Deferred compensation for executives under sec. 409A.

• Author: Singer, Stuart R.
• Position: Part 1

EXECUTIVE SUMMARY

* Sec. 409A treats almost every compensation deferral arrangement as a nonqualified deferred compensation plan, unless it is specifically excluded.

* Due to the scope of Sec. 409A, Treasury has issued, and will continue to issue, lengthy guidance on a number of questions.

* A plan is deemed to defer an item of compensation if the service provider has a legally binding right to the funds, but the compensation is payable in a subsequent tax year.

Sec. 409A regulates virtually every form of compensation earned, but not received, in the same tax year. Part I of this two-part article discusses the introduction of Sec. 409A and the definitions of compensation deferral and nonqualified defined compensation plan.

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Sec. 409A, enacted in October 2004 as part of the American Jobs Creation Act of 2004, imposed a new set of ground rules for taxation of deferred compensation.

This two-part article discusses how Sec. 409A and the current proposed regulations apply to deferred compensation arrangements. Part I, below, covers the introduction of Sec. 409A and the plans and types of deferred compensation subject to it. Part II, in the August 2006 issue, will address how Sec. 409A applies to stock arrangements, distributions and the election to defer compensation.

A failure of a specific deferral transaction (such as a stock option grant) to meet Sec. 409A requirements can mean immediate income recognition as of the date on which the individual's right to the compensation is no longer subject to a substantial risk of forfeiture. Under Sec. 409A(a) (1) (B), the tax on such income is increased by interest at the underpayment rate plus 1%, and a penalty, denominated an additional tax, of 20% of the deferred compensation.

As is the case for many tax laws, the impetus for enactment was not merely to collect more revenue, but to try to stop--or at least restrict--certain types of behavior by American businesses. For example, according to the February 2003 Report of the Joint Committee on Taxation, (1) Enron paid its executives approximately $53 million in accelerated distributions from deferred compensation plans in the weeks preceding bankruptcy. (2) That same report included in its recommendations that the existence of certain specific devices, such as an acceleration of distributions, disqualify any plan from deferral treatment.

New Statute's Coverage

Sec. 409A does not regulate those forms of deferral that are already highly regulated, such as qualified plans and incentive stock options (ISOs), or employee benefits such as vacation and sick pay. In addition, Sec. 409A is not intended "to prevent the inclusion of amounts in gross income under any other provision of this chapter or any other rule of law earlier than the time provided in this section." (3) (Emphasis added.)

Effective Date

Although Sec. 409A became effective on Jan. 1, 2005, taxpayers were initially given some transition relief, extending until Dec. 31, 2005, the deadline by which all plans and agreements had to be brought into conformity with all of its requirements. (4) A condition of this relief was that even if existing plans and arrangements were not immediately amended to conform to the statute and regulations, the parties had to act in good faith as if such amendments had been made. In September 2005, the corporate documentation and "good faith" compliance period was further extended to Dec. 31,2006.

In March 2006, Treasury granted transition relief for deferred compensation arrangements for offshore funding mechanisms and/or financial health triggers for distributions. (5) In general, for arrangements that were already in place as of March 21,2006, no amendment to bring them into compliance with Sec. 409A has to be adopted before Dec. 31, 2007. However, any transaction entered into after March 21, 2006, which constitutes the placement of funds overseas or activates a mechanism to provide for distributions on a change in the service recipient's financial health, will immediately be subject to the prohibitions of Sec. 409A. (6)

Additional Guidance

The reach of Sec. 409A is broad and deep, regulating not merely abusive rabbi trusts but all types of deferred compensation, equity-based and otherwise. As a result, Treasury has had to issue--and will continue to issue--lengthy and detailed proposed regulations on a number of issues and areas, including:

* Blocking structures seen as abusive, while permitting some types of deferral entered into as part of normal retirement planning and/or incentive compensation;

* Determining which equity-based compensation plans trigger immediate taxation on grant, vesting or on some other future event;

* Enabling service providers to preserve the right to defer taxation on compensation for earned services, while avoiding unintentional premature recognition of taxable income before such payments;

* Providing some guidance on the specific times, procedures and reporting of elections;

* Coining and defining some new terms (e.g., unforeseeable events legally binding right) and redefining some old ones (e.g., substantive risk of forfeiture); and

* Designing a practical safe harbor for change-of-control distributions.

Although Treasury has worked hard to fit Sec. 409A into the existing world of taxation and reporting of compensation income, the limited time available to date for this task has meant that two of the major areas that were the original reason for enactment are yet untouched--namely, parking of deferred compensation offshore and provision of so-called "financial health" triggers. In effect, taxpayers are given no guidance on whether or where there might be some flexibility in crafting plans to include one or both of these provisions in some measure. Moreover, some problems may be intractable. Certain rules depend on the existence of true arm's-length dealing between service providers and service recipients (not always the case in some corporations).

Background of Deferred Compensation

To understand how and why Congress acted, one should look at the more common nonqualified deferred compensation arrangements and how they were regulated under pre-Sec. 409A law: stock options, stock appreciation rights (SARs), phantom stock units, restricted stock and deferred bonuses.

NQSOs

There is no tax consequence to either the employee or the company at the time of grant of a nonqualified stock option (NQSO), unless the option itself has an ascertainable fair market value (FMV), which usually...