December 2007

Section 409A: New Rules For Deferred Compensation

The American Jobs Creation Act made substantial amendments to the Internal Revenue Code's (the "Code") treatment of deferred compensation. The changes were in part a reaction to the Enron scandal involving highly compensated executives taking early distributions of deferred compensation just prior to the company's bankruptcy. Congress recognized that these executives not only had the benefit of forestalling taxation at the time of deferral, but also controlled when the compensation was paid. The response, new Code Section 409A, requires that, unless certain requirements are met, compensation deferred (except under a qualified deferred pension or profit sharing plan) is includible in the employee's income at the time it is earned to the extent that it is not subject to a substantial risk of forfeiture.

The Treasury Department released its final regulations on Section 409A (the "Final Regulations") on April 10, 2007. Beginning on January 1, 2009, employee benefit and compensation arrangements must comply with Section 409A. The regulations are complex and somewhat unwieldy. For example, determining when compensation is "earned" or what constitutes a "substantial risk of forfeiture" involves detailed and complex analysis under the Final Regulations. This Legal Update summarizes some of the key concepts of Section 409A in an effort to provide an overview of these important tax law issues.

Section 409A of the Code contains special rules for compensation to which an employee or independent contractor has a legally binding right in one year but that is or may be received in a later year and is not subject to a substantial risk of forfeiture. Although this definition would seem to encompass almost all compensation beyond contemporaneously paid salary, the Code substantially limits Section 409A's reach. Section 409A does not apply to tax-qualified employer plans (e.g., pension, profit sharing, or 401(k) plans, 403(b) plans, simplified employee pension, and simple retirement accounts) or to certain employer-provided benefits (e.g., vacation leave, sick leave, compensatory time, disability pay, or death benefit plans).

Section 409A nonqualified deferred compensation, however, does include a significant number of compensation arrangements. Deferred salaries, sales commissions, supplemental executive retirement plans, severance payments, discounted stock options and stock appreciation rights (SARs), restricted stock units, phantom stock, split-dollar life insurance plans, and bonuses may all be subject to Section 409A. Various documents and agreements, such as employment agreements, change of control agreements, bonus plans, stock option plans, and severance agreements, are likely to contain nonqualified deferred compensation provisions. It should be noted that Section 409A applies only to compensation deferred after December 31, 2004. Further, amounts of deferred compensation that were both earned and vested prior to January 1, 2005 are grandfathered, and therefore outside the reach of Section 409A, unless materially modified after October 3, 2004.

Generally, Section 409A regulates the timing, not the amount, of deferred compensation payments. The Final Regulations contain several provisions outlining when an employee must make initial and subsequent elections to defer compensation. In general, an employee must elect to defer compensation before the beginning of the tax year in which it is earned. Once an initial deferral election is made, however, employees will find Section 409A offers little flexibility for subsequent deferrals. This makes it extremely important that the initial deferral election is done right the first time.

Because Section 409A applies to all compensation deferred after the end of 2004, employers and employees also must comply with Section 409A for both existing and new deferred compensation arrangements. Any arrangement that provides for deferred compensation, such as a bonus plan, severance agreement, or employment contract, must reflect the Final Regulations' complex timing rules. Failure to draft new plans or amend existing arrangements in compliance with the Final Regulations may be a costly mistake.

Section 409A penalties can be quite draconian for both unwitting employees and their employers. Nonqualified deferred compensation that violates Section 409A is included in the employee's taxable income in the year in which it is earned, rather than the year in which it is received. The IRS may also elect to impose interest and an additional 20% tax on the non-compliant compensation. Employers, however, should also be wary, as Section 409A requires that employers report and withhold taxes on non-compliant deferred compensation. Failure to do so may subject employers to penalties. This danger is multiplied by the fact that Section 409A's plan aggregation rules hold that a violation of Section 409A with respect to any aspect of a plan would result in triggering Section 409A penalties with respect to all benefits under the aggregated definition of a plan. Although not provided in the Code, it is also possible that an employee may attempt to impose liability on an employer for drafting an agreement that does not comply with Section 409A.

Section 409A of the Code is complex and far-reaching. Both employees and employers should have at least a cursory knowledge of the types of compensation affected by this important tax provision. Fortunately, there is time to do a careful and thorough review of all deferred compensation arrangements. Nonqualified deferred compensation arrangements must be documentarily and operationally compliant with Section 409A by January 1, 2009. It is highly recommended, however, that a diligent review of applicable plans be undertaken well before the deadline. Failure to timely amend a plan, arrangement or agreement may result in a violation of Section 409A and serious financial consequences.

• Learn the rules on the timing of initial and subsequent elections to defer compensation.
• Review all compensation arrangements and plans for nonqualified deferred compensation.
• Confer with counsel on all existing and new plans to ensure they comply with the Final Regulations.

FVLD publishes updates on legal issues and summaries of legal topics for its clients and friends. They are merely informational and do not constitute legal advice. We welcome comments or questions. If we can be of assistance, please call or write Jonathan Vegosen 312.701.6860 jvegosen@fvldlaw.com, Vance Liebman 312.701.6860 vliebman@fvldlaw.com, Michelle Wolf-Boze mwolf-boze@fvldlaw.com 312.701.6819, or your regular FVLD contact.