On June 21, the Treasury Department and the Internal Revenue Service (IRS) issued proposed Internal Revenue Code (Code) section 409A regulations, modifying existing proposed and final section 409A regulations regarding deferred compensation arrangements. The proposed regulations consist of 19 technical clarifications, most of which do not impact the core rules under the section 409A regulations. However, several of the technical clarifications are important in specific circumstances, including additional flexibility on the timing of payment following an employee’s death and clarifications and new limitations regarding the ability to correct document errors with respect to unvested deferred compensation.
Under Code section 409A, deferred compensation arrangements that do not satisfy certain requirements may subject employees1 to immediate income inclusion of deferred amounts and a 20% additional tax, in addition to other potential tax consequences. The Treasury Department and the IRS issued final regulations regarding the generally applicable rules of section 409A in 2007 and proposed income inclusion regulations for non-compliant deferred compensation in 2008. Since these regulations were issued, practitioners and plan sponsors have encountered various technical issues in interpreting the regulations. The proposed regulations address a number of these technical issues, as described in more detail below.
Changes with Broader Potential Application
Distribution Timing Following Death. Under the final regulations, distributions upon the death of an employee were subject to the same strict distribution timing rules as distributions upon other triggering events, such as a separation from service. For example, in many cases in which death resulted in a payment of section 409A deferred compensation, the payment had to be made by the end of the calendar year in which death occurred (or within 2-1/2 months following death, if later). This timing was often difficult to administer, because of delays in the employer learning of the death and the time required to identify the beneficiary or the estate of the deceased.
The proposed regulations offer significant relief for distributions upon death, permitting payment to be made at any time following death until December 31 of the year following the year of death. Employers can take advantage of this flexibility immediately and without the need for a plan amendment.
Sutherland Observation: Even though the proposed regulations allow immediate application of the additional time for payments following death, employers should consider the extent to which not paying promptly in accordance with the plan terms could subject the employer to possible contract claims from a beneficiary.
The current proposed income inclusion regulations contain anti-abuse rules that apply where the employer has a pattern or practice of using the proposed regulations to make impermissible time or form of payment changes. The preamble to the new proposed regulations reflects a concern that the current rules are not sufficient to address possible abuses, and the new proposed regulations make the following changes:
Corrections for Unvested Deferred Compensation. The existing proposed income inclusion regulations for non-compliant deferred compensation provide a significant avenue to correct plan documents that fail to comply with section 409A. Because the proposed regulations generally base section 409A income inclusion on whether the plan terms comply with section 409A in the year in which the deferred compensation ceases to be subject to a substantial risk of forfeiture, the rules generally permit correction of non-compliant plan document terms before the year in which the substantial risk of forfeiture lapses.
- Restrict the ability to change a time or form of payment to circumstances when (1) there was a reasonable, good faith basis to believe that the original provision was not permitted under section 409A, and (2) the correction to change payment form or timing is necessary to bring the arrangement into compliance with section 409A;
- Add examples of the types of facts that would indicate a violation of the anti-abuse rule; and
- Specify that if there is a particular correction method that would apply in any generally applicable plan document correction guidance, such as Notice 2010-6, that method must be followed.
Sutherland Observation: The modifications to the proposed regulations effectively foreclose using the unvested deferred compensation rule to make time or form of payment changes to a compliant deferred compensation arrangement.
Employee to Independent Contractor – Separation from Service. The final regulations provide that an employee generally has a separation from service when the employee and employer reasonably expect the employee’s services to permanently decrease to 20% or less than the average services provided before the change (the 20% Test). The final regulations provide that an independent contractor has a separation from service when the contractual relationship is completely terminated (the Contractual Relationship Test).
The proposed regulations clarify that when an employee becomes an independent contractor, the 20% Test applies to determine whether a separation from service has occurred. The preamble to the proposed regulations further notes that if there is not a separation from service upon the initial change to independent contractor status, a subsequent separation from service only occurs when the Contractual Relationship Test has been satisfied.
Sutherland Observation: The separation from service rules applicable for a change from employee status to independent contractor status are often critical when structuring executive post-employment consulting relationships, and the clarifications in the proposed regulations offer helpful insight into how the IRS views the analysis.
“Payment” for Section 409A Purposes. The final regulations stated various rules for determining the timing of when a “payment” has been made depending on the type of taxable event. The proposed regulations are intended to provide uniformity, providing that a payment for the purposes of section 409A is considered to have been made at the time that it results in taxable income to the employee for the then-current taxable year.
Sutherland Observation: One significant impact of this change is that it makes clear that replacing a cash payment of deferred compensation with a payment in the form of restricted stock or options would generally violate section 409A, because the amount would not be considered to be paid for section 409A purposes until the restricted stock becomes vested or the options are exercised.
Other Changes, Corrections and Clarifications
The proposed regulations make a number of changes and clarifications that apply in limited circumstances. These items include the following:
- The short-term deferral exception is expanded to take into account a delay in payments to avoid violating federal securities law or other applicable law.
- The final regulations include a general rule that options and similar stock rights are not excluded from section 409A if they are based on stock that includes a mandatory repurchase right or permanent put or call right at a stock price other than fair market value. The proposed regulations permit a repurchase, put or call to be based on a measure that is less than fair market value in the case of a for-cause termination or similar circumstances.
- Under the final regulations, it appeared that an option or similar stock right was exempt from section 409A only if the employee is employed by the employer at the time the option or stock right is granted; the proposed regulations provide that an option or stock right can also be exempt from section 409A if the grant occurs within 12 months before the employee commences employment.
- The involuntary separation pay exception (i.e., the two-times base pay or section 401(a)(17) limit rule) is clarified to provide that the exception can apply even if the employee had no compensation from the employer in the preceding year, such as an employee hired and fired in the same year.
- An arrangement for reimbursement or payment of legal expenses is generally not treated as a deferral of compensation.
- A deemed asset sale under Code section 338 is treated as a stock sale for purposes of the separation from service rules; accordingly, the parties cannot use the provision of the section 409A regulations that generally allows the parties to choose whether there is a separation from service in connection with an asset sale.
- The final regulations provide that a “service provider” can be an entity as well as an individual. The proposed regulations make conforming changes to various provisions consistent with this rule.
- An incorrect cross-reference to a provision of the bankruptcy law is deleted in the provisions of the regulations addressing acceleration of payments upon a corporate dissolution.
- The proposed regulations expand the special rules for recurring part year compensation, previously addressed under Notice 2008-62, thus permitting annualized pay for additional teaching positions (e.g., certain college and university faculty positions) without triggering section 409A.
- The final regulations contain special rules permitting flexibility in the timing of payment of certain stock-based deferred compensation in connection with a corporate or similar transaction. The proposed regulations clarify that the transaction-based compensation rules are also available with respect to statutory stock options and exempt options or stock rights.
- A plan subject to section 409A may be amended to add the death, disability or unforeseeable emergency of a beneficiary as potential earlier alternative payment events for beneficiaries who have become entitled to payment due to an employee’s death. Previously this rule only applied to employees, not beneficiaries. In addition, the proposed regulations clarify that a schedule of payments to an employee or a beneficiary that has already commenced to be paid may be accelerated upon the employee’s or beneficiary’s subsequent death, disability or unforeseeable emergency.
- Under the final regulations, the exception for accelerations of the time or schedule of a payment for foreign conflicts of interest covered only foreign earned income that was earned within the country promulgating the law. Under the proposed regulations, such accelerations are permissible if they are reasonably necessary to comply with a bona fide foreign ethics or conflicts of interest law.
- The rule allowing a plan termination in connection with a corporate transaction is clarified to explain that if a section 409A plan is terminated, the employer must terminate all plans of the same type as the terminated plan, not just the plan or plans in which the affected employees participated.
- Under the final regulations, offset provisions for an employee’s debts to an employer were generally not permitted, subject to a de minimis exception. The proposed regulations expand this exception, permitting plan provisions that allow offset to the extent reasonably necessary to comply with federal debt collection laws.
- The proposed regulations clarify that section 409A applies to the deferred compensation plans of nonqualified entities separately and in addition to section 457A.
The proposed regulations will become effective only after they are finalized, but in the meantime taxpayers may rely on their provisions. Although the modified language is not effective until finalized, proposed regulation language that merely clarifies current Treasury and IRS interpretations of existing language should be treated as already in effect.
The Treasury Department has requested comments on the proposed regulations by September 20, 2016.
Section 457(f) Proposed Regulations
The IRS issued proposed regulations under section 457(f) at the same time as the section 409A proposed regulations. Section 457(f) covers certain deferred compensation arrangements of state and local governments and tax-exempt entities. The section 457(f) proposed regulations overlap and interact with the section 409A regulations in a number of ways, and covered entities should consider both section 457(f) and section 409A in structuring and operating deferred compensation arrangements.