IRS and Treasury issue proposed regulations on income inclusion for failure to comply with Code section 409A

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1 February 11, 2009 IRS and Treasury issue proposed regulations on income inclusion for failure to comply with Code section 409A By John Lowell, Vice President, Aon Consulting As part of its triad of guidance in December, the IRS and Treasury published proposed regulations on income inclusion under Code section 409A. In this article, we discuss this guidance and amplify that failure to comply with 409A will result in significant confiscatory penalties. During December 2008, the IRS and Treasury issued three key pieces of guidance related to Code section 409A (1) guidance related to correcting certain operational failures under 409A, (2) guidance on reporting and wage withholding under 409A and (3) proposed regulations on income inclusion for failures to comply with 409A. In this article, we address that third piece of guidance. Readers should consider that the three pieces of guidance are intentionally intertwined and that consideration of any one without consideration of the other two will likely leave many questions unanswered. The proposed regulations are fairly long (90 pages) and quite complex. While most readers are probably quite familiar with the background on 409A, we ll discuss that in brief before moving on to the new guidance provided in the proposal. Section 409A was added to the Internal Revenue Code by section 885 of the American Jobs Creation Act of The thrust of that section of the legislation came from what were widely viewed as executive compensation scandals in situations such as that at Enron, where qualified retirement programs lost all or most of their value, but nonqualified deferred compensation programs remained intact and their participants benefited. Generally, 409A requires that for compensation deferred and vested after December 31, 2004, all plans of deferred compensation must be documented in writing, and all participants under those plans must make elections, at the time of deferral, as to the timing and form of payment from the plans. Violations generally are subject to a 20% penalty tax and a further tax equal to the interest that would have accrued on the tax that would have been payable on such deferred compensation had that compensation been included in the employee s income in the later of the year the amounts were earned or were no longer subject to a substantial risk of forfeiture. These taxes would be in addition to any ordinary income taxes payable for the year included in income. Violations retrospective only Prior to the issuance of these proposed regulations, there was concern among some practitioners that once a violation in a plan had occurred that all compensation ever deferred under that plan (after 2004) would be in violation of 409A. In other words, people feared, for example, that a violation in 2012, discovered in 2015, for a plan that had been in existence since 2005 would taint the entire value in the plan through The regulations clarify that such violations are retrospective only. So, in the above example, only the compensation (and earnings thereon) deferred through 2012 would be subject to income inclusion under Feburary 2009 page 1

2 409A, but amounts deferred after 2012 would not be subject to such income inclusion, so long as the plan complies in both form and operation during those subsequent years. In addition, the proposed regulations clarify that certain changes to timing and form of payment for nonvested amounts may be fixed without penalty. In this case, the requirement is that such change will not be treated as a violation if the plan is corrected to comply with 409A both documentarily and operationally by the end of the year in which the amounts actually vest. This issue may be particularly complex for plans with class year vesting where at any point in time, certain amounts are vested and others are nonvested and a particular change in election may relate to both vested and nonvested amounts (we discuss the bifurcation of vested and nonvested amounts later in the article). Date of calculation Another issue that was clarified by the proposed regulations is the calculation date for income inclusion. Practitioners had differed in their interpretation of the statute as to whether the amount of income to be included was calculated as of the date of violation, the date of income inclusion, the date the error was discovered or some other date. The regulations specify the amount to be included is calculated as of the last day of the taxable year during which the 409A violation occurs. This amount would include all of the following: amounts deferred in prior years unless they were not subject to 409A (generally amounts deferred prior to January 1, 2005) amounts deferred in the year in which the violation occurred, whether those amounts were deferred before the violation occurred, after the violation occurred, or on the date that the violation occurred any deemed investment earnings (net of any deemed investment losses) Amounts that, as of the last day of the year, were still eligible for short-term deferral treatment (generally paid within two and one-half months after the end of the year) as of the last day of the year would be excluded if they were actually paid by the end of the short-term deferral period. Specific types of plans Just as the final 409A regulations (those that deal with complying with 409A in form and operation) separate the universe of deferred compensation plans into multiple types, so do these income inclusion regulations. In the next sections, we consider the different types of plans subject to 409A and the income inclusion issues in the event of a 409A violation. First, however, we cover certain rules that apply generally to all types of nonqualified deferred compensation plans. February 2009 page 2

3 In general, for a plan that has a 409A violation, the amount included in income is, for a year, the amount deferred in that year less the amounts deferred in that year that are either subject to a substantial risk of forfeiture or that have previously been included in income, but in no case less than zero. Each year is to be analyzed independently. Thus, if amounts deferred during a year are not in violation, then those amounts are not subject to income inclusion even if other amounts deferred under the plan are. It is this language that provided for retrospective, but not prospective, analysis. Finally, with respect to changes in form of payment or timing of payment of nonvested amounts, the regulations contain an anti-abuse provision whereby a service provider who habitually makes such changes with respect to nonvested amounts shall be considered to be in violation of 409A with respect to those nonvested amounts. In the general case, the amount deferred for a taxable year is the present value of all future payments to which the service provider has a legally binding right under the plan as of the last day of the taxable year, plus the amount of any payments of amounts deferred during such taxable year. Present value is determined differently for different types of plans. In cases where the use of actuarial assumptions is necessary, those assumptions must be reasonable. The Commissioner of the IRS reserves the right to determine when such assumptions are unreasonable. In the event that assumptions are determined to be unreasonable, then the default assumptions for recalculation are the applicable federal rates for the last month of the taxable year under Code section 1274(d) and the applicable mortality table under Code section 417(e)(3). In determining the present value, the service provider is deemed to have terminated on the last day of the taxable year, and the present value generally is determined assuming payment is made in the form and at the time (where there are options) that produces the highest present value. Account balance plans Generally, account balance plans are exactly what they sound like those plans where the value to a participant is exactly equal to the stated balance of an account. Examples of such plans are supplemental deferral plans, excess 401(k) plans and nonqualified cash balance plans where the participant s benefit is equal to the vested account balance. For these plans, the present value of benefits as of the end of a taxable year is equal to the aggregate balance of all accounts under the plan as of the end of the taxable year. Nonaccount balance plans Nonaccount balance plans generally can be thought of as defined benefit excess plans or supplement executive retirement plans (SERPs). That is, they are usually plans where the benefit is stated as a periodic annuity payable at some future date and based on some mathematical formula normally tied to compensation, years of service and certain other February 2009 page 3

4 factors. In nonaccount balance plans, the present value is calculated using a reasonable interest rate and a reasonable mortality table, and assuming the participant terminates employment on the last day of the taxable year. These provisions can be illustrated by an example. Suppose a SERP provides for a benefit of 2% of final year s compensation per year of service with the company. The CEO was hired January 1, He has made an election under the plan to take a single life annuity beginning on the earlier of one year following date of termination or age 65. The plan provides that benefits are to be reduced by 5% per year for each year that benefit commencement starts before age 65. He was born on January 1, During 2012, the plan fails to comply with 409A and the CEO s plan compensation for that year was $10,000,000. To determine the includible income under 409A, we first determine the CEO s accrued benefit as of December 31, 2012 to be 2% * $10,000,000 * 8 years of service = $1,600,000 per year beginning at age 65 (January 1, 2015). Next, using reasonable interest rate and mortality assumptions, we calculate the actuarial present value of his benefit, both as a single life annuity of $1,600,000 beginning in 2015, and as a single life annuity of $1,440,000 (90% of the unreduced amount after applying the 5% per year reduction for early commencement) beginning January 1, Whichever is greater is the present value for purposes of determining the amount of includible income under 409A. Stock rights (SARs or options) Stock appreciation rights (SARs) and stock options generally allow a participant to benefit from the increase in value in the underlying stock from the grant price to the exercise price. In the case of a 409A violation, if the SAR or option had not already been exercised, the exercise price generally would be determined based on the value of the stock as of the last day of the employee s taxable year, and the amount of includible income per option or SAR would equal the spread (exercise price less grant price, but not less than zero). Had the right been exercised during the year of the violation, the present value per share would equal the spread on the date of exercise. Separation pay plans Separation pay plans or severance plans are programs under which an employee receives a specified amount of compensation only upon involuntary termination from service. Certain broad-based severance plans in which the amount of the payout does not exceed two times the pay cap under Code section 401(a)(17) are exempt from 409A. Should a separation pay plan be in violation of 409A during a year, the amount of income inclusion need not be calculated until and unless the employee actually suffers an involuntary termination and thus becomes entitled to that amount. When that time occurs, the present value is equal to the present value of the payments. February 2009 page 4

5 Bifurcation Earlier we noted that in the event that a calculation of income inclusion under 409A must be done that the benefits (and present value) are to be bifurcated between those that are vested and those that are nonvested. Whether a benefit is vested, or subject to substantial risk of forfeiture, is determined as of the last day of the taxable year. So, for example, if a violation occurred with respect to a plan on July 1, 2009, and a participant became vested in 50% of his benefit on September 1, 2009, then for the 2009 taxable year, that 50% would be considered to be vested even though it was not when the violation actually occurred. Future events Once an amount is included in income under 409A, it need not be included again when the amount is actually paid. Any amounts that were previously included in income offset future payments from the same nonqualified deferred compensation plan (or aggregated group of plans) solely for purposes of determining the taxable amount of such payments. To the extent that an amount which was previously includible in income under 409A is eventually forfeited (the service recipient might have become insolvent or declared bankruptcy, or the assumptions that were used might have turned out to be inaccurate over time), the employee is entitled to a deduction for the excess of the amount previously included in income over the amount actually received. However, no recovery of the 20% penalty tax or the interest tax on deemed underpayments is permissible. And, because the Internal Revenue Code generally matches up employer deductions with employee taxes and vice versa, the service recipient (employer) may be required to recognize like income or to reduce its net operating loss carryforwards. Other guidance In this month s newsletter, there are two other articles related to guidance on 409A. One is related to reporting and withholding and the other is related to a corrections program for certain operational, but not documentary failures. ##### For more strategies on retirement programs, contact John Lowell at or john.lowell@aon.com. February 2009 page 5