United States: Getting to Know (and Love) the Short-Term Deferral Rule

In its efforts to reform the rules governing deferred compensation as a part of the American Jobs Creation Act of 2004 (the "Act"), Congress chose to legislate broadly and to leave it to the regulators to adopt the necessary exceptions and carve-outs required to arrive at workable rules. The Act’s legislative history envisions, and newly enacted Code §409A requires, that the regulators will fill in the particulars of the regulatory scheme. In Notice 2005-1, and in the proposed regulation issued on September 29, 2005 (the "proposed regulation"), the IRS and the U.S. Department of the Treasury endeavored to follow Congress’ lead. In addition to rules targeting particular compensation types (e.g., equity-based compensation) and practices (e.g., "separation pay"), the regulators granted a broad-based exemption from Code §409A for amounts that are paid out within 2 ½ months after the end of the taxable year of the service provider or the service recipient in which the amounts are no longer subject to a substantial risk of forfeiture (i.e., they become vested). This rule is referred to as the "short-term deferral rule," and it is an essential feature of the Code §409A regulatory environment. This advisory explains the short-term deferral rule and its applications.

Code §409A regulates deferred, not current, compensation. Compensation is deferred when a service provider obtains a legally binding right to compensation in one year that is paid in a later year. But there are instances—annual bonuses, for example—where compensation is earned in one year and paid within a short period of time following the close of the year. While technically deferred compensation, these sorts of deferrals do not present the same opportunity for abuse as longer term arrangements. As a result, the regulators have chosen to exempt certain arrangements of this sort from the reach of Code §409A under the short-term deferral rule.

Under the short-term deferral rule, a deferral of compensation is deemed not to occur if (absent an election to otherwise defer the payment to a later period) at all times the terms of the plan require payment by, or an amount is actually or constructively received by the employee by, the later of—

• 2 ½ months from the end of the employee’s taxable year in which the amount is no longer subject to a substantial risk of forfeiture, or

• 2 ½ months from the end of the employer’s fiscal year in which the amount is no longer subject to a substantial risk of forfeiture.

Where an amount is never subject to a substantial risk of forfeiture, it is considered no longer subject to a substantial risk of forfeiture on the date that the employee first has a legally binding right to the amount.

The short-term deferral rule made its debut in Notice 2005-1, and it is carried over into the proposed regulation, with an important clarification. The proposed regulation makes clear that the short-term deferral rule does not require a written instrument. This is so despite the requirement in the proposed regulation that plans subject to Code §409A be in writing. So long as the requirements of the short term deferral rule are adhered to in practice, the arrangement will not be subject to Code §409A. But there’s a hitch: Where an arrangement is not in writing and payment is not timely made (except as a consequence of an unforeseeable administrative or solvency issue), the payment will result in an automatic violation of Code §409A. In contrast, where a right to a short-term deferral is reflected in a written instrument that otherwise complies with Code §409A, payment can be made at any time during the calendar year that includes the date specified for payment under a general rule permitting payment during the calendar year that contains the fixed payment date. (Of course, a late payment of this sort might separately violate the contract governing the payment of the compensation.)

The short-term deferral rule will undoubtedly attract schemes designed to avoid Code §409A’s reach, some of which the regulators have already anticipated. In particular, the proposed regulation clarifies that the short-term deferral rule can’t be used to permit the acceleration of the payment of deferred compensation in a manner that would otherwise violate Code §409A. The preamble to the proposed regulation offers the following example—

"[I]f a legally binding right to payment in Year 10 arises in Year 1, but the right is subject to a substantial risk of forfeiture through Year 3, paying the amount at the end of Year 3 would not result in the payment failing to be subject to section 409A, but rather generally would be an impermissible acceleration of the payment from the originally established right to payment in year 10."

Restricted Property

Notice 2005-1 and the proposed regulation make clear that transfers of restricted property are generally regulated under Code §83 instead of Code §409A. Thus, an employee who receives restricted property (e.g., employer stock) in connection with the performance of services may not have current income—by reason of the application of Code §83—because the property is nontransferable and subject to a substantial risk of forfeiture. But where the promise takes the form of a legally binding right to receive property (restricted or not) in a future year, Code §409A is implicated unless some other exemption (such as the short-term deferral rule) applies. The proposed regulation offers the following example of how this might occur:

Where an employee participates in a two-year bonus program such that, if the employee continues in employment for two years, the employee is entitled to either the immediate payment of a $10,000 cash bonus or the grant of restricted stock with a $15,000 fair market value subject to a vesting requirement of three additional years of service, the arrangement generally would constitute a short-term deferral because under either alternative the payment would be received within the short-term deferral period.

In this example, there are two vesting events, one governed by Code §409A and the other governed by Code §83. According to the proposed regulation, "where the promise to transfer the substantially non-vested property and the right to retain the substantially non-vested property after the transfer are both subject to a substantial risk of forfeiture . . . the arrangement generally would constitute a short-term deferral because the payment would occur simultaneously with the vesting of the right to the property." (Emphasis added.)

The proposed regulation provides some important and welcome rules affecting "separation pay." Separation pay refers to a broad category of plans that provide payments in the case of severance, and the proposed regulation provides some important safe harbor provisions in the case of certain involuntary terminations and voluntary terminations under a limited class of "window program" arrangements.

Even if involuntary separation payment arrangements do not satisfy the safe harbor provisions of the proposed regulation, they can still be structured to meet the short-term deferral rule and thereby avoid the application of Code §409A. But many separation pay plans pay benefits both in the event of involuntary termination, and in the case of a termination for "good reason"—i.e., constructive termination. In this case, the short-term deferral rule would be available only so long as termination for good reason constitutes a substantial risk of forfeiture. In the preamble to the proposed regulation, the regulators expressed unwillingness to endorse this approach. In their view, it is difficult as a factual matter to distinguish between a voluntary separation from service and a termination of services for good reason. As a result, severance arrangements with good reason payment triggers are unlikely to qualify for exemption from Code §409A under the short-term deferral rule.

The proposed regulation establishes a rule governing elections to further defer amounts that would not otherwise be subject to Code §409A due to the short-term deferral rule. For this purpose:

• The date the substantial risk of forfeiture lapses is treated as the original time of payment established by an initial deferral election, and
• The form in which the payment would be made absent a deferral election is treated as the original form of payment established by an initial deferral election.

The purpose of this rule is to recognize that there may be instances in which a plan might permit, and an employee might choose, to further defer amounts that would not otherwise be subject to Code §409A. Where this occurs, the employee will need to make the deferral election at least 12 months before the right to the payment vests, and payment must be deferred for a period of not less than 5 years.

Example: An employee is entitled to the immediate payment of a bonus upon the occurrence of an initial public offering under circumstances that would otherwise qualify as a short term deferral. Before the initial public offering, the employee elects to defer any potential bonus payment to a date 5 years from the date of the initial public offering. To comply with the initial deferral election rules, the deferral election must not be given effect for 12 months. Accordingly, if the initial public offering occurs within 12 months of the deferral election, the payment must be made at the time of the initial public offering in accordance with the short-term deferral rules.

The short-term deferral rule is an important exception to Code §409A. It offers plan sponsors and their advisors a multitude of planning opportunities so long as payment of a benefit is made proximate to vesting. But, as indicated above, the rule’s apparent simplicity can be misleading.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.