Originally published May 2008

Section 409A was added to the Internal Revenue Code of 1986 (Code) by the American Jobs Creation Act of 2004 in reaction to Enron,Tyco, and other corporate excesses. The intent of 409A is to limit the ability of executives to manipulate the payment of their own compensation to the detriment of regular employees and shareholders. However, benefits vested prior to January 1, 2005 (the effective date of 409A), may be grandfathered and exempt from 409A. In 2007, the Internal Revenue Service (IRS) and Treasury Department (Treasury) issued over 200 pages of complex regulations. Businesses have until December 31, 2008, to inventory and review their nonqualified deferred compensation (NQDC) plans and bring them into compliance. Code Section 409A applies to both foreign-owned companies operating in the United States and domestic companies with overseas operations.

Because United States citizens and resident alien individuals are generally taxed on their worldwide income wherever it is derived, if these individuals are transferred to foreign locations and are covered under foreign plans, these plans may be subject to Code Section 409A. Likewise, foreign companies who transfer nonresident aliens to United States operations must be certain that any NQDC plans in which these individuals participate meet the requirements of 409A. Any United States employer, regardless of whether it is a domestic company or a subsidiary of a foreign parent, is expected to maintain NQDC plans compliance subject to Code Section 409A. However, citizens or resident aliens who are working abroad and participating in a plan sponsored by a foreign employer also must comply with Section 409A.

During the comment period to the 409A regulations, Treasury and IRS received requests to exempt foreign plans or foreign employees from Code Section 409A. That general exemption was denied. Instead, the regulations include several specific exemptions. A foreign plan that does not meet one of the exemptions must comply with Code Section 409A, otherwise the individual taxpayer may be subjected to significant tax penalties.

Generally, 409A applies not only to what is considered a "traditional" NQDC plan - that is, where an employee elects to defer receipt of a portion of his or her compensation - but also to non-elective deferred compensation. In addition, 409A may apply to arrangements not normally considered to be traditional plans of deferred compensation, such as employment agreements and severance arrangements. Furthermore, 409A applies not only to plans that cover employees, but also to various other service providers such as to independent contractors, corporations, and partnerships.

In order for a plan to comply with 409A, it generally must, among other things:

  • be in writing

  • restrict the timing of elective deferrals

  • provide for distributions only upon permitted, predetermined events

  • require that the form and timing of the distributions be determined at the time of the deferral

  • restrict the ability to delay or accelerate payment

  • delay distributions to key employees of public companies upon separation from service

If an NQDC plan does not comply with the 409A requirements, then the compensation is taxed when it is no longer subject to a substantial risk of forfeiture (vested). Generally, compensation is subject to a substantial risk of forfeiture when the employee is required to provide substantial future services in order to become entitled to the compensation.

If a plan is subject to 409A and does not comply with the requirements of 409A, then the employee may be subject to adverse tax consequences, which include:

  • a requirement to include all deferred amounts in income from the taxable year in which such amounts cease to be subject to a substantial risk of forfeiture (to the extent not previously included in income)

  • an additional tax on the person covered under the noncompliant plan equal to 20 percent of the amounts includible in income

  • an additional tax equal to the interest, as determined using the IRS rate applied to underpayment of tax, plus 1 percent, that would have been imposed during the deferral period if the amounts had been includible in income when first deferred or, if later, when they ceased to be subject to a substantial risk of forfeiture (collectively referred to as "409A sanctions")

Code Section 409A applies to both foreign-owned companies operating in the United States and domestic companies with overseas operations.

Application of Code Section 409A to Foreign Plans

Within the global economy, 409A applies only to individuals subject to United States tax. These individuals include:

  • United States citizens and legal permanent residents (greencard holders) subject to United States tax on their worldwide individual income

  • temporary residents (aliens other than legal permanent residents) such as foreign nationals working in the United States that satisfy the "substantial presence test" (described below)

  • nonresident aliens with United States source income

Under the "substantial presence test" an individual will be considered a United States resident for income tax purposes if he or she is physically present in the United States on at least

  • 31 days during the current year

  • 183 days during the three-year period that includes the current year and the two years immediately before that, counting:

  • all the days present in the current year

  • 1/3 of the days present in the first year before the current year

  • 1/6 of the days present in the second year before the current year

A complete analysis of the substantial presence test is beyond the scope of this article. However, the Code provides rules for counting the days present in the United States, exemptions for certain individuals (e.g., a teacher or trainee here under a "J" or "Q" visa, a professional athlete temporarily in the United States to compete in a charitable sports event), and exceptions under the so-called "closer connection" exception.

Nonqualified retirement benefits whose source is outside the United States may be exempt from 409A. Exempt arrangements include:

  • foreign social security plans

  • plans addressed by a tax treaty

  • payments taxable under Code Section 402(b) when vested

  • broad-based foreign retirement plans

  • compensation of a nonresident alien already vested prior to his/her arrival in the United States even if he or she subsequently becomes a resident alien

  • various other exemptions such as compensation that is excluded under Code Section 911, certain Puerto Rican plans

Although all NQDC plans should be inventoried and reviewed for compliance with 409A, special attention should be paid to non-United States source retirement plans that cover any United States taxpayers (Non-US Plan). Companies should review each identified Non-US Plan to see if any of the 409A exemptions apply. If no exemption applies to the Non-US Plan and the benefit is not grandfathered, a company should determine whether the plan could be modified to comply with 409A or whether other actions may be required, such as establishing alternative programs or renegotiating employment agreements.

The foregoing is only a very brief review of a complicated area of United States tax law.

www.foxrothschild.com

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.