restrictions under section 409A(b) on certain trusts and other arrangements to pay for NQDC, however, was not extended past Dec. 31, 2007. Notice 2007-86 also discusses changes in payment elections or conditions on or before Dec. 31, 2008; payments that are linked to qualified plans and certain other plans; substitutions of nondiscounted stock options and stock appreciation rights for discounted stock options and stock appreciation rights; and other transition issues.
Notice 2007-89 provides guidance to employers and payers on their reporting and wage withholding requirements for calendar year 2007 with respect to amounts includible in gross income under section 409A.
“The most important thing that has to be done in 2008 is to recognize which clients are subject to section 409A,” says Leonard Witman, senior partner in the Florham Park, N.J., law firm of Witman Stadtmauer PA. “This is because you not only have issues with respect to deferred compensation, you have employment agreements. Or there can be buyouts for an accountant or lawyer or a doctor. The major concern is not addressing 409A and how to solve it, but is going back in your archives for past years to figure out which agreements are now going to be subject to 409A.” For example, Witman says, consider a CPA who leaves his practice and will be paid some percentage of the firm’s income for the next five years.
“If the terms of this arrangement include giving the CPA firm the ability to accelerate the income, for example, to pay the income over three years, then that is a section 409A issue,” Witman says. “Or a shareholder in a medical practice who leaves and is told that he or she will be paid over a period of time as it can determine that it can afford to pay it—that’s a 409A issue.”
According to Witman, the majority of the corporate agreements involved with professionals have provisions for accelerating or delaying payments, which can all trigger 409A issues.
“The corporate people don’t know which agreements are out there. You have to go through each one of your files to look at your old agreements to see if there is a 409A issue,” says Witman. “When CPAs are doing the tax returns this year, if the clients have a shareholders’ agreement or employment agreements that enable them to do payouts more than two-and-a-half months after the end of the year, then accountants should tell those clients to look at the agreements.”
DECISIONS FOR 2008
Once a CPA knows that a client has a section 409A issue, he or she has to make sure that the plan or arrangement will be fully compliant by the end of this year.
Payment elections. “You can make new elections regarding distributions dates and form during the transition period,” says William F. Sweetnam of the Groom Law Group, Chartered, in Washington, D.C. Sweetnam was benefits tax counsel at the Treasury Department when section 409A was enacted. “Previously, when you deferred compensation, there were a number of times when you could take the money earlier than when you thought you would take it out, but that doesn’t work under 409A. If my plan allowed people to take a distribution immediately with a 20% ‘haircut,’ now you know there is no good-faith interpretation that is going to allow you to continue this provision. You’ll have to get rid of that.”
Linked payments. The ability to link a payment election under an NQDC plan to an election under a qualified plan has been extended through 2008.
“In my experience with clients, a lot of these plans are linked or tied to a tax-qualified arrangement such as a traditional pension plan or a 401(k) plan, and they haven’t begun to figure out how they are going to de-link those things fully, and what their payment options are going to be, let alone to communicate that effectively to employees,” says Georgeann Peters, partner in the Columbus, Ohio, law office of Baker Hostetler. Many employers probably haven’t faced necessary decisions about the new structure, Peters said.
“This takes more vetting and discussion than a lot of the 409A compliance decisions that have to be made,” she adds.
Grandfathering. Clients also have to decide whether to preserve grandfather treatment for amounts deferred before 2005. “You have to evaluate how much money is at risk, because it is administratively more complicated to manage different buckets of money under different rules,” says Peters. “I think a lot of clients—surprisingly many—are deciding not to grandfather that money, just because of the administrative complexities involved.”
MORE REGULATION TO COME?
Two bills relating to this area were stripped from earlier legislation, but Sweetnam believes their provisions may re-emerge.
“If I’m planning on making any changes in deferred compensation, I would try to do it earlier in the year rather than later,” cautions Sweetnam. “I’m concerned that these possible additional pieces of legislation might be enacted and make it even more difficult for a plan sponsor or participant to change his or her elections.”
Peters agrees with this assessment. “Given the budget pressures and likely mood of Congress as we move forward, we’re going to see resurrected legislation to put dollar caps on deferred comp. I think some cap on deferrals is likely to come up again, because it would be a revenue raiser,” she says.
Jack Meola, a tax officer in the Bridgewater, N.J., office of Amper, Politziner & Mattia, suggests additional opportunities for accountants to help their clients with NQDC.
n Review services. “We were asked to review a deferred compensation plan from various aspects to verify that the journal entries were correctly done, that the documents were correctly done, and that the mechanical operations were set up properly,” Meola says. “While we found that the plan was satisfactory, we were able to formulate some suggestions for improvement.”
n Employment planning. Often, a CPA may assist a taxpayer entering into an employment negotiation with a company. If you have a high-net-worth individual involved, knowing and understanding the bells and whistles that should be in a document can be very important, because violations of section 409A don’t affect the company; they hurt the employee.
n Cash-flow analysis. The CPA can also help clients by planning out on a cash-flow basis the timing and what the cash flow would look like. If I am supposed to take the money in 2010, but in 2009 I decide to defer that money, it has to be deferred for five years and everything else rolls forward. The question then becomes, if the next payment was supposed to come in 2011, do you take that or do you defer it? You can do cash-flow analysis for this, and it can be a valuable tool for the client.
In December 2007, the IRS issued Notice 2007-100, which initiates a limited corrections program for inadvertent operational violations of section 409A and solicits comments for an expanded correction program in the future. This relief helps offset the problem that section 409A does not allow for de minimis violations. Even a violation involving a very small amount can trigger severe tax consequences for an entire plan benefit. However, the notice does not address corrections for noncompliant written plan documents.
The notice discusses methods for correcting certain operational failures during the taxable year of the service provider in which the failure occurs, to avoid income inclusion under section 409A, and transition relief limiting the amount includible in income under section 409A for certain operational failures occurring in a service provider’s taxable year beginning before Jan. 1, 2010.
“It doesn’t give a lot of relief, just a minimum amount,” says William F. Sweetnam of the Groom Law Group, Chartered, in Washington, D.C., who was benefits tax counsel at the Treasury Department when section 409A was enacted. “What’s going to happen is that during the year, lawyers and accountants are going to find inadvertent errors in deferred compensation that could be violations of 409A. It’s important for them to know about this corrections program to guide their clients through it. It’s better than nothing, but not great.”
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National Conference on Employee Benefits Plans, May 13–15, Las Vegas
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n IRC § 409A and related regulations and guidance have transformed tax treatment of nonqualified deferred compensation (NQDC) by prescribing rules for its election, timing, distribution and funding. Noncompliant plans may subject the plan participant to inclusion of deferred income and an excise tax of 20% of the amount required to be included, plus interest.
n Compensation may be considered constructively received by the plan participant unless it is subject to a substantial risk of forfeiture. The rules also restrict under what circumstances distributions may be made, when and in what form. Deferral elections must also follow a stricter regime than formerly.
n Many plans are affected, including some that may not previously have been considered deferred compensation.
n The IRS has granted transition relief for most provisions until the end of this year, which means CPAs may be called upon now to review plans’ compliance. Considerations to be weighed now include making new payment elections, whether elections linked with those of a qualified employer plan should be separated from it and whether to take advantage of grandfathering provisions for amounts that qualify to be exempt from section 409A.
Michael G. Stevens, Esq., CPA, LL.M., is an assistant professor of accounting at Queens College of the City University of New York. He can be reached at firstname.lastname@example.org.