In October 2004, Congress added Section 409A to the Internal Revenue Code to curb the perceived tax abuses of nonqualified deferred compensation arrangements. While Section 409A was effective as of Jan. 1, 2005, until now plans were only required to comply in operation on the basis of good faith. Effective Jan. 1, 2009, all nonqualified deferred compensation arrangements must comply with the rules set forth in the IRS regulations. This means that all nonqualified deferred compensation arrangements must be in writing and amended to comply with the IRS rules before the end of 2008.
Last year we reported that the IRS granted an extension for compliance with the final regulations until Dec. 31, 2008, IRS Grants a New Extension for Section 409A Compliance. We do not expect the IRS will grant another extension, however. Employers that have not yet reviewed their nonqualified deferred compensation arrangements for Section 409A compliance should review these plans immediately.
Failure to comply with the requirements of Section 409A will result in harsh tax consequences to the employee. The amount deferred will be subject to a 20 percent tax penalty plus interest on the amount of tax from the original date the compensation first vested. The combined effect of these penalties could substantially negate the benefit of the deferred compensation.
The following are some of the types of arrangements that can create Section 409A compliance issues: employment agreements, offer letters, consulting agreements, change in control provisions, stock incentive plans, bonus programs, retention programs, vacation programs with a cash provision, or any other deferred compensation arrangement with amounts or benefits earned in one tax year and paid in a future tax year.
Under the regulations, all nonqualified deferred compensation arrangements must be in writing. This requirement includes, for example, bonus programs that fail to qualify for an exception from the rules. Provisions in arrangements that are particularly problematic include:
- Failure to provide for a fixed payment date or other payment time that complies with Section 409A
- Payment dates in severance agreements that are tied to receipt of or the effective date of an executed release from the employee
- Failure to have a definition of termination of employment that complies with Section 409A, for example, an agreement that would allow (either explicitly or implicitly) continuing service as a independent contractor/consultant could violate Section 409A
- Inclusion of a definition of termination for good reason that fails to comply with Section 409A
- A change of control definition that does not comply with the Section 409A definition
- Provisions allowing offsets for employee liabilities to the employer
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
