YOUR BUSINESS NEEDS TO BE CONCERNED ABOUT 409A (EVEN IF IT DOESN T HAVE A DEFERRED COMPENSATION PLAN)

Transcription

1 YOUR BUSINESS NEEDS TO BE CONCERNED ABOUT 409A (EVEN IF IT DOESN T HAVE A DEFERRED COMPENSATION PLAN) The December 31, 2008 deadline for complying with the IRS s 409A rules for deferred compensation plans impacts much more than deferred compensation plans and could subject many common pay practices to substantial tax penalties By Vincent P. Cacciottoli, Esq. Don t Let the Name Fool You. Many executives have read in the business newspapers and magazines or have been told by their accountants that the IRS now has very detailed and complex rules governing deferred compensation plans. But many executives have simply shrugged this off saying, I don t have to worry, my company doesn t have a deferred compensation plan. But just because your company doesn t have a plan that s labeled deferred compensation doesn t mean that you re out of the woods. The problem is that the IRS s definition of deferred compensation is broad enough to pull in payroll practices and compensation arrangements that were never thought of as being deferred compensation before. This includes employment, severance and bonus agreements, salary continuation arrangements, consulting contracts, noncompete agreements and even partnership agreements and business buyout contracts. December 31, 2008 Deadline. To add to the problem, the IRS rules say that every plan, practice or arrangement that falls within the new definition of deferred compensation plan has to be reduced to writing and comply with the new rules by December 31, Failure to meet this deadline will result in substantial tax penalties to the executives, employees and independent contractors who are covered by noncomplying plans or arrangements. What the IRS Considers to Be a Deferred Compensation Plan. The IRS s definition of a deferred compensation plan is contained in the regulations that were issued to implement Section 409A of the Tax Code. The definition is deceptively simple. A deferred compensation plan is any plan, agreement or arrangement (even a handshake deal) that defers the receipt of compensation income to a year later than the year in which the compensation is earned. Simple enough, but as we ll see, this definition runs very wide and very deep, and many types of popular compensation and payroll practices get caught up in Section 409A s web. This Changes Everything. Section 409A is a milestone because it is the first time in history that there s been a section in the Tax Code that deals specifically with deferred compensation arrangements. Section 409A was enacted by Congress in response to Enron, where the executives were able to bail out of their deferred compensation plans as the company was going down, while the employees were stuck in their 401(k) plan. This issue could have been addressed with a Tax Code section that simply said: Executives can t bail out of their deferred -1-

2 compensation plans when their company is going down the drain. Instead, we got Section 409A, which is very broadly and generally worded. Now Section 409A itself only takes up four pages in the Tax Code, but its last subsection authorizes the IRS to issue such regulations as may be necessary or appropriate. Well, the IRS took the ball and ran with it and has ginned out some 400 pages of regulations (not to mention the other 600 or so pages of notices and guidance it has issued). So to plug up the Enron leak, Congress gave the IRS the authority to change the rules for everyone. The problem is that businesses, executives, unions and employees had built up certain long-standing compensation practices during the years when there was effectively no IRS regulation of deferred compensation. And now, these common practices are running afoul of the IRS s new rules. What s the big concern about noncompliance? Well, it s because there are Substantial Tax Penalties. Section 409A has some real teeth in it. It imposes a hefty tax if a deferred compensation arrangement fails to meet all the regulatory requirements. (This could be because the plan document contains a provision that doesn t satisfy the new rules or because the arrangement was operated in some way that violates the rules.) And this tax is imposed on the executive, employee or independent contractor, not the employer. In effect, Section 409A actually imposes two taxes: First, all of the deferred compensation (plus the investment earnings on it) is treated as taxable income to the executive, employee or independent contractor in the year the defect occurred. And there is an interest stinger on this. The taxable amount is subject to interest at the federal underpayment rate plus 1%. Second, there s a 20% penalty tax. Note, this doesn t mean the tax imposed under the first step above is increased by 20%. Instead, the executive, employee or independent contractor has to pay an additional penalty tax equal to 20% of the entire amount of the deferred compensation plus earnings. Aggregation Aggravation. And the tax picture can be even worse, since Section 409A aggregates plans for purposes of determining the amount subject to tax. There are nine different categories of plans for Section 409A purposes. For example, the rules distinguish between account balance plans versus nonaccount balance plans. (As its name implies, an account balance plan is one in which the deferred compensation is credited to an account in the participant s name, and that account is typically credited with investment earnings. In contrast, under a nonaccount balance plan, the participant does not have an account that can fluctuate based on investment earnings or losses. Instead, the participant is promised a certain stated benefit payable at sometime in the future. For example, Supplemental Executive Retirement Plans SERPs for short are nonaccount balance plans.) The rules further distinguish between account balance plans that are funded solely by the employer versus those into which participants voluntarily defer their compensation. -2-

3 So, if an executive happens to be in, say, two plans of the same type and there s a problem with one plan, the executive s account balances in both plans could be subject to tax. And when you re trying to figure out which plans are subject to this aggregation rule, don t forget that Section 409A considers any type of formal or informal agreement, arrangement or understanding to be a plan, regardless of what it is called. And Don t Forget About State Tax. The combined effect of the regular federal tax, the stinger penalty interest rate and the 20% penalty tax can easily push the federal tax bill over 70% and, in some cases, over 100%. And this is before you add in any state income tax. The amount of the deferred compensation plus earnings is subject to Oregon personal income tax. Fortunately, Oregon does not impose an interest stinger or a 20% penalty tax. But pity the people who are subject to California tax. California has enacted its own state version of Section 409A, so California taxpayers are also hit with a state 20% penalty and stinger interest rate. Add up the federal and state taxes, interest and penalties and some unlucky Californians will end up paying taxes that exceed their total deferred compensation account! A Tax Bill, But No Money? Just because the IRS hands you a tax bill on your deferred compensation doesn t necessarily mean that you re entitled to pull money out of that plan to pay the tax. Your ability to tap into your deferred compensation is subject to the terms of the plan. And your money may be locked up for some time like until you reach retirement age. So, worse case, you could be stuck with a huge tax bill, but no money to pay it with. But Who Will Really Pay the Tax? Although the Section 409A tax is levied on the participant in the deferred compensation plan and not the company, you can expect a participant who is handed a large tax bill because of his or her company s failure to comply with Section 409A to pursue an indemnification or negligence claim against the company. And keep in mind that, if the company winds up paying the participant s tax, that payment will itself be treated as taxable income to the participant, so the company may need to pay an additional tax gross-up payment to truly cover the participant s total tax liability for the company s Section 409A compliance failure. The tax gross-up payment will roughly add 50% to the amount the company will need to pay the participant, so the total tax bill to the company for a Section 409A error could be very costly. So, now that we ve got your attention, let s discuss some of the key provisions of the Section 409A rules. 409A s Reach is Wide. Given its very broad definition of deferred compensation plans, Section 409A has an extremely wide reach. Generally, tax-qualified retirement plans (including 401(k), pension, 403(b) and 457(b) plans, certain welfare plans (vacation, sick time, comp time, disability and death benefit arrangements) and certain foreign plans are excluded from the definition of deferred compensation plan. But any plan, agreement or arrangement (even verbal agreements) that doesn t fall within the narrow exceptions set out in the IRS regulations is potentially subject to Section 409A. -3-

4 As you would expect, traditional deferred compensation plans are covered, such as voluntary deferral plans, Supplemental Executive Retirement Plans (SERPs), excess benefit plans (plans that pay benefits over and above the IRS limits that apply to pension, profit-sharing and 401(k) plans) and Section 457(f) plans (used by tax-exempt organizations). What isn t so obvious is that other arrangements that have the effect of paying out compensation in a later year are also included, such as employment contracts and severance arrangements with delayed payments, certain partnership arrangements, sale of business agreements with continuing salary or consulting fee payments, noncompete agreements, phantom stock plans and discounted stock options. A more complete laundry list of what s covered by Section 409A is set out in the Appendix to this article. And It s Deep. Over the years, we ve all become used to the IRS regulating plans that provide benefits to the top-hat group or highly compensated employees. Section 409A is a different breed of cat, however. It applies to everyone, no matter how much or how little they make. There is no dollar threshold of annual compensation at which the Section 409A rules kick in. Section 409A s reach even extends beyond employees to independent contractors (including compensation paid to a company s board of directors). It even covers one-person compensation arrangements. And unlike ERISA, there is no blanket exemption for governmental employers or churches. Way Deep. Some public school districts learned to their dismay just how long the arm of Section 409A reaches. They were contacted by the IRS and informed that their practice of giving teachers the option of having their salary for the school year paid over 9 month (to track the school year) or over 12 months violated Section 409A. Since the school year straddles two of a teacher s calendar tax years, paying 9 months of salary over 12 months would defer a fraction of the salary into a later tax year. And Bingo! A Section 409A violation. So 12 months of pay is taxable in the first tax year and is also hit with the 20% penalty tax. At this point, you may be scratching your head and wondering how and why a piece of legislation that was passed to prevent Enron types of abuses in the executive suite would be used to clobber people sitting in the K-12 teachers lounge. Well, so did a lot of other people, and the IRS finally relented and issued a special notice generally allowing these types of spread out payment arrangements. But this example does go to show that, without a special dispensation from the IRS, no one escapes the reach of Section 409A. When Does Deferred Compensation Become Subject to Section 409A? Section 409A applies to any legally binding right to deferred compensation that became vested after December 31, Amounts that became vested before 2005 are not subject to the Section 409A rules, provided the plan under which they were earned is not materially modified after October 3, What s a Legally Binding Right? For purposes of Section 409A, a participant has a legally binding right to deferred compensation if the participant has a legally enforceable contractual right to receive payment. So, for example, there would be no legally binding right if the employer reserved the unilateral right to reduce the -4-

5 amount of the deferred compensation or terminate the deferred compensation plan after the participant performed the services that earned the deferred compensation. The IRS will, however, challenge the legitimacy of the employer s unilateral right to amend or terminate a deferred compensation plan if, for example, it does not appear that the employer would ever in fact exercise that right, or if the person entitled to the deferred compensation effectively controlled the employer (or is the family member of someone with that effective control). When Is Deferred Compensation Vested? What constitutes a vested amount for purposes of Section 409A is a little tricky. Generally, an amount becomes vested once the participant no longer has to perform substantial future services to receive the deferred compensation. For example, if a participant earns deferred compensation during 2008, but will not be entitled to receive it unless he or she is still employed on December 31, 2009, the participant becomes vested on December 31, 2009, if he or she is still employed on that date. In addition, a participant can become vested upon the occurrence of a condition, but only if that condition relates to the participant s performance or the employer s business activities or organizational goals. (For example, the company achieving a targeted earnings level or completing an initial public offering.) Where it gets confusing is that you can have a conditional right to payment that is considered to be vested for Section 409A purposes. To illustrate: Let s say a company makes a promise to pay an employee a severance benefit when the employee s employment terminates. Let s also say the company does not require the employee to work for any additional period of time or be employed on a certain date in order to receive the severance benefit. In that case, the employee has a vested right as soon as the promise is made. The fact that the employee may not terminate employment until well into the future is irrelevant. What Does Section 409A Require? Covering all of the rules set out in 400 pages of IRS regulations would go far beyond the scope of this article. So let s just hit the highlights. Written Plan Required. All deferred compensation plans must be in writing. This doesn t necessarily mean a formal plan document. In a pinch, a memo, offer letter or can suffice as long as the terms set out meet the Section 409A requirements. But any informal arrangement (such as a handshake agreement to continue paying a departing executive a salary continuation or other payment) has to be reduced to writing by December 31, Deadline for Deferral Elections. Generally, an election to defer salary or directors fees has to be made no later than December 31 of the year before the year in which the salary or fees will be earned. General Deadline for Bonus Deferral Elections. In general, an election to defer a bonus must be made before the year in which the bonus is earned, not the year it is paid. -5-

6 For example, an executive earns a bonus for 2010, but the bonus will not be paid until sometime in first quarter If the executive wants to defer any part of that 2010 bonus, the general rule is that the executive has to make the deferral election by December 31, Deadline for Performance-Based Bonuses. There is a special rule for performance-based bonuses. An election to defer a performance-based bonus must be made no later than six months before the end of the performance period, or, if earlier, the date the amount of the bonus is readily ascertainable. Let s say, an executive can earn a bonus in 2010 if sales revenues for that year increase by 15%. That executive will ordinarily have until June 30, 2010, to elect to defer that bonus. However, let s say that in April, the company lands a big contract, and by April 30, everyone is pretty sure the company will hit the 15% target that year. In that case, the deferral election deadline drops back to April 30, instead of June 30. In order to be performance-based, the performance period must be at least 12 months, and the performance criteria must be established within 90 days of the start of that period (or, if earlier, by the date the outcome is substantially certain). Time and Form of Payment. Both the time when the deferred compensation benefit is to be paid as well as the form of payment (e.g., lump sum or installments) have to be elected at the time the election to defer the compensation is made. This is perhaps the most controversial rule of Section 409A. It requires an executive, employee or independent contractor to select, perhaps many years in advance of when the benefit is payable, exactly when it is to be paid and how it will be paid out. This is in contrast to payments under a qualified plan, such as a 401(k) plan, where participants do not have to make those very important decisions until they are actually leaving the company and have a better idea of what their financial situation is. Downstream Elections Restricted. Once an election as to the time and form of payment is made, it can t be changed without complying with the 12-month/5-year rule. That is, the election change has to be made at least 12 months in advance of when the payment would otherwise be made, and here s the rough part the payment has to be pushed back 5 years. For example, you elected to receive a lump-sum payment on January 1, 2015, and now you want to change it to installment payments. You can do this if you make a change election at least 12 months in advance, but your installment payments now can t start until January 1, To try to give participants some flexibility, a plan can be restructured to allow participants to ladder their deferrals or have the deferrals credited to separate buckets. In this way, if the participant wants to make a downstream election later on, only a portion of the benefit will be subject to the 12-month/5-year rule, rather than the entire account balance. However, this feature makes plan administration much more complicated, and a sophisticated recordkeeping system is pretty much a necessity. -6-

7 Can t Accelerate Payments. Finally we get to Enron! The particular abuse in the Enron case is specifically prohibited so-called haircuts are no longer allowed. A haircut provision allowed executives to cash in their deferred compensation account if they took a 10% haircut (received 90% and forfeited 10%). Before Section 409A, haircut provisions were popular since deferred compensation is subject to the claims of the company s creditors and the 90% received after the 10% haircut was worth much more than 100% after the company filed bankruptcy. There are certain exceptions to the anti-acceleration rule such as a payment needed to comply with a qualified domestic relations order. Payments Allowed Only for Permitted Payment Events. Payments from a deferred compensation plan are allowed only for six events: (1) separation from service; (2) a date certain or a fixed schedule; (3) change in control; (4) death; (5) disability; or (6) an unforeseeable emergency. (All except death have special definitions set out in the IRS regulations.) Six-Month Delay for Public Company Key Executives. Payments of separation benefits to key executives of publicly traded companies have to be delayed for six months after they terminate employment. This rule applies to anyone who would be considered a key employee under the IRS s top-heavy rules for qualified plans. One of the problems with this rule is that, because public companies have so many employees, their plans were never in danger of being top heavy, so they never had any need to identify their key employees before. As discussed below, there are certain exceptions to the Section 409A rules, however, and if they are properly utilized, a key employee of a public company can receive at least $460,000 in benefits for a termination occurring in 2008 without regard to the six-month delay rule. Certain Rabbi Trusts Prohibited. Offshore rabbi trusts are now prohibited. (As a practical matter, creditors found it difficult if not impossible to reach trust assets held overseas.) There is also a ban on springing rabbi trusts that are tied to the employer s financial condition (e.g., a rabbi trust that first becomes funded or converts to a taxable secular trust if there is a significant downturn in the employer s financial health). W-2 and 1099 Reporting. Currently, amounts that are subject to tax under Section 409A need to be reported on the executive s/employee s W-2 or the independent contractor s Once the IRS issues further rules, the amount that is actually deferred in a year will also need to be reported, even though it is not yet payable. There Are Some Important Exceptions to Section 409A. Section 409A does contain some very useful exceptions, however. The key exceptions are the Short-Term Deferral exception and the 2 Times/2-Year exception. -7-

8 Short-Term Deferral Exception. Under the Short-Term Deferral exception, a payment is not considered to be deferred compensation if it is paid out within 2½ months after the end of the year in which the person has a vested right to the payment. This is a little tricky, however, since it does not apply to payments with an indefinite timeline. To illustrate: If I tell you in 2008 that I will pay you $1,000 within 2½ months after you terminate employment, that payment does not fall within the exception. Why? Because in order to fall within the exception, the payment has to be made by March 15, 2009, which is 2½ months after the end of the year in which you had a vested right to the payment. Since you might not terminate employment until after that date, the promised payment falls outside the exception. 2 Times/2-Year Exception. The 2 Times/2-Year exception is limited to involuntary terminations (including voluntary terminations for good reason as defined under the regulations) and voluntary terminations under certain window programs. A payment under these circumstances is not considered to be deferred compensation to the extent it does not exceed two times the lesser of your annual pay or the IRS limit on the compensation that can be taken into account for early retirement for determining contributions or benefits under a qualified retirement plan. That limit is $230,000 for 2008, so two times the limit is $460,000 for terminations in In addition, the payment has to be made by the end of the second year following the year of the termination (i.e., by December 31, 2010, for terminations in 2008). There are other exceptions available as well, such as for post-employment reimbursements. More than one exception can be used if it is applicable. One planning technique, known as stacking, piles up as many exceptions as are available in order to cut down, if not eliminate, the amount of the payment subject to Section 409A. IRS Correction Program. The IRS has launched a pilot program to allow Section 409A defects to be corrected. The program is limited in scope, however. It only covers unintentional operational defects (for example, through an administrative glitch, 5% of an executive s pay was taken out as a deferral instead of the 10% the executive had elected). The program does not provide relief for defective plan documents (or failure to have a written plan document) nor does it cover intentional or egregious errors (e.g., a CEO telling payroll to issue him a check regardless of what the plan says). The program is also limited in time. Generally, to avoid any tax penalty, a defect has to be corrected in the same tax year in which it occurred. If you correct in a later year, the amount of the error (as opposed to the entire deferred compensation account) is subject to regular income tax and the 20% penalty, but not the interest stinger. A correction that is made in a year later than the year in which the error occurred must be completed by the end of the second year after the year the error occurred. There is a dollar cap on the amount that can be corrected in a later year (it s the same as the 401(k) elective deferral limit $15,000 for 2008). The later-year -8-

9 correction program is due to sunset at the end of The same-year correction program is permanent. The correction program has a number of requirements that must be met. For example, some types of errors cannot be corrected if the employer has had a substantial financial downturn during the year. Also, there are certain notice and tax filing requirements that have to be followed. What to Do Now. So, with the December 31, 2008, deadline looming, what should you be doing now? We recommend that you Take an inventory of all the formal and informal arrangements your company may have that could possibly fall within the IRS s definition of a deferred compensation plan. (For example, check with payroll to see if they have any instructions from years ago to keep someone on the payroll or pay someone a certain amount after they leave the company.) Make sure all your company s arrangements for deferred salary payments, deferred bonuses, severance pay, rights to purchase company stock and any other deferred payment commitments are put in writing and meet the Section 409A restrictions. Look over how your deferred compensation arrangements have been run since 2005 (when Section 409A first became effective), and see if there are any operational errors that could be taken care of under the IRS s correction program before the time for making the correction runs out. Let your executives and employees know that this is their last chance to change their elections as to the time and form of payment of the deferred compensation benefits before the onerous 12-month/5-year rule comes into play on January 1, Make sure your executives and employees know that their deferral elections for 2009 salary and non-performance-based bonuses have to be in by Wednesday, December 31, 2008, even if this day isn t the close of their normal payroll period. Your company may want to consider putting in a custom-designed profit-sharing or pension plan in order to shift the retirement benefits for its owners or key executives into a qualified plan as much as possible. Remember, qualified plans are totally exempt from Section 409A, which means, for example, that participants can put off electing the time and form of payment until they leave the company. And unlike deferred compensation plans, qualified plans are protected from the company s creditors. In the pre-section 409A days, the high costs of plan design and testing discouraged the use of these custom plans. But new plan designs and the burdens, risks and high taxes imposed by Section 409A may make these costs bearable. -9-

10 Appendix EXAMPLES OF THE TYPES OF PLANS COVERED BY SECTION 409A Traditional deferred compensation plans Bonus deferral arrangements Incentive pay plans Employment agreements (including offer letters) Expense reimbursement agreements SERPs (Supplemental Executive Retirement Plans) Excess benefit plans (i.e., benefits above the qualified plan limits) Split-dollar insurance arrangements Discounted stock options Discounted stock appreciation rights (SARs) Restricted stock units (RSUs) Phantom stock plans Change-in-control agreements Severance pay arrangements Window early retirement programs Salary continuation agreements Post-employment consulting agreements Post-closing compensation or consulting fee payments after the sale of a business Noncompete agreements 457(f) plans (for tax-exempts) Retirement stipends Sabbatical programs Copyright 2008 Garvey Schubert Barer. All rights reserved. The information presented here is intended solely for informational purposes and is of a general nature that cannot be regarded as legal advice. -10-