Employers that maintain deferred compensation arrangements that are subject to US Internal Revenue Code (Code) Section 457A should be mindful of the rapidly approaching deadline for amending their plans to secure certain transition relief for amounts attributable to services performed prior to 2009.
As is described more fully below, such amounts are generally grandfathered from the provisions of Code Section 457A, but only for a limited period; they become taxable under Code Section 457A in the year in which they become vested or the last taxable year beginning before 2018, whichever comes later. Employers may wish to distribute such amounts at the time they become taxable, but, if the arrangement is also subject to Code Section 409A, the distribution may constitute an impermissible acceleration, triggering adverse tax consequences under Code Section 409A. The IRS has issued transition relief for amendments adopted to provide for the distribution of such grandfathered amounts in the year that they become taxable under Code Section 457A, but only if such amendments are in writing and effective no later than December 31, 2011.
Code Section 457A Background
Under Code Section 457A, compensation deferred under a nonqualified arrangement maintained by a nonqualified entity is generally included in gross income when it is no longer subject to a substantial risk of forfeiture. If, however, such compensation is not determinable at the time it is no longer subject to a substantial risk of forfeiture, it is not included in income until it becomes determinable; at that point, such compensation is subject to regular income tax as well as (i) an additional income tax equal to 20 percent of the amount of the compensation, and (ii) “premium interest.”
The term “nonqualified entity” generally includes the following entities (subject to a body of complex rules and exceptions):
- A foreign corporation, unless substantially all of its income is effectively connected with the conduct of a trade or business in the United States or is subject to a comprehensive foreign income tax, and
- A partnership, unless substantially all of its income is allocated to persons other than: (i) foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax, and (ii) organizations exempt from income tax under Title 26 of the US Code.
Code Section 457A Effective Date
Code Section 457A became effective for deferred amounts that are attributable to services performed after December 31, 2008. An amount that would otherwise be subject to Code Section 457A except for the fact that the amount is attributable to services performed prior to January 1, 2009 (Grandfathered Amount) is includible in income (to the extent not otherwise includible in income prior to 2018) in the later of (i) the last taxable year beginning before January 1, 2018, or (ii) the first taxable year in which such amount is not subject to a substantial risk of forfeiture (the applicable later year referred to as the “Grandfather Sunset Year”).
Code Section 409A Background
Subject to certain exceptions, Code Section 409A applies to all nonqualified arrangements (including individual agreements) that provide for a deferral of compensation. Generally, Code Section 409A applies to amounts deferred after December 31, 2004 (and amounts deferred prior to that date under an arrangement that is “materially modified”).
While the Code Section 409A rules are complex, and provide for many exceptions, they generally require that the time and form of distribution of deferred compensation be established in the year prior to the year in which the relevant services are performed, and, once such time and form of payment have been established, prohibit the acceleration of payment (referred to as the “anti-acceleration rule”). Violations of Code Section 409A trigger adverse tax consequences for the service provider, including the immediate taxation of the service provider’s vested accrued benefit (even if those benefits have not yet been distributed to him or her) and the imposition of a 20 percent additional income tax as well as interest.
Code Sections 409A and 457A may both apply to amounts deferred under the same arrangement.
Code Section 409A Issue For Grandfathered Amounts
Under Code Section 457A, a service provider entitled to receive a Grandfathered Amount in a year later than the Grandfather Sunset Year will nevertheless be taxed on such amount in the Grandfather Sunset Year, regardless of the fact that payment will not be made until a later taxable year. In such a circumstance, the service provider may prefer that payment coincide with the tax year in which the individual must include such amount in his or her income. However, accelerating the payment of a Grandfathered Amount to the Grandfather Sunset Year could be a violation of Code Section 409A’s antiacceleration rules triggering the 20 percent additional income tax and interest imposed by Code Section 409A. In addition, if the deferred compensation is grandfathered from the requirements of Code Section 409A (on account of being earned and vested prior to 2005), the acceleration may constitute a material modification, causing such amounts to become subject to Code Section 409A.
Example: A service provider (who is a US taxpayer) elects in 2006 to defer compensation earned for services performed in 2007 and that otherwise would have been paid in 2007 (the “Deferred Amount”). The service provider elects to have the Deferred Amount paid in a lump sum on January 1, 2025. The Deferred Amount is always fully vested. The Deferred Amount is deferred pursuant to a nonqualified arrangement maintained by a nonqualified entity. Thus, the Deferred Amount would be subject to Code Section 409A and would be a Grandfathered Amount under Code Section 457A. As described above, under Code Section 457A the Deferred Amount would be taxable to the service provider in 2017 (assuming the tax year for the service provider is a calendar year). However, pursuant to the terms of the plan, the service provider is not entitled to receive payment of such amount until 2025. Early payment of the Deferred Amount in 2017 when it becomes taxable would (absent the relief described below) violate Code Section 409A’s anti-acceleration rules.
In Notice 2009-8, the IRS granted limited transition relief for amendments to accelerate payment of Grandfathered Amounts to the year in which such amounts are taxable under Code Section 457A, without triggering adverse tax consequences under Code Section 409A. Notice 2009-8 provides that an amendment to a plan to change the time and form of payment of a Grandfathered Amount to conform the date of distribution to the date the amount may be required to be included in income under Code Section 457A, will not be treated as a violation of the anti-acceleration rule of Code Section 409A, provided that such change in the time and form of payment is established in writing and is effective on or before December 31, 2011. Further, if the affected compensation was earned and vested before December 31, 2004, and is grandfathered from Code Section 409A, such an amendment will not be treated as a material modification for purposes of Code Section 409A, again provided that such change in the time and form of payment is established in writing and is effective on or before December 31, 2011. (The Notice also contains certain additional relief (described in Q&A 26 of the Notice) from the anti-acceleration rule of Code Section 409A for the accelerated payment of amounts attributable to services performed after 2008 into the service provider’s taxable year in which such amounts are taxable under Code Section 457A, but this additional relief does not appear to apply to Grandfathered Amounts.)
In the example described above, if the plan is amended in writing effective on or before December 31, 2011, to accelerate payment of the Deferred Amount to 2017, the service provider may receive payment of the Deferred Amount in 2017 without incurring adverse tax consequences under Code Section 409A.
Plans are not required to be amended pursuant to the transition relief, but failure to take advantage of the transition relief may leave service providers taxable on Grandfathered Amounts in a tax year prior to the year in which payment of such amounts is made.