Unless the IRS agrees to the extension urgently requested by many tax professionals, December 31, 2007 is the deadline for making critical amendments to existing executive compensation arrangements, bonus plans, severance pay arrangements, releases and other such agreements to comply with the IRS's "non-qualified deferred compensation" rules under Internal Revenue Code (IRC) Section 409A. Failure to comply means that company executives may face taxes, penalties and interest. The impact of IRC § 409A is greater than most companies think because the IRS considers many basic employee agreements to be "non-qualified deferred compensation."
In April, 2007, the IRS issued the final Tax Regulations interpreting and explaining (at great length and detail) the non-qualified deferred compensation (NQDC) rules enacted under IRC § 409A.
Under IRC § 409A, all compensation that a company defers under a NQDC plan for all tax years can be considered by the IRS to be current income and therefore not deferred (to the extent such compensation is not subject to a substantial risk of forfeiture or previously included in gross income) unless the plan meets the distribution, acceleration of benefit, and election requirements under IRC § 409A and is operated in accordance with these requirements. If these requirements are not met, the consequences of failure fall directly upon individual executives and employees, not the employer. If a NQDC plan does not comply with IRC § 409A, all amounts deferred under the plan are included in income to the extent not subject to a substantial risk of forfeiture and not previously included in income. Such amounts are also subject to interest (at the underpayment rate plus one percentage point) on the tax underpayments and a 20% penalty.
Distributions from a NQDC plan may only be made upon one of six specified events: (1) separation from service, (2) disability, (3) death, (4) a specified time (or pursuant to a fixed schedule) specified under the plan when the compensation is deferred, (5) a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation, or (6) an unforeseen emergency, such as severe financial hardship resulting from illness, etc. If the employee is a "key employee," and there is a "separation from service," the employee cannot receive a distribution until six months after such separation. Plan administrators have no discretion regarding distribution timing. With few exceptions, payments under a NQDC plan cannot be "accelerated." Lastly, the "election" requirements are met if the initial election to defer compensation for services performed during a tax year is made no later than the end of the preceding tax year, although there is an exception for performance-based compensation (i.e., bonuses) and for the initial year of NQDC eligibility. Any subsequent election to defer compensation after the initial election generally may not take effect for 12 months, and the payment date must generally be deferred for five years from the date that the payment would otherwise have been made.
IRC § 409A does not apply to compensation that is subject to a substantial risk of forfeiture. The rights of a person to compensation are subject to a substantial risk of forfeiture, and IRC § 409A is avoided, if such person's rights to such compensation are conditioned upon the future performance of substantial services or the occurrence of a condition related to the compensation's purpose and there is a substantial forfeiture possibility.
What is a Non-Qualified Deferred Compensation Plan?
A NQDC plan is any plan that provides for the deferral of compensation that a participant has the right to receive that is payable in a later year, other than a qualified employer plan (e.g., a qualified retirement plan, tax-deferred annuity, simplified employee pension, or SIMPLE plan), and any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan. The term "plan" includes any arrangement, including an agreement or arrangement that includes just one person.
A NQDC plan can include annual bonuses if not paid within 2½ months after the end of an employer's or employee's tax year (whichever is later). NQDC plans can also include independent contractor relationships, unless the independent contractor is actively engaged in the trade or business of providing substantial services, other than as an employee or director of a corporation, and is providing significant services to two or more unrelated employers. Severance plans are also covered under IRC § 409A, unless its a severance plan that is collectively-bargained, a "window program" or an involuntary separation from service to the extent the separation pay does not exceed a certain amount.
IRC § 409A should generally not apply to non-qualified stock options (NQSOs) and stock appreciation rights (SARs), if they are not issued at a discount (i.e., the exercise price is never less than the fair market value of the underlying stock when the option or right is granted), or contain any deferral feature other than the option holder's right to exercise the option in the future.
Generally, IRC § 409A applies to compensation deferred in tax years beginning after December 31, 2004, and compensation deferred in tax years beginning before 2005 if a NQDC plan is "materially modified" after October 3, 2004. Because of the harsh consequences of non-compliance, the IRS permitted transition relief to allow employers time to bring existing plan documents into compliance with IRC § 409A. However, such transition relief is currently scheduled to expire on December 31, 2007.
Under the IRS's transition relief, as provided in Notice 2006-79, a NQDC plan adopted on or before December 31, 2007 does not violate the distribution, acceleration of benefits or election requirements under IRC § 409A if: (1) operated through Dec. 31, 2007 in reasonable, good faith compliance with the provisions of IRC § 409A and Notice 2005-1 and any other generally applicable guidance published with an effective date before Jan. 1, 2008, and (2) amended before Jan. 1, 2008 to conform with IRC § 409A and the final Tax Regulations.
IRC § 409A Compliance Process
Unfortunately, complying with IRC § 409A is no simple matter. Many companies have deferred compensation arrangements affecting their executives and employees. To comply with IRC § 409A, these agreements and plans must first be gathered up, and then reviewed, analyzed and amended—particularly the sections of the agreements involving severance payments. Companies need to carefully consider the implications of the required amendments to their business. Such amendments are also normally subject to review and approval by a compensation committee or by the Board of Directors, which can take time.
A company's management needs to consider and approve (or alter) the proposed changes after considering the implications and costs of such changes, which could include taxes, accounting matters, securities laws and employee relations. After approving the changes, the amendments to the agreements need to be sent to the individual executives and employees, and so there may be additional negotiations and changes to the amendment before it is signed and implemented.
Needless to say, the non-qualified deferred compensation rules under IRC § 409A are complex and affect a broad range of contractual relationships that should be reviewed before the end of the year, since there is currently no voluntary correction program for unintentional violations of IRC § 409A and "fail-safe" clauses (i.e., "This plan is intended to satisfy IRC § 409A and any ambiguity in the plan will be construed in a manner consistent with such intent") will be disregarded by the IRS.