Section 409A of the Internal Revenue Code of 1986 imposes additional income taxes on employees1 who participate in nonqualified deferred compensation plans that fail to meet the requirements of Section 409A, either because the plan fails to contain the required provisions or because the plan is not operated according to the statutory requirements. The Treasury Department and the Internal Revenue Service issued final regulations in April 2007 covering many aspects of Section 409A, such as the types of plans and arrangements that fall within the ambit of Section 409A and the documentary and operational requirements of Section 409A. These regulations do not, however, provide guidance on the consequences of violating Section 409A.
Although there continues to be no obligation for employers and other service recipients to report deferrals of compensation that comply with Section 409A, employers and other service recipients are currently required to report, and employers are required to withhold income taxes on, amounts includible in income by employees due to a violation of Section 409A.
On December 5, 2008, the Treasury Department and IRS issued proposed regulations describing the method for determining the amount includible in income, and the additional 20 percent income tax and premium interest tax applicable to such amount, in the event a plan fails to comply with the documentation or operational requirements of Section 409A. The IRS and Treasury also issued later in December 2008 Notice 2008-115 which provides interim guidance on income inclusion under Section 409A and income tax reporting and withholding.2 Until the proposed regulations are finalized and become effective, employers may comply with either Notice 2008-115 or the proposed regulations concerning these matters.
These proposed and interim rules clarify a number of uncertainties that exist under the statute concerning how the additional tax imposed for a Section 409A violation is calculated (and related reporting and withholding obligations). This article summarizes some aspects of these rules.
Employers should also be aware that the IRS has established a program for correcting failures to operate nonqualified deferred compensation plans in compliance with Section 409A, as described in the July 2009 issue of White & Case Executive Compensation, Benefits, Employment and Labor Focus.
Proposed regulations on Section 409A income inclusion and additional taxes
Under the proposed regulations, the amount includible in the income of an employee who participates in a nonqualified deferred compensation plan that fails to comply with Section 409A is determined using the following steps:
Step 1: As of the last day of the employee’s taxable year in which the failure occurs, determine the total amount deferred under the plan (and all similar plans of the employer under the Section 409A plan aggregation rules), which includes: (a) amounts deferred in the current and all prior years, and (b) any deferred amounts paid to the employee during the year of the failure;
Step 2: subtract any deferred amounts that are subject to a substantial risk of forfeiture (“unvested”) as of the end of the year, and
Step 3: subtract any deferred amounts that have been taxed in a previous year. This previously taxed amount is reduced to reflect payments made under the plan in previous years, since those payments also reduce the total amount deferred after the year of payment.
This amount includible in income under Section 409A is subject to two types of additional income taxes (on top of income taxes at ordinary income tax rates): (1) a 20 percent additional income tax, plus (2) a premium interest tax on hypothetical tax underpayments beginning with 2005.
Penalties only apply in year of Section 409A violation
Each taxable year is analyzed independently to determine if there was a failure to comply with Section 409A. Therefore, a Section 409A violation under a plan in a prior year generally will not result in a Section 409A income inclusion under the plan in a subsequent year in which the plan complies with Section 409A, even if total deferrals at the end of a subsequent year include unpaid deferrals from the earlier year in which the Section 409A violation occurred.3 Although each year is analyzed independently to determine whether amounts are includible in income, if there are Section 409A violations in multiple years (for example, as a result of a documentary failure retained in the plan over multiple years or operational failures that occur in multiple years), amounts included in income under Section 409A in one year are treated as amounts previously included in income for purposes of all later non-compliant years so that no deferred amount is ever includible in income twice under Section 409A.
Assume an employee makes fully vested deferrals under a plan during each of three years. Assume further that the plan violates Section 409A during each of the three years, and that these violations are discovered at the end of Year 3. Rather than including in the employee’s Year 3 income the total amount deferred at the end of Year 3, the employee must include in income for each of the three years the total amount deferred at the end of that year, less amounts included in income under Section 409A under the plan for the previous years.
Under the proposed regulations, an employee is not required to include in income deferred amounts that are unvested at the end of a taxable year in which a noncompliant deferral or acceleration occurs. According to the preamble to the proposed regulations, upon vesting in a later year in which the plan complies with Section 409A, those deferred amounts would not be includible in income under Section 409A as a result of the prior violation. Where an employee has both vested and unvested deferrals under a plan (including any other similar plan of the employer aggregated with that plan under the Section 409A plan aggregation rules) in the year of a Section 409A violation, it appears that the employee would include the vested deferrals in income under Section 409A but would not include the unvested deferrals in income under Section 409A so long as the plan complies with Section 409A in the year those unvested deferrals vest.
Interestingly, the proposed regulations’ and the preamble’s description of the treatment of unvested deferrals suggest that a plan document that violates Section 409A may be corrected without additional taxes under Section 409A to the extent that deferrals under the plan are unvested and do not become vested during the taxable year of the correction.
Assume that, during 2009, an employee is party to a change in control agreement that provides for a “single trigger” payment upon a change in control of his employer. The agreement’s change in control definition does not comply with the Section 409A change in control event definition. A change in control has not occurred. During 2009, the parties amend the agreement to include a Section 409A-compliant change in control definition. So long as a change in control does not occur during the remainder of 2009, it appears that the employee should not be subject to additional taxes under Section 409A due to the agreement’s violation of Section 409A following December 31, 2008, which was the end of the transition period for amending documents to comply with Section 409A. This is because the employee’s right to the payment does not vest until the change in control occurs.
Significantly, the proposed regulations have an anti-abuse rule to prevent employers and employees from using this approach to avoid the requirements of Section 409A, for example by allowing employees to routinely make late deferral elections for unvested compensation. This rule would authorize the IRS to treat unvested deferrals as vested (and includible in income under Section 409A) where the facts and circumstances indicate that an employer has a pattern or practice of permitting operational violations of Section 409A.
Uncertainties remain, however, concerning the proposed regulations’ and the preamble’s approach to unvested deferrals as illustrated by the following example.
Assume that in Year 1, an employee’s outstanding deferrals under an account balance plan (with which no other plans are aggregated) are fully unvested and payable in Year 3. In Year 1, the employee makes an impermissible deferral election to extend payment of those unvested deferrals from Year 3 to Year 5. No amount is includible in income under Section 409A in Year 1 because all deferrals are unvested in that year. To avoid any amount being includible in income under Section 409A in any future year, it is not clear whether the employer is required to ignore the impermissible deferral election and pay the deferrals in Year 3 or whether deferrals should be paid in Year 5 in accordance with the further deferral election.
Determinations made as of last day of taxable year
The total amount deferred for a taxable year and the portion thereof that is unvested are determined as of the last day of the employee’s taxable year and are not affected by when a Section 409A violation occurs, relative to any vesting, payments or deferrals under the plan, during that year.
Assume a plan fails to comply with Section 409A due to an operational failure on July 1 of a taxable year, and an employee’s deferred amount initially vests on October 1 of that taxable year. The employee’s total amount deferred under the plan as of the last day of that year would be includible in income under Section 409A.
Assume an employee receives a payment equal to her entire benefit under a plan on February 1 of a taxable year. On July 1 of that year, the plan is operated in a manner that fails to comply with Section 409A. The employee’s total amount deferred under the plan for that year includes this payment and is includible in income under Section 409A.
Assume that an impermissible accelerated payment is made under a plan to an employee on February 1 of a taxable year. The employee makes salary deferrals for periods after February 1 of that year under a deferral election that complies with Section 409A. Those deferrals would be required to be included in the employee’s total amount deferred under the plan for that year and included in income under Section 409A.
Calculation of total amount deferred
In general, the total amount deferred under a plan for a taxable year is the sum of (a) the present value of the future payments to which the employee has a legally binding right under the plan as of the last day of the taxable year, plus (b) any payments from the plan to the employee during such current taxable year.
The present value of future payments is determined by discounting payments according to an assumed interest rate and using reasonable actuarial assumptions and methods. If any actuarial assumption or method is not reasonable, as determined by the IRS, then the total amount deferred is determined using the applicable federal rate (based on annual compounding for the last month of the taxable year for which the amount includible is being determined) and, if applicable, the applicable Section 417(e) mortality table. Generally, payments can be discounted to reflect the possibility of nonpayment, such as the employee’s death prior to payment. However, the following cannot be taken into account in determining the present value of future payments:
- the risk that payments will not be made due to adverse investment experience, the employer’s unwillingness or inability to pay, future changes to the plan or law or similar risks or contingencies;
- payment restrictions that will or may lapse with the passage of time but which do not result in a substantial risk of forfeiture (such as a noncompetititon covenant); and
- any potential deferrals based on the employee’s performance of future services.
Account balance plan
For an account balance plan, the total amount deferred for a taxable year is generally the sum of (a) the employee’s account balance as of the last day of such year (including net earnings or losses credited through the last day of the year), plus (b) any payments from the plan to the employee during such current taxable year. If a plan violates Section 409A during two taxable years, notional earnings in the later year on deferrals that were includible in income under Section 409A in the earlier year are includible in income under Section 409A in the later year. Contrast this treatment with the FICA rules, under which income on deferrals that were taken into account as FICA wages in a prior year is exempt from FICA.
However, if earnings under the plan are based on an unreasonably high interest rate, the estimated present value of those future earnings is includible in the total amount deferred for the current year. Further, if earnings are based on a rate of return that does not qualify as either a reasonable interest rate or a return on a predetermined actual investment, then the estimated value of those future earnings is determined under the rule for “formula amounts” (described below at “Reimbursements, in-kind benefits and other uncertain future payments”) and added to the total amount deferred for the current year. The schedule for crediting earnings will generally be respected if the earnings are credited at least once a year.
As long as compensation is paid within two-and-one-half months after the end of the year in which the employee’s right to the compensation vests (the “short-term deferral period”), and the plan under which the compensation is paid does not provide for payment upon an event that will or may occur after the short-term deferral period, that compensation is exempt from Section 409A. Whether an amount is treated as a short-term deferral or as deferred compensation may not be known as of the last day of a taxable year because that determination may depend on whether the amount is in fact paid by the end of the short-term deferral period. An employee’s right to a payment that, as of the end of a taxable year, may or may not be a short-term deferral under the terms of the plan and the facts and circumstances is not included in the total amount deferred for that year. If this amount is not in fact paid by March 15 of the next year, it would be includible in the total amount deferred for that next year (in the event of a Section 409A violation in that next year).
Assume that during Year 1, an employee is entitled to a bonus with no specified payment date that would qualify as a short-term deferral if paid on or before March 15 of Year 2. That bonus would not be included in the total amount deferred for Year 1 under any circumstances. If that bonus is not in fact paid by March 15 of Year 2, the bonus would be included in the total amount deferred for Year 2 and includible in income under Section 409A for Year 2 because the bonus would constitute nonqualified deferred compensation without a specified payment date, as required by Section 409A.
Alternative times and forms of payment and payment triggers based on events
Where deferred amounts may be payable in alternative times and forms of payment or upon the occurrence of future triggering events, the present value of these amounts is calculated based on assumptions and rules provided in the proposed regulations.
Amounts that could be payable in alternative times and forms of payment under a plan are treated as payable at the time and in the form with the highest present value. An alternative time and form of payment can be disregarded for this purpose if:
- the employee must continue to work past the end of the year
- to be eligible for such alternative, or
such alternative is available only at the employer’s discretion, unless the employee has a legally binding right to any additional value that would be generated by the employer’s exercise of such discretion.
If an employee has elected a time and form of payment, or payments to an employee have already started, and neither the employee nor the employer can change the time and form of payment without the other’s consent (and the consent requirement has substantive significance), then no other time and form of payment is treated as available. An employee’s status as of the last day of the taxable year is assumed to continue in the future for purposes of determining the availability of any alternative time and form of payment that is conditioned on such status as of a future date unless such status-based requirement is not bona fide or does not serve a bona fide business purpose (marital status, parental status or status as a US citizen or lawful permanent resident is presumed for this purpose to be bona fide).
If an amount may be payable upon a triggering event that has not occurred by the end of the current taxable year, the event is generally assumed to occur at the earliest possible time that the conditions to payment reasonably could occur based on the facts and circumstances as of the last day of the taxable year. In general, if payment is triggered by termination or reduction in an employee’s services, such event is generally treated as occurring as of the last day of the current taxable year. However, if a right to payment upon a particular payment triggering event (disregarding any other potential payment triggers under the plan) is considered unvested, then that triggering event is disregarded.
If an amount otherwise payable to an employee on January 1, 2010, so long as he continues to work through that date, is also payable upon an earlier involuntary separation from service, the right to a payment upon involuntary separation from service is disregarded and the amount is treated as payable on January 1, 2010 only.
A payment trigger that is an unforeseeable emergency is also disregarded. The preamble to the proposed regulations states that it would not be necessary to make assumptions concerning amounts payable on an employee’s death or disability because any additional value due to the employee’s death or disability generally would be treated as payable under a death benefit plan or a disability benefit plan, which generally are exempt from the rules of Section 409A.
Reimbursements, in-kind benefits and other uncertain future payments
If amounts payable in future years under a plan depend on factors that are not determinable at the end of the current taxable year, after taking into consideration all of the assumptions and calculation rules in the proposed regulations, those amounts must be determined using reasonable, good faith assumptions and the facts and circumstances as of the end of the current year in calculating the total amount deferred for such year. By contrast, for FICA purposes, deferrals under a plan need not be taken into account until their value is reasonably ascertainable. This rule would not apply to amounts that are based on information that exists, but is not readily available, at the end of a taxable year.
This rule would apply to an employee’s right to receive future payments equal to one percent of an employer’s net profits over the next five calendar years. By contrast, this rule would not apply to a deferred amount based on the employer’s net profits for the current taxable year because the information necessary to determine the employer’s profits exists at the end of the current taxable year, even if that information is not immediately accessible.
This rule also does not apply to a right to payment based on the value of a predetermined actual investment, such as a specified number of shares of employer stock. If changed facts and circumstances in a later year indicate that the amount payable is likely to be different from the estimated amount includible under Section 409A in an earlier year, the estimated amount may still have been reasonable, and the increase or decrease due to changed circumstances would be treated as earnings or losses on the deferred amount (so that if the actual amount payable is higher than the amount previously taxed under Section 409A, that increase is not also taxed under Section 409A).
The total amount deferred under an arrangement providing for in-kind benefits or reimbursements or direct payments for in-kind benefits is the maximum amount that reasonably could be expended and reimbursed. Where an arrangement prescribes the maximum amount of expenses that may be reimbursed, that maximum amount is presumed to be reimbursed at the earliest possible times such expenses may be incurred under the arrangement. An employee may rebut this presumption by clear and convincing evidence that it is unreasonable to assume that the employee would expend the maximum amount of expenses eligible for reimbursement. This presumption does not apply to reimbursement of medical expenses. Once an employee incurs an expense subject to reimbursement, the total amount deferred is the amount incurred (and is no longer treated as a formula amount).
Stock options and stock appreciation rights
In general, stock options and stock appreciation rights (“SARs”) are exempt from Section 409A if they are granted with an exercise price at least equal to the fair market value of the underlying stock on the grant date and do not have any additional deferral features. An option or SAR that does not fall within this exemption is subject to Section 409A. If a non-exempt option or SAR violates Section 409A (which will typically be the case unless the option or SAR was intentionally structured to comply with Section 409A), and is outstanding at year end, the total amount deferred is the “spread” (or intrinsic value) of the option or SAR as of the end of the taxable year. Accordingly, for an outstanding stock option or SAR, the total amount deferred is the underlying stock’s fair market value on the last day of the taxable year less the exercise price (and less any amount paid for the option or SAR). If an option or SAR is exercised during the year, the payment amount, for purposes of calculating the total amount deferred for the year, is the excess of the fair market value of the stock on the exercise date over the exercise price (less any amount paid for the option or SAR).
Split-dollar life insurance arrangements
The total amount deferred under a split-dollar life insurance arrangement is determined under the income inclusion rules of the applicable split-dollar life insurance rules: Section 1.61-22 (endorsement method) or 1.7872-15 (loan method) of the Treasury Regulations. For arrangements that were entered into on or before September 17, 2003, and are not subject to these regulations, the total amount deferred is determined under Notice 2002-8 and any other applicable guidance.
Additional 20 percent and premium interest taxes
As described above, the amount includible in income under Section 409A for a taxable year is the total amount deferred (as of the last day of such year) less the sum of any unvested amounts and any amounts included in income in a previous year. The ordinary income tax due on this amount is increased by two additional income taxes: (1) a 20 percent additional income tax, plus (2) a premium interest tax on hypothetical tax underpayments beginning with 2005.
The premium interest tax applies to amounts that are includible in income under Section 409A in the current taxable year but which first became vested in a previous year. The premium interest tax is the amount of interest at the underpayment rate (under Section 6621), plus one percent, on the tax underpayment (“hypothetical underpayment”) that would have occurred had the deferred compensation been includible in the employee’s income in the year in which such compensation was first deferred or, if later, first vested. The proposed regulations describe the method (summarized below) by which the premium interest tax would be calculated. The preamble to the proposed regulations notes that calculating the premium interest tax may be cumbersome and solicits comments on appropriate safe harbor calculation methods.
(1) Determine the amount of deferrals subject to premium interest tax.
This is the total amount deferred and vested, and not includible in income in any previous taxable year, as of the end of the taxable year in which the Section 409A violation occurs (i.e., the amount required to be included in income under Section 409A, as described above). Note that this amount may be less than amounts deferred under the same plan in previous years due to payments or deemed investment or other losses in previous years.
(2) Allocate this amount to the year or years (beginning with 2005) in which it was initially deferred or vested.
In general, the amount initially deferred and vested during a particular taxable year is the excess (if any) of the vested total amount deferred for that year over the vested total amount deferred for the immediately preceding year. Amounts are only allocated to taxable years after 2004, and no amount is allocated to the year in which the Section 409A violation occurs because there is no hypothetical underpayment for that year. Any payments, deemed losses and previously taxed amounts are treated as coming from the oldest vested deferrals first, i.e., a “first-in-first-out” basis. This will generally result in a lower premium interest tax than other possible allocation methods.
The proposed regulations provide rules for determining the years during which the amount required to be included in income was first deferred or vested. The following example illustrates these rules.
Assume that an employee has fully vested deferrals and payments in Years 1, 2, 3 and 4 under a plan as shown below. Assume further that the vested total amount deferred in Year 4, US$300,000, is includible in the employee’s income under Section 409A due to a violation occurring in Year 4. No deferrals are includible in income until Year 4, except for payments made to the employee. Based on these facts, the amount includible in income in Year 4 is allocated to, and treated as first deferred in, the years shown in the last row below.
(3) Determine the hypothetical tax underpayment that would have resulted had such amounts been includible in income during that year.
A hypothetical tax underpayment is calculated for each taxable year as if the deferral allocated to such year in (2) above were additional taxable income paid to the employee in cash during such year. The hypothetical underpayment is calculated based on the employee’s taxable income, credits, filing status and other information for such year from the employee’s original or amended tax return for such year, with any IRS audit adjustments. The hypothetical underpayment reflects only the effects of the hypothetical additional income on the amount of federal income tax owed by the employee for such year, including, for example, the availability of deductions. Assumptions as to the potential effects of this hypothetical additional compensation that were not taken into account in the employee’s tax return, such as that the employee would have contributed it to a tax-qualified savings plan, are not permitted.
(4) Determine interest that would be due on hypothetical underpayment using underpayment rate (Internal Revenue Code Section 6621) plus one percentage point through last day of taxable year of Section 409A inclusion.
Payment of amounts previously included in income under Section 409A
Deferred compensation that has been taxed under Section 409A is not taxed a second time when it is actually paid to (or would otherwise be includible in income by) an employee. This is accomplished by giving the employee a deemed “basis” or “investment in the contract” for deferred compensation previously taxed under Section 409A. In general, amounts previously included in income under Section 409A are immediately applied (on a first-in-first-out basis) to each payment under the plan (and all plans aggregated with such plan under the Section 409A plan aggregation rules) until all amounts previously included in income have been paid. Deemed earnings on amounts previously included in income under Section 409A are included in income when those earnings are paid (and they are subject to earlier inclusion if there is another Section 409A violation).
Forfeiture or loss of amounts already included in income
In some cases, an employee may never actually receive amounts he or she previously included in income under Section 409A. This may result, for example, from the employer’s inability (e.g., due to insolvency or bankruptcy) or unwillingness to pay, forfeiture (under a risk of forfeiture that does not qualify as a substantial risk of forfeiture, such as a noncompetition covenant), deemed investment losses or inclusion of a formula amount (as described above) that is greater than the amount ultimately paid. An employee is entitled to a deduction for the taxable year in which the employee’s right to all deferred compensation under a plan (and all plans aggregated with such plan under the Section 409A plan aggregation rules) is permanently forfeited under the plan’s terms or otherwise permanently lost. A mere diminution in the amount deferred under a plan due to deemed investment losses or actuarial reductions is not treated as a permanent forfeiture or loss if the employee retains a right to payment of any amount of deferrals under the plan (since those losses or reductions could be reversed in subsequent years).
An employee’s deduction upon permanent forfeiture or loss would be the amount previously included in income under Section 409A, less any such amount allocated to a previous payment under the plan. This deduction will not leave the employee in the same position as if the amount forfeited were never subject to Section 409A penalties for at least a couple of reasons. The deduction generally would be treated as a miscellaneous itemized deduction subject to applicable deduction limitations (only deductible to the extent that the employee’s total miscellaneous itemized deductions exceed two percent of his or her adjusted gross income (“AGI”), subject to an overall limitation on itemized deductions if the employee’s AGI exceeds a threshold amount, and denial of deduction for purposes of computing the additional tax based on alternative minimum taxable income). Even assuming the amount forfeited is fully deductible, this deduction would only offset income taxable at ordinary income rates and would not compensate the employee for the additional 20 percent income tax previously paid upon the Section 409A violation.
Reporting and withholding requirements for Section 409A income inclusions
Reporting and withholding requirements in general
Notices 2006-100 and Notice 2007-89 permanently waived all reporting of deferrals that comply with Section 409A for 2005, 2006 and 2007. Notice 2008-115 continues to waive all reporting of Section 409A-compliant deferrals until further guidance is issued. According to the preamble of the proposed regulations, the IRS anticipates that such reporting will:
- be implemented beginning with the first taxable year after the income inclusion regulations are finalized;
- be based on the principles in the final income inclusion regulations, except that deferrals will not be required to be reported until they are reasonably ascertainable, as described in the FICA regulations (note that the income inclusion rules would require deferrals that are not reasonably ascertainable to be determined using assumptions, as described in “Reimbursements, in-kind benefits and other uncertain future payments” above); and
- include earnings on amounts deferred in previous years, if the amount of such earnings is reasonably ascertainable.
Notice 2008-115 (extending previously applicable guidance) requires reporting of amounts includible in income under Section 409A (a) by employers on Form W-2 (box 1 (as wages paid to the employee) and box 12 (using code Z)) (such amounts must also be reported as wages paid on line 2 of Form 941), and (b) by non-employer service recipients on Form 1099-MISC (boxes 7 (nonemployee compensation) and 15b (Section 409A income)). Employers must treat amounts includible in an employee’s income under Section 409A as wages subject to income tax withholding. The notice provides that such amounts are treated as “supplemental wages,” regardless of whether the employer has paid the employee any regular wages during the current year, for purposes of determining the amount of income tax withholdings. Employers can withhold income tax from supplemental wages at a flat 25 percent rate (however, if an employee’s supplemental wages for the current calendar year exceed US$1,000,000, the excess is subject to withholding at a 35 percent rate). According to the notice, no additional withholding is required for the additional 20 percent and premium interest income taxes imposed under Section 409A. Employees and nonemployees should be aware that estimated tax payments may be required to avoid additional taxes under Section 6654 of the Internal Revenue Code.
Calculation of income includible under Section 409A
Notice 2008-115 provides interim guidance on the calculation of amounts includible in income under Section 409A that follows principles similar to the more detailed rules of the proposed income inclusion regulations described above. Under the notice, like the proposed regulations, the amount includible in income under Section 409A for a year is the portion of the total amount deferred under the plan (using the plan aggregation rules) that, as of December 31 of such year, is not subject to a substantial risk of forfeiture and has not been included in income in a previous year, plus any deferrals paid during such year.
For deferrals under a plan that is not one of the following: an account balance plan, a nonaccount balance plan where the amount deferred is reasonably ascertainable, or stock options/SARs, the amount deferred as of December 31 of a calendar year must be determined under a reasonable, good faith application of a reasonable, good faith method (including reasonable, good faith assumptions, if applicable). An assumption with respect to a contingency that results in the lowest potential value of future payments is presumptively not a reasonable, good faith assumption, but this presumption can be rebutted by clear and convincing evidence that such assumption is reasonable.
Wage payment dates of income includible under Section 409A
For purposes of income tax withholding and reporting, amounts that are both includible in income under Section 409A and actually paid to the employee during the year are considered a payment of wages by the employer when paid to the employee. Amounts that are includible under Section 409A but not actually paid to the employee during the year are treated as a payment of wages on December 31 of such year. An employer that has an income tax withholding obligation for amounts includible under Section 409A by an employee, but not actually paid to the employee, may not have a readily available means to satisfy this obligation (especially in the case of a former employee who is not receiving actual wage payments). Under the notice, employers may satisfy any Section 409A withholding requirements by either (1) withholding required amounts from the employee’s pay by January 31 of the next taxable year or (2) paying the withholding tax on behalf of the employee and reporting such payment as additional compensation to the employee, and withholding applicable taxes from such payment.
Amounts includible in income under Section 409A(b)
The notice also addresses the wage reporting and withholding requirements that apply to amounts includible in income under Section 409A(b), which generally triggers additional income taxes when assets to pay nonqualified deferred compensation are set aside in a trust or other arrangement outside the US, when a plan provides that assets will be restricted to providing benefits under the plan in connection with a change in the employer’s financial health or when assets are set aside for, or restricted to, payment of benefits under a nonqualified deferred compensation plan during a “restricted period” with respect to a single-employer defined benefit pension plan with the employer’s controlled group. To date, no regulations (proposed or otherwise) have been issued concerning the funding limitations of Section 409A(b). Amounts taxable under Section 409A(b) that are not eligible for relief under Notice 2006-33 5 are treated, for income tax reporting and withholding purposes, as wages paid on the date the deemed transfer of property described in Section 409A(b) would be taxed under Section 83 of the Internal Revenue Code. Under Notice 2007-78, if an arrangement was potentially eligible for relief under Notice 2006-33 but was not made compliant with Section 409A(b) by December 31, 2007, the date of the deemed transfer of property is January 1, 2008.
Effective Dates; protection from future additional reporting or withholding
The preamble indicates that the proposed regulations on income inclusion will not be effective earlier than the taxable year following the year in which the regulations are finalized. Until further guidance is issued, in calculating amounts includible in income under Section 409A, taxpayers may comply with either all of the provisions of Notice 2008-115 or all of the provisions of the proposed regulations (but not part of the notice and part of the proposed regulations).
As noted above, the Treasury and the IRS anticipate that annual reporting of Section 409A-compliant deferrals will be required beginning with the first taxable year for which the proposed regulations are finalized and effective. The IRS has informally indicated that annual deferral reporting may be implemented as early as 2010.
Employers and payers that comply with Notice 2008-115 will not be liable for additional income tax withholdings or penalties, or be required to file or furnish corrected returns or statements, as a result of future guidance.