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ACTION REQUIRED TO AVOID 409A PENALTIES
George L. Chimento
May, 2005
1. Introduction
2. The penalties for plan failures
3. The four prohibited plan failures
4. Grandfather protection for certain plans
5. Identifying “deferred compensation plans” and “service providers”
6. Administrative issues and special transition rules
for various types of plans and plan features.
7. Stock options
8. Stock appreciation rights
9. Restricted property
10. The troubling concept of “vesting”
11. Special problems for 457(f) plans of non-profit organizations
12. Constructive receipt rules still apply
13. Trusts and partnerships
14. Reporting and withholding
15. Ending it all (by December 31, 2005)
16. Conclusion
1. Introduction
New §409A of the Internal Revenue Code has the snappy title “Inclusion in gross income
of deferred compensation under nonqualified deferred compensation plans.” The statute
lists four types of “plan failures”, any of which will trigger taxation, penalties, and late
payment interest. Two additional requirements apply if trusts are involved.
“Deferred compensation plan” does not just mean a SERP or an elective deferral
program. The term may include bonuses, severance, discounted stock options,
appreciation rights, and any other device which might defer taxation of service income to
a year after services were rendered. Starting in 2005, special IRS reporting requirements
apply to 409A benefits, even if not currently taxable. Withholding is also required on
taxable amounts.
This article lists various plans and arrangements (all referred to as “plans”) which are
subject to the new 409A rules, and points out immediate compliance issues. The sole
guidance to date is IRS Notice 2005-1 (the “Notice”). References in this article to Q&A’s
are to those in the Notice. The Notice allows plan sponsors until December 31, 2005 to
amend their plans retroactively to January 1, 2005 so that they have the necessary 409A
rules. Q&A 19(a). The Notice is clear that there is no relief for 2005 administrative gaffs,
unless based on a good faith interpretation of 409A. Q&A 19(a) & (b). Additional IRS
guidance is expected in late spring and early summer.
2. The penalties for plan failures
When 409A is violated, the penalties are: taxation of vested amounts, a 20% additional
tax, and interest at the IRS “late payment” rate plus 1%, calculated as if there were tax
underpayments in the year when deferrals first occurred, or were first vested, if later.
409A(a)(1). A plan failure unique to one individual will not penalize other plan participants.
If there is a plan failure, the penalty is assessed for all of the participant’s vested
benefits in all 409A plans of the same type. The three plan types are account balance,
nonaccount balance, and “neither” (for discounted options, appreciation rights, and other
equity based arrangements covered by 409A). Based on design, a severance plan may
be a nonaccount plan or an account plan. Q&A 9.
3. The four prohibited plan failures
Unless a plan has the grandfather protection described in Section 4 below, restrictive
rules apply as of January 1, 2005. The Notice requires that all plans (other than
grandfathered plans) must be amended by December 31, 2005 to prohibit plan failures.
Although the statute lumps the failures into three categories, there are really four of
them.
a. Distribution is only allowed for certain events. (1) at a specific date or
according to a fixed schedule specified at the time of the initial deferral election, or (2)
after separation from service, with a required 6 month delay for key employees at public
companies, or (3) after disability, or (4) after death, or (5) after unforeseeable emergency
(based on a very strict definition that excludes tuition and home purchase, and which
requires that no other resources are reasonably available), or (6) after a change in
majority ownership or effective control of a corporation (Q&A 12 & 13) or in the
ownership of at least 40% of the assets of a corporation (Q&A 14).
b. Acceleration of the time or schedule for payments will not be permitted except
in rare situations blessed by Treasury. Getting the money at an earlier date than
scheduled is a plan failure unless an exception applies. Importantly, a plan sponsor's
decision to accelerate vesting so that payment may be made for a permissible reason
under 409A, such as separation from service, is allowed. The Notice also permits early
payments for domestic relations orders, de minimis cash-outs of $10,000 or less, cash-
outs of any amount if uniformly required and limited to future accruals, payments required
to pay taxes under 457(f) plans (an issue for non-profit organizations for which vesting of
certain executive deferred compensation arrangements is a taxable event), and
divestitures required by conflict of interest rules (i.e. if a corporate officer accepts a
position with a regulator). Q&A 15. Treasury has not yet sanctioned acceleration of
installment payouts, if requested by the beneficiary of a deceased participant, but is
looking at the issue.
Special notes on the acceleration failure:
Impermissible acceleration is the most likely, inadvertent plan failure. Employers often agree
to accelerate severance payments, simply to get them off the books and to facilitate the
retirement of a disgruntled executive. Severance arrangements and payment terms will have
to be carefully analyzed before the December 31, 2005 amendment deadline. If a lump sum
will be the de facto exception to installment severance payments, it should be made the
normal form.
Terminating a plan to pay benefits earlier than scheduled will also be an impermissible
acceleration. But see Section 15 of this article for the special rule which permits terminations
by December 31, 2005. Also, a termination of a plan due to change in control is permitted if
payments are made within 12 months of the change in control, meaning that plans can be
designed without an automatic trigger on all changes in control. Q&A 11(a).
c. Deferral elections must comply with initial timing rules. They must be made
before the start of the tax year in which services will be performed. New participants
may make deferral elections within the 30 days following initial eligibility. A one-time
extension until March 15, 2005 was allowed for 2005 deferral elections. Q&A 21.
In the case of bonuses under performance based plans, which reward services over a
period of at least 12 months, the election must be made no later than 6 months before
the end of the service period (i.e. by June 30, 2005 for a 2006 bonus payable for 2005
services).
d. Postponement of payment date and changes in form of distribution must follow
special timing rules. The time and form of distribution must generally be selected before
the service period. A special exception allows participants to make an election of time
and form of distributions for 409A benefits by December 31, 2005. Q&A 21. This is not
applicable to Plans which wish to keep grandfather status, as those Plans must be
administered under their terms.
If the December 31, 2005 exception does not apply, deferrals of starting date or change
in form of payment must otherwise meet these rules:
i. If the payment was to be due on a fixed date or schedule, the election to defer
must be at least 12 months prior to the scheduled payment, and must postpone the
payment for at least 5 years from the date the payment was originally scheduled;
ii. If the payment was to be due because of a separation from service or change in
control, the election will not be effective for amounts payable in the following 12 months,
and the election must postpone the payments for at least 5 years from the date the
payment was originally scheduled;
iii. Elections to postpone payments due for other permitted reasons (i.e. death or
disability), can be effective no earlier than 12 months from the date the payment was
originally scheduled. The requirement of 5 years of additional deferral is not applicable.
4. Grandfather protection for certain plans
409A does not apply to amounts which were deferred and “vested” prior to 2005 under
plans in effect as of October 3, 2004. Q&A 16(a). The grandfather treatment extends to
post -2004 “earnings” on grandfathered amounts. Q&A 17(d). Grandfather treatment is
lost if a material modification of the plan occurs after October 3, 2004. Q&A 18. For
determining grandfather status, plans are not aggregated, as they would be for penalty
purposes after a plan failure, but are treated separately. Q&A 18(e).
Amounts are not “vested” for grandfather treatment unless the participant had a legally
binding right by December 31, 2004 which could not be altered by the plan sponsor. An
amount is not “vested” for grandfather purposes if it was contingent on post-2004
services or refraining from competition, because “vesting” for grandfather determinations
is based on Reg. §1.83-3(c). Q&A 16(b). Unfortunately, these post-employment
conditions are disregarded in determining if a benefit is taxable. See Section 10, which
points out the problems caused by the dual definitions of “vested.”
Any change to a plan intended to be grandfathered must be scrutinized to be sure it is
not a “material modification.” The following changes will not affect grandfathered status:
(1) amendments to segregate 409A deferrals from grandfathered amounts, so that the
plan operates under two sets of rules for new and old money; (2) changes of deemed
investment choices and rates of return, if reasonable under the rules of Reg. §31.3121(v)
(2)-1(d); (3) removal of benefit options and freezing of future accruals; (4) termination of
the plan and distribution of taxable benefits in 2005, even though this accelerates
payment of deferred compensation, one of the four prohibited “plan failures” under 409A.
The following changes would be impermissible modifications and cause loss of
grandfather status:
i. adding a provision, even if allowed by 409A, to grandfathered amounts. Q&A 18(a).
Example:
409A allows hardship distributions, but adding a hardship clause after October 3, 2004 to
grandfathered benefits will forfeit grandfather treatment. Q&A 18(a).
ii. making an administrative decision to give rights to a participant if these rights
were not part of the plan as in effect on October 3, 2004.
Example:
A grandfathered severance plan in an executive’s contract requires payments over 24 months
and does not provide for acceleration. A Committee decision to accelerate payments to a lump
sum destroys the grandfather, and subjects the unlucky participant to the 409A penalties if
this event occurs after December 31, 2005.
5. Identifying “deferred compensation plans” and “service providers”
Identification of plans is vitally important to satisfy goals of:
i. making the required retroactive compliance amendment no later than December
31, 2005, and
ii. good faith administration during 2005, and
iii. not inadvertently modifying grandfathered benefits, in writing or in practice, after
October 3, 2004.
A plan is any agreement, method or arrangement that defers compensation of a service
provider to a taxable year later than the year in which services were rendered. Q&A 4
and Q&A 9.
Certain plans which have qualified-type tax status are exempt from 409A:
i. qualified 401 plans,
ii. 403(a)&(b) arrangements,
iii. simplified IRA’s under 408(k)&(p),
iv. governmental plans, including qualified excess benefit arrangements under 414
(m),
v. 457(b) plans for employees of non-profit and governmental entities,
vi. pre-June 25, 1959 plans qualified under 501(c)(18). Q&A 3(b).
Certain welfare benefit programs are also excluded. “Bona fide” vacation leave, sick
leave, compensatory time payments, disability pay, and death benefit plans are excluded,
along with Archer Medical Savings accounts, Health Savings accounts, and medical
reimbursement arrangements (including 125 accounts). Q&A 3(c).
Service providers include affiliated non-employees, such as directors and “related”
consultants. Special attribution rules will ensnare non-employee services to family
companies, with even a 20% overlap in ownership. Q&A 8. Bona fide independent
contractors rendering substantial, non-director services to two or more entities
“unrelated” to the service recipient are exempt.
That leaves lots to be covered, and the Notice is clear that 409A plans are not limited to
ERISA plans. Q&A 9. 409A covers certain arrangements not readily thought of as deferred
compensation, as described in the following Section 6.
6. Administrative issues and special transition rules for various types of plans
and plan features.
The following discussion and examples apply to common situations which employers may
encounter. It is hardly exhaustive and does not address all of the situations discussed in
the lengthy Notice.
a. Initial deferral election deadlines
If the special March 15, 2005 deadline in the Notice for 2005 deferral elections has been
missed, it is too late to make a deferral election for regular 2005 earnings. December 31,
2005 will be the deadline for 2006 deferrals.
Example:
Executive is told he will get an unexpected promotion and pay raise, effective June, 2005, and
would like to defer it. It is too late for 2005. The election should have been made by the
special March 15, 2005 deadline, even though the executive did not know at the time that he
would get the promotion. If this fact situation occurred in 2006, the deferral election deadline
would be December 31, 2005.
b. Bonus programs
i. Short-term. A bonus payable in a year following the rendered services is subject
to 409A unless it meets a “short term deferral” exception in the Notice. If the bonus is
payable no later than 2 & 1/2 months following the year (or years) in which the rights to
the bonus become “vested”, and if the participant has no election as to when to receive
the payment, the bonus program is exempt from 409A. The 2 & 1/2 month rule applies to
the later of the Participant’s year or the Plan sponsor’s year in which the vested right first
occurs. Q&A 4(c).
Example:
Executive is awarded a bonus on March 15, 2006 for 2005 services. He had no ability to
direct that the bonus be payable on another date. The bonus program is exempt from 409A.
If the Sponsor’s year ended on June 30, 2006, the bonus could have been paid as late as
September 15, 2006.
ii. Long term. The short term payment exception does not apply to plans which
provide deferral choices to Participants or which do not make payment within the
2 & 1/2 month short-term deadline. Those plans will have to be in writing with all of the
specified 409A provisions. Provided that the performance period is at least 12 months,
deferral elections may be as late as 6 months before the end of the performance cycle.
Remember that the 6 months is measured from the end of the performance period, not
from the date the bonus will be paid. If a bonus is based on standards which are virtually
certain to be reached, or simply based on stock price appreciation, it will not qualify for
this special 6 month rule. Q&A 22.
Example:
Company pays bonuses in March, 2006 based on 2005 services. The Plan allows employees
to defer receipt of the bonus. Because this is a performance cycle of at least 12 months
(calendar year 2005) a deferral election may be made as late as June 30, 2005. Election prior
to the start of the service period, i.e. by December 31, 2004, is not required, unless the
bonus criteria are virtually certain to be met.
c. Special December 31, 2005 date to make elections of form and time of
distribution of 409A deferrals.
409A requires that the form and time of payment be elected no later than the initial
deadline for the deferral election. Acceleration of payment is generally prohibited and
changes in form and time of distribution must follow special timing rules. (See paragraphs
3.b and 3.d of Section 3 above.) Because this new regime is less flexible than past
practice, a Plan may allow participants until December 31, 2005 to make a new election
as to the time and form of payments, presumably after reflecting on 409A and the IRS
guidance. Q&A 21.
Note that this special December 31, 2005 election is not available to grandfathered
benefits which were vested by December 31, 2004 under a pre-October 4, 2004 Plan. To
preserve the grandfathering, those Plans must be administered according to their terms,
which may, or may not, have provided for new payment and distribution elections after
an initial deferral date. It is advisable to wait for the next round of IRS guidance before
amending plans or extending this feature.
Example:
Executive participates in a defined benefit SERP which is entirely paid for by his employer. The
plan has generally allowed participants to elect the form of distribution (pension or lump sum
equivalent) within 60 days preceding retirement, subject to consent of an administrative
committee. For those benefits under 409A, the Plan may permit the executive to make a
lump sum or annuity choice as late as December 31, 2005.
Example:
Executive participates in a defined contribution SERP. The December 31, 2005 special election
is available for the 409A deferrals. The Plan can be designed so that this is the sole election
and applies to future deferrals in later years. Or the Plan can provided that a separate election
apply to each year’s deferrals. In that latter case, the election must be made by the initial
deferral deadline for that payment.
d. Special Issues for severance plans.
Severance plans are covered by 409A. These may be promises in an executive’s
employment contract, or a broad-based program for a large population.
The Notice seeks comments, and provides limited interim relief in 2005. Collectively
bargained plans and plans which do not cover “key employees” under Code §416(i) are
exempt from 409A in 2005. To qualify for this relief, the Plan must meet the ERISA
regulatory interpretation (i.e. payable over no more than two years, unfunded, not
contingent on retirement, and not exceeding two years of salary).
The main issue for non-exempt severance plans will be prohibited acceleration. It is
common for employers to accelerate severance payments, and that is a Plan failure
triggering 409A taxes and penalty.
Example:
Executive severs employment and is entitled to two years of separation payments. The
employer decides to pay him a lump sum, just to get it off the books. Surprise! There is a
409A Plan failure, because the payment was accelerated.
"But wasn’t the amount grandfathered ?" the executive in the above example asks. The
contract was in effect before October 3, 2004, and has not been changed. The
employer’s lawyer then explains that the non-competition clause in the contract keeps it
from being a grandfathered “vested” benefit. However, for tax purposes, the non-
competition clause is ignored, and 409A taxes and penalties apply. (See Section 10,
which discusses the dual definition of “vesting.”) Making this a true tax disaster, the
penalty applies to all “non-account” deferred compensation of the participant, including
any 409A accumulations in his defined benefit SERP.
e. Special issues for “termination” payments.
One of the permitted 409A reasons to make payments is a “separation from service.” Use
of that term, rather than “termination of employment” is especially unfortunate, because
it resurrects for 409A the troubling “same desk” rule that was recently legislated away
for 401(k) and 403(b) plans. Transfers of employment within a controlled group will not
be distributable events. Retirement followed by continued service as a director will
probably be a separation from service which would permit payment. Continued service as
a consultant, based on the circumstances, may or may not be a separation from service.
More guidance is necessary. Consider the following example.
Example:
Company X has a grandfathered deferred compensation plan for employees. In connection
with sale of a small plant, the Plan Committee decides to accelerate payment to an officer who
will continue to manage that plant for the new buyer. No plan provision permits this, and the
plant represents less than 40% of corporate assets. There are two problems.
1/ Early payment in the absence of a plan provision permitting early payment voids the
grandfather protection for the entire plan. Q&A 18.
2/ Although Executive has terminated employment, he has not “separated from service.”
He is at the same desk, so the payment violates 409A, unless the payment qualifies as a
change in control payment, another permitted 409A payment reason. Unfortunately, the sale
of less than 40% of assets is not a change in control under the Notice. Q&A 14.
The resulting tax disaster in this example was caused by: (1) improper administration,
which forfeited the plan's grandfather status, and (2) a misunderstanding of the
“separation from service” concept that applies to 409A. Executive has been paid for an
impermissible reason under 409A, even though his employment terminated due to a sale
of the plant where he worked. He pays income tax on the distribution, which he
expected. He also must pay a 20% penalty due to the “plan failure”, plus late payment
interest.
f. Special issues for defined benefit SERP’s.
To grandfather or not to grandfather, that is the question. In non-account Plans with
graded vesting schedules which overlap December 31, 2004, is it worthwhile to keep
track of grandfathered accruals ? If the decision is “yes”, the grandfathered amount is
the amount which would have been payable if the participant terminated employment on
December, 31, 2004. Increases in compensation after December 31, 2004 will not be
considered, and the Plan’s actuarial provisions may be used only if they are reasonable.
Q&A17(a).
Most SERP’s do not provide for payments during employment, so the acceleration
prohibition discussed in Paragraph 3.b of Section 3 is not a problem.
The most common problem will be the distribution election. The timing rule of 409A,
described in Paragraph 3.d of Section 3, above, generally requires participants to elect
forms of payment before the start of a service period. Although not mentioned in the
Notice, Congressional Committee Reports recommend that particpants at retirement be
allowed to select one actuarially equivalent pension form over another. We believe this
procedure will be sanctioned in future IRS guidance.
Example:
Jack does not know which form of pension to elect when he starts the service period for each
year's pension accrual. He would prefer to wait until retirement. We think IRS guidance will
allow that, provided that his election is only to select among actuarially equivalent forms of
annuity and not to select a lump sum.
Paying lump sums will be more tricky. Electing a lump sum after the start of a service
period would be a prohibited acceleration of prior accruals. Lump sums will either have to
be elected in advance of the service period, or will have to be the plan's normal form of
payment. Grandfathered SERP's can maintain a lump sum or annuity choice procedure at
retirement, but only for vested accrued benefits as of December 31, 2004.
The special December 31, 2005 election to designate the time and method of
payment is very helpful for SERP's. If a SERP is designed to comply with 409A,
participants may elect any permitted form and any starting date by December 31, 2005
without violating 409A.
Example:
Employer does not want to maintain a grandfathered SERP for some accruals and a 409A
SERP for others. It bites the bullet and elects to have one SERP under 409A rules. It offers to
participants a choice, prior to December 31, 2005, to elect whether they want lump sums or
pensions at retirement. It tells those who want pensions that they can elect the form of
pension at retirement. It also allows them to select the year that payments start, helpful for
those who might want a year or two of deferral after retirement. This works under 409A.
For those who do not make a December 31, 2005 election, deferral of payment until after
retirement will require compliance with the postponement procedure described in
paragraph 3.d of Section 3, above.
Example:
Executive intends to retire and wants to defer the start of her SERP pension. For benefits
governed by 409A, the Plan must provide, if the election is made after
December 31, 2005: (i) the new starting date cannot be within 5 years of the initially
scheduled starting date, and (ii) the postponement cannot not be effective for pension
payments which are due within one year of the new election.
Another devilish issue for defined benefit SERP’s involves the reporting and withholding
requirements. These requirements are discussed briefly in Section 14 of this article, but
additional IRS guidance is promised.
7. Stock options
Qualified incentive options are exempt. Nonqualified stock options are also exempt from
409A, provided that: (1) the exercise price is at least equal to the fair market value when
granted, (2) the exercise profit is taxable as salary income under IRC §83, and (3) the
only income deferral is in the period between grant and exercise. Q&A 4(d).
If a discounted option is to be granted, an advance election will have to made as to the
time it will be exercised. The exercise time can be at a fixed date, or after a permissible
409A distribution event, such as death, disability, change in control, or separation from
service. Acceleration or deferral of the exercise date would be under the the same
restrictive rules as apply to other 409A deferred compensation.
Obviously, if discounted options have been granted and would qualify for the 409A
grandfather, it is critical not to modify them.
Example:
Executive gets a discounted option under a Plan which predates October 4, 2004 and has the
right to exercise it by December 31, 2004. The option is grandfathered and exempt from
409A coverage. In 2005, the Directors vote to re-price the option at more favorable terms for
executive. The modification brings the discounted option into 409A coverage. However, if the
re-pricing is set at the current value at the time, the option would then be exempt from
409A, unless the grantee has the right to defer the taxable gain to a post-exercise date.
The preamble to the Notice indicates that the Treasury is especially concerned about
options which are coupled with stock appreciation rights at a guaranteed level, effectively
giving executives a “no lose” proposition. The preamble to the Notice indicates that the
409A exemption for non-qualified options may be further limited to those which are
unaccompanied by such rights.
8. Stock appreciation rights
It’s really no surprise that stock appreciation rights are covered by 409A. They are simply
a form of deferred compensation tied to appreciation in stock values. The Notice does
provide some relief.
For public companies, the appreciation right will not be covered by 409A if: (1) the
exercise price is at least equal to the fair market value of the underlying stock when the
right is granted; (2) the only settlement for the right will be in traded shares of the public
company; (3) deferral of taxation at exercise is not permitted. Interestingly, if non-vested
shares are provided at exercise, the tax may be deferred until the vesting date.
For all companies, rights granted on or before October 3, 2004 will not be covered by
409A if (1) the exercise price is at least equal to the fair market value of the underlying
stock when the right is granted; and (2) further deferral of taxation at exercise is not
permitted. In fact, new grants after October 3, 2004, pursuant to a program which meets
these standards and which predates any new Treasury tightening of the rules, will not
be subject to 409A.Q&A 4(d)(iv).
9. Restricted property
Generally, IRC §83 will govern taxation. Persons who receive property (such as restricted
employer stock) will not be taxed until the vesting date under §83. However, the grant of
a right to receive property in the future will be subject to 409A. Q&A 4(e).
10. The troubling concept of “vesting”
Vesting determinations are important for two reasons:
(i) In a grandfathered plan (not modified after October 3, 2004), the only grandfathered
rights are those which were vested by December 31, 2004;
(ii) If a Plan failure occurs, 409A taxation and penalties apply to “vested” benefits in all
plans of the same type, and the penalty interest dates back to the initial vesting date.
As mentioned earlier, there are two different definitions of “vesting.” It’s no surprise that
the more restrictive definition applies to determining whether a benefit is grandfathered.
Vesting for grandfather determinations
A benefit will not be grandfathered unless it is:
(i) not conditioned on the performance of future services, and
(ii) not subject to a substantial risk of forfeiture as determined under IRC §83. Q&A
18(b).
Vesting for 409A tax purposes.
If a 409A plan failure occurs, vesting will be determined by the plan provisions. However,
the following vesting conditions will be disregarded:
(i) any condition added after the start of the service period, and
(ii) any condition to “refrain” from performing service (i.e. non-competition
requirements, even if legitimate), and
(iii) any condition which is unlikely to be enforced. Factors such as the effective
control of a Plan sponsor and the past history of enforcing similar forfeiture provisions will
be taken into account. Q&A 10.
Grandfather rule example:
Executive is entitled to ten years of salary continuation under a plan which contains features
that would be failures under 409A. He is vested under his agreement, but the agreement
prohibits competition and requires confidentiality. Remaining payments may be forfeited if
Executive violates the agreement. It’s unclear if the benefit is vested (and grandfathered) as
of December 31, 2004. Section 83 regulations are very skeptical about post-separation
vesting conditions. To prove that a benefit is vested and entitled to grandfather treatment,
the Plan sponsor will have to demonstrate that the post-employment conditions are illusory.
409A tax example:
Executive participates in a plan which is covered by 409A. There is a plan failure. The plan
requires non-competition throughout the pension period. Executive can prove he regularly
receives offers from competitors. The non-competition restriction is disregarded nonetheless.
The Executive is considered vested and 409A penalties apply, even though he could forfeit the
benefit if he competes.
11. Special problems for 457(f) plans of non-profit organizations
Deferred compensation plans of non-profit organizations are also regulated by IRC §457.
If the plan meets the modest limits ($14,000 maximum deferral in 2005) and other
requirements of §457(b), it is exempt from 409A. 409A applies to all other deferred
compensation plans, which also continue to be covered by 457(f).
§457(f) has been a problem for non-profit organizations since 1986. It requires that
deferred compensation be taxed as soon as it is vested, not when it is paid. For example,
if an executive retires and is entitled to a $50,000 annual penson, the lump sum
equivalent of that pension is taxable under 457(f) in the year of retirement. The taxable
"basis" is then applied, pro rata, to the future taxable payments in a manner similar to
the taxation of annuities.
Problem: Where does the tax money come from on §457(f) vesting? Fortunately, the
Notice allows a plan to provide that an amount necessary for this §457(f) tax can be
withdrawn, without triggering 409A penalties under the rule which prohibits acceleration.
Q&A 15(d).
Problem: Which of the dueling definitions of “vested” is applicable ? To avoid early
taxation under §457(f) on vesting, some non-profits designed these plans with
somewhat illusory vesting conditions. The regulations were skeptical of “non-compete”
and similar post-employment provisions, but there was no bright-line test. If a benefit
was subject to a real post-employment noncompetition provision, an executive would
never have been vested under 457(f), and would simply have paid tax on pension money
when received.
There is now a great conundrum in the 457(f) world. If grandfathering from 409A is
important for a 457(f) plan, it will be necessary to establish that a benefit was “vested”
by December 31, 2004. Of course, that means that income tax is owed (and probably
late) with respect to the vested benefit under §457(f).
Example:
Jill’s is age 60, and will forfeit her expected 457(f) pension if she does not comply with a
lifetime non-competition and consultation requirement. She has taken the position that she
is not “vested” under 457(f), due to the possibility of forfeiture conditions.
Jill’s pension also has a feature which would not pass muster under 409A. She can receive
the lump sum equivalent at any time after age 62, even if employed, by paying a 10%
penalty. But grandfathering of her accrued benefit as of December 31, 2004, will be allowed
only if she was vested at that date, and that is a concession that she has taken an incorrect
tax position under 457(f) and owes taxes on her vested benefit.
Careful planning is required for these situations, and grandfathering of 457(f) plans will
probably not be in vogue. One certainty is that it is impossible to have a tax position that
a benefit is vested for purposes of 409A grandfathering, but not vested for purposes of
§457(f) income tax. As discussed in Section 10, illusory vesting conditions will be
disregarded for purposes of applying the 409A tax and penalties, if a plan failure occurs.
12. Constructive receipt rules still apply
All deferred amounts, grandfathered or not, remain subject to the constructive receipt of
income rules. 409A(c). For example, if the terms of a grandfathered plan offer a choice of
lump sum or installments, without meaningful restrictions, IRS might assess income tax
on the lump sum equivalent as soon as it is available. This article will not analyze the
constructive receipt doctrine, as interpreted differently by the IRS and the courts.
Fortunately, 409A did not repeal a 1978 law, Sec. 132(a), PL 95-600, which prohibits the
IRS from issuing deferred compensation rules that supersede the law as in effect on
February 1, 1978. Periodically, prospective legislation is introduced to repeal the 1978
law, so constructive receipt may become a more difficult issue in future years.
13. Trusts and partnerships
Trusts for 409A benefits may not be invested offshore, or have impermissible “triggers” in
the event of declining financial condition of the plan sponsor. More IRS guidance is
expected, but “rabbi trusts” should be examined now. In addition, Treasury has solicited
comments for the application of 409A to partnership arrangements, an especially
complicated area that this article does not address.
14. Reporting and withholding
Commencing in 2005, deferrals after December 31, 2004 of at least $600 are reportable
to the IRS, even if they are not vested. Q&A 24. Form W-2 or 1099-MISC is acceptable.
The deferrals are not reportable for any service provider for whom there is not a W-2 or
1099-MISC reporting responsibility.
It is a departure from previous employment tax reporting requirements to require
reporting of non-vested money. Taking it a step further, increases in deemed “earnings”
are reportable, which is also new for vested benefits. Reporting requirements do not
extend to grandfathered benefits and earnings on them. Q&A 28.
For calendar 2005, taxable amounts which are not paid or made available may be treated
as having been paid, for withholding purposes, on December 31, 2005. Taxable amounts
paid or made available at an earlier date are subject to withholding as of that date. Q&A
32. Payroll Managers should review Q&A’s 24 through 38 closely. Additional guidance is
expected, especially for accruals under “nonaccount” plans, such as defined benefit SERP’
s with offsets based on qualified plan balances. Q&A 26.
15. Ending it all (by December 31, 2005)
December 31, 2005 is an important date.
i. It is the last day to make the necessary retroactive amendment to a plan so that
“plan failures” cannot occur.
ii. It is the last day for participants to elect the form and timing of distributions for
409A plan benefits.
iii. And it is the last day when a plan sponsor, or participant, can say “No mas.” Give
me the money and let me pay income taxes.
Deferred compensation rules are really not that unworkable under 409A. But for those
who want out, the Notice provides an exit. A plan may be amended to allow a participant
at any time during 2005 to terminate participation or cancel a deferral election, in whole
or in part, provided that the amount is includible in 2005 income (or in a later year when
first vested, in the case of amounts which are not vested in 2005).
The plan procedure does not have to be made available to all participants. It may also be
a unilateral decision by the plan sponsor. It does not have to apply to all plans of the
same type. It is limited solely to benefits subject to 409A. Q&A 20.
16. Conclusion
409A was a small piece of the American Jobs Creation Act, which greatly reduced
corporate income taxes. It was happily characterized as an offsetting revenue raiser. It is
so complicated that many unknowing persons will be ensnared, which is unfair. At this
writing (May, 2005), IRS has only published the Notice, and the next official "guidance" is
at least a month away. That does not leave much time to analyze and communicate plan
amendments to participants prior to the December 31 deadlines.
Our advice. If grandfathering is important, do not modify the terms or administrative
practices of the plans that provide those benefits. For 409A amounts, be prepared to
meet the December 31 deadlines, and, in the meantime, administer those amounts in
good faith compliance with the Notice.
This may not be relied upon as legal advice, or to avoid taxes and penalties. Any
communication with the author as to its contents, does not, of itself, create a lawyer-client
relationship. Distribution to promote, market, or recommend any arrangement or investment
to avoid or evade taxes, including penalties, is expressly forbidden. Under the ethical rules
applicable to lawyers in some jurisdictions, this may be considered advertising.
ACTION REQUIRED TO AVOID 409A PENALTIES
George L. Chimento
May, 2005
1. Introduction
2. The penalties for plan failures
3. The four prohibited plan failures
4. Grandfather protection for certain plans
5. Identifying “deferred compensation plans” and “service providers”
6. Administrative issues and special transition rules
for various types of plans and plan features.
7. Stock options
8. Stock appreciation rights
9. Restricted property
10. The troubling concept of “vesting”
11. Special problems for 457(f) plans of non-profit organizations
12. Constructive receipt rules still apply
13. Trusts and partnerships
14. Reporting and withholding
15. Ending it all (by December 31, 2005)
16. Conclusion
1. Introduction
New §409A of the Internal Revenue Code has the snappy title “Inclusion in gross income
of deferred compensation under nonqualified deferred compensation plans.” The statute
lists four types of “plan failures”, any of which will trigger taxation, penalties, and late
payment interest. Two additional requirements apply if trusts are involved.
“Deferred compensation plan” does not just mean a SERP or an elective deferral
program. The term may include bonuses, severance, discounted stock options,
appreciation rights, and any other device which might defer taxation of service income to
a year after services were rendered. Starting in 2005, special IRS reporting requirements
apply to 409A benefits, even if not currently taxable. Withholding is also required on
taxable amounts.
This article lists various plans and arrangements (all referred to as “plans”) which are
subject to the new 409A rules, and points out immediate compliance issues. The sole
guidance to date is IRS Notice 2005-1 (the “Notice”). References in this article to Q&A’s
are to those in the Notice. The Notice allows plan sponsors until December 31, 2005 to
amend their plans retroactively to January 1, 2005 so that they have the necessary 409A
rules. Q&A 19(a). The Notice is clear that there is no relief for 2005 administrative gaffs,
unless based on a good faith interpretation of 409A. Q&A 19(a) & (b). Additional IRS
guidance is expected in late spring and early summer.
2. The penalties for plan failures
When 409A is violated, the penalties are: taxation of vested amounts, a 20% additional
tax, and interest at the IRS “late payment” rate plus 1%, calculated as if there were tax
underpayments in the year when deferrals first occurred, or were first vested, if later.
409A(a)(1). A plan failure unique to one individual will not penalize other plan participants.
If there is a plan failure, the penalty is assessed for all of the participant’s vested
benefits in all 409A plans of the same type. The three plan types are account balance,
nonaccount balance, and “neither” (for discounted options, appreciation rights, and other
equity based arrangements covered by 409A). Based on design, a severance plan may
be a nonaccount plan or an account plan. Q&A 9.
3. The four prohibited plan failures
Unless a plan has the grandfather protection described in Section 4 below, restrictive
rules apply as of January 1, 2005. The Notice requires that all plans (other than
grandfathered plans) must be amended by December 31, 2005 to prohibit plan failures.
Although the statute lumps the failures into three categories, there are really four of
them.
a. Distribution is only allowed for certain events. (1) at a specific date or
according to a fixed schedule specified at the time of the initial deferral election, or (2)
after separation from service, with a required 6 month delay for key employees at public
companies, or (3) after disability, or (4) after death, or (5) after unforeseeable emergency
(based on a very strict definition that excludes tuition and home purchase, and which
requires that no other resources are reasonably available), or (6) after a change in
majority ownership or effective control of a corporation (Q&A 12 & 13) or in the
ownership of at least 40% of the assets of a corporation (Q&A 14).
b. Acceleration of the time or schedule for payments will not be permitted except
in rare situations blessed by Treasury. Getting the money at an earlier date than
scheduled is a plan failure unless an exception applies. Importantly, a plan sponsor's
decision to accelerate vesting so that payment may be made for a permissible reason
under 409A, such as separation from service, is allowed. The Notice also permits early
payments for domestic relations orders, de minimis cash-outs of $10,000 or less, cash-
outs of any amount if uniformly required and limited to future accruals, payments required
to pay taxes under 457(f) plans (an issue for non-profit organizations for which vesting of
certain executive deferred compensation arrangements is a taxable event), and
divestitures required by conflict of interest rules (i.e. if a corporate officer accepts a
position with a regulator). Q&A 15. Treasury has not yet sanctioned acceleration of
installment payouts, if requested by the beneficiary of a deceased participant, but is
looking at the issue.
Special notes on the acceleration failure:
Impermissible acceleration is the most likely, inadvertent plan failure. Employers often agree
to accelerate severance payments, simply to get them off the books and to facilitate the
retirement of a disgruntled executive. Severance arrangements and payment terms will have
to be carefully analyzed before the December 31, 2005 amendment deadline. If a lump sum
will be the de facto exception to installment severance payments, it should be made the
normal form.
Terminating a plan to pay benefits earlier than scheduled will also be an impermissible
acceleration. But see Section 15 of this article for the special rule which permits terminations
by December 31, 2005. Also, a termination of a plan due to change in control is permitted if
payments are made within 12 months of the change in control, meaning that plans can be
designed without an automatic trigger on all changes in control. Q&A 11(a).
c. Deferral elections must comply with initial timing rules. They must be made
before the start of the tax year in which services will be performed. New participants
may make deferral elections within the 30 days following initial eligibility. A one-time
extension until March 15, 2005 was allowed for 2005 deferral elections. Q&A 21.
In the case of bonuses under performance based plans, which reward services over a
period of at least 12 months, the election must be made no later than 6 months before
the end of the service period (i.e. by June 30, 2005 for a 2006 bonus payable for 2005
services).
d. Postponement of payment date and changes in form of distribution must follow
special timing rules. The time and form of distribution must generally be selected before
the service period. A special exception allows participants to make an election of time
and form of distributions for 409A benefits by December 31, 2005. Q&A 21. This is not
applicable to Plans which wish to keep grandfather status, as those Plans must be
administered under their terms.
If the December 31, 2005 exception does not apply, deferrals of starting date or change
in form of payment must otherwise meet these rules:
i. If the payment was to be due on a fixed date or schedule, the election to defer
must be at least 12 months prior to the scheduled payment, and must postpone the
payment for at least 5 years from the date the payment was originally scheduled;
ii. If the payment was to be due because of a separation from service or change in
control, the election will not be effective for amounts payable in the following 12 months,
and the election must postpone the payments for at least 5 years from the date the
payment was originally scheduled;
iii. Elections to postpone payments due for other permitted reasons (i.e. death or
disability), can be effective no earlier than 12 months from the date the payment was
originally scheduled. The requirement of 5 years of additional deferral is not applicable.
4. Grandfather protection for certain plans
409A does not apply to amounts which were deferred and “vested” prior to 2005 under
plans in effect as of October 3, 2004. Q&A 16(a). The grandfather treatment extends to
post -2004 “earnings” on grandfathered amounts. Q&A 17(d). Grandfather treatment is
lost if a material modification of the plan occurs after October 3, 2004. Q&A 18. For
determining grandfather status, plans are not aggregated, as they would be for penalty
purposes after a plan failure, but are treated separately. Q&A 18(e).
Amounts are not “vested” for grandfather treatment unless the participant had a legally
binding right by December 31, 2004 which could not be altered by the plan sponsor. An
amount is not “vested” for grandfather purposes if it was contingent on post-2004
services or refraining from competition, because “vesting” for grandfather determinations
is based on Reg. §1.83-3(c). Q&A 16(b). Unfortunately, these post-employment
conditions are disregarded in determining if a benefit is taxable. See Section 10, which
points out the problems caused by the dual definitions of “vested.”
Any change to a plan intended to be grandfathered must be scrutinized to be sure it is
not a “material modification.” The following changes will not affect grandfathered status:
(1) amendments to segregate 409A deferrals from grandfathered amounts, so that the
plan operates under two sets of rules for new and old money; (2) changes of deemed
investment choices and rates of return, if reasonable under the rules of Reg. §31.3121(v)
(2)-1(d); (3) removal of benefit options and freezing of future accruals; (4) termination of
the plan and distribution of taxable benefits in 2005, even though this accelerates
payment of deferred compensation, one of the four prohibited “plan failures” under 409A.
The following changes would be impermissible modifications and cause loss of
grandfather status:
i. adding a provision, even if allowed by 409A, to grandfathered amounts. Q&A 18(a).
Example:
409A allows hardship distributions, but adding a hardship clause after October 3, 2004 to
grandfathered benefits will forfeit grandfather treatment. Q&A 18(a).
ii. making an administrative decision to give rights to a participant if these rights
were not part of the plan as in effect on October 3, 2004.
Example:
A grandfathered severance plan in an executive’s contract requires payments over 24 months
and does not provide for acceleration. A Committee decision to accelerate payments to a lump
sum destroys the grandfather, and subjects the unlucky participant to the 409A penalties if
this event occurs after December 31, 2005.
5. Identifying “deferred compensation plans” and “service providers”
Identification of plans is vitally important to satisfy goals of:
i. making the required retroactive compliance amendment no later than December
31, 2005, and
ii. good faith administration during 2005, and
iii. not inadvertently modifying grandfathered benefits, in writing or in practice, after
October 3, 2004.
A plan is any agreement, method or arrangement that defers compensation of a service
provider to a taxable year later than the year in which services were rendered. Q&A 4
and Q&A 9.
Certain plans which have qualified-type tax status are exempt from 409A:
i. qualified 401 plans,
ii. 403(a)&(b) arrangements,
iii. simplified IRA’s under 408(k)&(p),
iv. governmental plans, including qualified excess benefit arrangements under 414
(m),
v. 457(b) plans for employees of non-profit and governmental entities,
vi. pre-June 25, 1959 plans qualified under 501(c)(18). Q&A 3(b).
Certain welfare benefit programs are also excluded. “Bona fide” vacation leave, sick
leave, compensatory time payments, disability pay, and death benefit plans are excluded,
along with Archer Medical Savings accounts, Health Savings accounts, and medical
reimbursement arrangements (including 125 accounts). Q&A 3(c).
Service providers include affiliated non-employees, such as directors and “related”
consultants. Special attribution rules will ensnare non-employee services to family
companies, with even a 20% overlap in ownership. Q&A 8. Bona fide independent
contractors rendering substantial, non-director services to two or more entities
“unrelated” to the service recipient are exempt.
That leaves lots to be covered, and the Notice is clear that 409A plans are not limited to
ERISA plans. Q&A 9. 409A covers certain arrangements not readily thought of as deferred
compensation, as described in the following Section 6.
6. Administrative issues and special transition rules for various types of plans
and plan features.
The following discussion and examples apply to common situations which employers may
encounter. It is hardly exhaustive and does not address all of the situations discussed in
the lengthy Notice.
a. Initial deferral election deadlines
If the special March 15, 2005 deadline in the Notice for 2005 deferral elections has been
missed, it is too late to make a deferral election for regular 2005 earnings. December 31,
2005 will be the deadline for 2006 deferrals.
Example:
Executive is told he will get an unexpected promotion and pay raise, effective June, 2005, and
would like to defer it. It is too late for 2005. The election should have been made by the
special March 15, 2005 deadline, even though the executive did not know at the time that he
would get the promotion. If this fact situation occurred in 2006, the deferral election deadline
would be December 31, 2005.
b. Bonus programs
i. Short-term. A bonus payable in a year following the rendered services is subject
to 409A unless it meets a “short term deferral” exception in the Notice. If the bonus is
payable no later than 2 & 1/2 months following the year (or years) in which the rights to
the bonus become “vested”, and if the participant has no election as to when to receive
the payment, the bonus program is exempt from 409A. The 2 & 1/2 month rule applies to
the later of the Participant’s year or the Plan sponsor’s year in which the vested right first
occurs. Q&A 4(c).
Example:
Executive is awarded a bonus on March 15, 2006 for 2005 services. He had no ability to
direct that the bonus be payable on another date. The bonus program is exempt from 409A.
If the Sponsor’s year ended on June 30, 2006, the bonus could have been paid as late as
September 15, 2006.
ii. Long term. The short term payment exception does not apply to plans which
provide deferral choices to Participants or which do not make payment within the
2 & 1/2 month short-term deadline. Those plans will have to be in writing with all of the
specified 409A provisions. Provided that the performance period is at least 12 months,
deferral elections may be as late as 6 months before the end of the performance cycle.
Remember that the 6 months is measured from the end of the performance period, not
from the date the bonus will be paid. If a bonus is based on standards which are virtually
certain to be reached, or simply based on stock price appreciation, it will not qualify for
this special 6 month rule. Q&A 22.
Example:
Company pays bonuses in March, 2006 based on 2005 services. The Plan allows employees
to defer receipt of the bonus. Because this is a performance cycle of at least 12 months
(calendar year 2005) a deferral election may be made as late as June 30, 2005. Election prior
to the start of the service period, i.e. by December 31, 2004, is not required, unless the
bonus criteria are virtually certain to be met.
c. Special December 31, 2005 date to make elections of form and time of
distribution of 409A deferrals.
409A requires that the form and time of payment be elected no later than the initial
deadline for the deferral election. Acceleration of payment is generally prohibited and
changes in form and time of distribution must follow special timing rules. (See paragraphs
3.b and 3.d of Section 3 above.) Because this new regime is less flexible than past
practice, a Plan may allow participants until December 31, 2005 to make a new election
as to the time and form of payments, presumably after reflecting on 409A and the IRS
guidance. Q&A 21.
Note that this special December 31, 2005 election is not available to grandfathered
benefits which were vested by December 31, 2004 under a pre-October 4, 2004 Plan. To
preserve the grandfathering, those Plans must be administered according to their terms,
which may, or may not, have provided for new payment and distribution elections after
an initial deferral date. It is advisable to wait for the next round of IRS guidance before
amending plans or extending this feature.
Example:
Executive participates in a defined benefit SERP which is entirely paid for by his employer. The
plan has generally allowed participants to elect the form of distribution (pension or lump sum
equivalent) within 60 days preceding retirement, subject to consent of an administrative
committee. For those benefits under 409A, the Plan may permit the executive to make a
lump sum or annuity choice as late as December 31, 2005.
Example:
Executive participates in a defined contribution SERP. The December 31, 2005 special election
is available for the 409A deferrals. The Plan can be designed so that this is the sole election
and applies to future deferrals in later years. Or the Plan can provided that a separate election
apply to each year’s deferrals. In that latter case, the election must be made by the initial
deferral deadline for that payment.
d. Special Issues for severance plans.
Severance plans are covered by 409A. These may be promises in an executive’s
employment contract, or a broad-based program for a large population.
The Notice seeks comments, and provides limited interim relief in 2005. Collectively
bargained plans and plans which do not cover “key employees” under Code §416(i) are
exempt from 409A in 2005. To qualify for this relief, the Plan must meet the ERISA
regulatory interpretation (i.e. payable over no more than two years, unfunded, not
contingent on retirement, and not exceeding two years of salary).
The main issue for non-exempt severance plans will be prohibited acceleration. It is
common for employers to accelerate severance payments, and that is a Plan failure
triggering 409A taxes and penalty.
Example:
Executive severs employment and is entitled to two years of separation payments. The
employer decides to pay him a lump sum, just to get it off the books. Surprise! There is a
409A Plan failure, because the payment was accelerated.
"But wasn’t the amount grandfathered ?" the executive in the above example asks. The
contract was in effect before October 3, 2004, and has not been changed. The
employer’s lawyer then explains that the non-competition clause in the contract keeps it
from being a grandfathered “vested” benefit. However, for tax purposes, the non-
competition clause is ignored, and 409A taxes and penalties apply. (See Section 10,
which discusses the dual definition of “vesting.”) Making this a true tax disaster, the
penalty applies to all “non-account” deferred compensation of the participant, including
any 409A accumulations in his defined benefit SERP.
e. Special issues for “termination” payments.
One of the permitted 409A reasons to make payments is a “separation from service.” Use
of that term, rather than “termination of employment” is especially unfortunate, because
it resurrects for 409A the troubling “same desk” rule that was recently legislated away
for 401(k) and 403(b) plans. Transfers of employment within a controlled group will not
be distributable events. Retirement followed by continued service as a director will
probably be a separation from service which would permit payment. Continued service as
a consultant, based on the circumstances, may or may not be a separation from service.
More guidance is necessary. Consider the following example.
Example:
Company X has a grandfathered deferred compensation plan for employees. In connection
with sale of a small plant, the Plan Committee decides to accelerate payment to an officer who
will continue to manage that plant for the new buyer. No plan provision permits this, and the
plant represents less than 40% of corporate assets. There are two problems.
1/ Early payment in the absence of a plan provision permitting early payment voids the
grandfather protection for the entire plan. Q&A 18.
2/ Although Executive has terminated employment, he has not “separated from service.”
He is at the same desk, so the payment violates 409A, unless the payment qualifies as a
change in control payment, another permitted 409A payment reason. Unfortunately, the sale
of less than 40% of assets is not a change in control under the Notice. Q&A 14.
The resulting tax disaster in this example was caused by: (1) improper administration,
which forfeited the plan's grandfather status, and (2) a misunderstanding of the
“separation from service” concept that applies to 409A. Executive has been paid for an
impermissible reason under 409A, even though his employment terminated due to a sale
of the plant where he worked. He pays income tax on the distribution, which he
expected. He also must pay a 20% penalty due to the “plan failure”, plus late payment
interest.
f. Special issues for defined benefit SERP’s.
To grandfather or not to grandfather, that is the question. In non-account Plans with
graded vesting schedules which overlap December 31, 2004, is it worthwhile to keep
track of grandfathered accruals ? If the decision is “yes”, the grandfathered amount is
the amount which would have been payable if the participant terminated employment on
December, 31, 2004. Increases in compensation after December 31, 2004 will not be
considered, and the Plan’s actuarial provisions may be used only if they are reasonable.
Q&A17(a).
Most SERP’s do not provide for payments during employment, so the acceleration
prohibition discussed in Paragraph 3.b of Section 3 is not a problem.
The most common problem will be the distribution election. The timing rule of 409A,
described in Paragraph 3.d of Section 3, above, generally requires participants to elect
forms of payment before the start of a service period. Although not mentioned in the
Notice, Congressional Committee Reports recommend that particpants at retirement be
allowed to select one actuarially equivalent pension form over another. We believe this
procedure will be sanctioned in future IRS guidance.
Example:
Jack does not know which form of pension to elect when he starts the service period for each
year's pension accrual. He would prefer to wait until retirement. We think IRS guidance will
allow that, provided that his election is only to select among actuarially equivalent forms of
annuity and not to select a lump sum.
Paying lump sums will be more tricky. Electing a lump sum after the start of a service
period would be a prohibited acceleration of prior accruals. Lump sums will either have to
be elected in advance of the service period, or will have to be the plan's normal form of
payment. Grandfathered SERP's can maintain a lump sum or annuity choice procedure at
retirement, but only for vested accrued benefits as of December 31, 2004.
The special December 31, 2005 election to designate the time and method of
payment is very helpful for SERP's. If a SERP is designed to comply with 409A,
participants may elect any permitted form and any starting date by December 31, 2005
without violating 409A.
Example:
Employer does not want to maintain a grandfathered SERP for some accruals and a 409A
SERP for others. It bites the bullet and elects to have one SERP under 409A rules. It offers to
participants a choice, prior to December 31, 2005, to elect whether they want lump sums or
pensions at retirement. It tells those who want pensions that they can elect the form of
pension at retirement. It also allows them to select the year that payments start, helpful for
those who might want a year or two of deferral after retirement. This works under 409A.
For those who do not make a December 31, 2005 election, deferral of payment until after
retirement will require compliance with the postponement procedure described in
paragraph 3.d of Section 3, above.
Example:
Executive intends to retire and wants to defer the start of her SERP pension. For benefits
governed by 409A, the Plan must provide, if the election is made after
December 31, 2005: (i) the new starting date cannot be within 5 years of the initially
scheduled starting date, and (ii) the postponement cannot not be effective for pension
payments which are due within one year of the new election.
Another devilish issue for defined benefit SERP’s involves the reporting and withholding
requirements. These requirements are discussed briefly in Section 14 of this article, but
additional IRS guidance is promised.
7. Stock options
Qualified incentive options are exempt. Nonqualified stock options are also exempt from
409A, provided that: (1) the exercise price is at least equal to the fair market value when
granted, (2) the exercise profit is taxable as salary income under IRC §83, and (3) the
only income deferral is in the period between grant and exercise. Q&A 4(d).
If a discounted option is to be granted, an advance election will have to made as to the
time it will be exercised. The exercise time can be at a fixed date, or after a permissible
409A distribution event, such as death, disability, change in control, or separation from
service. Acceleration or deferral of the exercise date would be under the the same
restrictive rules as apply to other 409A deferred compensation.
Obviously, if discounted options have been granted and would qualify for the 409A
grandfather, it is critical not to modify them.
Example:
Executive gets a discounted option under a Plan which predates October 4, 2004 and has the
right to exercise it by December 31, 2004. The option is grandfathered and exempt from
409A coverage. In 2005, the Directors vote to re-price the option at more favorable terms for
executive. The modification brings the discounted option into 409A coverage. However, if the
re-pricing is set at the current value at the time, the option would then be exempt from
409A, unless the grantee has the right to defer the taxable gain to a post-exercise date.
The preamble to the Notice indicates that the Treasury is especially concerned about
options which are coupled with stock appreciation rights at a guaranteed level, effectively
giving executives a “no lose” proposition. The preamble to the Notice indicates that the
409A exemption for non-qualified options may be further limited to those which are
unaccompanied by such rights.
8. Stock appreciation rights
It’s really no surprise that stock appreciation rights are covered by 409A. They are simply
a form of deferred compensation tied to appreciation in stock values. The Notice does
provide some relief.
For public companies, the appreciation right will not be covered by 409A if: (1) the
exercise price is at least equal to the fair market value of the underlying stock when the
right is granted; (2) the only settlement for the right will be in traded shares of the public
company; (3) deferral of taxation at exercise is not permitted. Interestingly, if non-vested
shares are provided at exercise, the tax may be deferred until the vesting date.
For all companies, rights granted on or before October 3, 2004 will not be covered by
409A if (1) the exercise price is at least equal to the fair market value of the underlying
stock when the right is granted; and (2) further deferral of taxation at exercise is not
permitted. In fact, new grants after October 3, 2004, pursuant to a program which meets
these standards and which predates any new Treasury tightening of the rules, will not
be subject to 409A.Q&A 4(d)(iv).
9. Restricted property
Generally, IRC §83 will govern taxation. Persons who receive property (such as restricted
employer stock) will not be taxed until the vesting date under §83. However, the grant of
a right to receive property in the future will be subject to 409A. Q&A 4(e).
10. The troubling concept of “vesting”
Vesting determinations are important for two reasons:
(i) In a grandfathered plan (not modified after October 3, 2004), the only grandfathered
rights are those which were vested by December 31, 2004;
(ii) If a Plan failure occurs, 409A taxation and penalties apply to “vested” benefits in all
plans of the same type, and the penalty interest dates back to the initial vesting date.
As mentioned earlier, there are two different definitions of “vesting.” It’s no surprise that
the more restrictive definition applies to determining whether a benefit is grandfathered.
Vesting for grandfather determinations
A benefit will not be grandfathered unless it is:
(i) not conditioned on the performance of future services, and
(ii) not subject to a substantial risk of forfeiture as determined under IRC §83. Q&A
18(b).
Vesting for 409A tax purposes.
If a 409A plan failure occurs, vesting will be determined by the plan provisions. However,
the following vesting conditions will be disregarded:
(i) any condition added after the start of the service period, and
(ii) any condition to “refrain” from performing service (i.e. non-competition
requirements, even if legitimate), and
(iii) any condition which is unlikely to be enforced. Factors such as the effective
control of a Plan sponsor and the past history of enforcing similar forfeiture provisions will
be taken into account. Q&A 10.
Grandfather rule example:
Executive is entitled to ten years of salary continuation under a plan which contains features
that would be failures under 409A. He is vested under his agreement, but the agreement
prohibits competition and requires confidentiality. Remaining payments may be forfeited if
Executive violates the agreement. It’s unclear if the benefit is vested (and grandfathered) as
of December 31, 2004. Section 83 regulations are very skeptical about post-separation
vesting conditions. To prove that a benefit is vested and entitled to grandfather treatment,
the Plan sponsor will have to demonstrate that the post-employment conditions are illusory.
409A tax example:
Executive participates in a plan which is covered by 409A. There is a plan failure. The plan
requires non-competition throughout the pension period. Executive can prove he regularly
receives offers from competitors. The non-competition restriction is disregarded nonetheless.
The Executive is considered vested and 409A penalties apply, even though he could forfeit the
benefit if he competes.
11. Special problems for 457(f) plans of non-profit organizations
Deferred compensation plans of non-profit organizations are also regulated by IRC §457.
If the plan meets the modest limits ($14,000 maximum deferral in 2005) and other
requirements of §457(b), it is exempt from 409A. 409A applies to all other deferred
compensation plans, which also continue to be covered by 457(f).
§457(f) has been a problem for non-profit organizations since 1986. It requires that
deferred compensation be taxed as soon as it is vested, not when it is paid. For example,
if an executive retires and is entitled to a $50,000 annual penson, the lump sum
equivalent of that pension is taxable under 457(f) in the year of retirement. The taxable
"basis" is then applied, pro rata, to the future taxable payments in a manner similar to
the taxation of annuities.
Problem: Where does the tax money come from on §457(f) vesting? Fortunately, the
Notice allows a plan to provide that an amount necessary for this §457(f) tax can be
withdrawn, without triggering 409A penalties under the rule which prohibits acceleration.
Q&A 15(d).
Problem: Which of the dueling definitions of “vested” is applicable ? To avoid early
taxation under §457(f) on vesting, some non-profits designed these plans with
somewhat illusory vesting conditions. The regulations were skeptical of “non-compete”
and similar post-employment provisions, but there was no bright-line test. If a benefit
was subject to a real post-employment noncompetition provision, an executive would
never have been vested under 457(f), and would simply have paid tax on pension money
when received.
There is now a great conundrum in the 457(f) world. If grandfathering from 409A is
important for a 457(f) plan, it will be necessary to establish that a benefit was “vested”
by December 31, 2004. Of course, that means that income tax is owed (and probably
late) with respect to the vested benefit under §457(f).
Example:
Jill’s is age 60, and will forfeit her expected 457(f) pension if she does not comply with a
lifetime non-competition and consultation requirement. She has taken the position that she
is not “vested” under 457(f), due to the possibility of forfeiture conditions.
Jill’s pension also has a feature which would not pass muster under 409A. She can receive
the lump sum equivalent at any time after age 62, even if employed, by paying a 10%
penalty. But grandfathering of her accrued benefit as of December 31, 2004, will be allowed
only if she was vested at that date, and that is a concession that she has taken an incorrect
tax position under 457(f) and owes taxes on her vested benefit.
Careful planning is required for these situations, and grandfathering of 457(f) plans will
probably not be in vogue. One certainty is that it is impossible to have a tax position that
a benefit is vested for purposes of 409A grandfathering, but not vested for purposes of
§457(f) income tax. As discussed in Section 10, illusory vesting conditions will be
disregarded for purposes of applying the 409A tax and penalties, if a plan failure occurs.
12. Constructive receipt rules still apply
All deferred amounts, grandfathered or not, remain subject to the constructive receipt of
income rules. 409A(c). For example, if the terms of a grandfathered plan offer a choice of
lump sum or installments, without meaningful restrictions, IRS might assess income tax
on the lump sum equivalent as soon as it is available. This article will not analyze the
constructive receipt doctrine, as interpreted differently by the IRS and the courts.
Fortunately, 409A did not repeal a 1978 law, Sec. 132(a), PL 95-600, which prohibits the
IRS from issuing deferred compensation rules that supersede the law as in effect on
February 1, 1978. Periodically, prospective legislation is introduced to repeal the 1978
law, so constructive receipt may become a more difficult issue in future years.
13. Trusts and partnerships
Trusts for 409A benefits may not be invested offshore, or have impermissible “triggers” in
the event of declining financial condition of the plan sponsor. More IRS guidance is
expected, but “rabbi trusts” should be examined now. In addition, Treasury has solicited
comments for the application of 409A to partnership arrangements, an especially
complicated area that this article does not address.
14. Reporting and withholding
Commencing in 2005, deferrals after December 31, 2004 of at least $600 are reportable
to the IRS, even if they are not vested. Q&A 24. Form W-2 or 1099-MISC is acceptable.
The deferrals are not reportable for any service provider for whom there is not a W-2 or
1099-MISC reporting responsibility.
It is a departure from previous employment tax reporting requirements to require
reporting of non-vested money. Taking it a step further, increases in deemed “earnings”
are reportable, which is also new for vested benefits. Reporting requirements do not
extend to grandfathered benefits and earnings on them. Q&A 28.
For calendar 2005, taxable amounts which are not paid or made available may be treated
as having been paid, for withholding purposes, on December 31, 2005. Taxable amounts
paid or made available at an earlier date are subject to withholding as of that date. Q&A
32. Payroll Managers should review Q&A’s 24 through 38 closely. Additional guidance is
expected, especially for accruals under “nonaccount” plans, such as defined benefit SERP’
s with offsets based on qualified plan balances. Q&A 26.
15. Ending it all (by December 31, 2005)
December 31, 2005 is an important date.
i. It is the last day to make the necessary retroactive amendment to a plan so that
“plan failures” cannot occur.
ii. It is the last day for participants to elect the form and timing of distributions for
409A plan benefits.
iii. And it is the last day when a plan sponsor, or participant, can say “No mas.” Give
me the money and let me pay income taxes.
Deferred compensation rules are really not that unworkable under 409A. But for those
who want out, the Notice provides an exit. A plan may be amended to allow a participant
at any time during 2005 to terminate participation or cancel a deferral election, in whole
or in part, provided that the amount is includible in 2005 income (or in a later year when
first vested, in the case of amounts which are not vested in 2005).
The plan procedure does not have to be made available to all participants. It may also be
a unilateral decision by the plan sponsor. It does not have to apply to all plans of the
same type. It is limited solely to benefits subject to 409A. Q&A 20.
16. Conclusion
409A was a small piece of the American Jobs Creation Act, which greatly reduced
corporate income taxes. It was happily characterized as an offsetting revenue raiser. It is
so complicated that many unknowing persons will be ensnared, which is unfair. At this
writing (May, 2005), IRS has only published the Notice, and the next official "guidance" is
at least a month away. That does not leave much time to analyze and communicate plan
amendments to participants prior to the December 31 deadlines.
Our advice. If grandfathering is important, do not modify the terms or administrative
practices of the plans that provide those benefits. For 409A amounts, be prepared to
meet the December 31 deadlines, and, in the meantime, administer those amounts in
good faith compliance with the Notice.
This may not be relied upon as legal advice, or to avoid taxes and penalties. Any
communication with the author as to its contents, does not, of itself, create a lawyer-client
relationship. Distribution to promote, market, or recommend any arrangement or investment
to avoid or evade taxes, including penalties, is expressly forbidden. Under the ethical rules
applicable to lawyers in some jurisdictions, this may be considered advertising.
