White & Case LLP - News - 409A IRS Code Alert: Deadline Approaches for Bringing Nonqualified Deferred Compensation Plans into Compliance

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409A IRS Code Alert: Deadline Approaches for Bringing Nonqualified Deferred Compensation Plans into Compliance
A Q&A Discussion with White & Case's Kenneth A. Raskin
August 23, 2007

The US Treasury Department and the IRS recently issued final regulations under Internal Revenue Code Section 409A ("409A"), the landmark provision that marked a major change in the tax treatment of certain deferred compensation plans. The final regulations contain limited transition periods expiring at the end of 2007 and other guidance that will have an immediate impact on employers, from major corporations to small enterprises.

In the following Q&A, Kenneth A. Raskin, head of the White & Case's Global Executive Compensation, Benefits and Employment Law Practice, explains the scope, compliance requirements and consequences of a violation of 409A. For a more detailed description of 409A, click here to access our comprehensive report, or inquire with the contacts referenced at the end of this Q&A.

Q: Can you touch upon some of the general requirements under 409A?

Kenneth: 409A provides that all amounts deferred under a nonqualified deferred compensation plan are included in income when deferred (or, if later, when the amounts are no longer subject to a substantial risk of forfeiture), unless certain requirements established by 409A are satisfied. The requirements include rules regarding the timing of deferral and distribution elections, and permissible distribution events.

Q: What are the consequences of a failure to comply with 409A?

Kenneth: If an amount of deferred compensation is required to be included in income under 409A, that amount is subject to ordinary income tax, plus an additional 20 percent income tax, and interest may be assessed on tax underpayments in certain circumstances.

Q: When do the final regulations take effect?

Kenneth: 409A is currently effective, but the final regulations will not become effective until January 1, 2008. A nonqualified deferred compensation plan subject to 409A will not be treated as violating 409A on or before December 31, 2007 if the plan is operated in reasonable, good-faith compliance with 409A, and the plan is amended on or before December 31, 2007 to conform to the provisions of 409A and the final regulations. Employers maintaining nonqualified deferred compensation plans that are subject to 409A should operate the plans in reasonable, good-faith compliance with 409A at all times. Compliance with the final regulations before 2008 is not required, but constitutes reasonable, good-faith compliance with 409A.

All nonqualified deferred compensation plans that are not grandfathered will need to be put in writing and amended to comply with 409A by December 31, 2007.

Q: What types of plans are grandfathered?

Kenneth: Generally, amounts deferred and vested in taxable years beginning before January 1, 2005 (as well as earnings on these amounts), commonly referred to as grandfathered amounts, are not subject to 409A as long as the plan under which the amounts are deferred is not materially modified after October 3, 2004.

Q: Which types of plans in general are subject to 409A?

Kenneth: 409A applies to nonqualified deferred compensation plans, which are plans and arrangements that provide for the deferral of compensation, other than tax-qualified plans and plans that provide vacation leave, sick leave, compensatory time, disability pay or death benefits. A plan provides for deferral of an employee's compensation if, under the plan, and the relevant facts and circumstances, the employee has a legally binding right during a taxable year to compensation that is or may be payable to the employee in a later taxable year.

Q: Is 409A applicable to independent contractors and directors, as well as employees?

Kenneth: Yes, 409A generally applies to all service providers, including outside employees, directors, independent contractors and personal service corporations.

Q: Are there exceptions that will bring nonqualified deferred compensation plans outside the scope of 409A?

Kenneth: Yes, even if a plan falls within the general definition of a nonqualified deferred compensation plan, it may meet one of several specified exceptions that will bring the plan outside the scope of 409A.

The most commonly used exception is the exception for "short-term deferrals." This exception provides that a deferral of compensation does not occur if the plan under which the payment is made does not provide for a deferred payment, and the compensation is paid within two and a half months after the later of (i) the end of the employee's first taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture or (ii) the end of the employer's first taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture.

Q: Can you describe the plan aggregation rules under 409A?

Kenneth: All plans in which an employee defers compensation that fall within the same category, as I'll describe in a moment, are aggregated for certain purposes under 409A, including initial participation determinations, plan terminations and income inclusion upon a 409A violation. The categories of plans that are aggregated for certain purposes under 409A are : (i) account balance plans where deferrals of compensation are at the election of the employee, (ii) account balance plans where deferrals of compensation are not at the election of the employee, (iii) non-account balance plans, (iv) separation pay arrangements providing benefits under a "window program" or upon involuntary separation from service, (v) in-kind benefits or reimbursements of expenses that do not constitute a substantial portion of the employee's compensation for services or separation, (vi) split-dollar life insurance arrangements, (vii) certain amounts deferred under foreign plans, (viii) stock rights and (ix) all other plans.

Q: By which date must elections to defer compensation to a later date be made?

Kenneth: Elections to defer compensation to a later date must, generally, be made before the close of the tax year preceding the year during which the compensation is earned. There are also several specified exceptions in the regulations that permit elections to be made at a later date under certain circumstances.

Q: Can the time or schedule of deferred compensation plans be accelerated?

Kenneth: With respect to elections made after December 31, 2007, 409A prohibits the acceleration of the time or schedule of deferred compensation payments, except in certain specified instances.

Q: Under 409A, when can deferred compensation be distributed?

Kenneth: 409A prohibits plans from permitting distributions of deferred compensation prior to the occurrence of one of the following: (i) the employee's separation from service, (ii) the date the employee becomes disabled, (iii) the date the employee dies, (iv) a time or fixed schedule specified under the plan on the date of the deferral, (v) the date of a change in the ownership or effective control of a corporation or in the ownership of a substantial portion of its assets, or (vi) the occurrence of an unforeseeable emergency.

Deferred compensation payments upon the separation from service of certain key employees of a company that has publicly traded stock may not be made before the date that is six months after the date of separation from service.

Q: Are stock-based plans subject to 409A?

Kenneth: Certain types of stock-based compensation are subject to 409A, while other types of stock-based compensation may be structured to be excluded from 409A. Restricted stock grants are not subject to 409A. In most cases, stock options and stock appreciation rights with exercise prices equal to the fair market value of the underlying stock on the date of grant will not be subject to 409A.

Q: What are some of the rules affecting separation pay plans?

Kenneth: Separation pay plans and severance agreements may be subject to 409A. The final regulations clarify and expand several of the exemptions from 409A that are applicable to separation pay plans and also provide guidance to facilitate compliance of separation pay plans that are subject to 409A. For example, a separation pay plan where severance is paid upon an actual involuntary separation from service or pursuant to a "window program" is exempt from 409A if the entire amount paid under such plan to any employee does not exceed two times the employee's compensation for the year prior to separation (or, if less, two times the annual compensation limit then applicable to tax-qualified plans, the limit being $225,000 for 2007) and is paid no later than December 31 of the second calendar year following the calendar year in which the employee's separation from service occurs. The final regulations provide circumstances under which an employee's separation from service will be considered as an involuntary separation from service. The final regulations provide that an employee's separation from service for "good reason" may qualify as an involuntary separation from service.

Q: Have you any final words of advice for employers?

Kenneth: Employers should review all of their compensation arrangements to determine whether such arrangements are subject to 409A. Employers maintaining nonqualified deferred compensation plans that are subject to 409A should (i) maintain the plans in operational compliance with a reasonable, good-faith interpretation of 409A at all times up through December 31, 2007, (ii) adopt amendments to bring the plans into full administrative compliance with 409A by December 31, 2007, and (iii) ensure that the plans are in writing by December 31, 2007. Failure to take such actions may result in material adverse tax consequences to employees entitled to compensation under such plans.

Kenneth A. Raskin, a partner based in White & Case's New York office, is the head of the Firm's Global Executive Compensation, Benefits and Employment Law Practice. He focuses on executive compensation and employee benefits law, and provides counsel on the entire spectrum of employee benefit concerns. Mr. Raskin may be reached at kraskin@whitecase.com.

"Talking" features White & Case lawyers answering questions about emerging legal and business issues. For more information or to schedule an interview with Mr. Raskin, please contact Reilly Starr at rstarr@whitecase.com.

Any information contained in this interview is for educational purposes only. It should not be construed as legal advice.

	In the Media
Expertise Employment & Benefits Locations New York	409A IRS Code Alert: Deadline Approaches for Bringing Nonqualified Deferred Compensation Plans into Compliance A Q&A Discussion with White & Case's Kenneth A. Raskin August 23, 2007 The US Treasury Department and the IRS recently issued final regulations under Internal Revenue Code Section 409A ("409A"), the landmark provision that marked a major change in the tax treatment of certain deferred compensation plans. The final regulations contain limited transition periods expiring at the end of 2007 and other guidance that will have an immediate impact on employers, from major corporations to small enterprises. In the following Q&A, Kenneth A. Raskin, head of the White & Case's Global Executive Compensation, Benefits and Employment Law Practice, explains the scope, compliance requirements and consequences of a violation of 409A. For a more detailed description of 409A, click here to access our comprehensive report, or inquire with the contacts referenced at the end of this Q&A. Q: Can you touch upon some of the general requirements under 409A? Kenneth: 409A provides that all amounts deferred under a nonqualified deferred compensation plan are included in income when deferred (or, if later, when the amounts are no longer subject to a substantial risk of forfeiture), unless certain requirements established by 409A are satisfied. The requirements include rules regarding the timing of deferral and distribution elections, and permissible distribution events. Q: What are the consequences of a failure to comply with 409A? Kenneth: If an amount of deferred compensation is required to be included in income under 409A, that amount is subject to ordinary income tax, plus an additional 20 percent income tax, and interest may be assessed on tax underpayments in certain circumstances. Q: When do the final regulations take effect? Kenneth: 409A is currently effective, but the final regulations will not become effective until January 1, 2008. A nonqualified deferred compensation plan subject to 409A will not be treated as violating 409A on or before December 31, 2007 if the plan is operated in reasonable, good-faith compliance with 409A, and the plan is amended on or before December 31, 2007 to conform to the provisions of 409A and the final regulations. Employers maintaining nonqualified deferred compensation plans that are subject to 409A should operate the plans in reasonable, good-faith compliance with 409A at all times. Compliance with the final regulations before 2008 is not required, but constitutes reasonable, good-faith compliance with 409A. All nonqualified deferred compensation plans that are not grandfathered will need to be put in writing and amended to comply with 409A by December 31, 2007. Q: What types of plans are grandfathered? Kenneth: Generally, amounts deferred and vested in taxable years beginning before January 1, 2005 (as well as earnings on these amounts), commonly referred to as grandfathered amounts, are not subject to 409A as long as the plan under which the amounts are deferred is not materially modified after October 3, 2004. Q: Which types of plans in general are subject to 409A? Kenneth: 409A applies to nonqualified deferred compensation plans, which are plans and arrangements that provide for the deferral of compensation, other than tax-qualified plans and plans that provide vacation leave, sick leave, compensatory time, disability pay or death benefits. A plan provides for deferral of an employee's compensation if, under the plan, and the relevant facts and circumstances, the employee has a legally binding right during a taxable year to compensation that is or may be payable to the employee in a later taxable year. Q: Is 409A applicable to independent contractors and directors, as well as employees? Kenneth: Yes, 409A generally applies to all service providers, including outside employees, directors, independent contractors and personal service corporations. Q: Are there exceptions that will bring nonqualified deferred compensation plans outside the scope of 409A? Kenneth: Yes, even if a plan falls within the general definition of a nonqualified deferred compensation plan, it may meet one of several specified exceptions that will bring the plan outside the scope of 409A. The most commonly used exception is the exception for "short-term deferrals." This exception provides that a deferral of compensation does not occur if the plan under which the payment is made does not provide for a deferred payment, and the compensation is paid within two and a half months after the later of (i) the end of the employee's first taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture or (ii) the end of the employer's first taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture. Q: Can you describe the plan aggregation rules under 409A? Kenneth: All plans in which an employee defers compensation that fall within the same category, as I'll describe in a moment, are aggregated for certain purposes under 409A, including initial participation determinations, plan terminations and income inclusion upon a 409A violation. The categories of plans that are aggregated for certain purposes under 409A are : (i) account balance plans where deferrals of compensation are at the election of the employee, (ii) account balance plans where deferrals of compensation are not at the election of the employee, (iii) non-account balance plans, (iv) separation pay arrangements providing benefits under a "window program" or upon involuntary separation from service, (v) in-kind benefits or reimbursements of expenses that do not constitute a substantial portion of the employee's compensation for services or separation, (vi) split-dollar life insurance arrangements, (vii) certain amounts deferred under foreign plans, (viii) stock rights and (ix) all other plans. Q: By which date must elections to defer compensation to a later date be made? Kenneth: Elections to defer compensation to a later date must, generally, be made before the close of the tax year preceding the year during which the compensation is earned. There are also several specified exceptions in the regulations that permit elections to be made at a later date under certain circumstances. Q: Can the time or schedule of deferred compensation plans be accelerated? Kenneth: With respect to elections made after December 31, 2007, 409A prohibits the acceleration of the time or schedule of deferred compensation payments, except in certain specified instances. Q: Under 409A, when can deferred compensation be distributed? Kenneth: 409A prohibits plans from permitting distributions of deferred compensation prior to the occurrence of one of the following: (i) the employee's separation from service, (ii) the date the employee becomes disabled, (iii) the date the employee dies, (iv) a time or fixed schedule specified under the plan on the date of the deferral, (v) the date of a change in the ownership or effective control of a corporation or in the ownership of a substantial portion of its assets, or (vi) the occurrence of an unforeseeable emergency. Deferred compensation payments upon the separation from service of certain key employees of a company that has publicly traded stock may not be made before the date that is six months after the date of separation from service. Q: Are stock-based plans subject to 409A? Kenneth: Certain types of stock-based compensation are subject to 409A, while other types of stock-based compensation may be structured to be excluded from 409A. Restricted stock grants are not subject to 409A. In most cases, stock options and stock appreciation rights with exercise prices equal to the fair market value of the underlying stock on the date of grant will not be subject to 409A. Q: What are some of the rules affecting separation pay plans? Kenneth: Separation pay plans and severance agreements may be subject to 409A. The final regulations clarify and expand several of the exemptions from 409A that are applicable to separation pay plans and also provide guidance to facilitate compliance of separation pay plans that are subject to 409A. For example, a separation pay plan where severance is paid upon an actual involuntary separation from service or pursuant to a "window program" is exempt from 409A if the entire amount paid under such plan to any employee does not exceed two times the employee's compensation for the year prior to separation (or, if less, two times the annual compensation limit then applicable to tax-qualified plans, the limit being $225,000 for 2007) and is paid no later than December 31 of the second calendar year following the calendar year in which the employee's separation from service occurs. The final regulations provide circumstances under which an employee's separation from service will be considered as an involuntary separation from service. The final regulations provide that an employee's separation from service for "good reason" may qualify as an involuntary separation from service. Q: Have you any final words of advice for employers? Kenneth: Employers should review all of their compensation arrangements to determine whether such arrangements are subject to 409A. Employers maintaining nonqualified deferred compensation plans that are subject to 409A should (i) maintain the plans in operational compliance with a reasonable, good-faith interpretation of 409A at all times up through December 31, 2007, (ii) adopt amendments to bring the plans into full administrative compliance with 409A by December 31, 2007, and (iii) ensure that the plans are in writing by December 31, 2007. Failure to take such actions may result in material adverse tax consequences to employees entitled to compensation under such plans. Kenneth A. Raskin, a partner based in White & Case's New York office, is the head of the Firm's Global Executive Compensation, Benefits and Employment Law Practice. He focuses on executive compensation and employee benefits law, and provides counsel on the entire spectrum of employee benefit concerns. Mr. Raskin may be reached at kraskin@whitecase.com. "Talking" features White & Case lawyers answering questions about emerging legal and business issues. For more information or to schedule an interview with Mr. Raskin, please contact Reilly Starr at rstarr@whitecase.com. Any information contained in this interview is for educational purposes only. It should not be construed as legal advice.