Non-Qualified Deferred Compensation

Section 409A Notice

The American Jobs Creation Act of 2004 created a new Section 409A of the Internal Revenue Code.  That statute is the Congressional response to Enron-style abuses.  Accordingly, it is broad in scope, affecting virtually every nonqualified retirement plan and deferred compensation arrangement, whether offered by the a large publicly-traded multi-national corporation or by a small, privately held company.  If an Employer has granted any form of deferred compensation to it's employees, all plan participants may be subject to startling and unprecedented tax consequences if the deferred compensation arrangements do not comply with Section 409A of the Internal Revenue Code. 

What are the consequences of not being in compliance?

Under the new rules, participants in a deferred compensation arrangement that is determined not to comply with Section 409A (i.e. the persons benefiting from the arrangement), will be required to pay federal and California income taxes and penalties of up to approximately 75% of the amount of the deferral, plus interest on such tax retroactive to the original deferral date.  These sums could be imposed and payable without regard to when the deferred income is actually paid, in effect creating “phantom income” with no cash to pay these extraordinary levels of tax.  Although the primary impact of Section 409A is on the participant – not on the company, conscientous employers should take the necessary steps to minimize the risk of noncompliance.

What deferred compensation arrangements are subject to compliance with Section 409A?

The scope of what constitutes a deferred compensation arrangement is very broad.  Some of the most common nonqualified deferred compensation plans and arrangements subject to Section 409A include: 

  • Elective deferred compensation (e.g., salary or bonus deferral programs)
  • Non-elective deferred compensation (e.g., SERPs)
  • Salary continuation plans
  • Change of Control payments
  • Restricted Stock or Phantom Stock Plans
  • Non-qualified stock option plans
  • Stock Appreciation Rights
  • Severance Pay arrangements
  • Split Dollar Insurance Agreements
  • Litigation settlements granting deferred compensation
  • Any other arrangement, whether or not in the form of a formal “plan,” that has the effect of deferring compensation relating to one taxable year into a subsequent taxable year (other than amounts paid within 2-1/2 months of the end of the year to which the service relates) (e.g. a contractual provision in an employment agreement)

Section 409A does not, however, affect tax qualified retirement plans, such as Incentive Stock Option Plans, ESOPs, 401(K) Plans, 457(b) Plans, Section 403 Annuity Plans, SEPs, SIMPLEs or bona fide vacation, sickness or disability plans and death benefit plans.

The IRS finally published Final Regulations under Section 409A in 2008.  The new rules are not only extraordinary in their consequences, but unusually complex in their details.  Indeed, there remain many open questions among practitioners about how best to respond to these new rules.  In any event all deferred compensation arrangements subject to Section 409A (such as those enumerated above) should be reviewed for or drafted in compliance with the new rules.  While many deferred compensation arrangements will not require any corrective measures, some may require significant amendment in order to avoid the disastrous results of noncompliance with Section 409A.  Moreover, in some cases, while a deferred compensation arrangement may be adequately documented, the Sponsor will need to be aware of the IRS requirements for proper implementation and administration of the plan to ensure that it's arrangement is considered to be in compliance.

What are the specific statutory requirements for deferred compensation plans?

All non-qualified deferred compensation arrangements must satisfy the following specific requirements:

  • The Plan or arrangement must be in writing
  • Benefits can only be paid upon the following events:
    • A fixed and ascertainable date or dates
    • Death
    • Disability
    • Termination of Service
    • Unforeseeable Emergency
    • Change of Ownership
  • Benefits cannot be accelerated or delayed except in limited circumstances.
  • Various other technical and documentary requirements

The new rules are most problematic in developing non-qualified stock option or similar equity sharing arrangements.  The best strategy is to design option programs that escape the new regulations, which contain specific rules for how to accomplish that result.

Companies that have any kind of deferred compensation arrangements, should contact us immediately.  In particular, if they have a non-qualified stock option plan, it is imperative that it be reviewed for compliance with the new rules as soon as possible.  We can work with clients to determine whether their plans are out of compliance, and if so, what needs to be done.