Section 409A Transition Relief May Still Be Available for “Non-Vested” Amounts

April 6, 2009

The deadline for amending most nonqualified deferred compensation arrangements to comply with Internal Revenue Code section 409A has passed. However, employers — if they act quickly — may still have a chance to bring certain “non-vested” arrangements into compliance with plan document requirements. Otherwise, employers should start to focus on the penalties that must be paid as a result of documentary non-compliance.

Nonqualified deferred compensation arrangements encompass a wide swath of the spectrum of compensatory arrangements between businesses and their employees and other service providers. They include (but are not nearly limited to) traditional deferral arrangements (such as supplemental retirement plans and voluntary deferred compensation plans); annual and long-term cash incentives; some types of stock-based incentives (options, restricted stock, restricted stock units, etc.); employment and severance arrangements; and certain types of fringe benefits. Some of these arrangements may be exempt from section 409A — if they are properly designed and operated. However, many other arrangements cannot be exempt.

Nonqualified deferred compensation arrangements that are subject to section 409A are required to comply with section 409A’s requirements in both form and operation (for more information on these requirements, see our seriesSection 409A: Countdown to Full Compliance”). The form requirements are met only if the written document or documents that constitute the arrangement contain certain terms and conditions (and avoid containing certain others). The deadline to comply with section 409A was December 31, 2008. If the document or documents constituting a nonqualified deferred compensation arrangement did not contain all required terms and conditions by this date, or if they contained any term or condition not permitted under section 409A, the arrangement generally is deemed to be in violation of section 409A.

The consequences of a section 409A violation are harsh:

  • Immediate inclusion by the employee of all amounts deferred under the arrangement and all similar arrangements (other than grandfathered amounts, if any);
  • Imposition of an additional 20% penalty tax, payable by the employee; and
  • Imposition of an underpayment interest penalty, payable by the employee and retroactive to the year in which the deferred amounts were first earned or vested and should have been included in income.

As a result, employees who had expected to pay 35% of their deferred compensation in tax to the federal government many years in the future might find themselves giving up double that amount, or more, this year.

The Treasury Department and Internal Revenue Service have responded to concerns about the oppressive effects of section 409A violations by creating a limited correction program for certain operational failures (see our earlier article). However, the agencies have not yet instituted a corrections program for document violations. Even a minor and wholly unintended defect in the document or documents constituting a nonqualified deferred compensation arrangement will automatically result in a section 409A violation — regardless of the magnitude of the defect or whether the offending provision even benefitted the employee.

As a result, the stakes for amending nonqualified deferred compensation arrangements to comply with section 409A by the December 31, 2008 deadline were incredibly high. Already, it has become clear that not all arrangements that are covered by section 409A were amended in time. In some cases, an employer may not have recognized that an arrangement was subject to section 409A (an easy mistake, given the immense scope and complexity of the rules). In other cases, an arrangement may have been reviewed and amended with the intention of complying, but not all the section 409A issues were identified and corrected. Finally, arrangements that were clearly covered by section 409A may simply not have been identified prior to the December 31 deadline.

At present, an employer faced with a plan document failure does not have many options. Unless the Treasury Department and Internal Revenue Service provide relief in the future for plan document failures of the kind the employer has experienced, there will be nothing for the employer to do in most cases except to report the violation, fix the problem so that it does not affect any future deferrals, and move on. This, of course, will require the employee to pay tax, penalty, and interest in amounts that may be substantial and will invariably create friction between the employer and the employee as to who will be ultimately responsible for this liability (possibly resulting in the employer making a tax gross-up payment to the employee).

However, there may be an opportunity to correct errors with respect to certain types of noncompliant plans. Based on proposed Treasury Department and Internal Revenue Service regulations regarding the calculation of tax for section 409A violations, it appears that there may be a limited opportunity to amend documents for deferred amounts that have not yet vested. Under the proposed regulations (see our previous article), non-vested deferred compensation amounts are not included in income until the taxable year in which they vest. Furthermore, if the arrangement is amended to comply with section 409A prior to the beginning of the taxable year in which the amounts do vest, then the amounts will not be included in ordinary income until the intended distribution date, and will avoid the Section 409A penalty and interest taxes completely, assuming ongoing operational compliance with section 409A.

In commenting on this issue, government representatives have raised questions as to whether the final regulations may place some limits on the ability to make corrective amendments to arrangements covering unvested benefits. However, pending finalization of the proposed regulations, employers may determine that such amendments are permissible based on a reasonable good faith interpretation of the proposed regulations.

Relying on such an approach may be beneficial for many different types of arrangements that impose vesting conditions. In addition, we think it may be of particular help with noncompliant severance arrangements. Severance arrangements (including stand-alone severance agreements, employment agreements that provide for severance benefits, change-of-control agreements, and the like) are generally subject to section 409A unless the compensation payable under the arrangement qualifies for one of several narrowly-drawn exceptions. We have found that severance arrangements have frequently been overlooked in connection with section 409A compliance, and it is likely that many employers currently have severance arrangements in place with unanticipated section 409A problems.

Under a typical severance arrangement, benefits are payable only if the employee is terminated involuntarily. This generally means that the benefits are not vested for section 409A purposes until the severance actually occurs. Therefore, employers may still be able to amend these arrangements in a timely manner to comply with section 409A. The key is that these arrangements must be amended before the beginning of the year in which the employee’s right to the benefits becomes vested. Section 409A compliance amendments that are adopted during the year in which benefits vest will not prevent a violation of section 409A.

It is also important to note that, if an arrangement provides for both vested as well as non-vested amounts, the relief only applies with respect to the amounts that are non-vested; the vested amounts are ineligible for the relief and will generally be subject to the section 409A penalties. Moreover, the Internal Revenue Service has the authority to examine the individual facts and circumstances to determine whether an amount is vested or not. Even if the arrangement, by its terms, provides that an amount has not vested, the Internal Revenue Service can exercise this authority to deem the amount vested if it concludes there has been abuse of this relief.

Even though adopting a section 409A compliance amendment in 2009 will not help employees whose benefits vest in 2009, it is important for affected employers to take advantage of this opportunity as soon as possible. This is because the Treasury Department and Internal Revenue Service could potentially decide to tighten or eliminate this relief when it issues the final section 409A income inclusion regulations. The final regulations are expected sometime later this year.

We anticipate that there will be many employers who will be in a position to take advantage of this interpretation of the proposed regulations, provided they act soon. The first step is to identify any severance or other nonqualified deferred compensation arrangements that are subject to section 409A and that have not been amended to fully address section 409A compliance issues. The next step will be to determine whether any of these arrangements provide for non-vested amounts that might be candidates for this relief. Again, since correction of a plan document error generally is not available after an employee’s right to deferred compensation vests, employers should be taking action now to identify and review arrangements with vesting conditions to confirm whether corrective amendments are necessary.

For more information, please contact the authors or other members of our Employee Benefits practice.