By December 31, 2008, all nonqualified deferred compensation arrangements subject to Section 409A of the Internal Revenue Code must be formalized in a written document that complies with Section 409A and the authority thereunder. If such an arrangement fails to satisfy the documentary compliance requirements of Section 409A, the vested benefits of employees and other service providers participating in the arrangement may become subject to adverse tax consequences, including:
- Accelerated taxation
- An additional 20 percent federal income tax
- Interest at the underpayment rate plus an additional one percent.
Background on Section 409A
Section 409A generally provides that vested amounts deferred under a nonqualified deferred compensation arrangement are currently includible in taxable income, unless the arrangement meets specified documentation and operational requirements.
To satisfy the documentation requirements, all material terms of the deferred compensation arrangement must be in writing, including:
- The identity of the covered participants
- The deadline for elections to defer compensation
- The amount of compensation to be deferred
- The time and form of payment of the deferred compensation
- The restrictions on the ability to change the designated time and form of payment
- The list and definition of the permitted distribution events
- The six-month delay of any payment of deferred compensation to “specified employees” of public companies on account of their separation from service.
To satisfy operational requirements, companies must administer nonqualified deferred compensation arrangements in accordance with Section 409A and the written terms of the arrangement.
Accordingly, for example, the arrangement must be administered to:
- Effectuate applicable restrictions on deferral elections
- Limit the time and form of payments to one or more of the six permissible payment events
- If funding is utilized, prohibit impermissible offshore funding arrangements and funding during the period the company’s pension plan is in “at-risk” status
- Prohibit an impermissible acceleration or delay in payments of deferred compensation
- Fulfill tax reporting and withholding obligations.
All companies, who have not already done so, should immediately identify and, if necessary, amend plans and arrangements (written and unwritten) that are potentially subject to Section 409A. Common types of arrangements which potentially provide nonqualified deferred compensation subject to Section 409A include:
- Deferred salary and compensation plans
- Certain bonus and incentive pay plans
- Supplemental executive retirement plans (SERPs)
- Certain stock rights
- Employment or consulting agreements and offer letters
- Reimbursement policies
- Severance agreements
- Split-dollar life insurance policies
- Change-in-control agreements
- Tax gross-up arrangements
Upon identifying nonqualified deferred compensation arrangements, companies should contact legal counsel to perform a comprehensive review to ensure that the identified arrangements are either exempt from, or brought into compliance with, the technical requirements of Section 409A.
Amendments to nonqualified deferred compensation arrangements may require consent from affected service providers, review and approval of the board of directors or compensation committees, revision of employee communications and election forms to comply with the law and the corresponding plan document, and disclosures in SEC filings for public companies. Accordingly, companies should act immediately to stay on track to meet the documentary compliance deadline.
Other Section 409A Year-End Deadlines to Watch For
Section 409A has been in effect since January 1, 2005, and all arrangements have generally been subject to good faith operational compliance since that time. While identifying and amending nonqualified deferred compensation arrangements, companies should audit their operations for compliance with Section 409A. This review of operational procedures will help companies determine whether the IRS correction program for certain unintentional operational failures is available. In particular, certain operational failures that occurred in 2008 may be cured under the correction program by December 31, 2008, in order to avoid accelerated income inclusion and tax penalties.
The IRS and Treasury have provided transitional relief regarding documentary compliance, which ends on December 31, 2008. Companies should take advantage of this final opportunity, which allows for payment election changes without regard to the “anti-acceleration” and “five-year” rules. After 2008, any change to the time or form of a payment of deferred compensation must be scheduled for a date that is at least five years from the originally scheduled payment date.
The process of amending nonqualified deferred compensation arrangements may be extremely involved and time-consuming. Without delay, companies should inventory all compensation arrangements potentially subject to Section 409A and determine whether the identified arrangements are either exempt from, or brought into compliance with, the technical requirements of Section 409A.