On April 17, 2007, the Department of Treasury issued final regulations under Code section 409A, relating to nonqualified deferred compensation, which become effective on January 1, 2008. Like the proposed regulations, the final regulations are long, complex, highly nuanced, and formalistic. They do, however, provide some liberalization and clarification of the regulations that were proposed in October 2005.
Background and General Principles
Congress enacted section 409A as part of the American Jobs Creation Act of 2004, in part as a response to the Enron debacle. Section 409A superimposes additional, black letter requirements on the cash method principles (i.e., constructive receipt and economic benefit) that had previously governed the income tax treatment of nonqualified deferred compensation. The statute generally requires that elections to defer compensation be made prior to the year in which compensation is earned, allows deferred compensation to be paid only at pre-established times and for certain events, prohibits accelerated payments, and limits re-deferral for payment at a later time.
However, Congress provided very little guidance on what “nonqualified deferred compensation” means for purposes of section 409A, and more than half of the final regulations is devoted to defining compensation arrangements that are and are not covered by section 409A, as well as identifying various sub-species of covered arrangements; this accounts for much of the complexity and nuance. Seemingly simple questions, like whether stock options or severance arrangements are covered by section 490A, are subject to detailed rules and exceptions and exceptions to exceptions.
All of this matters because Congress has made the stakes extraordinarily high. If a nonqualified deferred compensation plan covered by section 409A fails to comply with the requirements of section 409A, whether in form or in operation, the employee is taxable on the value of the deferred compensation to the extent of his vested rights, whether or not the deferred compensation has been received. In addition, he or she is subject to a penalty (additional tax) equal to 20% of the value of the vested, noncompliant deferred compensation, plus an interest charge at the deficiency rate plus 1%. These punitive consequences apply to any act of noncompliance, no matter how minimal, benign, or inadvertent. The IRS has been given no authority to absolve for good cause or harmless error, and employers are legally compelled to report events of noncompliance on Form W-2.
The following highlights several key provisions of the final regulations, focusing on those areas where important changes from the proposed regulations have been made.
Stock Options and Stock Appreciation Rights
Stock options and stock appreciation rights are generally exempt from section 409A (not treated as non-qualified deferred compensation plans) if (i) the stock is “service recipient stock,” (ii) the strike price is never less than the fair market value of the stock on the date of grant, and (iii) the option contains no additional deferral feature. The final regulations liberalize each of these requirements to some degree.
Under the final regulations, stock qualifies as service recipient stock if it is common stock of the corporation by which the employee is employed or any corporation in an upward chain of corporations that has at least a 50% (20% if there are legitimate business criteria) ownership interest in the employer corporation. With respect to the strike price requirement, the final regulations continue to narrowly restrict the use of average trading prices for publicly traded stock, but in the case of nonpublicly traded stock (e.g., of start-up companies), the valuation requirements have been liberalized. Lastly, and significantly for many companies, the final regulations allow the section 409A exemption to be retained upon the extension of stock options, provided the extension does not extend beyond the earlier of the original maximum term or 10 years from the date of the original grant; also, re-pricing of “underwater” options to current market value is treated as a re-issuance, not a prohibited reduction of the strike price or additional deferral feature.
Termination of Employment
If deferred compensation is payable upon termination of employment, which is one of the permissible payment triggers under section 409A, it is essential to know when an employee has terminated, lest there be a prohibited delay or acceleration of payment. Questions commonly arise when employees are kept on the payroll with reduced or minimal duties or are granted terminal leaves. The final regulations impose a presumption of termination of employment if an employee’s actual services have been permanently reduced by 80% (compared with the preceding 36 months), and impose a presumption that employment has not terminated if an employee’s services have not been reduced by more than 50%. Various factors may be adduced to rebut the presumption of termination.
Tax Gross-Up Payments
Particularly because of the risk of punitive employee taxation under section 409A attributable to employer foot-faults, it is important to know whether and how section 409A applies to payments made by employers to reimburse employees for the resulting tax liabilities. Similar issues arise with respect to tax reimbursements attributable to the golden parachute rules of section 280G. The final regulations provide that a right to a tax gross-up payment constitutes deferred compensation covered by section 409A, but that such payments are section 409A compliant if made by the end of the year following the year in which the employee’s tax liability is satisfied.
Post-Termination Reimbursements and Fringe Benefits
The final regulations contain a series of provisions relating to noncash benefits and reimbursement arrangements for former employees. Although wading through the various rules is a chore, they will allow most such benefits to be continued without violation of section 409A. First, benefits that are excluded from gross income (such as insured post-retirement health benefits) are generally exempt from section 409A. Second, reimbursement or provision of benefits such as outplacement services and moving expenses are exempt if reimbursed by the end of the third year following termination or provided by the end of the second year. Third, indemnifications for expenses or damages for claims against the employee for his actions as an employee are exempt. Other fringe benefits (such as reimbursement of country club dues or the right to use corporate aircraft following termination of employment) are not exempt, but are section 409A compliant if the former employee does not have any right to convert the benefits to cash for other uses, and reimbursements or benefits provided in one year do not affect the amount or level of reimbursements or benefits available in any other year.
The final regulations do not clarify, however, how the six-month delayed payment rule for specified employees applies to such fringe benefits and reimbursements.
The final regulations maintain the requirement that a nonqualified deferred compensation plan covered by section 409A must be in writing and continue to provide that a written plan provision that violates the requirements of section 409A (even if it never comes into play) constitutes a section 409A violation, with all the attendant tax sanctions. Since existing plan documents must be amended to conform to the final regulations by December 31, 2007, and since there is no provision allowing subsequent repairs to defective documents that would avoid a section 409A violation with respect to then existing deferred compensation rights, getting the plan document right must be taken seriously. However, the final regulations reflect some recognition of the absurdity of this regime by slightly limiting the provisions that must be included in a written plan. On the other hand, the final regulations provide that a “savings clause” in a plan document that purports to override any provision inconsistent with the requirements of section 409A will be disregarded.
More section 409A guidance is to come, though it is unclear when. Not yet addressed are valuation rules for unpaid deferred compensation rights, the statutory requirement that the amount of compliant deferred compensation rights be reported annually on Form W-2 or 1099, and the prohibitions on offshore and certain other funding techniques. But those unaddressed issues provide little respite from the formidable compliance challenges that the final regulations pose for employers, employees, and tax practitioners.
This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.