Delaying compensation the right way – compliance with IRC Section 409A
April, 2007
It used to be that if you wanted to provide "something extra" to your executives, an uncomplicated supplemental executive retirement plan ("SERP") would do the trick. Along the same lines, for personal tax reasons, an executive might want to defer a portion of her salary or a bonus a year or two beyond the end of the year in which it would typically be paid. So long as the executive could not control when the cash was paid and an agreement was in place before the money was earned, a simple agreement would suffice. If the executive and her employer wanted to actually set aside funds or purchase life insurance to fund the deferral agreement, the parties would establish a "Rabbi Trust" (named for an IRS private letter ruling in which a rabbi and his congregation used this type of arrangement). These arrangements were generically called "nonqualified deferred compensation", since they were structured to avoid the myriad of requirements applicable to "qualified" retirement plans under the Internal Revenue Code ("IRC"). In addition, these arrangements were also designed to avoid regulation by the Department of Labor under the Employee Retirement Income Security Act of 1974 ("ERISA"), by (i) deferring income only to a time before retirement or termination of employment and (ii) restricting participation in these arrangements to a select group of management or highly compensated employees ("top hat plan").
But in the wake of executive compensation scandals at companies like Enron, Congress decided it was time to specifically regulate this area and passed new IRC Section 409A in October of 2004. Section 409A has created the backdrop for what is now a virtual labyrinth of complicated regulations governing virtually any legally binding right to future taxable compensation by "service providers" (i.e., employees or independent contractors) and applies to both taxable and tax-exempt "service recipients". After nearly two and one-half years and hundreds of public comments on the statute and the proposed regulations issued in September of 2005, the Treasury issued final regulations on April 10, 2007.
If you have a plan or arrangement covered by Section 409A, the law requires that it (i) be in writing, (ii) contain the mandatory provisions of the IRC and regulations relating to the deferral election and payment, and (iii) be operated in accordance with those provisions. A "plan" does not have to be recorded in extensive detail and may consist of several documents, but is specifically required to list the time and form of payment. A "savings clause" (e.g., "we intend the plan to meet Section 409A requirements") will not save a noncompliant plan from the consequences described below. Also, a Section 409A deferral must be reported on either a Form W-2 or 1099, depending upon whether the service provider was an employee or independent contractor.
If a Section 409A arrangement does not meet the Section 409A requirements, the service provider will be subject to immediate taxation on the deferred amounts, an excise tax equal to 20% of the amount of deferred compensation required to be included in income, and a higher interest rate applicable to the period during which the deferral was not included in income, on top of the normal penalties and interest if timely payment of those amounts is not made. While the penalties apply to the service provider, it can be expected that the service provider will be knocking on her employer's door and asking why the employer did not make sure that their arrangement complied with Section 409A. So you should consider Section 409A an employer matter as much or more than an employee matter.
Should you think that Section 409A doesn't apply to arrangements that you use, consider the following examples. Say you choose to delay payment of a bonus to either yourself or to your employees beyond two and one-half months after the close of a calendar year (assuming you're a calendar year employee) – Section 409A applies! (there is possible relief if you meet specific guidelines.) How about the case where an executive negotiates a severance arrangement in a voluntary termination setting in which payments in addition to her earned salary and bonus are paid at future dates – Section 409A applies! (assuming the arrangement falls within the "separation pay plan" provisions and doesn't qualify for possible relief). Or how about where the executive enters into a buy-sell arrangement or a sale of assets, stock or her business in which payments will be made for a covenant not to compete at future dates – Section 409A applies! Or perhaps an equity right is granted to an employee without the company taking the time to determine the true "fair market value" of the company stock – Section 409A applies!
Scared yet? First, you need to get your Section 409A plans and arrangements in order by the compliance deadline date which is January 1, 2008. The IRS has already delayed full implementation of Section 409A twice. Taxpayers were initially ordered to have their Section 409A plans in compliance by the end of 2005. This was then extended to the end of 2006 and then to the end of 2007. There is little likelihood of an additional extension.
Second, the scope of Section 409A does have its limits. For example, Section 409A only applies in the case of a binding agreement; so if there's no "promise", there's no binding agreement. We would not suggest that you place any bets that an employer will win the argument that it indisputably said "I might pay you $X, but I might not..." So, in general, it would be advisable to err that a binding promise exists and to comply with Section 409A. Also, if a payment is received within two and one-half months of the later of the end of the taxable year of the service provider or the service recipient, Section 409A does not apply. There are many other situations that fall outside of Section 409A.
Do not wait to make your deferral arrangements Section 409A compliant. Identification and corrective action will take time and we suggest that you begin this process now. By December 31, 2007, documents must be conformed for periods on or after January 1, 2008. While taxpayers have to show good-faith compliance during this transition period (since enactment through 2007), no retroactive amendments are required to bring the plan into compliance, or to document operational compliance. Memoranda to file, elections, agreements and other documents should be used to substantiate compliance. The exception to no retroactive amendments before 2008 is that discount options need to be reformed before the end of 2007. Further, Section 409A provides certain "grandfathering" of arrangements that do not comply with Section 409A. The members of BHB's Tax Practice Group are available to assist you with identifying Section 409A compliance issues and making sure that your compensation plans meet the requirements of Section 409A. Please call Regina J. Schroder at (916) 930-2520, regina.schroder@bullivant.com or John Magliana at (503) 499-4648, john.magliana@bullivant.com.
Circular 230 Compliance: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.