Over the next several weeks, we will be writing about five common Code Section 409A design errors and corrections.
It should (but will not) go without saying that Code Section 409A has an extraordinarily broad reach. Many claim this reach is overbroad. One commonly cited example of this overbreadth is that Code Section 409A regulates taxable employee reimbursements.
Why does Code Section 409A regulate reimbursements? The concern is that an employee and employer will collude to achieve reimbursement of extravagant personal expenses many years after the expense is incurred. This “late” reimbursement would have the effect of unreasonably deferring taxation of the reimbursable expense, potentially into a year that is tax-advantageous for the employee.
The IRS’s solution? Ensure that expenses eligible for reimbursement are objectively determinable and reimbursed within a limited period of time following the date in which the expense is incurred. Here’s a list of the IRS’s requirements:
- Definition of Reimbursable Expense. Code Section 409A requires an objectively determinable definition of an expense eligible for reimbursement. The description of the reimbursable expense does not need to be extensive, but does need to be written into the relevant plan document (which could be an employment agreement).
- Prescribed Reimbursement Period. Eligible expenses must be incurred during a prescribed period of time. This period of time can be as long or as short as desired – the lifetime of the service provider works for Code Section 409A purposes. Again, this needs to be written into the plan document.
- Reimbursement Limits Affect Only One Calendar Year. The amount of expenses eligible for reimbursement in one taxable year cannot affect the amount eligible for reimbursement in other taxable years. This requirement must be reflected in the plan document.
- Reimbursement Timing. Reimbursements must occur by the end of the taxable year following the year in which the expense was incurred.
- No Exchange or Liquidation. The right to reimbursement can not be subject to liquidation or exchange for another benefit.
Of these requirements, the requirement that the amount of reimbursements in one year not affect another year is often the biggest stumbling block. Consider, for example, a multi-year employment agreement that, for corporate governance reasons, limits reimbursable expense over the life of the agreement to $20,000. This provision violates Code Section 409A. If the employee incurs $5,000 in expenses in the first year of the contract, the amount eligible for reimbursement in the second year is necessarily affected. Similar problems would arise for a specified reimbursement amount that applies to a non-calendar contract year (for example, “during the first year following hire”) in an employment agreement.
What should you do if your plan document or employment agreement provides for expense reimbursements, but doesn’t contain the required language? Amend the plan or employment agreement to include the required language. If the problem is that a plan caps reimbursements to a pre-specified amount over multiple taxable years, the amount eligible for reimbursement should be pro-rated among the years in which the reimbursement could occur. And if the problematic reimbursement provision would apply during the one year period following the date of correction, penalties could apply. As with all Code Section 409A documentary corrections, certain correction documents must be filed with the IRS.