U.S. Internal Revenue Code §409A provides a wide range of very restrictive rules pertaining to “nonqualified” deferred compensation plans and many other types of compensation arrangements that may defer compensation.
On June 22, 2016, the Internal Revenue Service issued proposed changes to the regulations under IRC §409A. This post reviews a few highlights of the proposal that may be of interest to employers and employees.
Coordinated proposed regulations were issued under IRC §457, a deferred compensation provision for state and local governments and tax-exempt organizations – see our recent post.
The proposed changes to the §409A regulations contain nearly 20 substantive points. The overall tone is tinkering that will address minor issues that have arisen over time. Most changes are helpful to taxpayers, with a couple of changes designed to close potential loopholes. The following are some highlights of the proposed regulations.
Separations From Service
The current regulations provide that a “separation from service” may or may not occur when an employee terminates employment and has an ongoing consulting agreement. The determination of whether there is a separation from service (thus triggering payment of deferred compensation) is to be made based on what the facts and circumstances show is a reasonable expectation of how many hours will be required under the consulting agreement.
The proposed regulations and preamble seem to provide that if a separation from service does not occur at the time of the transition to the consulting agreement, a separation from service cannot be deemed to occur until the consulting agreement has entirely ceased. This may be an important planning consideration in relation to terminations of executive employment agreements.
A non-statutory stock option can avoid the application of §409A if certain requirements are met in relation to the option and the type of stock being issued. One requirement is that the stock cannot be subject to a mandatory repurchase obligation (other than a right of first refusal) that has a price less than fair market value. Nor can the stock have a permanent put or call right that has a price less than fair market value.
The proposed regulations will modify this rule to allow for a purchase price that is less than fair market value in limited circumstances. Those circumstances would include an employee’s involuntary separation for cause, or the occurrence of a “condition” that is within the control of the employee, such as violation of a non-compete or non-disclosure requirement.
In another vein, the current regulations require that the employee actually be employed by the corporation granting the option (or an affiliate) at the time the option is granted. The proposed regulations will allow an option to be issued to an individual if it is reasonably anticipated that he or she will become an employee or service provider within 12 months.
In an asset deal, the employees who go to work for the buyer will have a separation from service. That may trigger required payouts under nonqualified deferred compensation plans. However, the current regulations allow the buyer and seller to agree not to treat the transaction as a separation from service for employees who go to work for the buyer.
The proposed regulations will clarify that no such election is available when a stock sale occurs, even if the buyer makes an election under IRC Section 338 to have the transaction treated as an asset sale. In a stock sale, a separation from service may or may not occur, depending on the underlying facts and circumstances.
In addition, the current regulations provide a special exception for certain change in control payouts for employees who are holders of company stock or stock rights. If the payments are spread out after the closing, no violation of the Section 409A rules will exist as long as (i) the payments are made under the same terms and conditions as apply to other shareholders, and (ii) are made within five years. The proposed regulations will extend this treatment to statutory stock options and otherwise clarify its availability.
Under current rules, the §409A regulations define nine different types of §409A plans (e.g., elective deferrals, nonelective deferrals and stock rights plans). In order for an employer to terminate a §409A plan, the employer must terminate all deferred compensation plans of the same type, and not adopt any plans of the same type for three years.
The proposed regulations will clarify that this rule extends to all employees of the employer, not just the ones who were participating in the terminated plan.
The Short-Term Deferral Exemption
A compensation arrangement is not subject to §409A if the compensation earned under the arrangement is paid within 2½ months following the later of (i) the end of the calendar year in which it is earned, or (ii) the employer’s tax year in which it is earned. Quite often, this date becomes March 15 following the end of the calendar year
In the past, delayed payments have been permitted on account of three specific reasons. The proposed regulations will expand the reasons for delay to include potential violations of U.S. securities laws or other applicable law.
Enforcement of Legal Claims
Under current regulations, the §409A rules do not apply to amounts paid to reimburse an employee for settlement of a bona fide claim against an employer based on violation of applicable law, including reimbursement of attorney fees and costs.
The proposed regulations will expand this exception to also apply to reimbursements of attorney fees and costs that are provided for under an employment agreement or other deferred compensation plan, if an employee or service provider has to enforce his or her rights under the agreement or plan.
Payments Upon and After Death
The proposed regulations will modify the rules regarding the timing of payments after the death of an employee to prevent inadvertent violations of §409A. Essentially, no violation will be deemed to occur if payment is made by December 31 of the following calendar year.
The proposed regulations will clarify that after the death of an employee, it is permissible to accelerate payments on account of the disability or death of the beneficiary, or an unforseeable emergency of the beneficiary.
Recurring Part-Year Compensation
The current regulations have an exception from the §409A rules for “recurring part-year compensation”. For example, this applies to teachers who have 9 or 10 month service periods that may begin in August or September and end in May or June. Often, they are paid over a 12 month period, the effective of which is to push some compensation into a later year.
The current exception states that it applies only if the compensation being deferred into the following year is not more than a limit tied to IRC §402(g) (currently $18,000). The proposed regulations will tie the limit to IRC §401(a)(17) (currently $265,000). This will expand the availability of this common sense exception.