This communication briefly summarizes some of the more important provisions of Section 409A of the Internal Revenue Code of 1986, as interpreted by the IRS Final Regulations under Section 409A issued on April 17, 2007. This memo is for informational purposes only and does not constitute legal advice. It does not describe all of the requirements of Section 409A. For specific information about the application of Section 409A or other legal requirements, contact a member of the Dinsmore & Shohl, LLP Compensation & Benefits Practice Group.
Under U.S. Treasury Regulations, we are required to inform you that any tax advice contained in this memo is not intended to be relied upon, and cannot be relied upon, as substantial authority to avoid penalties under the Internal Revenue Code.
I. Section 409A Overview.
Section 409A governs the deferral of compensation pursuant to a nonqualified deferred compensation plan. Compensation is considered deferred under the Final Regulations whenever a plan, employment contract, or arrangement provides to a "service provider" (typically this means an employee but can include an independent contractor) a legally binding right in one taxable year to compensation in a future taxable year. For amounts deferred by a service provider under a nonqualified deferred compensation plan to continue to qualify for deferred taxation under Section 409A, the nonqualified deferred compensation plan maintained by the "service recipient" (that is, the employer or other entity for whom the service provider performs services) must satisfy the following rules:
A. Permissible Distribution Events. Under Section 409A, deferred amounts may not be distributed earlier than one of the following dates:
- The service provider's separation from service (6 months after separation from service for a service provider who is a “specified employee” of a publicly-traded company).
- A specified employee means a service provider who, as of the date of the service provider's separation from service, is a "key employee" (as defined under the rules applicable to top-heavy qualified retirement plans) of a publicly-traded company. A service provider is a key employee if, at any time during the 12-month period ending on a "specified employee identification date," the service provider is (i) an officer with a salary greater than $145,000 for 2007 (indexed for inflation thereafter) (limited to 50 officers), (ii) a 5% owner of the company, or (iii) an 1% owner of the company with compensation from the company in excess of $150,000. If a service provider is a key employee as of a specified employee identification date, the service provider is treated as a key employee for purposes of Section 409A for the entire 12-month period beginning on the specified employee effective date. Unless another date is selected by the service recipient, the "specified employee identification date" is December 31. The default "specified employee effective date" is the first day of the fourth month after the specified employee identification date, unless another date is selected by the service recipient. The specified employee identification date and the specified employee effective date used by a service recipient must be the same for all of the service recipient's nonqualified deferred compensation plans. If the service recipient selects a specified employee identification date or a specified employee effective date other than the default date, that date needs to be specified in each plan or a separate document that is applicable to all nonqualified deferred compensation plans.
- the date a service provider becomes "disabled."
- A service provider is disabled if the service provider is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or can be expected to last for a continuous period of not less than 12 months, or is, by reason of any medically determinable physical or mental impairment that can be expected to result in death or can be expected to last for a continuous period of not less than 12 months, receiving income replacement benefits for a period of not less than 3 months under an accident and health plan covering employees of the participant's employer. The Final Regulations allow a plan to provide that a service provider will be deemed disabled if the service provider is determined to be totally disabled by the Social Security Administration.
- the service provider's death;
- a specified time or schedule of payments that is fixed or elected at the time of the deferral;
- a change in the ownership or effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the
- corporation (The Final Regulations incorporate specific definitions of these terms.); or
- in the event of an "unforeseeable emergency."
- An unforeseeable emergency is a severe financial hardship to the service provider resulting from an illness or accident to the service provider, the service provider's spouse, the service provider's beneficiary, or the service provider's dependent; loss of the service provider's property due to casualty; or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the service provider.
B. Deferral Elections.
Section 409A requires that all deferral elections of compensation (salary or bonus) which is not "performance-based compensation" must be made no later than the last day of the taxable year preceding the taxable year for which the compensation is being deferred. There are exceptions for deferral elections made upon initial eligibility and for performance-based compensation. In the case of the first year in which a service provider becomes eligible to participate in a plan (including for this purpose any other plan required to be aggregated for purposes of Section 409A, i.e., an account balance plan), an initial deferral election may be made within 30 days after the date the service provider first becomes eligible to participate in the plan. Newly eligible service providers who are former active participants who ceased to be eligible to participate in the plan will be eligible for the initial deferral election rules if (i) before becoming eligible to participate in the plan , the service provider had been paid all amounts previously deferred under the plan and, on and before the date of the last payment, was not eligible to participate for periods after the last payment; or (ii) the service provider has not been an active participant in the plan for at least 24 months.
With respect to performance-based compensation, an initial deferral election generally may be made up to six months before the end of the performance period. The Final Regulations provide a specific definition of "performance-based compensation." Generally, the definition requires that performance-based compensation must be contingent on preestablished organizational or individual performance criteria. The performance criteria must relate to a performance period of at least 12 consecutive months.
C. No Acceleration of Distributions.
Section 409A provides that a deferred compensation plan may not permit the acceleration of the time or schedule of any payment of benefits under the plan, subject to limited exceptions specified in the Final Regulations.
D. Changes to Elections.
Section 409A permits subsequent election changes to the timing or form of distribution if the deferred compensation plan provides that such changes (1) cannot take effect until at least 12 months after the date the election is made; (2) must defer the distribution for at least 5 additional years; and (3) must be made at least 12 months before the original distribution commencement date.
E. Written Plan Requirement.
The Final Regulations require that all deferred compensation plans be maintained pursuant to a written plan document. To satisfy this requirement, the plan must specify, at the time an amount is deferred, the amount which the service provider has a right to be paid (or the formula to determine such amount in the case of an amount determinable under an objective, nondiscretionary formula), and the payment schedule or payment triggering events that will result in payment of such amounts.
F. Effective Date.
The Final Regulations are generally effective January 1, 2008. All deferred compensation plans must be amended to comply with Section 409A and the Final Regulations issued thereunder by December 31, 2007. Section 409A was generally effective for amounts deferred on or after January 1, 2005. During the period between the effective dates of Section 409A and the Final Regulations, plans and other arrangements subject to Section 409A are required to operate in "good faith compliance" with the requirements of Section 409A. The Final Regulations incorporate several transition rules which apply during this period.
G. Failure to Comply with these Requirements.
Failure to comply with Section 409A will subject each service provider to whom the failure relates to immediate taxation on all compensation deferred under the deferred compensation plan for all taxable years, unless such amounts are subject to a substantial risk of forfeiture or were previously included in gross income. In addition, each such service provider will be assessed interest and a 20 percent penalty on the taxable amount.