Employers must act by the end of the year to bring their deferred compensation plans and arrangements into compliance with Section 409A of the Internal Revenue Code of 1986, as amended, Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans (“Section 409A”). The temporary transition relief provided by the Internal Revenue Service, which had been previously extended, is now set to expire on December 31, 2008, and no further extensions are expected. Therefore, deferred compensation plans and arrangements need to be in documentary and operational compliance by December 31, 2008, or employees may face income tax consequences and an excise tax of twenty percent on “deferred” compensation amounts.
Final Chance to Change Elections Before December 31, 2008
After December 31, 2008, when the transition rules expire, tough new restrictions on the ability to change deferred compensation payment elections will become effective. Until December 31, 2008, an employer may in certain circumstances allow employees to amend their existing payment elections with respect to compensation that has already been deferred to provide for new payment elections with respect to both the time and form of payment without violating Section 409A. If an employer amends a plan and/or employees amend their elections in 2008 for this purpose, certain deferred compensation amounts can be paid out as early as January 2009.
Exemption for Grandfathered Plans
Compensation deferred under plans that have not been materially modified since October 3, 2004, may be grandfathered. Therefore, depending on the provisions of their plans, employers may be able to terminate and cash out their grandfathered plans without making material modifications, which would otherwise subject their plans to Section 409A. Employers should consider whether it may be desirable to pursue the option of terminating a grandfathered plan according to its terms and paying out the grandfathered amounts to the plan participants.
Beyond Traditional Deferred Compensation Plans
Employers should review not just “traditional” deferred compensation plans, but any plan or arrangement that provides for a deferral of compensation under its terms or operation, including those for non-employee directors and independent contractors. Employers should especially review the following types of arrangements for Section 409A compliance:
- Traditional deferred compensation plans (e.g. supplemental executive retirement plans, excess benefit plans and top hat plans)
- Individual employment, change in control, golden parachute and severance agreements
- Severance plans
- Stock options, restricted stock, restricted stock units and other equity compensation awards and plans
- Long-term incentive plans
- Post-retirement and other reimbursements and in-kind benefit arrangements
- Any other arrangement, program or practice that could result in the deferral of income
Amending Plans for Compliance
Employers should ensure that their plans are amended to be compliant with or exempt from Section 409A before December 31, 2008. The consent of affected parties or the approval of the Board of Directors may be necessary to amend these agreements, so employers should act quickly. Some examples of typical types of amendments that may be necessary or beneficial are set forth below.
Allowable Time and Form of Payment and Allowable Distribution Events
- Establish compliant payment triggers and time and form of payment options for deferred compensation plans, and eliminate noncompliant distribution events from plan documents (such as “haircut” provisions which permit unauthorized accelerations of payments or provisions providing for immediate distribution of benefits upon certain plan terminations).
- Conform the definitions of “change in control” and “disability” in each plan to those set forth in the Section 409A regulations, ensuring that any such distribution event will be compliant.
- Consider “de-linking” any nonqualified and qualified plans by changing existing payment provisions in plans or existing payment elections by a participant so that such provisions do not look to a qualified plan to determine the time and form of payment.
Severance Payment Compliance
- Amend employment agreements to provide for severance benefits upon a “separation from service” (not just upon “termination”) as defined in accordance with Section 409A.
- Amend severance plans and individual agreements to ensure that the payment of severance benefits to certain key employees does not occur during the first six months after termination or that such amounts are excluded from the six-month delay requirement.
- Consider if definition of “good reason” should be altered to comply with Section 409A safe harbor.
Stock Options and Stock Appreciation Rights
- Review plans and agreements for stock options or SARS in order to exempt the stock options or SARs from the application of Section 409A.
- Consider whether to amend plans to ensure that certain payments, including reimbursements, are made within the short-term deferral period, thereby exempting them from Section 409A.