Following the recent presidential election, tax professionals are busy analyzing predicted (and hoped for) tax reform proposals, including the potential reduction in the top marginal rates for individuals. Obviously it is unclear whether and when rates will be reduced, if at all, and how soon thereafter rates may creep up again.
Tax rate proposals invariably lead to discussions relating to the timing of compensation payments, including payments with respect to existing arrangements. A reduction in the top marginal rate, not to mention the potential repeal of the surtax imposed on wages and certain self-employment income under Obamacare, can significantly enhance a service provider’s after-tax compensation. On the other hand, compensation expense deductions could become less valuable from the service recipient’s perspective.
Planning for, or altering, the timing of compensation payments, such as by potentially deferring from a current year to the following year (depending on the effective date of a rate reduction) must be carefully vetted under the nonqualified deferred compensation rules of section 409A of the IRS Code. As outlined below, section 409A limits the ability to either delay or accelerate scheduled compensation payments. This article is intended as a cautionary note with respect to the section 409A issues that must be considered before altering the timing of compensation payments.
Section 409A: In General
Section 409A generally provides that if a nonqualified deferred compensation arrangement fails to meet certain requirements, compensation deferred under the arrangement must be included in the service provider’s taxable income at the first time the deferred amount is no longer subject to a substantial risk of forfeiture (i.e., the amount is taxable when the compensation first vests regardless of when paid). Deferral arrangements that violate section 409A also result in an additional tax of 20 percent on the service provider (which is in addition to the service provider’s regular federal income taxes), and in certain cases can result in an interest toll-charge.
A service provider is broadly defined for these purposes to include an individual or an entity performing services as an employee, and also includes certain independent contractors.
Deferral of Compensation
Section 409A applies broadly to any nonqualified plan or arrangement providing for the deferral of compensation. The US Department of Treasury regulations under section 409A (the 409A Regulations) state that a plan or arrangement generally provides for the deferral of compensation if, under its terms and the relevant facts and circumstances, a service provider has a legally binding right arising during one taxable year to compensation that is or may be payable to (or on behalf of) the service provider in a later tax year. As a result, section 409A extends beyond traditional deferred compensation programs and can apply to bonus arrangements, severance compensation, SERPs and change of control and retention arrangements, to name a few. An exception from certain—but not all—of the section 409A requirements is provided for in the case of short-term deferrals providing for payment no later than 2.5 months following the end of the tax year in which vesting occurs.
Importantly, equity arrangements that are subject to section 83 (such as restricted stock awards and profits interests) are outside of section 409A. Stock options, however, as well as contractual equity-based compensation arrangements, such as stock units and stock appreciation rights, are subject to section 409A (although options and stock appreciation rights are potentially eligible for the stock-rights exception to section 409A).
Section 409A Requirements In order for a nonqualified deferral arrangement to avoid the penalties imposed by section 409A, the following 409A Requirements must be met:
- Permissible Distribution Events. Compensation deferred under the arrangement may not be paid any earlier than upon the occurrence of one or more of the following “Permissible Distribution Events” (as defined): (1) termination of the service provider’s service relationship; (2) the service provider’s disability; (3) the service provider’s death; (4) at a specified time or pursuant to a fixed schedule specified at the time the arrangement is entered into; (5) upon a change in the ownership or effective control of the service recipient, or in the ownership of a substantial portion of its assets; or (6) upon the occurrence of an unforeseeable emergency.
- No Provisions for the Acceleration of Payments. The arrangement may not permit the acceleration of the time or schedule of any payment thereunder, except as permitted in the regulations.
- Timing of Elections. If elections are made by a service provider with respect to the deferral of compensation and/or with respect to the form or timing of any payments thereunder, such elections must be made in accordance with the timing of election requirements of section 409A.
- Rabbi Trusts. If a nonqualified deferred compensation arrangement is funded with a rabbi trust, certain limitations are imposed on the terms of the trust itself.
Note that the 409A Regulations restrict the time period within which a payment must be made following the designated payment event by providing that if a payment is scheduled to be made within a designated period following the occurrence of the specified event, the period must be objectively determinable and nondiscretionary at the time the event occurs and must either (1) begin and end within the same taxable year of the service provider, or (2) be limited to not more than 90 days following the event and the service provider cannot have a right to designate the taxable year of payment.
Although much of the focus of section 409A is on deferrals, an anti-acceleration rule generally prohibits making payments earlier than the time at which they are otherwise scheduled to be paid. The anti-acceleration rule may be a critical roadblock to altering the timing of compensation payments in many cases.
The 409A Regulations include 13 limited exceptions to this anti-acceleration rule. One important exception that may become a focal point for planning in connection with a rate reduction is the plan termination exception, which is subject to the following requirements:
- The plan termination does not occur proximate to a downturn in the financial health of the service recipient;
- The service recipient terminates all agreements, methods, programs and other arrangements sponsored by the service recipient that would be “aggregated” with any terminated and liquidated agreements, methods, programs and other arrangements under the 409A Regulations;
- No payments in liquidation of the terminated plan are made within 12 months of the date the service recipient takes all necessary action to irrevocably terminate and liquidate the plan (except for payments that would otherwise be made if the termination had not occurred);
- All payments with respect to the terminated plan are made within 24 months of the date the service recipient takes all necessary action to irrevocably terminate and liquidate the plan; and
- The service recipient does not adopt a new (successor) plan that would be aggregated with any terminated and liquidated plan under the 409A Regulations within three years following the date the service recipient takes all necessary action to irrevocably terminate and liquidate the plan.
The 409A Regulations include strict limitations on the timing of deferral elections and the ability to alter elections once made.
Under the general initial deferral election rules, an election satisfies section 409A only if the election to defer compensation for services to be performed during a service provider’s taxable year is made—and becomes irrevocable—not later than the last day of the prior year. Limited relief from the timing of an initial deferral election is provided for in the case of certain qualifying performance-based compensation.
The 409A Regulations also provide rules for the timing of deferral elections with respect to short-term deferrals. Specifically, in the case of compensation that would otherwise meet the short-term deferral exception (absent an election to defer), a deferral election may be made in accordance with the further deferral requirements (described below), applied as if the scheduled payment date for the amount is the date the substantial risk of forfeiture lapses.
Further Deferral Considerations
Although much of the planning around the timing of compensation payments intended to take advantage of rate reductions may be focused on accelerating payments that are otherwise scheduled to be made in the future, any such planning must also be mindful of the fact that the 409A Regulations generally prohibit further deferrals beyond the tax year in which a payment is otherwise scheduled to be made. Note that there is a limited exception that provides that a payment will be treated as having been made at the time specified under the arrangement (and thus in compliance with section 409A) if the payment is in fact made at a later date within the same taxable year of the service provider or, if later, within 2.5 months following the date specified for payment and further provided that the service provider cannot be permitted, directly or indirectly, to designate the taxable year of payment. As such, this rule may, under the right circumstances, allow payment to be made in the tax year following the year in which the distribution event occurred.
The 409A Regulations also permit so-called further deferral elections, but only if the further deferral election is made at least one year prior to the date the first payment is otherwise scheduled to be made absent the new election, and the further deferral election must also result in payment being deferred for a period of not less than five years from the date such payment would otherwise have been paid.
Assuming tax rates may be lower over the next couple of years and then will increase again, it is likely that strategies will focus on causing compensation payments to be made during this window. As described above, these strategies will have to run the section 409A gauntlet, including in particular the anti-acceleration rules and the timing of election rules.
The other challenge to be addressed will be the balance between preserving (from the employer’s perspective) vesting and forfeiture conditions imposed on a variety of compensation arrangements while at the same time potentially allowing service providers to take advantage of rate reductions. Often these goals will be mutually exclusive. Employer’s also will have to factor in the “cost” of accelerating compensation payments to the extent the tax benefit of the related deduction is lower.