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COPYRIGHT 2005 Aspen Publishers, Inc.
One of the most significant US employee benefit developments since the passage of the Employee Retirement Income Security Act (ERISA) in 1974 was the enactment of Internal Revenue Code Section 409A in the fall of 2004. This deceptively simple section revolutionizes nonqualified deferred compensationu principally by establishing deadlines by which deferral elections must be made and by regulating distribution practices.
Section 409A applies to a great deal more than just traditional nonqualified deferred compensation plans. Its broad ambit reaches individual agreements, stock options, and other benefits (including severance) that practitioners traditionally have not considered deferred compensation.
Every US employer needs to analyze the impact of Section 409A on its employees, directors, partners, and independent contractors, and on the employer itself. Few will be unaffected. Most employers need to take proactive steps by the end of 2005 to preclude the imposition of significant tax penalties--income taxation in the later of the deferral or vesting year, a 20 percent excise tax, and interest penalties. Although these penalties would be imposed on the recipients of deferred compensation, their unanticipated imposition will create significant issues for employers, such as demands for tax penalty gross-ups, and tax reporting and withholding issues.
Section 409A analysis is arcane because of its unexpectedly wide scope and complex rules. The Internal Revenue Service has only issued one installment of guidance to date, IRS Notice 2005-1, 2005-2 I.R.B. 274 (December 20, 2004), a long set of Q&As that also provides transition relief. Much more extensive guidance is expected in the late summer or early fall of 2005. Although the Internal Revenue Service may extend IRS Notice 2005-1's transition relief, it has not yet indicated whether it will do so. Hence, the time for coming into complete compliance with Section 409A is fast approaching.
Although this guide is intended to help employers determine the programs and arrangements to which Section 409A applies and whether they are Section 409A-compliant, it is not a comprehensive exposition of Section 409A's intricacies. Moreover, there just is not enough guidance at present to determine the extent, if any, to which Section 409A will apply to certain arrangements. Split-dollar life insurance is a good example. Dan Hogans, the Treasury official most responsible for issuing Section 409A guidance, has been publicly quoted as saying that split-dollar life "is something that we're still thinking about.... People should sit tight on split-dollar [i.e., not do anything on account of Section 409A until guidance is issued]." (1) Given the many uncertainties about how Section 409A will be applied, if diagnoses made using this guide prove not to be 100 percent accurate, they at least will be very useful.
The next section helps employers compile a comprehensive list, using the form set forth in Figure 1, of all programs or arrangements to which Section 409A might apply. Later guidance in this article helps employers determine the extent to which those programs or arrangements are exempt from Section 409A. Finally, we help employers determine whether nonexempt portions of programs or arrangements comply with Section 409A.
IDENTIFY PROGRAMS OR ARRANGEMENTS TO WHICH SECTION 409A MAY APPLY
Section 409A potentially applies to any program or arrangement that effectively defers compensation. For example, it can apply to an oral promise that may not even remotely resemble a deferred compensation plan, to a promise made to a single individual, or to a terminal leave of absence with pay or taxable benefits. This guide uses the term "plan" to refer to any arrangement or program to which Section 409A may apply.
The core element that makes Section 409A potentially applicable is the creation of a legally enforceable right to receive compensation that, but for Section 409A, would be taxed in a later tax year of the employee or other service provider. (2) Legally enforceable rights can be created by contract or by operation of law. For example, an employee's right to receive payment for December services during a normal pay period that ends in January is a plan to which Section 409A potentially applies (although it qualifies for the "payroll period" and "short-term deferral" exemptions described later).
It is important to distinguish between legally enforceable rights and preconditions to payment. A legally enforceable right generally is one that could be enforced in a court of law if the preconditions to payment were satisfied. Thus, for example, a scientist's unconditional right to receive a payment if he or she wins the Nobel Prize is a legally enforceable right. In contrast, a right to receive a payment contingent on the payer's electing to make one normally would not constitute a legally enforceable right.
Section 409A applies to plans benefiting individuals, such as employees, directors, partners, and proprietors. (3) IRS Notice 2005-1 includes a "plumbers exemption" that exempts from Section 409A payments or other rights extended to a nonemployee/nondirector engaged in a trade or business that provides services to two or more unrelated recipients. (4) Section 409A does not apply to arrangements between taxpayers all of whom use the accrual method of accounting (which individuals almost never use). (5) IRS Notice 2005-1 refers to persons or entities potentially subject to Section 409A as "service providers," and refers to the persons for whom they work as "service recipients." This article uses the same terms.
With these basics in mind, the first step an employer following this article should take is to list each of its plans on the form in Figure 1. Some employers will find it helpful to review the next section of this article before compiling a comprehensive plan list, because doing so should enable them to omit plans that are clearly exempted from Section 409A, such as tax-qualified retirement plans.
In many cases, no single individual within an employer will be able to identify all of the employer's plans. Therefore, a representative group of knowledgeable individuals drawn from each of the employer's units probably should compile plan lists (using the form in Figure 1) and then work collectively to aggregate them into a single comprehensive plan list that will serve as a starting point for the employer's efforts to come into complete Section 409A compliance.
DETERMINE WHICH PLANS ARE EXEMPT FROM SECTION 409A
The following types of plans are exempt from Section 409A. In completing the form in Figure 1, designate whether a plan or plan feature is Section 409A-exempt in the "409A-Exempt?" column by identifying all applicable exemptions using the numbers set forth in the following list. If only part of a plan is exempt, if it is uncertain that an exemption applies, or if the exemption is only temporary (e.g., exemption 16), put "See note x" in the "409A-Exempt?" column and attach an explanation.
1. Non-"Plan" Payments: Section 409A only applies to amounts deferred...
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