Legal Updates

4/23/2007

Section 409A Countdown to Full Compliance - Installment No. 1: Covered Arrangements / Short-term Deferral Exception / Plan Aggregation

The following article is the first in a series about Section 409A that we will distribute to clients and friends over the next few months. The series is designed to help employers understand and address the most significant issues and areas of concern presented under Section 409A.

For additional information, see our other Section 409A news items.

In this installment we review the rules for identifying which types of compensation arrangements are subject to Section 409A and the rules for aggregating various plans in which an employee or other service provider participates. If you are not already a subscriber and would like to receive our Section 409A Countdown to Full Compliance series by e-mail, please use our online sign-up form.

The final regulations refer to the person who will receive the deferred compensation as the “service provider,” which includes employees and independent contractors, and the person who will pay the deferred compensation as the “service recipient.” In this series, we will frequently use the more common terminology of “employee” for “service provider” and “employer” for “service recipient,” although it is important to keep in mind that many types of non-employee service providers may also be subject to these rules, including directors. In addition, all section references are to the Internal Revenue Code of 1986, as amended, unless otherwise noted.

Identifying and Categorizing Covered Arrangements

Section 409A applies to any “nonqualified deferred compensation plan.” This term is broadly defined to include any plan or other arrangement that provides for the deferral of compensation, subject to certain exceptions. The first step in complying with Section 409A is to have a clear understanding of which compensation plans and other arrangements are covered by Section 409A.

Employers then need to identify, on a plan participant by plan participant basis, all of the plans of a similar type in which each participant participates in order to treat these similar plans as a single aggregated plan for purposes of Section 409A. This plan aggregation requirement plays an important role in determining how to comply with certain requirements of Section 409A and in identifying the nature and scope of the tax consequences to individual participants if Section 409A is violated.

Exempt Plans

The most important categories of exempt plans are qualified retirement plans (such as Section 401(k) plans, 403(b) arrangements, simple retirement accounts, etc.) and most types of welfare benefit plans. The final regulations provide a number of important clarifications for determining which plans are subject to Section 409A:

• Welfare Plans. This exception includes bona fide vacation leave, sick leave, compensatory time, disability pay and death benefit plans. The final regulations make clear that a medical reimbursement plan, including a health savings account, is also exempt so long as the health benefits or reimbursements provided under the plan are not taxable to recipients. Consequently, a self-insured health plan that violates the nondiscrimination rules of Section 105(h) generally would not be exempt and therefore would need to comply with Section 409A.

• Nontaxable Benefits. The final regulations clarify that arrangements which provide nontaxable benefits are not subject to Section 409A so long as the employee’s rights to those nontaxable benefits were not received in exchange for taxable benefits and the employee does not have any right to exchange those benefits for taxable benefits. As a result, promises to provide nontaxable fringe benefits in the future generally should be exempt form Section 409A.

• Section 457 Plans. Section 409A does not apply to eligible Section 457(b) deferred compensation plans sponsored by state and local governments and certain tax-exempt entities. However, Section 409A does apply to ineligible deferred compensation plans described in Section 457(f). The regulations clarify that Section 409A applies separately and in addition to the requirements of Section 457(f). As a result, a Section 457(f) plan could satisfy or violate the requirements of Section 409A without satisfying or violating the requirements of Section 457(f), and vice versa.

• Certain Foreign Plans. Section 409A generally does not apply to plans where contributions are not taxable to employees under a bilateral tax treaty. In addition, Section 409A does not apply to broad-based foreign retirement plans where the employee is not eligible to participate in a U.S. tax-qualified plan. If the employee is a U.S. citizen or lawful permanent resident, the exception only applies to nonelective deferrals of foreign earned income that do not exceed the Section 415 limitations. The final regulations also exclude plans that provide deferred compensation that is not taxable to the employee because: (A) the employee was a nonresident alien at the time, (B) the employee was a qualified individual and the deferred compensation would have been exempt under Code Section 911, (C) the employee is an employee of a foreign government or international organization, or (D) generally, the individual is a bona fide resident of Guam, Somoa, the Northern Mariana Islands or Puerto Rico. Where substantially all active participants are residents of a U.S. possession, a plan may be treated as a broad-based foreign plan. Tax equalization arrangements, designed to compensate an employee for the excess taxes imposed by a foreign jurisdiction, also are generally exempt from Section 409A. The final regulations expand this provision to include reimbursements of U.S. taxes that exceed foreign taxes, but require that the tax equalization payment be made by the end of the second taxable year of the employee following the deadline for filing a U.S. tax return reflecting the compensation for which the equalization payment is provided.

• Certain Stock Rights. Incentive stock options that meet the requirements of Section 422 and rights to purchase stock under an employee stock purchase plan qualified under Section 423 are exempt from Section 409A. The circumstances under which certain other stock rights may be exempt from Section 409A will be discussed in a later installment on equity compensation.

• Certain Separation Pay Arrangements. Certain types of severance arrangements may be exempt from Section 409A. The conditions for these exemptions are somewhat complex and each separation pay arrangement needs to be carefully reviewed to determine whether some or all of the severance pay or other rights provided under the arrangement would qualify for one of the exemptions. Separation pay will be explored in greater detail in a later installment.

• Plans for Independent Contractors. Section 409A does not apply to amounts deferred pursuant to an arrangement between an employer and an unrelated independent contractor if (1) the independent contractor provides significant services during the year to at least two or more unrelated employers and (2) the independent contractor is actively engaged in a trade or business, other than as a director of a corporation or in a similar position with non-corporate employer. For purposes of these rules, the independent contractor is treated as providing significant services to multiple employers so long as no more than 70% of its total yearly revenue comes from any particular employer. Section 409A does apply to compensation arrangements between an independent contractor and an employer that involve the provision of management services (such as investment advisory services for an employer whose primary trade or business involves the management of investments).

• Miscellaneous Exempt Arrangements. The final regulations also create new exceptions for certain indemnification and liability insurance arrangements, rights to legal fees or legal settlements and plans that provide for educational assistance benefits to an employee (but not to his or her dependents).

What is Deferred Compensation?

Plans that do not otherwise fall into one of these exceptions will generally be subject to Section 409A if they provide for a deferral of compensation. A plan provides for the deferral of compensation for purposes of Section 409A if the employee has a legally binding right to compensation that is or may be payable to (or on behalf of) the employee in a later year.

A “legally binding right” generally does not exist if the employer has unfettered discretion to reduce or eliminate the compensation after the employee has performed the relevant services, provided the discretion has substantive significance and is not exercisable only upon a condition. However, a legally binding right may exist even where payment of the compensation is also subject to an objective condition, such as a condition creating a substantial risk of forfeiture (like a vesting schedule).

• Compliance Tip – An arrangement does not have to be reflected in a formal plan document or otherwise be written to be subject to Section 409A. We recommend that an employer conduct a thorough review of its employee communications, compensation and benefits policies, pay practices, collective bargaining agreements, employment agreements, severance plans and agreements and any other written or informal compensation or benefits plan or program to insure that it has identified all covered arrangements.

Short-Term Deferral Exception

There is an important exception from the definition of deferred compensation, and thus from coverage under Section 409A, for arrangements that provide for a “short-term deferral.” A payment is a short-term deferral if the compensation is received by the employee (actually or constructively) within 2½ months after the end of the first taxable year in which the amount is no longer subject to a substantial risk of forfeiture, and there was no election by the employee to pay the compensation on or after a date or an event that could occur after the 2½-month deadline.

If the employer and the employee have different taxable years, the year which ends later is used for purposes of determining the 2 ½ month deadline. For example, if the employee had a calendar tax year and the employer has a fiscal tax year that ends on January 31, and the employee’s right to a payment ceased to be subject to a substantial risk of forfeiture on December 15, the 2 ½ month deadline would be the following April 15th.

A substantial risk of forfeiture for purposes of Section 409A exists if entitlement to the amount is conditioned on:

• the performance of substantial future services by any person, or

• the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. The condition must relate to the employee’s performance or the employer’s business activities or organizational goals.

The short-term deferral exception is specifically not available if the terms of the arrangement provide or could provide for payment beyond the end of the 2½-month period, even if payment is actually made before the end of the 2½-month period. Thus, a payment linked to an employee’s separation from service would not qualify for the exception even if the separation occurs and payment is made by the 2-½ month deadline.

Certain delays of payment beyond the 2-½ month payment deadline are permitted. For example, a payment may be made after the 2½-month will not cause the exemption to be lost if (1) it was administratively impractical to avoid the deferral beyond the 2½-month period; (2) the impracticality was unforeseeable; and (3) the payment is made as soon as practicable. Delay is also permitted if making the payment within the deadline would have jeopardized the employer’s ability to continue as a going concern, and if delay would be necessary to avoid loss of a deduction under 162(m) and it was not reasonable to anticipate that Section 162(m) would apply to the payment at the time the promise to make the payment became legally binding. A payment delay that occurs for any other reason will generally cause the arrangement to be subject to Section 409A

• Compliance Tip – Arrangements that are intended to comply with the short-term deferral exception generally should be amended to specify the payment deadline because doing so may allow the arrangement to comply with Section 409A in the event that payment is made after the deadline and none of the late payment exceptions apply. Under the final regulations, the payment deadline will be treated as a specific payment date and actual payment will be treated as timely if the payment occurs before the end of that year.

Plan Aggregation Rules

The rules which require aggregation of like plans for each employee were modified in the final regulations to create nine different plan categories:

• Account balance plans which permit employee deferrals. Examples include supplemental 401(k) plans and elective bonus deferral programs.

• Account balance plans with no elective deferrals.

• Non-account balance plans. This category will include defined benefit SERPs and other arrangements under which benefits are based on a formula.

• Separation pay plans where amounts are payable solely upon an involuntary separation from service or as a result of participation in a window program.

• In-kind benefits or reimbursements. This category is limited to arrangements that do not constitute a substantial portion of overall compensation payable in connection with a separation from service.

• Split-dollar life insurance arrangements.

• Modified foreign earned income plans.

• Stock rights. Examples include stock options or SARs that were granted with a discounted exercise price, that pertain to ineligible stock or that otherwise fail to meet the requirements for exemption from Section 409A.

• All other arrangements not described above.

These categories are primarily important for purposes of determining the adverse tax consequences resulting from an operational failure to comply with Section 409A. For example, if an employee participates in a supplemental 401(k) plan, an elective bonus deferral program and a SERP, a failure to operate the supplemental 401(k) plan in compliance with Section 409A will cause the amounts under that plan and under the elective bonus deferral program to be subject to the income inclusion and 20% penalty imposed under section 409A. However, amounts accrued under the SERP to be taxable will not be affected. Aggregation rules are also important for purposes of initial deferral elections and special rules regarding plan termination. Those rules will be addressed in greater detail in future installments of Section 409A Countdown to Compliance.

To see the next installment of our Section 409A commentary, click here.

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McGuireWoods news is intended to provide information of general interest to the public and is not intended to offer legal advice about specific situations or problems. McGuireWoods does not intend to create an attorney-client relationship by offering this information, and anyone's review of the information shall not be deemed to create such a relationship. You should consult a lawyer if you have a legal matter requiring attention.