I.R.C. § 409A and the Small Business

• Author: Michael J. Hussey
• Position: Associate Professor of Law, Widener University
• Pages: 889-928

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I.R.C. § 409A AND THE SMALL BUSINESS

MICHAEL J. HUSSEY^*

I. INTRODUCTION

The general public may think nonqualified deferred compensation involves only large corporations who simply cannot find enough ways to give their executives more money in a favorable tax manner. However, the reach of § 409A is far and wide. As a result, many ordinary business planning agreements often not thought to be nonqualified deferred compensation are swept up in § 409A’s broad net.¹

This article is designed to do two things. First, this article recounts the development of I.R.C. § 409A and its regulations. This article briefly describes what led to § 409A, how § 409A changed prior law, and the current status of nonqualified deferred compensation.

Second, this article identifies several business succession planning techniques that give rise to § 409A issues. This article develops a hypothetical example to show how these techniques might be used in small business succession planning and the § 409A implications of each technique. Given that nonqualified deferred compensation is usually thought of as involving only large corporations, many traps for the unwary exist when dealing with closely-held corporations.

This article begins with a short historical account of the enactment of
I.R.C. § 409A. In Part II, this article continues with a summary of the major changes to nonqualified deferred compensation as a result of I.R.C. § 409A.

In Part III, this article discusses recent guidance on I.R.C. § 409A including I.R.S. Notice 2008-113,²I.R.S. Notice 2008-115,³and Proposed

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* Associate Professor of Law, Widener University. Thank you to Regina Burch and Capital University Law School for the invitation to participate in symposium entitled: Small Business Succession Planning: Helping the Family, Building the Plan held on October 22, 2008. Thanks to William Drennan and Juliet Moringiello for their comments and suggestions on prior drafts.

¹See I.R.S. Notice 2005-1, 2005-2 I.R.B. 274 (“The application of § 409A is not limited to arrangements between an employer and an employee. For example, § 409A may apply to arrangements between a service recipient and an independent contractor, or arrangements between a partner and a partnership . . . .”).

²2008-51 I.R.B. 1305.

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Treasury Regulation § 1.409A-4.⁴Even with the final regulations becoming effective for taxable years beginning after December 31, 2008,⁵

the work on § 409A guidance is not complete. Proposed Treasury Regulation § 1.409A-4 fills in one missing part by providing administrative guidance on determining the amounts includible when a plan fails to meet the requirements of I.R.C. § 409A.⁶

Still unknown is whether additional guidance will be issued regarding the applicability of § 409A to partners and partnerships. As provided in
I.R.S. Notice 2005-1 and in the preamble to the final regulations, until further notice, taxpayers may treat the issuance of an interest in a partnership the same as an issuance of stock.⁷

In Part IV, this article discusses planning opportunities that are available for small businesses using nonqualified deferred compensation. Generally, closely-held businesses are formed as an S Corporation, a partnership, or a limited liability company electing to be taxed as a partnership. As such, these small businesses have pass-through taxation.⁸

Often, the effect of pass-through taxation is that no tax benefit can be realized by a nonqualified deferral of compensation because the employee participating in the nonqualified deferral plan is also an owner of the business.⁹Part IV of this article also explores several business planning

³2008-52 I.R.B. 1367.

⁴73 Fed. Reg. 74,380 (Dec. 8, 2008).

⁵See I.R.S. Notice 2007-86, 2007-46 I.R.B. 990.

⁶See Prop. Treas. Reg. § 1.409A-4, 73 Fed. Reg. 74,380, 74,381 (Dec. 8, 2008) (“These proposed regulations address the calculation of amounts includible in income under section 409(A)(a), and related issues including the calculation of the additional taxes applicable to such income. Section 409(A)(a) generally provides that amounts deferred under a nonqualified deferred compensation plan in all years are includible in income unless certain requirements are met.”).

⁷I.R.S. Notice 2005-1, 2005-2 I.R.B. 274; Application of Section 409A to Nonqualified Deferred Compensation Plans, 72 Fed. Reg. 19,234, 19,243 (Apr. 17, 2007).

⁸See I.R.C. § 701 (2006) (partnerships); id. § 1366 (S corporations); see also Richard Winchester, Working for Free: It Ought to be Against the (Tax) Law, 76 MISS. L.J. 227,

241–42 (2006).

⁹Cf. MICHAEL G. GOLDSTEIN ET AL., TAXATION AND FUNDING OF NONQUALIFIED

DEFERRED COMPENSATION 213–14 (1998) (neither a partnership’s partners nor an S

Corporation’s shareholders realize tax deferral under I.R.C. § 404(a)(5)).

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techniques in which I.R.C. § 409A could have an impact on succession planning in closely-held businesses.

Finally, in Part V, this article explores a hypothetical example to show how § 409A is applicable and what considerations should be addressed by the client’s advisors.

A. Overview

1. Before § 409A

In a nonqualified deferred compensation agreement, an employer and an employee agree that income earned by the employee in the current taxable year will be deferred to a future taxable year.¹⁰Prior to § 409A, an employer would credit an employee’s “account” with earnings or losses based upon some predetermined index. To avoid the deferred compensation being includible in the employee’s gross income under the constructive receipt doctrine,¹¹the employee only has the employer’s unsecured promise to pay in the future.¹²This arrangement is advantageous to the employee because the employee delayed the receipt of income and thus delayed the paying of taxes unless there is a substantial risk of forfeiture (other than FICA taxes) related to that income.¹³To

avoid the requirements of ERISA, nonqualified deferred compensation plans may only be made available to a “select group of management or highly compensated employees.”¹⁴

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¹⁰Section 409A does not apply to certain deferred compensation agreements. See § 409A(d)(1)–(2). For example, sick leave, disability pay, and certain pensions are excluded. Id.

¹¹The constructive receipt doctrine is discussed in Treasury Regulation § 1.451-2 (as amended in 1979).

¹²Cf. I.R.C. § 83 (2006) (requiring that property be subject to a substantial risk of forfeiture in order for the tax consequences to be deferred).

¹³Prop. Treas. Reg. § 1.409A-1, 70 Fed. Reg. 57,930, 57,930 (Oct. 4, 2005) (citing Treasury Regulation § 3121(v)(2) and its special timing rule concerning FICA taxes).

¹⁴29 U.S.C. §§ 1051(2), 1081(a)(3), 1101(a)(1) (2006).

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2. The Enactment of § 409A

In February 2002, the Senate Finance Committee directed the Joint Committee on Taxation to investigate Enron.¹⁵The Joint Committee’s

report totaled 723 pages (not including the four appendices) detailing many of the abuses at Enron, including those involving nonqualified deferred compensation.¹⁶

Building upon the Joint Committee’s Report, in October 2004, Congress enacted the American Jobs Creation Act of 2004.¹⁷Among its provisions was the creation of a new section of the Internal Revenue Code.¹⁸I.R.C. § 409A added very detailed requirements for nonqualified deferred compensation plans. Both initial and subsequent elections to defer compensation must be made at very specific times.¹⁹A narrow list of permissible triggers for payment is given.²⁰If a plan fails to comply with § 409A, then there are severe income tax consequences including inclusion of the deferred compensation in income with interest at the underpayment rate plus an additional 1 percent, and a 20 percent penalty based upon the now includable amount.²¹

In Autumn 2005, the Treasury Department issued Proposed Regulations for § 409A.²²On April 17, 2007, the Treasury Department issued final regulations.²³Including its Preamble, the final regulations as

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¹⁵STAFF OF JOINT COMM. ON TAX’N, 108TH CONG., REPORT OF INVESTIGATION OF

ENRON CORPORATION AND RELATED ENTITIES REGARDING FEDERAL TAX AND

COMPENSATION ISSUES, AND POLICY RECOMMENDATIONS , VOLUME I: REPORT, at 1 (Comm.

Print 2003), available at www.gpo.gov/congress/joint/jcs-3-03/vol1/index.html. Enron filed for bankruptcy protection on December 2, 2001 (Case 01-16034, S.D. New York).

¹⁶Id. at 14.

¹⁷See American Jobs Creation Act of 2004, Pub. L. No. 108-357, 118 Stat. 1418 (codified as amended in scattered sections of 26 U.S.C.).

¹⁸Id. § 885.

¹⁹See I.R.C. § 409A(a) (2006).

²⁰Id. § 409A(a)(2)(A) (requiring distributions from nonqualified deferred compensation plans be made no earlier than “separation from service,” date of disability, “death,” a predetermined date, change in ownership, or “an unforeseeable emergency”).

²¹Id. § 409A(a)(1).

²²Prop. Treas. Reg. § 1.409A-1, 70 Fed. Reg. 57,930, 57,930 (Oct. 4, 2005).

²³Treas. Reg. §§ 1.409A-0, -1, -2, -3, -6 (2007).

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formatted in the Treasury’s press release run 397 pages²⁴and still have sections reserved for future guidance.²⁵The final regulations were to be applicable to taxable years beginning on or after January 1, 2008.²⁶A

major requirement of the regulations was that all nonqualified deferred compensation plans needed to be in written compliance on or before December 31, 2007.²⁷

Faced with the task of reviewing and amending existing nonqualified deferred compensation plans, not to mention...