THE NONQUALIFIED DEFERRED COMPENSATION ADVISOR 2007 SUPPLEMENT PPA Restricts Trusts for Top Executives The Pension Protection Act added new restrictions to IRC Section 409A to prohibit top executives from setting aside assets (such as in rabbi trusts) while the company's defined benefit pension plan is under-funded or while the company is in bankruptcy. The restrictions apply to any transfers or reservations after the date of enactment. Under the new rules the restricted period is any period during which the employer is in bankruptcy, during which a company's plan is in "at-risk" status, or during the six months before or after an insufficient plan termination. Violating the new restrictions results in the usual penalties under IRC Section 409A: immediate loss of deferral and retroactive recognition of income, an additional 20% penalty tax, and interest at 1% greater than the usual underpayment rate. Pension Protection Act, Sec. 116. IRC Secs. 409A(b)(3). Tax Facts on Insurance & Employee Benefits: Q 115. IRS Extends Transition Relief for Deferred Compensation Plans In October 2006, the IRS released Notice 2006-79 providing transition relief for nonqualified deferred compensation plans under IRC Section 409A. In the Notice, the IRS announced that final regulations under 409A will not become effective until January 1, 2008, rather than January 1, 2007 as previously announced. The Notice extends through 2007 most of the transition relief previously provided for 2006. The Notice also provides transition relief for certain payment elections in linked qualified plans and for certain collective bargaining arrangements. The IRS issued Notice 2005-1 on December 20, 2004 providing initial guidance on IRC Section 409A. On October 4, 2005, the IRS published proposed regulations under 409A. The preamble to the proposed regulations clarified and extended certain provisions of the transition guidance provided in Notice 2005-1, generally through December 31, 2006. Under the proposed regulations, the final regulations were proposed to be effective January 1, 2007. In Notice 2006-79, the IRS provides that any nonqualified deferred compensation plan adopted on or before December 31, 2007 will not be treated as violating IRC Section 409A if it operates in reasonable, good faith compliance with 409A and applicable provisions of Notice 2005-1 and if the Copyright 2007 The National Underwriter Company 1
plan is ultimately amended on or before December 31, 2007 to conform to the provisions of 409A and the final regulations. Plans are not required to comply with the proposed or final regulations prior to January 1, 2008, but compliance with either the proposed or final regulations will constitute reasonable, good faith compliance with 409A. Notice 2006-79 generally extends transition relief allowing the substitution of non-discounted stock options and stock appreciation rights for discounted options and rights through December 31, 2007, but excludes certain discounted stock options and rights issued to officers, directors, and 10% shareholders (those subject to disclosure requirements under Section 16(a) of the Securities Exchange Act of 1934). Specifically, transition relief is not extended if the corporation involved has reported or reasonably expects to report a financial expense due to the issuance of a discounted option or right which expense was not timely reported on financial statements for the period in which the expense should have been reported under generally accepted accounting principles. Notice 2006-79 also extends transition relief for wrap plans, supplemental employee retirement plans, and other nonqualified plans that are controlled by a payment election under a related qualified plan. For these plans elections as to the timing and form of payment under the nonqualified plan that are controlled by the qualified plan are permitted through December 31, 2007. For this relief to apply, the determination of the timing and form of the payment must be made in accordance with the terms of the nonqualified plan as of October 3, 2004. Notice 2006-79 provides that nonqualified plans maintained pursuant to collective bargaining agreements in effect on October 3, 2004 are not required to comply with 409A on or before the earlier of December 31, 2009 or the date when the last controlling collective bargaining agreement expires. Notice 2006-79, 2006-43 IRB 763. ASRS: Sec. 64, 310-360, 420, 440, 480. Tax Facts on Insurance and Employee Benefits: Q 115. IRS Allows Early FICA Deduction for Accrual Taxpayers In March 2007, the IRS ruled that accrual-basis taxpayers who meet certain tests may deduct FICA taxes on deferred compensation before the year in which the deferred compensation is actually paid. The ruling reversed a 38- year-old ruling under which the IRS maintained that an accrual-basis taxpayer could not deduct otherwise-deductible payroll taxes until the year the deferred compensation itself was paid and deductible. Under IRC Section 404(a)(5), nonqualified deferred compensation is not deductible until the taxable year in which the compensation is includible in the employee s gross income (the matching rule). Employment taxes, however, are not subject to the same rules as the income tax. Under IRC Section 3121(v)(2), deferred compensation is generally subject to FICA and FUTA taxes as of the later of the performance of services or the time when there is no longer a 2
substantial risk of forfeiture of the right to the deferred compensation. This means that in the case of vested deferred compensation, payroll taxes are payable when the services are performed, even though the deferred compensation may be paid much later. In Revenue Ruling 2007-12, the IRS ruled that the matching rule under IRC Section 404 does not apply to an accrual-basis taxpayer s payroll tax liability. Provided the employer meets the standard timing rules under IRC Section 461, the employer s payroll taxes will be deductible in the year services are performed. Under the timing rules, an amount is deductible when 1. all the events have occurred that establish the fact of the liability, 2. the amount of the liability is determinable with reasonable accuracy, and 3. economic performance has occurred with respect to the liability. In Ruling 2007-12, the IRS found that the requirements for deductibility had been met (including the recurring item exception under the regulations) by the taxpayer. The taxpayer could, therefore, deduct the payroll taxes in the year in which the services were provided even though the deferred compensation itself would not be deductible until the following year. The IRS did make clear in the ruling that changing the treatment of payroll tax liabilities would constitute a change in method of account. Taxpayers must obtain the consent of the IRS under IRC Section 446(e) and Treasury Regulation 1.446-1(e)(2)(i). Rev. Rul. 2007-12, 2007-11 IRB 685. ASRS: Sec. 64, 470.1. Tax Facts on Insurance and Employee Benefit: Q 123. IRS Issues Final Deferred Compensation Regulations In April 2007, the IRS issued final regulations under IRC Section 409A. The regulations are generally applicable for taxable years beginning on or after January 1, 2008. The final regulations do not extend any transition relief beyond December 31, 2007, so all deferred compensation arrangements must comply with the rules, both in writing and in operation, by the beginning of 2008. The final regulations generally implement the proposed regulations published on September 30, 2005, but include revisions in a few areas. The final regulations do not address several issues, including the calculation and timing of amounts includible in income under IRC Section 409A, the reporting and withholding requirements under IRC Section 409A, the application of IRC Section 409A(b) to offshore trusts or arrangements with financial triggers, or the application of IRC Section 409A to partners and partnerships. The IRS will provide future guidance on these issues. 3
Deferral Elections with Respect to Commissions The final regulations generally adopt the proposed rule for the timing of deferral elections with respect to commissions. This rule treats services related to a commission payment as performed in the year in which the customer remits payment to the employer. The final regulations add to this an option to treat the services as performed in the year in which the sale occurs. The alternative rule must be applied consistently to all similarly-situated employees. Independent Contractors The final regulations adopt the rule for independent contractors found in the proposed regulations and in Notice 2005-1. Under the rule, IRC Section 409A does not generally apply to amounts deferred under an arrangement between a service recipient and an unrelated independent contractor, if, during the contractor's taxable year in which the amount is deferred, the contractor provides significant services to each of two or more service recipients that are unrelated, both to each other and to the independent contractor. The final regulations also retain the safe harbor provision that an independent contractor will be treated as providing significant services to more than one service recipient where not more than 70% of the total revenue of the trade or business is derived from any particular service recipient (or group of related service recipients). This rule is important to many insurance agents who work for multiple insurance companies. Under the final rule, a contractor who has met the 70% threshold in the immediately proceeding three years will be deemed to meet the threshold in the current year, as long as he does not know or have reason to know that he will fail to meet the threshold in the current year. Short-Term Deferrals The final regulations largely adopt the approach used in both the proposed regulations and in Notice 2005-1 that excludes certain "short-term deferrals" from the coverage of IRC Section 409A. Under this rule, a deferral of compensation does not occur when amounts are paid within 2½ months after the end of the year in which the employee obtains a legally-binding right to the amounts. Under this rule, many multi-year bonus arrangements that requirement payments promptly after the amounts vest will not be subject to IRC Section 409A. The final regulations do liberalize the standard under which a payment can be a short-term deferral even if it is delayed by unforeseeable events. The final regulations provide generally that payment maybe delayed where the payment would jeopardize the ability of the employer to continue as a going concern. Wrap Plans The final regulations generally adopt the relief provided in the proposed regulations with respect to the election-timing and the anti-acceleration rules for 4
changes in the amount of benefits under wrap plans, supplemental employee retirement plans, and other nonqualified plans that are controlled by a payment election under a related qualified plan. The final regulations extend this relief to certain broad-based foreign retirement plans and provide additional relief for matching contributions contingent upon the making of an after-tax contribution. Changes in Time and Form of Payment Under IRC Section 409A and the final regulations, plans may only permit an employee to make a subsequent election to delay or change the form of a payment in limited circumstances: 1. the election may not take effect until at least 12 months after the date on which the election is made; 2. the payment with respect to which the election is made must be deferred for at least five years (except for payments made on account of death, disability, or unforeseeable emergency); 3. the election must be made not less than 12 months prior to the date of the scheduled payment. The final regulations adopt the general rule that each separately identified amount to which an employee is entitled to receive on a determinable date is a separate payment. Plans have flexibility to separately identify payments, but once payments have been separately identified, any subsequent aggregation must comply with the above requirements. A series of installment payments under a single plan will generally be treated as a single payment for purposes of the subsequent election rules; however, a plan may specify that a series of installment payments is to be treated as a series of separate payments. 26 CFR Part 1 [RIN 1545-BE79]. ASRS: Sec. 64, 110-130. Tax Facts on Insurance & Employee Benefits: QQ 116, 118-120. IRS Explores Taxation of Deferred Compensation Trust In July 2007, the IRS issued a revenue ruling describing a deferred compensation plan under which an employer contributes to a non-exempt trust on behalf of a group of highly compensated employees. The ruling describes the deferred compensation plan, the contributions, investment earnings, and distributions, and outlines the resulting income and employment tax treatment for an employee and the employer. The Plan and the Trust In the ruling, an employer has created a deferred compensation plan for 50 key executives, all highly compensated employees. Under the plan, the employer contributes each year on behalf of each participant to a nonqualified, non-exempt trust. Under the terms of the trust, its assets are not subject to the 5
claims of the employer s creditors, and the assets of the trust may only revert to the employer once all obligations to participants and beneficiaries are satisfied. Under the plan, a participant s entire interest in the trust becomes vested after completing two years of service following the date the participant becomes eligible for the plan. Plan participants or their beneficiaries are entitled to receive their vested interest in the trust upon death, disability, or termination of employment. In addition, the trust is required each year to distribute to each participant an amount the trustee reasonably estimates will equal the amount of Federal, state, and local income and employment taxes payable by the participant with respect to the increase in the participant s vested accrued benefit during the year. The trust may make the distribution in part in cash and in part in the form of applicable employment tax withholding. The Money On each January 1 of 2007 through 2010, the employer contributes $100,000 to the trust on behalf of a participant, Mr. Alpha. At the close of business on December 31, 2008, Mr. Alpha s interest in the trust is worth $214,000. Mr. Alpha s interest in the trust first becomes vested the next day, January 1, 2009. On that date, the fair market value of his interest is $314,000 (including the new contribution). In 2009, the trustee distributes $132,000 to Mr. Alpha, partially in cash and partially in the form of withholding. The value of his interest in the account at the end of 2009 is $198,000. In 2010, the trustee distributes $48,000 to Mr. Alpha, and the year-end value of his interest is $270,000. Tax Treatment for the Employee Although Mr. Alpha receives contributions to the trust on his behalf in 2007 and 2008, he does not have any taxable income from the contributions or trust in those years because his interest is not yet vested. Instead, Mr. Alpha is subject to income tax in 2009, the first taxable year in which his interest is not subject to a substantial risk of forfeiture. For 2009, Mr. Alpha must include $330,000 in his gross income as compensation. This reflects the $132,000 distribution he actually receives plus the $198,000 year-end market value of his account. For 2010, Mr. Alpha must include $120,000 in his gross income. This reflects the $48,000 distribution he receives plus the $72,000 in as-yet-untaxed value of his account ($270,000 less $198,000). Tax Treatment for the Employer The employer is entitled to a deduction for its contributions to the trust in the year in which the contributions are includable in the Mr. Alpha s income. The employer, therefore, receives no deduction in 2007 or 2008, but receives a 6
$300,000 deduction in 2009, when Mr. Alpha becomes vested in his trust account. The employer likewise receives a $100,000 deduction in 2010. Employment Tax Treatment The timing rules for federal employment taxes (FICA and FUTA) differ from those for federal income tax. If vested, contributions to the trust are taxable at the time of contribution. If not yet vested, the contributions are subject to FICA and FUTA taxes at the time of vesting. Unlike the rule for federal income tax, the valuation is determined at the time of vesting, not at year end. For Mr. Alpha, this means that on January 1, 2009, $314,000 is subject to FICA and FUTA taxes, both the newly vested account balance and the 2009 contribution. On January 1, 2010, the $100,000 contribution is subject to FICA and FUTA taxes. Rev. Ruling 2007-48, 2007-30 IRB 129; ASRS: Sec. 64, 430-430.5, 470.1. Tax Facts on Insurance & Employee Benefits: QQ 111, 114, 123. IRS Extends Written Plan Deadline for Deferred Compensation Plans In October 2007, in response to calls for additional time to comply with the final deferred compensation regulations, the IRS provided additional guidance and transition relief, including an extension to December 31, 2008 of the deadline to adopt written plan documents that comply with IRC Section 409A. The relief does not excuse taxpayers from complying with 409A in operation. On April 17, 2007, the IRS issued final regulations under IRC Section 409A. The regulations are final January 1, 2008 and apply to taxable years beginning on or after that date. As issued, the final regulations required deferred compensation plans to fully comply with 409A both operationally and in writing by that date. The new IRS notice provides limited relief with respect to the plan document requirement under 409A. As long as a plan is operationally compliant with the final regulations as of January 1, 2008, the plan need not be reduced to writing by that deadline. The plan must ultimately be amended in writing by December 31, 2008, retroactive to January 1, 2008. Under the new notice, a plan may not, after December 31, 2007, change the time and form of a deferred payment except as permitted under the final regulations. Furthermore, a plan must timely designate in writing, before January 1, 2008, compliant time and form of payment rules for previously deferred compensation. In other words, the transition relief does not extend to that part of a plan specifying the time at which or the circumstances under which deferred compensation will be paid. That part of a plan must be amended by January 1, 2008. 7
But where a plan permits a payment upon occurrence of a permitted event such as a separation of service, a change in control event, an unforeseeable emergency, or a disability, the plan need not amend the definition to comply with the final regulations by January 1, 2008. The plan must operationally apply a definition of the distribution events consistent with the regulations and must retroactively amend the definitions by December 31, 2008. The IRS also announced their intention to issue guidance in the near future establishing a limited voluntary compliance program for certain unintentional operational failures to comply with 409A. The guidance should provide methods to correct such failures within the same taxable year without tax consequences and other methods by which the consequences of such failures in a previous taxable year may be mitigated. Notice 2007-78, 2007-41 IRB ; ASRS: Sec. 64, 110-130. Tax Facts on Insurance & Employee Benefits: Qs 116, 118-120. 8