Noncompliance Potentially Devastating
Schottenstein Zox & Dunn Co., LPA
October 7, 2008
BACKGROUND
In what some have described as the most significant federal tax legislation in over 20 years, Congress, by way of the enactment of Internal Revenue Code section 409A, has overhauled dramatically the taxation of so-called nonqualified deferred compensation arrangements. Congress enacted section 409A in the aftermath of Enron and other corporate scandals to address what Congress and the Internal Revenue Service viewed as inappropriate manipulations of the amounts and timing of deferred compensation payments.
GENERAL STRUCTURE
As described in our July 2007 Client Alert, section 409A imposes new strict requirements on nonqualified deferred compensation arrangements. Generally speaking, an arrangement provides for "deferred compensation" where the employee1 has a legally binding right to compensation that is payable during a subsequent tax year. The 409A requirements generally relate to initial (and subsequent) deferral elections, the timing of distributions and funding. Section 409A has been in effect since the beginning of 2005; however, the IRS postponed the deadline for full compliance so as to permit the IRS to finalize regulations intended to "clarify and explain" section 409A and its requirements.
COMPLIANCE DEADLINE
The IRS issued final 409A regulations in April of 2007. Aside from being lengthy (approximately 400 pages, including preamble), the final 409A regulations contain many detailed and complex rules and will involve significant plan administration. Of greatest immediate significance, however, is that all covered deferred compensation arrangements (whether written or unwritten) must be brought into written compliance with 409A and the final regulations by December 31, 2008. No extension of this deadline is expected. Accordingly, with just a few months remaining in this transition period, it is critical that prompt action be taken to ensure compliance.
COST OF NONCOMPLIANCE
The cost of an arrangement's noncompliance with 409A and the final regulations is potentially devastating. All amounts deferred under a noncompliant arrangement are included in the employee's income immediately upon vesting (as opposed to the time of payment). Also, on top of the regular income tax due, an additional 20 percent tax is imposed. Finally, the interest rate imposed on an underpayment of tax resulting from a 409A violation is one percent higher than the regular underpayment rate. These sanctions are imposed on the employee, but employers will feel their impact through employment agreement indemnification provisions or through employee dissatisfaction resulting from an unexpected tax bill.
RECOMMENDATION
In light of the rapidly approaching year-end compliance deadline and the high cost of noncompliance, we recommend that employers (and employees) promptly take the following actions:
• Identify all plans, agreements and other arrangements that may provide for deferred compensation covered by 409A and the final regulations. Part of the difficulty of identifying covered arrangements is that 409A does not apply merely to "formal" deferred compensation plans; rather, 409A broadly applies to a surprisingly wide variety of arrangements. Common types of arrangements that may be subject to 409A include:
- employment agreements;
- traditional deferred compensation plans, such as supplemental executive retirement plans (SERPs), so-called "top-hat plans," and director fee deferral programs;
- change-in-control plans and agreements;
- bonus plans;
- severance plans, agreements, and policies;
- retention agreements;
- long-term incentive plans;
- parachute plans;
- split-dollar insurance arrangements;
- stock options, stock appreciation rights, phantom stock plans, restricted stock units (RSUs), performance share awards, and other equity incentive arrangements with respect to corporations, limited liability companies, and other business or investment entities;
- deferred salary plans;
- multiple-year reimbursement arrangements (e.g., for COBRA reimbursements, allowances, in-kind benefits);
- section 457(f) plans;
- tax gross-up arrangements;
- excess benefit plans; and
- 401(k) "wrap" plans.
On the other hand, various arrangements are exempt from 409A requirements. Exempt arrangements include qualified employer plans (e.g., 401(k) plans, ESOPs, simplified employee pensions (SEPs), SIMPLE retirement accounts, section 403(b) tax-sheltered annuities and section 457(b) plans), incentive stock option (ISO) plans, and certain welfare benefit plans (e.g., certain vacation leave, sick leave, compensatory time, disability pay and death benefit plans).
• Have all identified arrangements reviewed for compliance with 409A and the final regulations.
• Prepare, and have in place by December 31, 2008, needed amendments and any other necessary documentation. Again, the IRS has given taxpayers until the end of 2008 to bring deferred compensation arrangements into written compliance with 409A and the final regulations. Depending on the terms of a particular arrangement, board approval, employee elections or consents, shareholder approval, compensation committee approval, and/or other actions may be required in order to make compliance amendments or other changes effective.
We encourage you to consult us with any questions that you may have concerning the impact of 409A and how the requirements of 409A and the final regulations may apply to any of your compensation-related plans, agreements and other arrangements.
Please contact:
Nate Hamilton (614.462.5056), John Terakedis (614.462.5002),
Theresa Finneran (614.462.5026) or any other Schottenstein Zox & Dunn attorney for further information.2
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1Although this client alert speaks in terms of employees and employers, 409A and the final 409A regulations also can be applicable to independent contractors and their clients, customers or other service recipients.
2This client alert is intended only as a general discussion of 409A compliance issues and is not intended as, nor may it be relied upon as, legal advice.
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