Closely held employers and Sec. 409A.

• Author: Altieri, Mark P.

EXECUTIVE SUMMARY

* Sec. 409A's definition of NQDCAs is extremely broad and potentially ensnares employment, severance and bonus arrangements.

* Most deferral arrangements are subject to Sec. 409A, unless specifically excluded.

* A tax adviser must determine whether an NQDCA is subject to a substantial risk of forfeiture or inherently suffers from a plan failure.

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Sec. 409A potentially affects every nonqualified deferred-compensation arrangement (NQDCA). This article analyzes Sec. 409A's particular applicability to the types of NQDCAs more commonly maintained by closely held employers.

Most practitioners are aware that a new and sweeping provision, Sec. 409A, was added to the Code by the American Jobs Creation Act of 2004. Its rules potentially affect every "nonqualified" arrangement that defers the receipt of compensation income to a year later than that in which earned. (1) Generally, the Sec. 409A rules apply to compensation deferred under a nonqualified deferred-compensation arrangement (NQDCA) after 2004. Since the advent of Sec. 409A in October 2004, the IRS and Treasury have provided clarifying notices and proposed regulations, as discussed below.

Business publications have been awash with summaries of the Sec. 409A rules, but little in the literature separates the many detailed rules more applicable to the publicly traded employer from those of particular interest to the closely held employer. This article explains the application of the Sec. 409A rules to NQD-CAs likely to be maintained by closely held employers for key employees and highlights any necessary amendments.

Noncompliance Penalty

In general, Sec. 409A imposes a tax acceleration and a significant penalty to the extent that an NQDCA experiences a "plan failure" (described below) so that plan benefits to be paid in the future are not subject to a "substantial risk of forfeiture" (SROF). For example, a contractual requirement to render substantial future services before benefits vest constitutes an SROF. On a plan failure, absent an ongoing SROF, not only will all deferred compensation (plus income attributable to it) be accelerated into income, but a 20% penalty tax will be imposed in that year.

Relevant Authority

A number of primary and secondary authority sources help to understand Sec. 409A's breadth. In addition to Sec. 409A, there is a helpful narrative in the legislative history embodied in the House Report. (2) The IRS has provided guidance in notices; Notice 2005-1, (3) issued in December 2004, is the most helpful and relevant. In responding to public comments on Notice 2005-1, and to provide additional and new guidance, Treasury issued proposed regulations in October 2005 (proposed regulations). (4) Final regulations should be issued in the near future and are expected to be virtually identical to the proposed regulations.

Intent

Sec. 409A is generally applicable to NQDCAs maintained by closely held employers. However, the true abuse that Sec. 409A was intended to correct occurred with more sophisticated NQDCAs; manipulation as to the initial deferral decision and the timing of benefit payments was common before 2005. For NQDCAs maintained by closely held employers that are traditional nonqualified plans, the new rules typically will not require substantial amendments. The terms of these closely held plans may already largely follow the requirements laid out under the Sec. 409A rules (i.e., payments under the plans will not occur until a specified date, separation from service, death or disability, and there is no mechanism to either accelerate or further defer payment of the scheduled deferred compensation). Still, a closely held NQDCA will need to conform its definition of these triggering events to those required under the Sec. 409A roles. Additionally, as noted below, the definition of an NQDCA is extremely broad and goes well beyond traditional NQD-CAs to potentially ensnare employment, severance and bonus agreements. These latter agreements are a potential trap for the unwary adviser of the closely held employer, even if he or she is somewhat well-versed in the Sec. 409A implications as to traditional NQDCAs.

Compliance Timeframe

Sec. 409A generally applies to income deferred after 2004, or prior to 2005 that vests after 2004. Notice 2005-1 originally required amendments to bring NQDCAs into conformity with Sec. 409A to be made before 2006. The proposed regulations had extended the amendment deadline to the end of 2006. (5) However, a few areas required attention during 2005. These included timing rules for "elective" deferrals and the cancellation of outstanding deferral elections or the termination of an NQDCA before it became subject to Sec. 409A. Neither of these areas were typically of interest to NQDCAs maintained by closely held employers. Lastly, Notice 2006-796 extended the amendment deadline to Dec. 31, 2007.

Multi-Pronged Analysis

Comprehension of Sec. 409A is made particularly difficult by a required three-pronged analysis. The first step is to determine whether an arrangement to defer compensation is an NQDCA under Sec. 409A. The second step is a determination whether benefits are subject to an SROF. If not, the final determination is whether the NQDCA, at the first time it is not subject to an SROF, inherently suffers from a "plan failure." The convergence of these three events invokes Sec. 409A's income acceleration and penalties; amounts deferred under the NQDCA for the current and all preceding tax years subject to Sec. 409A are includible in gross income and are subject to an additional penalty of 20% of the compensation required to be included in gross income. Interest is also added at the underpayment rate plus 1% from the year in which the amount was deferred. (7)

What Is an NQDCA?

Generally: An NQDCA under Sec. 409A may be an individualized arrangement (e.g., an employment agreement) or a more formal and broader plan (e.g., a nonqualified supplemental retirement plan in which all management-class employees participate). Notice 2005-1 and the proposed regulations specifically state that Sec. 409A is potentially applicable regardless of whether the arrangement constitutes an Employee Retirement Income Security Act of 1974 (ERISA) pension plan. (8) Sec. 409A is generally looking for an arrangement that provides for the deferral of the compensation owed to a "service provider" (in which he or she has a...