The Impact of Proposed Section 409A Regulations
September 6th, 2016
Internal Revenue Code section 409A provides requirements for nonqualified deferred compensation plans and imposes penalties on plans that do not comply with those requirements. In 2007, the Internal Revenue Service (“IRS”) issued final regulations (the “current regulations”) defining certain terms and setting forth key requirements for deferral elections and distributions, as well as many other aspects of deferred compensation. In 2008, the IRS issued proposed regulations to provide guidance on amounts includable in income under Code section 409A as well as guidance on the taxes imposed if the requirements of Code section 409A were not satisfied. Last month, the IRS issued new proposed regulations (the “proposed regulations”) that clarify and modify the 2007 final regulations and the 2008 proposed regulations.
The following is an overview of the most significant clarifications and modifications provided by the newly proposed regulations.
Section 457(f) and Section 457A Plans
The proposed regulations clarify that the rules under Code sections 457(f) (with respect to nonqualified deferred compensation arrangements for tax exempt organizations) and 457A (with respect to certain foreign corporations that maintain nonqualified deferred compensation arrangements) apply separately and in addition to the rules imposed by Code section 409A.
Short-Term Deferral Rule
Code section 409A provides an exemption for amounts that are paid within 2 ½ months after the end of the taxable year in which the amount vests (i.e., short-term deferrals). The current regulations also exempt payments that otherwise qualify as short-term deferrals, but are made after the 2 ½ month period, for various specified reasons (i.e., administrative impracticability, the payment would jeopardize the employer’s ability to continue as a going concern, lack of deductibility under Code section 162(m), etc.). The proposed regulations would extend this exception to include payments that would otherwise qualify as short-term deferrals, but are delayed to avoid violating federal securities laws or other applicable laws.
The current regulations provide that transaction-based compensation may be paid at a designated date or pursuant to the same schedule and under the same terms and conditions as apply to payments to shareholders generally, but not later than five years after the change in control. The proposed regulations clarify that the special payment rules for transaction-based compensation apply to stock rights and statutory stock options that do not otherwise provide for deferred compensation before the transaction. As such, the proposed regulations provide additional flexibility for employers to use stock rights and incentive stock options that provide for delayed transaction-based compensation without running afoul of Code section 409A.
Payment on Account of Death
The current regulations provide that a payment made on account of death satisfies the requirements of Code section 409A if it is paid in the same taxable year as the service provider’s death, or if later, by the 15th day of the third month following the individual’s death. This provision proved especially difficult for employers in situations where the death occurred late in the taxable year.
The proposed regulations would provide employers with additional flexibility by extending the time to make such payments. Under the proposed regulations, payments upon death satisfy Code section 409A if they are made before December 31st of the calendar year following the service provider’s death. Additionally, the rules applicable to amounts payable upon the death of a service provider would also apply to amounts payable upon the death of a beneficiary.
Plan Terminations and Liquidations
The proposed regulations clarify the rules under the current regulations that permit accelerated payments in connection with the termination and liquidation of a nonqualified deferred compensation plan outside of a change in control or a corporate dissolution, provided certain requirements are satisfied. Many service recipients and practitioners had questioned whether the plan termination requirements only apply to all plans of the same type or only those plans that would be aggregated with the targeted plan if the employee was an actual participant. The proposed regulations provide that the plan liquidation rules are not ambiguous, and, as such, only apply if the employer terminates and liquidates all plans of the same category that the employer sponsors, and not merely all plans in which the employee actually participates.
Income Inclusion Rules
The 2008 proposed income inclusion regulations allow employers to correct certain plan provisions relating to the time and form of payment under a plan that fails to comply with the requirements of Code section 409A while the amounts are unvested, without including the amounts in income or incurring an additional tax. In order to prevent abuse, the newly proposed regulations clarify that the correction methods described in the income inclusion regulations are only available to employers who can reasonably conclude that their plan violates Code section 409A (i.e., changes to time and form of payments cannot be made if the existing provisions meet the Code section 409A requirements). Additionally, the proposed regulations provide that deferred compensation will generally be treated as vested (and therefore corrections cannot be made), despite being unvested, if there is “a pattern or practice” of permitting corrections or changes to plan provisions that do not violate Code section 409A.
Service Recipient Stock
Under the current regulations, certain stock options and stock appreciation rights granted with respect to service recipient stock are exempt from the rules of Code section 409A. “Service recipient stock” is generally defined as stock of the employee’s direct employer, that is not subject to a mandatory repurchase obligation or a permanent put or call right if the stock price under such obligation is not the fair market value of the stock.
The newly proposed regulations expand the definition of “service recipient stock” in two ways:
• First, the proposed regulations clarify that stock rights will not be subject to Code section 409A if they are subject to a repurchase obligation at a price below fair market value in connection with a termination for cause or a breach of a non-compete or non-solicitation agreement. As such, this expanded definition provides employers with a new ability to reduce payments under stock rights due to bad behavior.
• Second, the proposed regulations clarify that certain stock awards made to prospective employees will qualify for the stock rights exception to the rules of 409A. Consequently, corporations will be allowed to grant certain stock rights to prospective employees as part of the recruitment process, before the individual begins working for the corporation. This exception will apply if the corporation reasonably believes that the stock recipient will begin providing services within 12 months after the grant date, and if the individual actually provides services with the same 12-month period. However, if service does not actually begin within that period, the stock rights must be forfeited.
Separation Pay Plan
Under the current regulations, separation pay up to the lesser of (1) the employee’s annualized compensation in the taxable year preceding the separation from service, or (2 ) two times the Code section 401(a)(17) limit (paid within two years) is exempt from 409A. The newly proposed regulations provide additional clarification that this rule can be applied to service providers that are terminated in the same year they are hired by using the individual’s annualized compensation for the year of termination.
Employment-Related Legal Fees and Expenses
Under the current regulations, an arrangement that provides for amounts to be paid as settlements or awards resolving bona fide legal claims based on a variety of employment-related issues are exempt from Section 409A (i.e., wrongful termination, employment discrimination, workers’ compensation statutes, etc.). The newly proposed regulations clarify that an arrangement that provides for the reimbursement of legal fees incurred to enforce a bona fide legal claim against the employer (with respect to employment) are also exempt from Code section 409A.
Recurring Part-Year Compensation
Under the current regulations (including IRS Notice 2008-62), “recurring part-year compensation” is defined as compensation paid for services rendered during a period of less than 12 months, that is paid over 12 months and is paid over more than one taxable year. For example, a teacher or professor providing services to an educational institution over a school year.
The proposed regulations provide that a plan or arrangement under which the employee received recurring part-year compensation does not defer payment of any of the recurring part-year compensation if certain requirements are satisfied. First, payment of any of the part-year compensation must be made prior to the last day of the 13th month following the first day of the service period for which the recurring part-year compensation is paid. Second, the amount of the service provider’s recurring part-year compensation does not exceed the annual compensation limit under Code section 401(a)(17) for the calendar year in which the service period commences ($265,000 for 2016).
Although the clarifications and modifications provided by the newly proposed regulations are significant, we do not expect that they will require employers to make many changes to their nonqualified deferred compensation arrangements at this time. Many of the proposed changes apply to very specific situations that only arise occasionally, and other changes may be taken advantage of without action from employers.
If you have any questions about the newly proposed regulations, please feel free to contact our experts at Compensation & Benefit Solutions.
Unless otherwise indicated, all “Section” references are to the Internal Revenue Code of 1986, as amended (the “Code”), and to the proposed, temporary and final Treasury Regulations promulgated thereunder (the “Regulations”).