The Internal Revenue Service (IRS) has recently issued proposed regulations on nonqualified deferred compensation plans under Internal Revenue Code (Code) Section 409A. The regulations clarify and modify specific provisions in the final regulations; they also replace provisions in previously proposed regulations on income inclusion. Although the regulations have been issued in proposed form, taxpayers may rely on them until the final regulations are issued.
Code Section 409A sets forth requirements regarding income inclusion for nonqualified deferred compensation plans. Compliance with the requirements is important to avoid the current taxation and potential imposition of an additional 20 percent tax and interest. In April 2007, the IRS issued final regulations under Code Section 409A. In December 2008, the IRS issued additional proposed regulations on the calculation of amounts includible in income under Code Section 409A and the additional taxes imposed thereunder.
The newly issued proposed regulations make a number of changes to the current proposed and final regulations. Among the more significant changes, the proposed regulations would:
- Modify the “short-term deferral rule” to allow a delay in payments to avoid violating federal securities or other applicable laws.
- Clarify that a stock right, which does not otherwise provide for a deferral of compensation, will not be treated as deferred compensation solely because the amount payable upon an involuntary separation from service for cause is based on a measure that is less than fair market value.
- Modify the definition of the term “eligible issuer of service recipient stock” to provide that it includes a corporation (or other entity) for which a person is reasonably expected to begin, and actually begins, providing services within 12 months after the grant date. This change clarifies that companies can grant stock rights for purposes of Code Section 409A to employees as part of employment negotiations before they are hired.
- Clarify that certain separation pay plans that do not provide for a deferral of compensation because of an exception in the rules may apply to a service provider who had no compensation from the service recipient during the year preceding the year in which a separation from service occurs. In these cases, the employee’s annualized compensation for the tax year of separation may be used for purposes of the separation pay plan exception. This change clarifies that the separation pay plan exception is available for an employee whose employment begins and ends in the same tax year.
- Provide that a plan under which a service provider has a right to payment or reimbursement of reasonable attorneys' fees and other expenses incurred to pursue a bona fide legal claim does not provide for a deferral of compensation.
- Clarify that a service provider who ceases providing services as an employee, and begins providing services as an independent contractor, is treated as having a separation from service if, at the time of the change in employment status, the level of services reasonably anticipated to be provided after the change would result in a separation from service under the rules applicable to employees.
- Clarify that the rules for the transaction-based compensation exception apply to statutory stock options.
- Provide that the addition of the death, disability, or unforeseeable emergency of a beneficiary who has become entitled to a payment due to a service provider's death (as a potentially earlier or intervening payment event) will not violate the prohibition on acceleration of payments.
- Modify the conflict of interest exception to the prohibition on the acceleration of payments to allow the payment of all types of deferred compensation to comply with bona fide foreign ethics or conflicts of interest laws.
- Clarify and modify the anti-abuse rule in the income inclusion regulations on the treatment of deferred amounts subject to a substantial risk of forfeiture for purposes of calculating the amount includible in income.