Editor: Please give us some facts about your background and practice. Why has Section 409A of the Internal Revenue Code become a subject of your primary interest?
Nassau: When I began practice as a tax lawyer, I was one of the few who enjoyed employee benefits, which was generally the least popular area of tax practice. That gave me a head start in the area when ERISA was passed, and I developed a niche practice in benefits which continues to the present. Section 409A fell squarely into that.
Editor: What is the history of Section 409A? What abuses prompted its enactment?
Nassau: Section 409A was adopted in the American Jobs Creation Act of 2004 in reaction to perceived abuses in the aftermath of Enron and WorldCom. Rank and file employees there were stuck holding worthless stock in their section 401(k) plan accounts, while senior management drew down millions of dollars of deferred compensation before the companies entered bankruptcy. Congress found this offensive and responded with Code Section 409A.
Section 409A sets forth detailed rules on how compensation may be deferred and, once deferred, how and when it can be paid. Under the new rules, deferred compensation may be paid only upon one of six permissible events: (1) a fixed time or schedule specified at the time of deferral, (2) separation from service, (3 ) disability; (4) death, (5) unforeseeable emergency, or (6) a change in control event, each (other than death) as defined in regulations (including anti-abuse rules to prevent collusive manipulation of the termination date). The time and form of payment must be set at the time of deferral and may not be changed later except under restrictive rules, generally requiring that any payment after the change be postponed for at least five years and that the change election be made at least 12 months in advance of the prior payment date. Also, the date payment is made in relation to the event must not be so loosely worded as to create possibilities of manipulation affecting the year of payment. The regulations provide a safe harbor allowing payment: as soon as practicable within the same calendar year or within 90 days of the event so long as there is no collusion between employer and employee as to when payment is made. However a mere "as soon as practicable" should be avoided.
Finally and importantly, Section 409A prohibits the highest paid 50 officers of a public corporation from receiving deferred compensation on separation from service until at least six months after the separation.
Editor: What are the penalties for violation of the rules for non-qualified deferred compensation plans?
Nassau: Section 409A imposes a 20 percent penalty tax on both the offending deferral amount and all other deferrals under the same plan and any like plans, both for the year of the offense and all prior years subject to Section 409A, including earnings thereon. Nine different plan categories exist for "like plan" purposes, including elective account balance plans, non-elective account balance plans, nonaccount balance plans, separation pay plans, and "stock rights" plans. In addition, the deferrals subjected to penalty will be included in income retroactively to the year of deferral (or vesting, if later), rendering the employee liable for the resulting income taxes earlier than expected and also for back interest for the intervening years. The result can be draconian, and employers and their counsel must devote a major effort to understanding the many and often difficult rules of the regulations in order to avoid costly violations.
Editor: How do you define "deferred compensation"?
Nassau: There is no significant definitional issue for elective deferral plans or plans designed on their face to provide retirement income, such as plans providing benefits in excess of Code limits on qualified plan benefits or "SERPs" having their own benefit formula, However, identification of "deferred compensation" in other situations can be difficult, including in bonus plans, severance situations and employment agreements generally. An entire set of special rules is required to deal with the application to stock options and similar equity compensation.
Under the general definition, the potential for deferred compensation exists whenever compensation may be payable after the year in which a "legal right" to the payment arises (i.e., a right enforceable in the manner of a contract). whether or not payment is subject to further conditions, so long as the conditions are objective in nature and do not require further discretionary action by the employer. Accordingly, employers need to review all such arrangements, including incentive compensation and severance arrangements and any other type of irregular form of compensation, whether payable in cash or stock or comprising in-kind benefits or reimbursement arrangements, and whether provided in a formal plan or policy, an employment contract or form of separation agreement or contemplated by a form of offer letter, and also arrangements covering U.S. citizens or resident aliens working abroad.
The next step is to determine whether any of a number of exceptions in the regulations render the arrangement either not "deferred compensation" or otherwise take it outside of Section 409A. Of prime importance is the "short-term deferral rule," which excludes payments that in all events must be made by March 15 following the year in which the compensation is no longer subject to a substantial risk of forfeiture (or the equivalent where the employer is on a fiscal year). Unfortunately, these exceptions are subject to many nuances. For example, if a plan or agreement makes termination of employment a possible payment event and termination could occur after March 15 of the year in which the payment right arises, the payment is deferred compensation and must comply with Section 409A, even if payment is made by the March 15 short-term deferral deadline. Many problems arise because of uncertainty as to what constitutes a substantial risk of forfeiture under the special definition in the Section 409A regulations, which is narrower than that under Code section 83.
Editor: Do bonuses fall under the definition of deferred compensation?
Nassau: They may, depending on the circumstances. Bonuses payable only following the exercise of genuine employer discretion in the year of payment will not be deferred compensation, because they are paid in the year the legal right to the payment arises. If payable after the year the right arises, however, bonuses generally constitute deferred compensation unless excluded by the short-term deferral rule. The latter will exclude bonuses conditioned on the employee's remaining employed on the payment date, assuming that requirement will be enforced in practice.
It is important for bonus plans to be carefully drafted and at a minimum specify an appropriate payment date or range of dates, in order to avoid any possible Section 409A violation (as could arise if the payment were delayed so as not to be a short-term deferral and the plan lacked the specified payment date required by Section 409A). Accordingly, bonus plans that vest in the year before payment should specify a payment date in the following year, such as March 15, or range of dates between January 1 and March 15 (and thus precluding payment in the year earned). If the payment date is thus specified and payment is delayed, the regulations provide rules and exceptions to avoid any resulting violation of Section 409A (including its requirement that deferred compensation have a specified payment date), such as a rule treating payment at any later date in the same year as payment on the originally specified date.
Editor: What is the situation faced by an employee dismissed without cause?
Nassau: Payments for involuntary termination without cause (generally including termination under a well drafted good reason clause) may fall in a number of distinct different categories, each with different consequences under Section 409A, depending on when a "legal right" to payments arises, when payments are no longer subject to a substantial risk of forfeiture, whether they replace any other benefits, including any benefits forfeited, and the language of the applicable employment or severance agreement. If the employee is among the top 50 paid officers of a public corporation, any amounts constituting deferred compensation cannot be paid until after six months following the separation date. However, either of two rules may be used to avoid such a delay, in whole or in part. If the employee had no "legal right" to the amount involved prior to the date of involuntary termination, or any such right was subject to a substantial risk of forfeiture as defined under Section 409A (under which requirements for a release or a noncompetition covenant do not create a substantial risk), payments separately identified and required to be made no later than March 15 of the year following the year of the involuntary termination may be excluded from "deferred compensation" under the short-term deferral rule.
A second, "separation pay" exception excludes amounts payable only upon an involuntary (or good reason) severance and not available upon any other separation (and not a "substitute" for other payments, such as amounts forfeited upon separation), provided the arrangement by its terms requires payments to be completed by the end of the second year following the separation. This exclusion can apply to payments not excepted by the short-term deferral rule, up to the lesser of (i) amount of the employee's annual compensation rate at the termination date, or (ii) twice the limit on compensation includable under qualified plans for the separation year - e.g., $450,000 for 2007, when the Code limit is $225,000, If the payments exceed this limit, only the excess need be treated as deferred compensation and be subjected to the six-month delay rule (if applicable) and other Section 409A requirements.
The restrictive definition of "substantial risk of forfeiture" and the requirement for specificity in tying payments to a permitted event call for careful drafting when making a release or other commitment a condition of payment, and in defining the time at which the severance terms must be finally and irrevocably accepted. For example, a severance agreement providing for payment upon execution of a release without setting a deadline for execution will not create a short-term deferral, and absence of such a deadline will also make the limited amount severance pay exception inapplicable. The result will be deferred compensation which violates Section 409A because of the absence of the required specific time for payment.
Editor: What should a company and its employees do now?
Nassau: They must first understand that the final regulations are enormously complex, devote the effort needed to identify arrangements potentially subject to Section 409A and attend to any drafting useful in taking arrangements outside of Section 409A. Arrangements that remain should then be carefully reviewed and changes in company practice and documentation made as necessary to ensure full compliance with the regulations by their January 1, 2008 effective date. This will include preparing and executing definitive plan documentation by December 31, 2007 which contains at least the basic elements required by the regulations, as well as all other terms needed for compliant operation in accordance with the intended business deal. Public corporations must ensure that the documentation includes legally enforceable provisions embodying the six-month delay rule, and (as during the current "good faith" compliance period) maintain procedures for identifying the "specified employees" subject to the delay requirement. By the fall of 2007, any changes needed in prior provisions governing time or form of payment or the like should be identified and arrangements made to implement them by year-end. The transition rule allowing changes to be made during 2007 free of the usual restrictions on changing the time and form of payment will allow this to be done consistent with Section 409A. Where appropriate, employees may be provided with new election forms determined to comply with Section 409A, accompanied by default rules that force any previously noncompliant plan choices into a compliant mode.
Published July 1, 2007.