Internal Revenue Code ("Code") Section 409A places significant limitations on the flexibility of deferred compensation arrangements. There has been interim guidance from the Internal Revenue Service that permitted good faith administration during a transition period. The final regulations under Code Section 409A were issued in April 2007 and become effective January 1, 2008. Until December 31, 2007, we are in a "transition period" during which employers are permitted to amend their plans and practices as necessary to comply with the requirements of Code Section 409A. (While there is an effort to try and extend the effective date, it is not certain whether it will be successful.)
Every traditional deferred compensation plan, employment agreement, severance arrangement, and equity plan must be reviewed and most likely amended by December 31, 2007.
The penalty for noncompliance with the applicable requirements of Code Section 409A applies to the employee (not the employer) and includes immediate taxation of amounts intended to be deferred, as well as an additional 20 percent tax on noncomplying deferred compensation. However, an employer is responsible for properly withholding applicable taxes and will have tax reporting obligations. A more detailed explanation of the final regulations can be found in our Client Alert sent out in April of this year available on our Website here.
The most difficult part of Code Section 409A is that it not only applies to what are normally considered traditional deferred compensation arrangements, but also to arrangements not traditionally viewed as deferred compensation. Such arrangements include severance arrangements, employment or separation agreements, certain equity arrangements, and split-dollar life insurance arrangements. Code Section 409A does not apply to tax-qualified pension plans or Section 403(b) plans, but it does apply to other nonqualified pension arrangements.
The first step in complying with Code Section 409A on a timely basis is to identify all arrangements subject to the requirements of Code Section 409A and to obtain copies of all applicable documentation. The documentation should then be reviewed to determine if it is in compliance and what steps, if any, are necessary to ensure compliance. In most cases, required changes will be limited and will likely consist of including specific provisions as to times and forms of payout to avoid employer or employee discretion. In addition, with respect to certain deferred compensation payments made upon termination of employment to specified officers and other key employees of public companies, Code Section 409A also imposes a six-month delay on such payments (which must be specifically reflected in the documents governing such arrangements).
The arrangements that should be reviewed include:
- All employment agreements.
- All severance or termination agreements and severance plans, arrangements, or practices.
- Every deferred compensation plan (taken broadly, any arrangement that involves amounts or benefits earned in one year and paid in a future year—many of these may be exempt because of what is known as a "short-term deferral" or due to one of the other exemptions, but they should still be reviewed). As noted above, any tax-qualified pension plan or 403(b) plan is exempt, but nonqualified pension benefit plans (including SERPs) must be reviewed.
- Any post-employment reimbursement plan or payment plan.
- Any post-employment consulting arrangement should be examined to ensure it is compliant.
- Any termination-oriented sabbatical or leave arrangements.
- All equity plans and grants.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
