The Internal Revenue Service has issued long-awaited final regulations on nonqualified deferred compensation arrangements in which employers delay payment of wages or salaries earned by an employee in one year to a later year. The regulations explain how employers should design and operate these arrangements to comply with Internal Revenue Code Section 409A. This law was passed by Congress in late 2004 to rein in perceived abuses such as those identified during the Enron scandal. All nonqualified deferred compensation documents and arrangements must be amended to comply with the final regulations on or before Dec. 31, 2007.
With limited exceptions, nonqualified deferred compensation includes any compensation earned one year (even if it is subject to forfeiture or other conditions), but paid in a subsequent year. It includes many arrangements that employers may not normally consider "deferred compensation," such as, severance plans, bonus arrangements, employment agreements (including a signed and acknowledged offer letter), perquisites and benefits paid after termination, stock options, split-dollar life insurance contracts and arrangements with independent contractors and partners. Even employers without traditional nonqualified deferred compensation plans are likely to have arrangements covered by Section 409A.
Failure to comply with Section 409A can create disastrous tax consequences for affected employees. The employee could be subject to an additional tax penalty of 20 percent on the deferred compensation and interest on the tax from the date he or she vested. In some circumstances, the interest and penalties could exceed the amount of the actual payment of compensation. Employers also could be exposed to liability both to the IRS and the employee.
The IRS had previously issued proposed regulations for Section 409A, and the final regulations contain few surprises and, generally, provide greater flexibility for employers and employees than the proposed regulations. Notable clarifications and changes to the proposed regulations include:
- Plan Documents. The rule that nonqualified deferred compensation plans must be in writing is continued under the final regulations. Any informal practices that provide for deferred compensation must be identified and documented to avoid Section 409A penalties.
- Stock Options. Stock options that would have terminated prior to the end of the original option period, (e.g., when an employee terminates employment) can be extended until the end of the option period or 10 years, whichever is shorter, without creating deferred compensation. For valuing shares of stock subject to an option, the final regulations do not allow employers to use the incentive stock option rule of any "good faith" valuation method, but do provide limited safe harbor valuation methods.
- Severance Agreements. With respect to an involuntary termination, a severance agreement that provides less than two years compensation (limited to 401(a)(17) amount for retirement plans, currently, $225,000 per year) and is paid out within a two-year period following separation from employment is not treated as deferred compensation. However, agreements that provide severance pay upon a voluntary termination or exceed the permissible amount or payment period must comply with Section 409A. The final regulations treat a termination by the employee for "good reason" as an involuntary termination if certain notice and employer cure periods are included and provide a safe harbor definition for "good reason." The agreement to provide severance pay for "good reason" must be documented in writing in advance.
- Timing of Payments. Payment times for deferred compensation must be established at the time the deferral is made or the right to deferred compensation is granted. In addition, the written arrangement must specify payment only upon a specified event, such as, separation from service, death, disability, change of control or unforeseeable emergency, or at a stated time and schedule. Any subsequent change of the payment date must be made at least one year before the scheduled payment and delay payment at least five years after the originally scheduled payment.
- Same Desk Rule. The new rules permit employers to adopt the "same desk rule" for nonqualified plans so that no payment is due, for example, upon a change of control if the employee continues to work for the successor. The new rules also provide exceptions for domestic relations orders, conflicts of interest involving ethics agreements with the Federal government and compliance with ethics or conflicts of interest laws. The rules also permit payment of tax gross-ups.
Employers should review all arrangements that may provide for deferred compensation to determine how they are affected by the final regulations and what modifications must be made to the plans or arrangements by Dec. 31, 2007 to comply with the new regulations. We recommend that the following steps be taken to help ensure compliance with the new rules:
- Identify each plan or agreement that may fall within the broad reach of Section 409A and any related funding arrangement. This process should involve educating in-house counsel, human resources personnel, officers and managers who may craft and/or approve employment agreements. It may not be possible in a large organization for one department or office to be aware of all employment or side agreements that exist within the organization, therefore, education of appropriate management personnel is an important part of this first step to compliance.
- Once each arrangement is identified, work with company counsel or employee benefits attorney to ascertain the areas of noncompliance and prepare necessary amendments to bring the plans into compliance with the final regulations.
- Obtain approval of the group or individual required to amend each plan or arrangement. Generally, this will be the board of directors or the compensation committee. In some cases, the company will not be able to unilaterally amend the agreement or arrangement, but will have to seek employee approval. This process will require the education of the employees and timely presentation to them of the requisite changes.
We are required by irs circular 230 to inform you that any statements contained herein are not intended or written to be used, and cannot be used, by you or any other taxpayer, for the purpose of avoiding any penalties that may be imposed under federal tax law.
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.
