ALI-ABA Course of Study Executive Compensation: Strategy, Design, and Implementation June 19-20, 2008 New York, New York

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1 351 ALI-ABA Course of Study Executive Compensation: Strategy, Design, and Implementation June 19-20, 2008 New York, New York A Road Map for Complying with the Final Regulations Under Code Section 409A (Handout) By Keith A. Mong Buchanan Ingersoll and Rooney PC Washington, D.C.

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3 353 EXECUTIVE COMPENSATION LIBRARY JOURNAL REPORTS: LAW AND POLICY 2008 A Road Map for Complying With the Final Regulations Under Code Section 409A By Keith A. Mong, Buchanan Ingersoll & Rooney PC Washington, D. C. April 2008 This article is a revised and updated version of a two-part series published in Tax Management's Compensation Planning Journal in August and September In this iteration, author Keith Mong has brought the two parts together and addressed the latest transitional relief, correction program, and withholding and reporting notices issues by the IRS after the articles were first published. I. Introduction The Internal Revenue Service (IRS) one year ago issued final regulations under Internal Revenue Code 409A ( 409A), 1 which imposes new rules on nonqualified deferred compensation arrangements. Section 409A was added by the American Jobs Creation Act of and was generally effective for amounts deferred on and after Jan. 1, However, before the effective date of the final regulations, Jan. 1, 2009, 3 employers are generally permitted to comply with the new requirements under a reasonable, good faith compliance standard, taking into account the interim guidance issued by the IRS before the final regulations become effective. 4 Now that the final regulations have been issued, all arrangements subject to the new rules must be in compliance with the final regulations, both in form and operation, no later than Dec. 31, This article is intended to provide plan sponsors with a road map for complying with the final regulations by the end of This article provides a general overview of the new rules and discusses the arrangements that are subject to 409A, including the numerous arrangements that are excepted from the new rules and the specific requirements that must be satisfied in order to comply with the final regulations by the end of Because of the broad scope of arrangements that are potentially subject to 409A and the complexity and volume of the guidance that has been issued to date, this article does not address all of the exceptions, special rules and requirements that may apply and is only intended to provide a general framework for complying with the final regulations. As a result, before any specific actions are taken to comply with the final regulations, plan sponsors should consult with an experienced practitioner or consultant who is well versed in the new rules. In addition, because all arrangements subject to the new rules must be 1

4 354 in compliance with the final regulations by the end of 2008, plan sponsors should start the compliance process as soon as possible. II. Overview of 409A The deferred compensation rules under 409A potentially apply to any agreement or arrangement that provides for the deferral of compensation (including those covering only one person). 5 Certain tax-favored retirement plans (e.g., qualified retirement plans, 403(b) plans) and bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plans are statutorily excepted from the new rules. 6 Section 409A generally imposes three new requirements, which must be satisfied both in form and operation: (1) election restrictions, (2) distribution restrictions, and (3) acceleration restrictions. 7 The new requirements are in addition to the existing rules, and do not replace them. As a result, a deferred compensation plan will need to satisfy both the new rules and the existing rules (e.g., constructive receipt, economic benefit and 83, to the extent applicable). The election restrictions impose requirements with respect to both the timing of a participant's initial deferral election as well as the designation of the time and form of distributions. With respect to a participant's initial deferral election, the initial election to defer compensation for services performed during a taxable year generally must be made no later than the close of the preceding taxable year. 8 There are two statutory exceptions. First, in the case of a new plan or a participant first becoming eligible under a plan, the initial deferral election generally must be made within 30 days of initial eligibility. 9 Second, the deferral election with respect to performance-based compensation can be made at least six months before the end of the performance period, provided such performance period is at least 12 months. 10 Under the new rules, the time and form of distributions must be designated at the time of the initial deferral election. 11 However, the new rules allow for changes that further delay or change the form of payment if certain requirements are met. 12 For example, in certain cases, a change may be permitted if the change is made at least one year in advance of the originally scheduled payment date and the change delays the originally scheduled payment date at least five years. The distribution restrictions provide that deferred compensation cannot be distributed any earlier than one of six specified events: (1) separation from service (for specified employees of publicly traded companies, the deferred compensation must not be distributed for at least six months after separation from service); (2) disability (as narrowly defined in the statute); (3) death; (4) a specified time (or fixed schedule specified under the arrangement as of the date of deferral), but not an event; (5) a change in the ownership or effective control of the corporation or in the ownership of a substantial portion of the assets of the corporation (to the extent provided by the Treasury); or (6) the occurrence of an unforeseeable emergency (as narrowly defined in the statute). 13 The acceleration restrictions provide that the deferred compensation cannot be accelerated except as otherwise provided in regulations. 14 For example, so-called haircut provisions, which allow for the accelerated distribution of deferred compensation if there is a reduction in the amount payable (e.g., a 10 percent reduction), are no longer be permissible. 2

5 355 Section 409A also imposes new rules regarding the funding of deferred compensation arrangements. 15 Assets that are located outside of the United States or that become restricted to the payment of deferred compensation in connection with a change in the employer's financial health would be taxable to the participants when transferred outside of the United States or set aside. 16 In addition, with respect to a plan sponsor that maintains a defined benefit pension plan, if any assets are transferred to a trust, set aside, reserved or restricted to the payment of nonqualified deferred compensation during a restricted period, any assets so set aside or restricted would become immediately taxable to certain top executives. 17 For this purpose, the term restricted period, with respect to the defined benefit pension plan, means: (i) the period of time when the defined benefit plan sponsor is a debtor in bankruptcy; (ii) six months before or after the date that an underfunded defined benefit plan is terminated; and (iii) any period of time during which a defined benefit plan is at risk under the new funding rules added by the Pension Protection Act of There are significant adverse tax consequences if the new requirements are not satisfied: (1) all deferred compensation must be included in income in the current taxable year to the extent not subject to a substantial risk of forfeiture and not previously included in income (including deferrals in prior years); (2) an additional tax is imposed equal to the interest, using the IRS s underpayment rate plus 1 percent, that would have been imposed during the deferral period if the deferred compensation had been includible in income when first deferred (or not subject to a substantial risk of forfeiture); and (3) an additional tax is imposed equal to 20 percent of the deferred compensation. 19 The new rules also require all deferred compensation to be reported on IRS Form W-2 or Form 1099 in the year of deferral, even though the compensation may not yet be taxable. 20 In addition, amounts includible in gross income under 409A generally are treated as wages subject to the federal income tax wage withholding requirements. 21 The new rules statutorily apply to amounts deferred on or after Jan. 1, Amounts deferred (earned and vested) before Jan. 1, 2005, are not subject to the new rules unless there is a material modification of the arrangement on or after Oct. 3, The final regulations are effective April 17, 2007 (the date they were published in the Federal Register) and are generally applicable for taxable years beginning on or after Jan. 1, III. General Framework for Complying With the Final Regulations Employers 25 should consider completing the following steps in order to comply with the final regulations by the end of 2008: (1) Identify All Arrangements Potentially Subject to 409A Section 409A potentially applies to a broad range of plans, many of which have not traditionally been thought of as nonqualified deferred compensation arrangements. As discussed further below, 409A can apply to any arrangement that provides for the deferral of compensation, which is generally defined as any arrangement that provides a service provider with a legally binding right to compensation in a particular year that may be includible in the service provider's taxable income in a later year. 3