The Section 409A, which was added to the Internal Revenue Code in 2004, imposes strict requirements on any nonqualified arrangement that defers the payment of compensation to a future year. If the Section 409A requirements are not met, not only is the deferred compensation subject to immediate tax upon vesting, but severe penalties are imposed as well. The types of arrangements that are subject to Section 409A are surprisingly broad. It may be readily apparent that supplemental executive retirement plans and elective deferred compensation arrangements are subject to Section 409A. However, Section 409A also may apply to arrangements that are not typically considered deferred compensation, such as employment agreements, separation pay plans and bonus or incentive plans.
There is concern that many taxpayers are not in full compliance with Section 409A, despite the requirement that all plan documents be in compliance with Section 409A by January 1, 2009. The lack of compliance likely results from many factors, including the breadth of the application of Section 409A, the complexity of the underlying regulations, the lack of guidance on what terms must be included in plan documents and unanticipated positions taken by the Internal Revenue Service (the “Service”). Indeed many taxpayers who reviewed their arrangements for compliance with Section 409A may be surprised to learn that certain of their plan documents are not compliant.
In recognition of these issues, the Service issued IRS Notice 2010-6 (the “Notice”) to allow taxpayers to correct certain provisions in a deferred compensation arrangement that do not comply with Section 409A. The Notice incentivizes taxpayers to make corrections no later than December 31, 2010 by enabling them to avoid hefty penalties if corrections are completed by this date. A taxpayer must meet certain requirements to be eligible for relief under the Notice. One such requirement is that the federal income tax return of the service provider (e.g. employee[i]) cannot be under examination with respect to any matter and the federal tax return of the service recipient (e.g. employer) cannot be under examination with respect to nonqualified deferred compensation for any taxable year in which the document failure existed. In addition, a taxpayer must take specific actions to complete the correction, such as correcting all plans that have substantially similar document failures. The document correction generally must be disclosed to the Service through a statement attached to both the service recipient’s and service provider’s federal tax returns. This alert focuses on the provisions that may be corrected under the Notice, but does not address all of the requirements and conditions that must be satisfied to make the corrections acceptable to the Service (see http://www.irs.gov/irb/2010-03_IRB/ar08.html).
The Notice contains helpful guidance even for employers who believe that their arrangements are in full documentary compliance with Section 409A. After many arrangements had already been amended the Service articulated its position that Section 409A could be violated if payment of deferred compensation was conditioned upon the execution of a release, as described below. In view of the prevalence of release provisions in separation agreements and plans, employers and executives, at a minimum, will want to review whether they are party to an arrangement with a release that needs to be amended. This alert begins by discussing how release provisions need to be structured to comply with Section 409A and then reviews other plan document failures that may be corrected under the Notice.
Employment agreements and plans that provide separation pay typically require that an employee execute a release before receiving separation benefits. The Service takes the position that conditioning payment of separation benefits upon the execution of a release violates Section 409A, unless certain requirements are met. Section 409A could also be violated if payment were conditioned upon other employment-related actions by the employee, such as the execution and submission of a noncompetition agreement or a nonsolicitation agreement. The reasoning behind the Service’s position is that an employee may impermissibly influence the timing of a payment by deciding when to execute and submit the release. For example, if an employee is terminated towards the end of the year, the employee, by determining when to sign the release, could decide whether to receive payment in the year of termination or in the succeeding year. Although the Service’s position has the greatest application to employment agreements and separation pay plans, it could apply to other arrangements, such as an equity plan that provides for payment upon the execution by an employee of a noncompetition agreement.
The Notice provides that if payment is conditioned upon the employee signing a release or upon the employee taking any other action, then the agreement must be amended to designate a definite date on which the separation benefits will be paid (or will begin to be paid). If the agreement or plan provides for payment within a designated period following the employee’s separation from service, then payment must be made on the last day of the designated period. If no such designated period for payment is specified, then the agreement or plan must provide for payment upon either the 60th or 90th day following the separation from service. The amendment must be made before the date of the separation from service or other event that triggers payment.
Certain agreements and plans providing for separation pay are not subject to Section 409A. Section 409A generally does not apply to involuntary separation pay that (1) does not exceed the lesser of $490,000 (as indexed) or two times the employee’s annual compensation and (2) is paid by no later than the end of the employee’s second taxable year following the year of separation. Also, Section 409A generally does not apply to separation pay that is paid no later than the 15th day of the third calendar month following the taxable year in which the employee attained a vested right to the separation pay. Unless it is certain that the separation pay plan or agreement would be exempt from Section 409A in all events, the best practice is to ensure the arrangement incorporates the Service’s recommended language, and to amend it if necessary to avoid an inadvertent violation of Section 409A.
Impermissible Payment Events
Section 409A permits deferred compensation to be paid only upon the following six events:
- A Separation from Service;
- A Specified Time (or pursuant to a fixed schedule);
- Change in Control; and
- Unforeseeable Emergency.
Each of these events is defined in extensive regulations under Section 409A. The Notice permits certain provisions that provide for payment upon an event other than the above-described permissible events to be amended to comply with Section 409A, as described below.
Separation from Service. A plan or agreement may provide for payment of deferred compensation upon a separation from service. For purposes of Section 409A, an employee is considered to have had a separation from service if the employee dies, retires, or otherwise has had a termination of employment with the employer. For this purpose, employer means all companies under common control (generally using a 50 percent control test). Whether a termination of employment has occurred depends on whether the facts and circumstances indicate that the employer and employee reasonably believed that no further services would be performed after a certain date or that the level of services would substantially decrease (generally meaning a reduction of at least 80 percent).
A plan or agreement violates Section 409A if it permits payment upon a change in employment that is not a separation from service as described above. The Notice permits the following types of disqualifying provisions to be amended:
- A provision that allows payment based on the level of services provided by the employee, such as a change from full-time to part-time.
- A provision that conditions payment upon the capacity in which the employee provided the services. For example, it would not be permissible to provide for payment upon an individual’s change in status from employee to independent contractor (without the required reduction in services provided by the individual).
- A provision that conditions payment upon a change in the recipient of the services. For example, it would not be permissible to provide for payment upon an employee changing employment from one subsidiary to another subsidiary. This is because the employee must cease providing services for all businesses under common control in order for a separation from service to occur.
The disqualifying provision may be amended so that a distribution is permitted upon a separation from service but the amendment cannot change the plan to permit either additional or fewer payment events than what was allowed prior to the amendment. The correction must be made before the date a payment event, as specified by the plan prior to the correction, occurs and before the date of a separation from service.
Change in Control. A plan or agreement may provide for payment of deferred compensation upon a change in control with respect to an employee. For purposes of Section 409A, a change in control means one of the following events:
- A change in the ownership of a corporation through the acquisition by one person, or more than one person acting as a group, of more than 50 percent of the total fair market value or total voting power of the stock of the corporation;
- A change in the effective control of a corporation through the acquisition by one person, or more than one person acting as a group, of 30 percent or more of the total voting power of the stock of the corporation or the date a majority of the directors is replaced during a 12-month period by directors whose appointment or election is not endorsed by a majority of the existing directors; or
- A change in the ownership of a substantial portion of a corporation’s assets by one person, or more than one person acting as a group (at least 40 percent of the total gross fair market value).
The Notice permits a plan to be amended that provides for a payment upon the sale of some or all of the equity or assets of the employer (other than the sale of specifically identified assets or a specifically identified type of asset) or a change in the effective control of the employer, even though the event, as defined by the plan, does not meet the requirement of a change in control for purposes of Section 409A. The amendment may allow for payment to be made upon a change in control event, as defined by the Section 409A regulations, but the amendment cannot change the plan so that either additional payment events or fewer payment events are permitted than what was allowed under the plan prior to its amendment. The correction must be made before an event occurs that is not a change in control event, but would have permitted payment under the plan.
Disability. A plan or agreement may provide for payment of deferred compensation upon an employee’s disability. Section 409A defines when an individual is considered to be disabled for this purpose. A plan or agreement that provides for payment upon an employee’s illness or other incapacity which results in an inability to perform the employee’s duties, but which does not qualify as a disability under Section 409A, may be amended under the Notice. The arrangement may be amended either by removing the impermissible payment event or conforming it so that the payment event is a disability under Section 409A. The amendment may be made either before or after the date the employee has an illness or an incapacity that would permit payment under the plan. If the amendment is made after the occurrence of such an illness or incapacity, additional corrective action will be required.
Other Corrections of Impermissible Payment Events. The Notice also permits a plan to be amended if the plan provides for payment upon events, some of which are permissible payment events under Section 409A and some of which are not. The plan must be corrected by removing the impermissible payment events in the plan and in all other plans sponsored by the service provider. The correction generally must be made before the date any impermissible payment event occurs. However, the correction may be made later with respect to a service provider who has not elected to receive payment upon the impermissible payment event and who would not otherwise be entitled to a deferred amount upon the impermissible payment event.
The Notice also permits a plan to be corrected if it only provides for payment upon events that are not permissible payment events under Section 409A. This type of plan may be amended by removing the impermissible payment events and providing for payment upon the later of the service provider’s separation from service and the sixth anniversary of the date of correction. The amendment must be made before any of the impermissible payment events provided under the plan have occurred.
Impermissible Payment Periods
The regulations under Section 409A generally require that payment of deferred compensation be made, or begin to be made, on a designated payment date following a permissible payment event. It is also permissible to provide that payment will be made within a designated period that is not more than 90 days following the designated payment date so long as the employee does not have the right to designate the taxable year in which payment must be made.
The Notice allows a plan that provides for payment to be made more than 90 days but earlier than 366 days following a permissible payment event to be amended. The plan may be amended to either remove the period for making payment following the permissible payment event or to keep the period but provide that it may not exceed 90 days and that the employee does not have a right to designate the taxable year of payment. The amendment may be made either before or after a permissible payment event occurs, but a penalty will generally apply if the amendment is made after a permissible payment event occurs.
Impermissible Payment Schedules
For each permissible payment event available under a plan, the Section 409A regulations provide that the plan may designate only one time and form of payment of a deferred compensation amount upon the occurrence of such event, subject to the following exceptions. The first exception is for a plan that pays benefits upon disability, death, a change in control or an unforeseeable emergency. For each of these events, it is permissible to provide an alternate payment schedule if the event occurs on or before one specified date. For example, it would be permissible to provide a lump sum payment of deferred compensation if a change in control occurred before the date an employee turned age 55 and to provide for five installment payments if a change in control occurred on or after that date.
If the payment event is a separation from service, a different time and form of payment may be permitted with respect to the following separations from service:
- A separation from service during a limited period of time not in excess of two years following a change-in-control event;
- A separation from service before or after a specified date or a separation from service before or after a combination of a specified date and a specified period of service; and
- A separation from service not described above.
The Notice allows a plan that provides for different forms of payment upon a voluntary and involuntary separation from service to be corrected. In this instance, a plan may be amended to provide that the form of payment upon a voluntary separation from service will be the same form of payment as the plan had provided for an involuntary separation from service. The amendment must be made before the date a separation from service occurs that could trigger an impermissible payment.
If there are other impermissible multiple forms of payment, the Notice prescribes an ordering rule for removing the multiple forms of payment. Under this ordering rule, the method of payment that is retained under the plan must be that which results in pushing out the payment of deferred compensation under the plan. The amendment must be made before the date a payment event occurs that could result in an impermissible form of payment.
The ability to change the time or form of a deferred compensation payment is not permitted under Section 409A, subject to certain limited exceptions. The Notice permits a plan that includes impermissible discretion over the time or form of payment of deferred compensation to be amended to remove the discretion under certain circumstances. A prerequisite for the amendment is that the employee and employer cannot have exercised their discretion or if the discretion has been exercised, such exercise must be revoked more than one year before the payment event occurs. Special rules apply if there is more than one plan that has substantially similar provisions with discretion over the time or form of payment.
Impermissible Discretion to Accelerate Payments
Section 409A generally does not permit the payment of deferred compensation to be accelerated. If a plan gives the employer the discretion to accelerate payment of deferred compensation, the Notice permits the plan to be amended to remove the discretion before the earlier of the date a payment is made pursuant to the exercise of the discretion or the date the employer irrevocably exercises its discretion.
An example of a provision that could be amended under the Notice is a plan termination provision that allowed for immediate payment of deferred compensation upon termination. Although Section 409A permits a plan to be terminated, as a general rule payment as a result of the termination must be deferred until one year after the date of termination.[ii] The Notice would permit a termination provision to be amended to provide a one-year delay for payment when necessary to comply with the regulations.
Impermissible Reimbursement or In-Kind Benefit Payments
An agreement to reimburse an employee for expenses or to provide the employee with in-kind benefits must meet the following requirements if the agreement is subject to Section 409A[iii]:
- The agreement must provide an objectively determinable nondiscretionary definition of the expenses to be reimbursed or the in-kind benefits to be provided;
- The provision of expense reimbursement or in-kind benefits must be provided for an objective and specifically prescribed period (e.g. for the employee’s lifetime);
- The expense reimbursement and/or in-kind benefits provided in one year can not affect the amount available in future years;
- Any reimbursement must be made by the last day of the taxable year following the taxable year in which the expense is incurred; and
- The right to reimbursement or in-kind benefits cannot be subject to liquidation or exchange for another benefit.
If an agreement or plan gives an employee the right to a reimbursement or an in-kind benefit that does not comply with the foregoing requirements, the Notice allows the agreement or plan to be amended so that it is compliant with the regulations. The amendment must be made before the date an event occurs that would cause the employee to be eligible for reimbursement or in-kind benefits subject to Section 409A. If the agreement or plan needs to be amended to ensure that the amount of reimbursement or in-kind benefits available for one year is not affected by the amount available for a future year, the Notice provides a method for allocating the amount of reimbursement or in-kind benefits to be provided over multiple years.
Failure to Include Six-Month Delay for Certain Public Company Employees
Section 409A requires that deferred compensation payments payable upon a separation from service to a key employee of a public company be delayed until six months after the separation from service. The six-month delay requirement is part of Section 409A to avoid the potential perceived abuse of a high-level employee terminating employment and receiving an immediate deferred compensation payout because of concern over the company’s financial status.
A plan may be amended to add the six-month delay of payment provision before an event occurs that would entitle the employee to payment. However, the plan must also be amended to prohibit payments for 18 months following the date of correction. The Service considers the six-month delay requirement to be a critical part of Section 409A and thus, decided to impose a non-monetary penalty on this type of document failure by not allowing any distributions to key employees for at least 18 months after the failure is corrected. For example, if a key employee separates from service less than 12 months after the date of correction, the key employee must wait until 18 months after the date of correction to receive his or her distribution, rather than just six months after the separation from service.
Impermissible Initial Deferral Elections
If an employee is permitted to defer compensation, the deferral election generally must be made and become irrevocable no later than the close of the employee’s taxable year preceding the year for which the employee performs the services for which the compensation is earned. For example, if an employee wants to defer the base salary and bonus he earns for 2011, the election must generally be made no later than December 31, 2010. Special timing rules for deferral elections are provided for the year in which an employee first becomes eligible for the deferred compensation plan and for performance-based compensation, which is strictly defined.
The Notice permits a plan to be amended to comply with the deferral election rules under Section 409A within a limited time frame. The employer must take commercially reasonable steps to identify and correct substantially similar defective provisions in all plans.
The Notice gives certain employers who adopt a new deferred compensation plan an additional period to bring the plan into compliance. In order to obtain the relief, the employer generally cannot have previously adopted a deferred compensation plan of the same type.[iv] In determining whether a taxpayer is eligible for the relief, grandfathered plans may be disregarded as well as any plan under which all amounts have been paid or forfeited.
An employer that qualifies for the relief for new plans must adopt amendments to bring the plan into compliance with Section 409A within a specified period of time. That period ends at the end of the calendar year in which, or the 15th day of the third calendar month following, the date the first legally binding right to deferred compensation arose under that plan and all other plans of the same type.
Amendment Cut-off Date for Certain Provisions
As a general matter, the Notice does not require that amendments be made by a specific date, although there are significant cost savings that may be realized if the amendments are done by December 31, 2010. However, there are two types of impermissible provisions where corrections must be made on or before December 31, 2011, as described below.
Linked Deferred Compensation Plans. Section 409A issues may arise if the amount of deferred compensation or the time or form of payment under a deferred compensation plan is affected by the amount deferred or the payment provisions of another deferred compensation plan. Such linkage can result in a Section 409A violation because it may result in an impermissible change in the time and form of payment under one of the deferred compensation plans. For example, if the benefit under NQDC Plan A was reduced by the benefits provided under NQDC Plan B, an increase in the benefits under NQDC Plan B would reduce the benefits under NQDC Plan A. If NQDC Plan A provided for a lump sum payment upon a separation from service and NQDC Plan B provided for ten annual installments upon a separation from service, an increase in the benefits provided by NQDC Plan B means that an amount that would have been paid in a lump sum under NQDC A will now be made in ten annual installments. This change in the method of payment violates Section 409A.
The Notice permits impermissibly linked deferred compensation plans to be amended on or before December 31, 2011 and provides guidance on how the correction should be made.
Payment Schedules Determined by the Receipt of Payments by the Employer. Section 409A allows deferred compensation to be paid at a specified date or pursuant to a fixed schedule of payments. Certain deferred compensation plans may condition payment upon the timing of payments received by the employer, for example, amounts collected on accounts receivable. The Section 409A regulations provide that a payment schedule that is determined by reference to the timing of payments received by the employer is treated as a fixed schedule of payments if the following conditions are met:
- First, the payments must arise from bona fide and routine transactions in the ordinary course of business;
- Second, the employee must not have effective control of the employer, the person from whom such payments are due, or the collection of any of the amounts due to the employer;
- Third, the payment schedule must provide an objective, nondiscretionary method of identification of the payments to the employer which will determine the amount to be paid to the employee;
- Fourth, the payment schedule must provide an objective, nondiscretionary schedule under which payments will be made to the service provider; and
- Fifth, the payments to the employer on which the employee’s deferred compensation is based must result from sales of a type that the service recipient is in the trade or business of making and makes frequently, and either all such sales must be taken into account or there is a legitimate, non-tax business reason for only taking specific sales into account.
The Notice provides that a deferred compensation plan that fails to satisfy either one or both of the third and fourth conditions may be amended to satisfy such conditions on or before December 31, 2011. In addition, the employer must correct any operational failures resulting from making payments that would not have been made if the corrected provisions had been included in the plan or from failing to make payments that should have been made if the corrected provisions had been included in the plan.
The Notice provides welcome relief for employers who discovered new deferred compensation arrangements after the December 31, 2008 plan document deadline and employers who did not undertake a thorough review prior to January 1, 2009. In addition, any employer who has employment agreements or separation pay plans with releases should review those arrangements to make sure that the releases do not impermissibly give the employee the right to designate the time of payment of the deferred compensation. The Notice provides an incentive for making amendments by December 31, 2010 by generally not imposing monetary penalties for amendments made by December 31, 2010. Thus, employers may find it to their financial advantage to make any required corrections by the end of the calendar year.