December 31, 2008, marked the end of the transition period for the amendment of plan documents to comply with the applicable requirements of Section 409A of the Internal Revenue Code of 1986, as amended (the Code). Having just completed the amendment process, employers and employees affected by 409A may believe that they are "done with 409A." Are they? The answer is an emphatic no.

Section 409A of the Code requires that each deferred compensation plan comply, both in form and operation, with detailed and complex tax qualification requirements. Section 409A can apply to a broad range of deferral arrangements – e.g., employment, severance, change in control, bonus and reimbursement arrangements and arrangements providing for the grant of "in the money" stock options and stock appreciation rights (SARs).

The remainder of this article explores several of the most pressing 409A issues with which employers and employees will need to contend in 2009. If 409A applies, the employee is subject to ordinary income tax, IRS interest and a 20 percent penalty tax; the employer has enhanced income tax reporting and withholding obligations and employee relations issues with which to contend.

Continuing Documentary And Operational Compliance

Effective January 1, 2009, each deferred compensation plan must comply, both in form and operation, with the applicable requirements of the Final Regulations. Care must be taken to ensure that arrangements in existence prior to 2009 are not modified in a way that violates 409A, and that new arrangements are structured to comply with 409A.

There are several areas of potential non-compliance:

  • Six-Month Delay Rule – For a public company, either not having language in the plan prohibiting payments of deferred compensation to a "specified employee" during the first six months following termination, or making payments in violation of this rule.
  • Separation Pay Exception on Account of "Good Reason" – Amending an existing "good reason" definition that does not require materially adverse action to be taken against the employee does not work to exclude the separation pay from 409A.
  • Short-Term Deferral Exception – Not paying a bonus or severance amount by March 15th of the year following the year in which it is "vested" (e.g., because a release needs to be negotiated) removes the bonus or severance amount from the "short-term deferral" exclusion to 409A coverage.
  • Deferral Elections – Making initial deferral elections after the beginning of the service year, other than with respect to certain performance-based compensation, or, in the case of subsequent deferral elections, not requiring the payments be delayed for at least five years, generally would violate 409A.
  • Payment Triggers – 409A permits payments of deferred compensation to be made only upon the occurrence of a limited number of events: (1) "separation from service"; (2) "disability"; (3) death; (4) at a specified time or pursuant to a fixed schedule; (5) a "change in control"; or (6) an "unforeseeable emergency."
  • Option/SAR Repricing – Many private companies do not follow the IRS guidelines for determining "fair market value" for purposes of determining the exercise price of options and SARs.
  • Anti-Acceleration Rule – 409A generally prohibits the acceleration of payments of deferred compensation to any employee.

Use Of IRS Correction Program To Correct 409A Violations

In December 2008, the IRS released Notice 2008-113. This Notice provides procedures under which taxpayers may obtain relief for operational violations of 409A(a), the subsection of 409A that contains it rules on distributions, deferral elections and acceleration of deferred payments. Covered operational failures include incorrect payments of deferred compensation, improper deferrals and the setting of erroneous exercise prices for options and SARs. The Notice does not provide relief for the failure of a plan to comply with the plan document requirements of the Final Regulations.

The Notice conditions relief upon the satisfaction of certain "general" eligibility requirements:

  • Avoidance of Recurrence of Failure – The employer must take commercially reasonable steps to avoid a recurrence of the failure.
  • Return Must Not Be "Under Examination" – The federal income tax return of the employee for the taxable year in which the failure occurred cannot be under examination by the IRS.
  • Provision of Certain Information – The Notice requires the employee to attach certain information to his or her tax return for the taxable year in which the failure occurred or was discovered, as applicable.
  • Errors Must Be Inadvertent and Unintentional – IRS rules exist for making such a determination.
  • Employer Must Not Be Experiencing a Financial Downturn – Relief is not available if the failure occurs during any taxable year in which the employer experiences a financial downturn that indicates that the employer will not be able to pay the amount that comes due.

How To Calculate The 409A "Exposure" If The Requirements Of 409A Are Violated

One of the more vexing issues under Section 409A relates to the manner in which the amount required to be included in income, and, if applicable, subject to IRS interest and the 20 percent penalty tax, is to be calculated. The IRS did not issue comprehensive guidance on this issue until December 2008, when it issued voluminous Proposed Regulations on the topic.

The Proposed Regulations contain numerous special rules and present many complexities that need to be navigated:

  • Effect of Failure to Comply with Section 409A(a) on Amounts Deferred in Subsequent Years – A failure to satisfy the requirements of 409A(a) during an employee's taxable year would not affect the taxation of amounts deferred under the plan for a subsequent taxable year during which the plan complies with 409A(a).
  • Treatment of Nonvested Amounts – Nonvested deferred amounts generally would not be includible in income under Section 409A(a) in the year of the impermissible act; nor would interest or the additional 20 percent penalty tax apply.
  • Calculation of Amount Includible in Income for the Taxable Year in which 409A(a) Is Violated and All Preceding Taxable Years – To calculate the amount includible in income, Step 1 is to determine the "total amount deferred" for the taxable year and all preceding taxable years. Step 2 is to calculate the portion of such "total amount deferred" that is either nonvested or previously has been included in gross income. Step 3 is to subtract the result under Step 2 from the result under Step 1.
  • General Rule for Calculation of Total Amount Deferred – In general, the "total amount deferred" for a taxable year equals the present value as of the close of the last day of the employee's taxable year of all amounts payable to the employee under the plan, plus amounts paid to the employee during the year.
  • Plan-by-Plan Determination – Each type of plan – e.g., account balance plan, non-account balance plan, stock right plan, separation pay plan, reimbursement arrangement, split dollar life insurance plan – generally has its own rules for the determination of the "total amount deferred."

The IRS proposes that the Proposed Regulations take effect for taxable years beginning on or after the issuance of final regulations on this topic. However, before the applicability date of the final regulations, taxpayers may rely on the Proposed Regulations "only to the extent provided in further guidance." Further, it seems unlikely that the IRS will extend this effective date by 60 days, pursuant to the guidelines set forth in the Obama Administration's January 20, 2009, "regulatory review" memorandum to federal agencies – the notice and comment period for the Proposed Regulations does not expire until March 2009, and the Proposed Regulations have a delayed effective date.

Wage Withholding And Reporting Requirements Applicable To 409A For The 2008 Taxable Year And Subsequent Taxable Years

In December 2008, the IRS issued Notice 2008-115, which provides interim guidance to employers and employees on 409A wage withholding and income tax reporting requirements. This interim guidance is effective for calendar year 2008 and applies for all subsequent taxable years until the IRS issues further guidance.

The principal provisions of the interim guidance can be summarized as follows:

  • Annual Deferrals: Amounts Reportable on Form W-2 – An employer is not required to report amounts deferred during the year under a nonqualified deferred compensation plan subject to Section 409A (reporting otherwise would be required in box 12 of Form W-2);
  • Reporting and Withholding: Amounts Includible in Gross Income under 409A – An employer is required to report, for federal income tax purposes, amounts includible in gross income under 409A as wages paid on line 2 of Form 941, Employer's Quarterly Federal Tax Return, and in box 1 of Form W-2. An employer also must report such amounts as Section 409A income in box 12 of Form W-2 using code Z.

    Amounts includible in gross income under Section 409A constitute "supplemental wages" subject to the special withholding rules applicable to such wages. Withholding does not apply to the 20% penalty tax or any IRS interest.

    In the Notice, the IRS clarifies that taxpayers may rely upon the Proposed Regulations on income inclusion for purposes of calculating amounts subject to these reporting and withholding requirements (it is unlikely that the action will be taken pursuant to the "regulatory review" memorandum that will affect the scope of this reliance); and
  • Employees' Income Tax Reporting and Tax Payment Requirements with respect to Amounts Includible in Gross Income under Section 409A – An employee must report as income and pay any taxes due relating to amounts includible in gross income under Section 409A for a calendar year. The same methods for calculating the amounts required to be included in gross income as apply to the employer above generally apply to the employee. In addition, an employee must pay the additional 20 percent penalty tax and IRS interest when such amounts are due.

Section 409A of the Code will continue to require vigilance on the part of employees and employers in 2009 and subsequent taxable years.

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