Funding arrangements under sec. 409A.

• Author: Lennon, Susan

Under Sec. 409A(a), deferred compensation arrangements must satisfy requirements relating to the timing of (l) elections to defer compensation, (2) changes in the time and form of payments and (3) distributions of deferred compensation. According to Sec. 409A(b), deferred compensation arrangements cannot be funded directly or indirectly in offshore trusts, unless the plan participant provides substantial services in the foreign jurisdiction in which the trust is located. Further, taxpayers cannot use a trust or other funding arrangement that restricts access to the assets by the employer's creditors if the employer's financial health declines (a so-called "springing trust"). Violations of the Sec. 409A rules trigger accelerated income tax, interest on the participant's deferred compensation from the vesting date, and an additional 20% tax on such compensation.

Effective Date of Sec. 409A for Funding Arrangements

The restrictions on deferral elections and distributions apply to deferred compensation that becomes vested, or is granted, on or after Jan. 1, 2005. Under a technical amendment to Sec. 409A(b) included in the Gulf Opportunity Zone Act of 2005, the restrictions on foreign and offshore trusts apply to any assets in offshore mists or springing trusts on or after Jan. 1, 2005. Thus, the mist provisions apply to deferred compensation funded on Jan. 1, 2005 even if the deferred compensation itself is grandfathered under Sec. 409A because the employee's right to the compensation had vested before 2005.

In recent guidance, the IRS has applied its post-2004 definition of "deferred compensation"--essentially, any amount of compensation the right to which is vested in one tax year but which is paid in another--to define the types of assets subject to Sec. 409A(b) both before and after Jan. 1, 2005.This definition broadens Sec. 409A's scope beyond what was traditionally considered to be deferred compensation, to include traditional bonus and salary deferral programs and supplemental executive retirement plans, as well as certain stock-based compensation, taxable fringe benefits and severance-pay arrangements.

Transition Rules for Grace-Period Assets

On March 21, 2006, the IRS issued Notice 2006-33, which gives transition guidance for offshore and springing trusts with respect to assets set aside as of March 21, 2006...