October 2007

DEADLINE LOOMS FOR 409A DOCUMENT COMPLIANCE

Sec. 409A was added to the Internal Revenue Code in 2004 and is generally effective for compensation deferred beginning in 2005. The general rule of this provision is that unless the requirements of Sec. 409A are met, amounts deferred under a nonqualified deferred compensation plan are includible in an individual’s gross income to the extent they are not subject to a substantial risk of forfeiture and were not previously included in income.

What Falls under 409a?
Sec. 409A covers any arrangement under which compensation is deferred, unless tax law has provided an exception. So, for example, retirement plans qualified under Sec. 401(a), simplified employee pensions (SEPs), 401(k) plans, tax-sheltered annuities and the like, though providing for the deferral of current compensation, are not subject to Sec. 409A because tax law has provided exceptions for them. Bona fide sick leave or vacation plans, disability plans, death benefit plans and certain medical expense reimbursement arrangements also generally do not fall under Sec. 409A. Stock option plans and other equity-based compensation plans, and separation pay plans, are not covered by Sec. 409A if they meet certain conditions. Sec. 409A regulations also include a short-term deferral rule under which certain payments of this type would not be considered a deferral of compensation.

Documentary Compliance
During April 2007, the Internal Revenue Service released final regulations on Sec. 409A. A critical provision of the final regulations involves documentary compliance. Though the final rules are effective for tax years beginning on or after January 1, 2008 (with good faith compliance currently required), they retain the previously proposed date of December 31, 2007, as the time by when the written document establishing the nonqualified plan must reflect the 409A provisions. This includes, for example, language regarding the timing of elections, where the general rule is that a participant’s irrevocable election to defer compensation for services performed in a taxable year must be made before the beginning of the year. Documentary compliance also includes language regarding distributions. In order to meet the requirements of Sec. 409A, plan distributions must be limited to the following events:

• Separation from service.
• A fixed time, or pursuant to a fixed schedule, that is established under the plan.
• Death.
• Disability.
• A change in control of the organization.
• An unforeseeable emergency.

As noted above, equity-based arrangements and separation pay arrangements are excluded from Sec. 409A in certain situations. One clarification in the final rules has to do with stock options and stock appreciation rights. To be excluded from 409A, these must be issued on “service recipient stock” (along with meeting other requirements). The final rules expand “service recipient stock” to include any class of common stock.

The final rules also offer limited situations where the expiration time for stock rights can be extended without subjecting them to Sec. 409A (which would be the usual result of an extension). Regarding separation pay, final rules recognize that a voluntary separation for good reason may, in some cases, be treated the same as an involuntary termination.

Compliance Is Essential
The consequences of failing to comply with the provisions of Sec. 409A is that all amounts deferred under the plan will be included in participants’ income in the tax year in which the compliance failure occurred, to the extent that these amounts are vested and were not previously taxed. Such amounts also are subject to a 20% tax penalty plus interest.

Though any tax law is complex, Sec. 409A is especially so; the final regulations entail almost 400 pages! And, with the end-of-year documentary compliance deadline, it is important to assess any nonqualified plans in your organization for compliance. The penalties are too severe to risk.