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On October 22, 2004, Congress changed the taxation of deferred compensation by adding Section 409A to the Internal Revenue Code (the "Code"). As the legal community waits for additional guidance on Section 409A, a number of problems have already been identified. In some cases, the upcoming guidance may resolve these issues. In other cases, the issue will not even be addressed. This column describes some of the unresolved issues under Code Section 409A and potential solutions for the careful practitioner; however, a brief recap of the basic Code Section 409A requirements is necessary in order to set the stage for a discussion of the unresolved issues.
Recap of Code Section 409A Rules
The consequences of noncompliance with Code Section 409A fall upon the employee in the form of:
1. Accelerated inclusion of deferred compensation in the employee's income,
2. An additional 20 percent tax on the included compensation, and
3. A payment of interest (at the IRS required rate plus one percent) on the taxes that would have been payable on the deferred amount if it had been taxable when it was originally deferred.
Under IRS Notice 2005-1 (the "Transition Rules"), most plans may be amended prior to the end of 2005 without adverse tax consequences, as long as they ate operated in good faith compliance with the new rules during 2005. [2005-2 IRB 274]
Plan Failure Under Code Section 409A
The consequences of noncompliance with Code Section 409A flow from what is called "plan failure." Plan failure occurs if the plan document, as written, fails to follow new restrictions on distributions of plan benefits, acceleration of plan benefits, and elections with respect to initial deferrals of income and subsequent deferrals of distributions.
Distribution Events (Code Section 409A(a)(2))
Distribution of benefits may occur upon the earlier of six specified events:
1. Separation from service;
4. Unforeseeable emergency;
5. Change in control of a corporation; and
6. Any specified time, of pursuant to a fixed schedule.
For key employees of publicly traded corporations, a distribution upon separation from service can be made no earlier than six months after the separation from service.
Deferral Elections (Code Section 409A(a)(4))
In general, the initial election to defer compensation may only be made in the year prior to the year in which the relevant services ate performed. There ate two exceptions to this rule. First, an employee may make a prospective election to defer compensation within 30 days of the employee's first becoming eligible to participate in a plan. Second, for performance-based compensation, the election may be made six months prior to the end of the performance period.
A participant may change the time or form of payment, but only if the election is made 12 months prior to the first (current) payment date, is effective 12 months from the date of the change, and the first date an amount was previously payable is extended by five years. In essence, in order to change the timing or form of a distribution, the participant must be willing to delay receipt of the distribution by an additional five years.
Acceleration of Payments (Code Section 409A(a)(3))
The last requirement of Code Section 409A is that the time or schedule of any payment may not be accelerated. Notice 2005-1 specifically indicates that acceleration of satisfaction of a substantial risk of forfeiture (e.g., acceleration of vesting) by an employer is not considered an acceleration of the time or schedule of payment, provided that the other Code Section 409A requirements are met. As noted, …