Section 409A: Deferred Compensation Creates an Immediate Headache
Well-paid employees have historically tried to defer parts of their compensation into later years, expecting that overall they will benefit, either by growing their funds tax-free until retirement, or by accessing the funds in later years when they expect to be subject to tax at a lower rate. Deferring some compensation to save for retirement is considered a good thing, and hence we have tax-favored “qualified” plans and arrangements like 401(k) plans, individual retirement accounts, and traditional pension plans. However, over the past few decades some employees deferred large amounts of money, much of it in ways that were perceived as abusive to the tax system.
Too much of a good thing, as it were, prompted Congress to act and in late 2004 it adopted Internal Revenue Code Section 409A (“409A”), which established strict limits on “nonqualified deferred compensation.” The limits are enforced by stiff taxes and penalties that apply if the new rules aren’t met. The rules first became effective on January 1, 2005 but are receiving a lot of attention at the moment because December 31, 2007 marks the end of a transitional period after which full compliance with all of 409A’s nuances will be required.
Under 409A, an agreement provides for deferred compensation if an employee or other affected service provider obtains in Year 1 a legally binding right to receive compensation which will or may be paid in Year 2 or later. This means, for example, that if the parties agree that the payment will be made upon the happening of an event (such as a performance milestone) which could occur in a later year, then the arrangement provides for the deferral of compensation. Many common types of compensation arrangements are potentially subject to 409A, including employment agreements and offer letters, severance agreements, change of control agreements, bonus plans, commission plans, certain stock options and equity rights arrangements (such as stock appreciation rights, phantom stock arrangements and restricted stock units), salary deferral arrangements and traditional deferred compensation plans. Even though 409A is expansive, certain types of plans and agreements are generally exempt from it; these include qualified plans (such as 401(k) plans and pension plans), most group health plans, bona fide sick leave and vacation pay plans, disability insurance plans, group life insurance plans, incentive stock options granted under Code Section 422, and direct grants of corporate stock.
Each non-exempt arrangement must meet certain strict requirements in order to comply with 409A. In most cases, this means meeting specific requirements related to the time at which the initial decision to defer the compensation is made, prohibiting any later changes to the timing of the payments (i.e., they can’t be further deferred unless very strict rules are met, and they cannot be accelerated), limiting the time at which payment can be made to certain fixed events or dates, including death, disability, termination of service, change of control, or a fixed date set at the time the plan is adopted.
Each of these payment dates has its own set of complex definitions, rules and requirements establishing what the IRS really means when it says disability, change of control, etc. (death was graciously left alone). It is generally possible to meet the business goals of a deferral arrangement while still complying with 409A, but doing so requires a great deal of attention to detail and forethought at the time the compensation arrangement is originally established. It is also generally possible to revise existing compensation arrangements to comply with 409A, although the window of opportunity in which to do so is shrinking, as all existing compensation arrangements which are not exempt from the rules must be amended to be in compliance by December 31, 2007.
Making the effort to amend existing arrangements, and to prepare new arrangements to comply with 409A is well worth the time and expense involved, because the consequences of not complying are drastic.
If 409A is violated, employees and other affected service providers are subject to regular income tax on the value of the deferred compensation as soon as it vests – even if it is not yet paid. The tax imposed on this income is increased by a penalty tax equal to 20% of the amount of the deferred compensation. If an employee does not timely pay the tax (including the penalty), he or she is subject to interest at a higher than normal rate on the underpayment. When state level taxes are added, the taxes and penalties can exceed 85%, all this before the employee receives any actual cash. While it is the employee and not the employer who bears the tax burden, in addition to having dismayed employees, employers do have certain withholding and reporting obligations and can be subject to monetary penalties for failure to comply with these obligations. In other words, 409A imposes very significant negative tax consequences if a company pays or promises to pay deferred compensation that is not exempt from and does not comply with 409A’s requirements. It is incumbent upon both employers and employees to take 409A seriously and to plan ahead to avoid its reach. The consequences to employees of failing to do so are drastic and they are best avoided if at all possible.
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