Internal Revenue Code Section 409A ("Section 409A") became effective on January 1, 2005. It radically changed the procedures that employers must establish and follow when their employees defer compensation to a later year, and when they receive payments of previously deferred compensation that was not fully vested on December 31, 2004.
The penalties for violating Section 409A are severe. Amounts deferred under defective plans or arrangements will generally be taxable immediately to service providers (referred to below as "participants" or "employees") and subject to an additional 20% penalty tax, plus interest at the underpayment rate plus 1%. For the affected employee, these penalties apply to all amounts deferred under the defective plan, as well as all amounts deferred under all other plans and arrangements of the same type in which the employee participates, for the taxable year of noncompliance and all prior taxable years, whether or not they are also defective. The first wave of IRS audits is expected to examine 2005 compliance beginning in 2007.
Interim guidance was provided last December in Treasury Notice 2005-1 ("Notice 2005-1"). On September 29, 2005, the IRS and the Treasury issued proposed regulations under Section 409A, which afford substantial relief by confirming that a number of common pay practices will not involve a payment of deferred compensation. However, many traps remain and employers will need to exercise great care to avoid them.
This article identifies issues that require immediate attention, either because of year-end 2005 deadlines, or because of issues that may need to be faced throughout 2006, and highlights certain considerations for ongoing compliance.
Overview Of Regulations
By way of background, Section 409A generally requires that (i) an irrevocable election to defer be made prior to the beginning of the year in which the compensation will be earned; (ii) both the time and form of payment be specified irrevocably when the deferral election is made; (iii) a specified payment date or dates be objectively determinable when the deferral election is made, without the exercise of employer or employee discretion; and (iv) no acceleration of deferred compensation be permitted, except in very limited circumstances.
Section 409A and guidance issued to date create two sets of obligations: (i) until December 31, 2006, except for grandfathered deferred compensation arrangements, good-faith operational compliance with the requirements of Section 409A and (ii) not later than December 31, 2006, completion of required amendments to all deferred compensation arrangements. Full compliance with all rules will be required starting in 2007. Interim compliance with either the proposed regulations or Notice 2005-1 will be deemed good-faith compliance with Section 409A.
What Employers Should Do Now
Review All Compensation Plans
Since the rules are currently effective, employers should be certain that an appropriate individual or team has been designated to be responsible for compliance. Section 409A applies to all nonqualified deferred compensation plans, including many compensation arrangements and practices that were not previously considered to involve a deferral of compensation. A partial list of plans and agreements that may be covered includes (i) voluntary deferral plans and arrangements, and mandatory plans that do not require any deferral elections but that result in the deferral of compensation; (ii) equity compensation plans ( e.g., plans that provide for grants of stock options, SARs, phantom stock units, restricted stock units and/or deferred shares (collectively, "stock rights"), and all related forms of grant agreements), and amendments to any of the foregoing that might involve modifications or extensions of a participant's rights; (iii) employment and consulting agreements; (iv) severance pay plans, change-in-control plans and separation agreements; (v) long-term and short-term incentive plans; and (vi) 401(k) wrap plans and supplemental executive retirement plans (SERPs).
Actions Needed in 2005
2006 Deferral Elections. Participants who wish to defer compensation that will be earned in 2006 must make their deferral elections no later than December 31, 2005.
Include March 15, 2005 Deferral Election Rights in Plan Documents by December 31, 2005. Employers that permitted employees to defer 2005 compensation by making their deferral elections as late as March 15, 2005 must amend their plan documents by December 31, 2005 to reflect the deferred election date.
One-Time Opt-Out Election. Until December 31, 2005, employers may terminate any nonqualified deferred compensation plan or arrangement and distribute the amounts deferred, provided that any vested deferred compensation that is distributed is included in 2005 income. Employers may also amend any plan to allow employees to terminate their participation in the plan, or to cancel one or more outstanding deferral elections, provided that any related vested deferred compensation is included in 2005 income.
2005 Changes to Form and Timing of Payments. The time by which participants may change a prior deferred compensation election to modify the form of payment, or to accelerate or delay the timing of payment, without violating the subsequent deferral or anti-acceleration rules has been extended until December 31, 2006, provided that the relevant plan or arrangement is amended by such date. However, participants who wish to accelerate a payment of deferred compensation into 2006, or further defer a payment that would otherwise be paid in 2006, may do so only if an election is filed in 2005 and there is no constructive receipt under pre-409A principles.
Exercise or Cash-Out of Discounted Stock Rights. Discounted stock rights are generally subject to Section 409A, and can be terminated without penalty by exercising them and cashing them out in 2005. Alternatively, prior to December 31, 2005, they can be replaced by stock rights with an exercise price at fair market value on the original date of grant, together with a cash payment equal to the lost discount.
2005 Forms W-2 and 1099. Employers need to decide what compensation has to be reported as deferred in 2005. Information reporting of 2005 deferrals to employees on Form W-2 and non-employees on Form 1099-MISC will generally be required by January 31, 2006, if the amount deferred exceeds $600. Guidance under Notice 2005-1 provides that employers need only report compensation actually deferred during or after 2005, and makes clear that the deferral takes place during the taxable year when the employee first acquires a legally binding right to payment in a later year, regardless of whether the payment is subject to a substantial risk of forfeiture.
Actions Needed In 2006
Plan Document Compliance. Employers have until December 31, 2006 to amend plan documents to comply with the Section 409A provisions that require the inclusion of specific plan language.
Replacement of Discounted Stock Rights. Until December 31, 2006, discounted stock rights that were not terminated in 2005 can be replaced with new stock rights that have an exercise price equal to the fair market value of the stock on the original date of grant. However, any make-up payment made in 2006 for the lost discount must be subject to vesting in a future year.
Payment Elections Controlled by a Linked Qualified Plan. Until December 31, 2006, elections as to timing and form of payment under a nonqualified 401(k) wrap plan or SERP will not violate Section 409A if such payments are controlled by payment elections under a linked qualified plan.
Considerations For Ongoing Compliance
Avoid Modifications of Stock Rights. Any modification of a stock right (other than a timely modification to bring it into compliance with Section 409A) will cause it to become subject to and potentially defective under Section 409A. The term "modification" means any (i) reduction in exercise price, (ii) addition of a deferral feature or (iii) extension or renewal of the stock right. Exceptions are provided for any stock right that is extended to a date that is no later than the later of (i) the 15th day of the third month following, or (ii) December 31 of the calendar year in which the right would otherwise have expired. The proposed regulations also confirm that the acceleration of vesting, the addition of the right to use previously acquired stock to pay the exercise price and the addition of a stock withholding feature to satisfy applicable tax withholding will not constitute modifications.
Employer Common Stock Only. To be exempt from Section 409A, stock rights must relate to common stock of the employer that is readily tradable on an established securities market or, if not so tradable, to the class of employer common stock with the highest aggregate value of any class of employer common stock on the grant date, or other employer common stock having substantially similar rights (disregarding differences in voting rights). Any stock rights on preferred stock, or rights on common stock that are subject to a mandatory repurchase obligation or put or call rights (that are not lapse restrictions) based on a measure other than fair market value, will not be exempt from Section 409A.
Dividends. Dividends paid to the holder of a stock option or SAR upon exercise will be treated as a discount to the exercise price and will cause it to be subject to Section 409A from the outset, unless the right to the dividends is set forth in a separate arrangement from the option or SAR grant or plan document and independently complies with Section 409A.
Separation from Service. Severance pay, whether pursuant to a severance pay plan, a change-in- control agreement or an individually negotiated employment agreement or separation agreement, may constitute deferred compensation subject to Section 409A. However, an exemption is provided for severance arrangements where the severance is paid upon an employee's involuntary separation from service or pursuant to a window program, provided that the severance amount (i) does not exceed the lesser of (A) two times the employee's aggregate annual compensation for the year immediately prior to the year of termination or (B) two times the compensation limit under Section 401(a)(17) of the Code for the year prior to termination ( i.e., $205,000 for 2005 terminations, and $210,000 for 2006), and (ii) is paid no later than December 31 of the second calendar year following the year of termination.
Because severance payments are generally subject to a "substantial risk of forfeiture," involuntary separation pay arrangements that do not qualify for the prior exemption may still be exempt from Section 409A under the "short-term deferral" exception, if paid within 21/2 months following the end of the year in which the involuntary termination occurs.
Note that a payment upon a resignation for "good reason" may not be considered subject to a "substantial risk of forfeiture," and therefore neither of the exemptions described above may be available for payments made to key employees of public companies with good-reason provisions. Until further guidance is provided, arrangements for key employees with good-reason termination provisions should be analyzed on a case-by-case basis to determine whether it is advisable to delay severance payments until six months following any termination of employment.
Published December 1, 2005.