Recent IRS efforts have provoked renewed discussion of the legal regimes governing nonqualified deferred compensation plans. First, the IRS announced a small-scope audit project addressing Code section 409A (“409A”). Second, the IRS released Revenue Ruling 2014-18 addressing Code section 457A (“457A”). In view of these efforts, employers that provide nonqualified deferred compensation plans to their executives should understand both the guidance to date concerning 409A and 457A and areas for possible further development.
Code section 409A
- Treasury Regulations
Final Treasury regulations under 409A were issued in 2007 and became generally effective for tax years beginning on or after January 1, 2009 (the “Final Regulations”).
The Final Regulations outline the legal regime under 409A which imposes strict rules on the form and operation of nonqualified deferred compensation plans for U.S. taxpayers, along with immediate income inclusion and significant tax penalties for participants in noncompliant plans. This regime includes definitions of key concepts such as (1) nonqualified deferred compensation plan, (2) deferral of compensation, (3) substantial risk of forfeiture, (4) service provider, (5) service recipient, and (6) separation from service. It also includes requirements for initial and subsequent deferral elections and their interaction with elections under other employer plans and with other legal obligations such as domestic relations orders. Finally, it includes permissible payment events such as separation from service, unforeseeable emergency, and disability, as well as exceptions to the general prohibition under 409A on acceleration of payments.
The Final Regulations reserve two major areas for future guidance: calculation of income inclusion under 409A and funding of nonqualified deferred compensation plans. In 2008, the IRS issued proposed regulations which provide detailed rules for determining the amount includible in income due to failure to meet the requirements of 409A and the calculation of any additional taxes due with respect to the failure. Taxpayers may currently rely on these proposed regulations only to the extent provided in IRS Notices 2008-115 and 2010-6 which are discussed separately below.
Guidance regarding funding remains forthcoming. Until such time, pursuant to IRS Notice 2006-33 taxpayers may rely on a reasonable, good faith interpretation of the applicable provisions of 409A. While nonqualified deferred compensation plans for purposes of 409A will generally also constitute “top hat” plans which must be unfunded in order to comply with the Employee Retirement Income Security Act (“ERISA”), 409A includes its own funding rules which affect the use of rabbi trusts that could otherwise satisfy ERISA.
- Other IRS Guidance
Subsequent to the Final Regulations, the IRS issued Notices addressing three major compliance issues under 409A: operational failures, documentary failures, and wage withholding and reporting. Also, some guidance issued prior to the Final Regulations remains in effect with respect to specific issues.
The tax consequences of operational and/or documentary noncompliance with 409A can be severe for affected participants in nonqualified deferred compensation plans. In order to mitigate those consequences in certain situations, the IRS issued Notice 2008-113 with respect to operational failures and Notice 2010-6 with respect to documentary failures. (Both Notices were later modified by Notice 2010-80.) Notice 2008-113 provides correction mechanisms for operational failures such as failing to defer compensation or deferring compensation in excess of the agreed amount. Notice 2010-6 provides correction mechanisms for documentary failures such as impermissible payment events and impermissible definitions of otherwise permissible payment events. Taxpayers who timely follow the prescribed correction mechanism may obtain relief from the full application of the income inclusion and the additional taxes under 409A.
While the tax burdens of 409A fall primarily on the affected participants in nonqualified deferred compensation plans, determining the amounts to include in income and the proper withholding and reporting with respect to such amounts is the responsibility of the entity paying the compensation. IRS Notice 2008-115 provides interim guidance on these obligations. It also permits taxpayers to rely on the proposed income inclusion regulations discussed above when determining amounts includible in gross income and the taxes payable with respect thereto, provided the taxpayer complies with all the provisions of the proposed regulations.
Additional information and reporting guidance is available in IRS Notice 2005-1 which remains in effect with respect to specific issues not superseded by the Final Regulations. These issues include the application of 409A to arrangements of certain tax-exempt organizations and to arrangements between a partnership and a partner of the partnership.
- Case Law
To date, two court rulings have addressed 409A. Because of the dates of the applicable facts, both rulings are based on IRS Notice 2005-1, relevant portions of which have been superseded by the Final Regulations. The extent to which these rulings will be cited as authority in future decisions based on the Final Regulations therefore remains to be seen. Regardless, they are worth noting because they address areas which are likely to recur in litigation: income inclusion under 409A, what constitutes a substantial risk of forfeiture, and what if any exceptions to 409A apply to a given set of facts.
In Slater v. Commissioner, the Tax Court found that an independent contractor’s commissions were not subject to a substantial risk of forfeiture and thus had to be included in income under 409A. In Sutardja v. United States, the Court of Federal Claims found that discounted stock options constituted deferred compensation to which the plaintiff had a legally binding right for purposes of 409A. Further, the option term of up to ten years precluded the application of the short-term deferral exception to 409A even when the plaintiff exercised the option within two-and-a-half month period for short-term deferrals.
Code section 457A
No final or proposed Treasury regulations exist under 457A which applies to the nonqualified deferred compensation plans of nonqualified entities such as employers in certain offshore jurisdictions. The IRS has indicated informally that proposed regulations are unlikely to be issued in the near future. Pending further guidance which the IRS has stated will be prospective only, taxpayers may rely on IRS Notice 2009-8 which consists of a series of questions and answers addressing topics including (1) the effective date of 457A, (2) when compensation is includible in income, (3) what constitutes a substantial risk of forfeiture, (4) what constitutes a short-term deferral, (5) which entities are subject to 457A, and (6) the interaction of 457A and 409A.
Taxpayers may also rely on Revenue Ruling 2014-18 which amplifies portions of IRS Notice 2009-8 with regard to nonstatutory stock options and stock appreciation rights. Specifically, Revenue Ruling 2014-18 provides that (1) a nonstatutory stock option exempt from 409A is exempt from 457A, (2) a stock appreciation right exempt from 409A that at all times by its terms must be settled, and is settled, in service recipient stock is exempt from 457A, and (3) a stock appreciation right that may be or is settled other than in service recipient stock is not exempt from 457A, regardless of whether the stock appreciation right is a nonqualified deferred compensation plan for purposes of 409A.
409A and 457A are complex legal regimes for which formal guidance continues to develop. This client alert summarizes areas of existing and potential future guidance.