Internal Revenue Code section 409A

Section 409A of the United States Internal Revenue Code regulates the tax treatment of the “nonqualified deferred compensation,” whether paid to executives or any other employees.

History

Section 409A was added to the Internal Revenue Code, effective January 1, 2005, under Section 885 of the American Jobs Creation Act of 2004. Section 409A regulates the tax treatment of the “nonqualified deferred compensation,” whether paid to executives or any other employees. The effects of Section 409A are far reaching, because of the exceptionally broad definition of “deferral of compensation.” Section 409A was enacted, in part, in response to the practice of Enron executives accelerating the payments under their deferred compensation plans in order to access the money before the company went bankrupt. [http://www.house.gov/jct/s-3-03-vol1.pdf]

The Internal Revenue Service (IRS) issued initial guidance on December 20, 2004 in the form of Notice 2005-1, which established various interim rules and definitions, and provided for a standard of “reasonable good faith compliance” to apply until the time that regulations were published. Long awaited final regulations were published on April 17, 2007. The IRS has since issued Notice 2007-86, which provides the final regulations will become effective (and the reasonable good faith compliance standard will expire) on January 1, 2009.

Basic Summary

Section 409A generally provides that unless a “nonqualified deferred compensation plan” complies with various rules regarding the timing of deferrals and distributions, all amounts deferred under the plan for the current year and all previous years become immediately taxable, plus a 20% penalty tax, to the extent the compensation is not subject to a “substantial risk of forfeiture” and has not previously been included in gross income. The result of these restrictions is that most of the details under a deferred compensation arrangement must be in writing and “hard-wired” into the arrangement from the beginning (unless one of the exceptions from the regulations applies). Subsequent changes to the time or form of payment can be made only under limited and tightly restricted circumstances. In addition, Section 409A regulates the funding of nonqualified deferred compensation plans through offshore accounts.

Under regulations issued by the IRS, Section 409A applies whenever there is a “deferral of compensation,” which occurs whenever the service provider (e.g. an employee) “has a legally binding right during a taxable year to compensation that … is or may be payable to (or on behalf of) the service provider in a later taxable year.” There are various exceptions, excluding from the Section 409A rules compensation that would otherwise fall within this definition, including: qualified plans (e.g. 401(k), 403(b), and 457(b) plans), certain foreign plans, and welfare benefits including “bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan,” and welfare benefits excluded from gross income. Other exceptions include those for “short-term deferrals” (i.e. payments made within 2 ½ months of the year in which the deferred compensation is no longer subject to a substantial risk of forfeiture), certain stock options and stock appreciation rights, restricted property under Section 83, and certain separation pay plans (mostly involuntary severance plans and separation pay up in general up to a limit of $15,500 in 2008, subject to future increases).

Timing Restrictions

Section 409A’s timing restrictions fall into three main categories: (1) restrictions on the timing of distributions; (2) restrictions against the acceleration of benefits; and (3) restrictions on the timing of deferral elections.

Distributions under a nonqualified deferred compensation plan can only be payable upon one of six circumstances: (1) the service provider’s (e.g. the employee’s) separation from service; (2) the service provider’s becoming disabled; (3) the service provider’s death; (4) a fixed time or schedule specified under the plan; (5) a change in ownership or effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation; or (6) the occurrence of an unforeseeable emergency. In addition, Section 409A provides that with respect to certain “key employees” of publicly traded corporations, distributions upon separation from service must be delayed by an additional six months following separation (or death, if earlier).

Section 409A prohibits the acceleration of the time or schedule of benefits under a nonqualified deferred compensation plan. However, the regulations provide for a number of limited exceptions (which do not allow a service provider to accelerate payments on his/her exercise discretion). These exceptions include accelerations necessary to comply with a domestic relations orders or avoid a violation of ethics laws, or payments to cover state, local, foreign, or federal employment taxes. In addition, a change to the time or form of payment made pursuant to the rules covering subsequent deferral elections (discussed below) that results in a more rapid schedule of payments (not to be confused with an earlier payment commencement date) will not constitute a violation of the anti-acceleration rule.

The rules restricting the timing of elections as to the time or form of payment under a nonqualified deferred compensation plan fall into two categories: (1) initial deferral elections; and (2) subsequent deferral elections. As a general rule, initial deferral elections must be made no later than the close of the service provider’s taxable year immediately preceding the service year. The term “initial deferral elections” includes all decisions, whether made by the service provider or service recipient, as to the time or form of payment under the plan. Once the initial deferral election is made, a change to the time or form of payment under the plan can only be made under the rules governing subsequent deferral elections. A subsequent deferral election is proper only if the change to the time or form of payment does not take effect for at least 12 months after the change is made. Further, the change must provide that payment under the plan will commence at a date 5 years later than the date the payment on which payment would have commenced before the change (except with respect to payments made upon death, disability, or unforeseeable emergency).