Legal Bulletins

To combat abusive compensation practices such as those perpetrated in recent years by high-profile companies and their executives, Congress added a new Section 409A to the Internal Revenue Code. Section 409A and the IRS’s recently proposed implementing regulations redefine the deferred compensation arena and govern not only new non-qualified deferred compensation plans, but existing ones as well. The adverse consequences to plan participants when an arrangement fails to comply with Section 409A are significant—accelerated recognition of taxable income that otherwise would have been deferred into future taxable years, imposition of substantial interest on the taxes due on that accelerated income, and a 20% penalty tax.

What Does Section 409A Cover?

Section 409A covers most types of non-qualified deferred compensation plans. Under the law, a “deferred compensation plan” is any arrangement that calls for compensation to be earned in one year but paid in another year. Arrangements that raise 409A concerns include:

• Non-qualified stock options;
• Stock appreciation rights (SARs);
• Phantom stock awards;
• Restricted stock units;
• Performance units;
• Employment agreements that provide severance or retirement benefits;
• Deferred bonuses and other similar awards;
• Change-of-control agreements;
• Split-dollar life insurance arrangements (such as those typically related to COLI and BOLI policies); and
• Compensation arrangements involving Rabbi Trusts.

Incentive stock options and qualified employee stock purchase plans are exempt, as are qualified retirement plans (such as 401(k) plans), vacation time and sick time that accrue in one year but are used in another, disability pay and most forms of death benefits. Some of the arrangements listed above can be exempt if they satisfy certain conditions. For example, a non-qualified stock option will be exempt if, among other things, its exercise price can never be less than the fair market value (as defined in the regulations) of the underlying security on the date of grant, it relates to a fixed number of securities, and it does not grant any right to defer the receipt of compensation after exercise. This same exemption is available for SARs. Other arrangements will be exempt so long as the time for payment complies with certain short-term deferral requirements.

Compensation that was deferred and vested prior to January 1, 2005 is generally grandfathered and not subject to Section 409A, but it can become subject to Section 409A if the arrangement providing for the deferred compensation is materially modified after October 3, 2004.

What Does Section 409A Require?

The adverse tax consequences described above come into play in most cases if an employee has the ability to manipulate the timing of payment of the deferred compensation. To comply with Section 409A, therefore, non-exempt deferred compensation can be paid to a participant only upon the occurrence of one or more of the following six events: (1) a specified time or pursuant to a fixed schedule specified at the date the compensation was deferred; (2) separation from service; (3) disability; (4) death; (5) change in ownership or effective control of the employer (as defined in Section 409A); or (6) the occurrence of certain unforeseen emergencies. Special requirements apply to payments to key employees of publicly-traded companies. Plans no longer may permit the acceleration of the time originally specified for payment, such as pursuant to a “haircut” provision that allows a participant to accelerate the payment of deferred compensation if he or she forfeits a certain percentage of the compensation. Likewise, Section 409A prohibits the extension of the payment date for deferred compensation, unless the extension is agreed to at least one year before the compensation would otherwise be paid and the new payment date is at least five years later than the original date. Plans must require that the election to defer compensation in the first place must be made during the year preceding the year in which the compensation is earned, although there is an exception for when employees first become eligible to participate in the plan.

What Should Employers Do Now?

Because the IRS has not yet issued final regulations, all non-qualified deferred compensation plans are subject to a “good faith interpretation” standard until January 1, 2007. That means the plans must be operated in compliance with just the statutory language of Section 409A, not the IRS proposed regulations. On and after January 1, 2007, plans must comply with the IRS regulations as well. Accordingly, every employer who has any form of non-qualified deferred compensation arrangement for its employees should consult with its professional advisors now to determine whether those arrangements currently comply with Section 409A and, if not, what amendments need to be made before December 31, 2006 to ensure compliance. Employers who are thinking of adopting non-qualified deferred compensation arrangements should likewise discuss proposed arrangements with their advisors to ensure compliance.