Effective Immediately: Risks of 409A Penalties Exist for Taxpayers Not in Compliance with Proposed Regulations
The American Jobs Creation Act of 2004, added section 409A to the Internal Revenue Code (IRC). Section 409A generally provides that if certain requirements are not met at any time during a taxable year, all amounts deferred under a nonqualified deferred compensation plan are taxable to the employee/service provider to the extent not subject to a substantial risk of forfeiture and not previously included in income. If deferred compensation is required to be included in income under 409A, the income taxed to the employee is further subject to penalties of interest and a 20% tax in addition to normal federal income taxes. Therefore, it is very important that deferred compensation agreements comply with IRC 409A.
Final regulations related to 409A were issued in 2007 and proposed regulations in 2008 were issued related to the income inclusion rules. Recently, the Internal Revenue Service issued proposed regulations in an effort to clarify and modify parts of the final regulations as well the proposed income inclusion regulations. For the most part, the proposed regulations are consistent with how the final regulations have been interpreted and applied. The proposed regulations do provide some helpful guidance, however, the revisions to the proposed income inclusion regulations limit the ability to make changes to unvested amounts without incurring the very punitive Section 409A penalties.
Some of the proposed changes include:
- Modification of the short-term deferral exception to permit a delay in payments to avoid violating federal securities laws or other applicable law.
- Clarification that a stock right that does not otherwise provide for a deferral of compensation will not be treated as providing for a deferral of compensation solely because the amount payable under the stock right upon an involuntary separation from service for cause, or the occurrence of a condition within the service provider’s control, is based on a measure that is less than fair market value.
- Revision of the rules to allow pre-employment equity grants to be exempt from Section 409A. This change means that options and stock appreciation rights granted to employees prior to employment commencement can still qualify for an exemption under Section 409A as long as the employee begins providing services within 12 months after the grant date.
- Clarification of the Involuntary Separation Pay Exception. The proposed regulations provide that separation pay plans intended to be exempt from Section 409A under the involuntary separation pay exception can still meet this exception even where an employee had no compensation from the employer during the year preceding the year of termination (generally, to utilize this exception, an employer must be able to calculate the employee’sprior year compensation).
- Modification of the rules regarding recurring part-year compensation. The proposed regulations provide that an arrangement under which an employee receives recurring part-year compensation that is earned over a period of service is not subject to Section 409A if certain requirements are met. The arrangement must not defer payment of any of the recurring part-year compensation to a date beyond the last day of the 13th month following the first day of the service period for which the recurring part-year compensation is paid, and the amount of the employee’s recurring part-year compensation does not exceed the annual compensation limit under Section 401(a)(17) ($265,000 for 2016) for the calendar year in which the service period commences.
- Clarification that a service provider who ceases providing services as an employee and begins providing services as an independent contractor is treated as having a separation from service. This separation from service occurs if, at the time of the change in employment status, the level of services reasonably anticipated to be provided after the employee’s change would result in a separation from service under rules applicable to employees.
- Addition of a rule regarding when payment has been made. The proposed regulations add a generally applicable rule to determine when a payment has been made for all provisions of the regulations under Section 409A. Under the guidance, a payment is made, or the payment of an amount occurs, when any taxable benefit is actually or constructively received.
- Clarification and modification of the rules applicable to amounts payable following death. The proposed regulations clarify that the rules applicable to amounts payable upon the death of an employee also apply to amounts payable upon the death of a beneficiary. In addition, as the time periods for the payment of amounts following death in the final regulations often are not long enough to resolve certain issues related to the death (for example, confirming the death and completing probate). Thus, the proposed regulations provide that an amount payable following the death of an employee, or following the death of a beneficiary who has become entitled to payment due to the employee’s death, will be considered timely paid if it falls in the set payment period. The payment must be made at any time during the period beginning on the date of death and ending on December 31 of the first calendar year following the calendar year during which the death occurs.
- Provisions that the addition of the death, disability, or unforeseeable emergency of a beneficiary who has become entitled to a payment due to a service provider’s death as a potentially earlier or intervening payment event will not violate the prohibition on the acceleration of payments.
- Clarification of certain rules permitting payments in connection with the termination and liquidation of a plan not made in connection with a change in control. The proposed regulations clarify that the acceleration of a payment pursuant to this special acceleration rule is permitted only if the employer terminates and liquidates all plans of the same category that the employer sponsors, and not merely all plans of the same category in which a particular employee actually participates. The proposed regulations also clarify that under this rule, for a period of three years following the termination and liquidation of a plan, the employer cannot adopt a new plan of the same category as the terminated and liquidated plan, regardless of which employees participate in the plan.
- Limitations on ability to make corrections of unvested amounts under the proposed income inclusion regulations. The proposed regulations include provisions which allow employers to make changes to nonqualified deferred compensation plans before amounts under the plans are vested without causing penalties to be incurred under Section 409A. However, due to perceived abuses, the revised proposed regulations curb the ability to make corrections. These revised proposed regulations may not be used to make changes to plan provisions that are already compliant with Section 409A. In addition, any corrections made under these revised proposed regulations must be made in accordance with existing guidance regarding corrections (IRS Notice 2010-6) to the extent possible. Thus, employers who have corrected Section 409A failures using the proposed income regulations in the past, should review these new proposed regulations before making similar changes/corrections going forward.
- Clarification that various provisions of the final regulations recognize that a service provider can be an entity as well as an individual.
The proposed regulations amending the final regulations under Section 409A are proposed to be applicable on or after the date on which they are published as final regulations, but taxpayers may rely on these proposed regulations immediately. Until the Treasury Department and the IRS issue further guidance, taxpayers may rely on the proposed income inclusion regulations, as modified by these new proposed regulations, for purposes of calculating Section 409A penalties.
Please contact your Sikich professional if you have any questions on these Section 409A regulations.