Internal Revenue Code
Section 409A regulates deferred compensation plans and other arrangements,
including severance plans, annual bonus payments, long-term incentive
arrangements, stay bonuses, and settlement agreements upon termination. Section
409A rules govern compensation that was deferred or became vested after Jan. 1,
2005. Because employers have faced many difficulties trying to comply with
these rules, the IRS has allowed a delay in achieving compliance until Dec. 31,
2008. Here, we’ll explain what employers that offer nonqualified deferred
compensation plans need to know about the law.
Section 409A
Requirements
Under Section 409A, any
arrangement that provides for compensation to be paid in a year later than the year
in which it was earned may be considered a deferred compensation plan.
Accordingly, companies offering such programs must be aware that Section 409A
regulates many elements of deferred compensation plans, including:
• The timing and form
of plan distributions. At the time the deferred compensation plan is set
up, the plan must state the form of the distributions to be made and their
timing. Distributions may commence at a fixed date or when an employee
separates from service, or upon death, disability, change of control, or an
unforeseeable emergency.
• Deferral elections.
An employee’s election to defer compensation must generally be made in the
calendar year before the calendar year in which the compensation is
earned. Employers should note that there are special deferral timing rules for
an employee’s initial eligibility to participate, as well as deferrals of
performance-based compensation.
• Exception for first
year of plan eligibility. When an employee first becomes eligible to
participate in a deferred compensation plan, a deferral election may be made
within one month of his or her eligibility date, and it may apply only to
compensation earned after the election date.
• Exception for
performance-based compensation. If compensation is earned during a year and
can be classified as performance-based compensation, an initial deferral
election may be made as late as six months before the end of the measurement
period.
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Applicable Plans,
Exceptions
Deferred compensation
plans governed by Section 409A come in several forms, including:
• “discounted” stock
options and stock-appreciation rights (for corporations and limited liability
companies), granted at an exercise price below fair market value or subject to “put”
or “call” rights or dividend preferences
• supplemental executive
retirement plans (SERPs)
• phantom stock and
restricted stock units (for corporations or limited liability companies)
• certain executive
separation-pay arrangements
• nonqualified 401(k)
salary deferral or “wrap” plans
• certain bonus and
incentive deferral arrangements
• 457(f) plans for
nonprofit organizations
The Section 409A rules
do not apply to certain plans, including:
• 401(k) plans
• annuity plans
• simplified employee
pension (SEP) plans or savings incentive match plans for employees (SIMPLE IRA)
• vacation, sick leave,
compensatory time, disability plans, or death benefit plans
• annuity contracts of
educational institutions, churches, and tax-exempt charitable organizations
• eligible deferred
compensation plans offered by government employers and tax-exempt organizations
Umbrella Documents
An employer may adopt “umbrella”
documents that amend all plans of the same type or category to comply with
Section 409A. However, if the umbrella document amends a deferred compensation
plan or an employment agreement that requires employee consent, the document
must be signed by each affected employee.
Compliance Tips
Here are several
practice tips that
employers can follow to comply with Section 409A:
• Inventory all
arrangements that contain deferred compensation.
• Determine which
arrangements are subject to Section 409A.
• Confirm that all such
arrangements currently comply with the law.
• Amend any noncompliant
arrangements by the end of 2008.
• Consider adopting
umbrella documents in 2007 that contain the necessary Section 409A language for
all similar arrangements.
• Set up a team to focus
on achieving Section 409A compliance.
the time to review plans that may be subject to Section 409A. The deadline will
approach quickly, and employees at companies that haven’t achieved compliance could
face immediate taxation—in addition to a 20 percent penalty and interest.