When the American Jobs Creation Act of 2004 was signed into law, it added a new Section 409A to the Internal Revenue Code. Section 409A applies to deferred compensation arrangements, excess plans, supplemental executive retirement, change in control agreements, incentive compensation arrangements and severance arrangements. Because so many of these arrangements are the subject of employment contracts, employment attorneys representing executives should be mindful of the rules when drafting benefit provisions and counseling their clients about the tax implications of these arrangements. In April 2007, the IRS issued its final 409A regulations, which set the framework within which employment contracts must be drafted or revised. In December 2007, the IRS issued Notice 2007-100, which provides guidance on the correction of certain operational failures of nonqualified deferred compensation plans.
What is 409A?
Section 409A does not replace, but instead overlays Internal Revenue Code Sections 83 (performance of services) and 451 (constructive receipt), as well as other Code sections addressing tax treatment of deductions and timing and taxation of distributions from nonqualified plans. The impact of 409A is much broader, as it addresses the structure of deferred compensation plans (requiring that they be written down), provides that the exercise price for employee stock options must be at least equal to the fair market value of the stock on the date of option grant, mandates that employee stock options may not be granted on companies “downstream” from the employer, and sets forth definitions of plan terms such as “disability”, “change in control” and termination of employment for “cause” or “good reason” may require amendment.
The importance of understanding 409A is the impact on the client. Failure to comply with 409A has a negative financial consequence on the individual in the form of additional income taxes, as the deferred amounts and potential excise taxes. Plans covered by 409A must have been in “good-faith” (operational compliance) with 409A since January 2005, even if they have not come into written compliance.
The IRS issued Notice 2007-86 and Notice 2007-89, which together extend through 2008 most of the transitional relief that had previously been in effect only until December 31, 2007, in particular, the general plan amendment deadline. Plans will be in compliance for 2008 provided they continue to operate under a “good faith, reasonable interpretation” of Section 409A, which generally means employers can continue to follow, for one more year, the transitional rules issued by the IRS after Section 409A was enacted, in Notice 2005-1. Notice 2007-89 also extends the effective date for reporting 409A deferrals, so that employers generally need not do so on their Forms W-2 and 1099 for 2007. However, employers must report 409A inclusions. Finally, Notice 2007-86 also extends until the end of 2008 the time during which employees can make new payment elections, with certain restrictions, without triggering Section 409A.
Employment Agreements and 409A
Subsequent deferrals. One of the major practices that 409A is directed to is what are known as “subsequent deferrals”. When an employment contract provides that the employee earns an annual bonus based upon an agreed-upon event or formula, and also agree upon the year in which it is paid (for example, bonus earned in 2008 will be paid in 2011), but subsequently, after the bonus is earned, the employer and employee modify the agreement so the bonus is not payable until a later date (for example 2012). Under 409A, the subsequent deferral will be subject to severe tax penalties, including retroactive inclusion of the bonus in 2007 and imposition of a 20 percent excise tax.
Severance pay safe-harbor. More notable for the employee representative is the tax treatment of deferred compensation paid in the form of severance for “good cause” resignations. The final 409A regulations provide a safe-harbor for “good cause” resignations that, if met, will result in the severance payments being exempt from 409A requirements. To which fall within the safe-harbor, an employment agreement must contain the following provisions:
- Voluntary separation from service within two years after the occurrence of one or more “good reason” events;
- Amount, time and form of payment of any deferred compensation attributable to a good reason resignation identical to that attributable to an involuntary separation of service;
- Executive notice provision requiring the employee to provide notice of the conditions believed to constitute good reason for a voluntary resignation within 90 days of their occurrence, with the employer given at least 30 days in which to remedy those conditions and avoid payment of deferred compensation.
The final regulations set forth six good cause conditions triggering the safe-harbor provision involve the material diminution in:
- The employee’s base compensation;
- The employee’s authority;
- The authority, duties or responsibilities of the employee’s supervisor to whom the employee is required to report;
- The employee’s budgetary authority;
- Geographic location the employee performs services;
- Any action or inaction that constitutes a material breach of the terms of an applicable employment agreement.
If these requirements are met, the severance pay is excluded from coverage under 409A.
Other post-termination benefits. Other post-termination benefits, provided for a “limited time”, such as COBRA premiums, or medical expense, relocation expenses, outplacement services and other in-kind benefits under $5,000 are also exempted from 409A.
Counseling Employees During Drafting and After Operational Non-Compliance
Employee representatives should make a concerted effort to secure for their clients information about the operational compliance of other deferred compensation arrangements or and other plans covered under 409A. Assurance of operational compliance during this transitional period should become a standard provision in an employee’s contract. It can serve as a basis for relief should the employer fail to meet the IRS requirements.
With Notice 2007-100, the IRS has provided employees the ability to avoid the consequence of unintentional operational failures. For example, following a timely election to defer 50 percent of a bonus payable in 2007, the employer unintentionally defers only 10 percent of the bonus and pays the balance of the deferral to the employee. This operational violation can be corrected with the return of the excess deferral on or before the end of the calendar year. Such amount can be credited to the employee’s account, and not included in the employee’s compensation or reported by the employer on the employee’s Form W-2.
As the IRS will receive further comments regarding relief for unintentional noncompliance with 409 A, employee counsel should continue to monitor future announcements regarding correction programs that may be available so that you can assist your clients during this transition period of operational compliance for employers.
Denise M. Clark practices employment and employee benefits law.