Getting up to speed on the final regulations for deferred compensation.

• Author: Misher, Norman J.

Section 409A of the Internal Revenue Code of 1986 requires that nonqualified deferred compensation plans meet specific requirements relating to the timing of deferral elections, the time and manner in which distributions may be made, and the circumstances under which amounts previously deferred may be either further deferred or accelerated. If these requirements are not met, the amount deferred is generally included in the income of an employee in the year in which the employee became vested in the right to receive the compensation, a 20-percent additional tax is imposed on that income, and an interest charge may also be imposed.

In April 2007, the Internal Revenue Service issued final regulations under section 409A that address many (but by no means all) of the questions that have arisen regarding the application of the complex provisions of the statutory provision to deferred compensation plans. The final regulations are effective on January 1, 2008, and, thus, all deferred compensation plans subject to section 409A must be in full compliance by the end of this year. This article provides an overview of key topics covered by the final regulations, with a particular focus on issues that were not addressed, or that were addressed differently in the notices and proposed regulations that preceded the final regulations.

Nonqualified Deferred Compensation Plan

A nonqualified deferred compensation plan under section 409A means any plan that provides for a deferral of compensation. Thus, section 409A deferred compensation plans are not limited to arrangements between employers and employees. (1) Section 409A also applies to arrangements between a corporation and one or more of its outside directors or independent contractors.

The final regulations provide that whether a plan provides for deferral of compensation is generally determined at the time the employee obtains a legally binding right to compensation under the plan. The determination that a plan constitutes a deferred compensation plan is not affected by a retroactive change to the plan to characterize the employee's right as one that does not provide for the deferral of compensation.

The final regulations provide that the following plans are not subject to section 409A:

* Qualified employer plans, such as 401(k) plans, pension plans, and tax deferred annuities.

* Certain welfare benefit plans, such as bona fide vacation leave, sick leave, compensatory time, disability pay, and death benefit plans.

* Medical reimbursement arrangements that provide benefits that are excludable from gross income.

* Certain foreign retirement plans that provide benefits to a broad-based group of employees.

* Contributions made on behalf of employees (and earnings thereon) that are excludable from income under an income tax treaty.

Deferral of Compensation

1. In General

   Under the final regulations, a plan generally provides for the deferral of compensation if the employee has a "legally binding right" during one taxable year to compensation that is (or may be) payable to the employee in a later taxable year. For this purpose, a plan will be treated as providing for a payment to be made in a subsequent year whether the plan explicitly so provides (including through a deferral election by the employee) or the deferral condition is inherent in the agreement. For example, if the parties agree that payment will be made upon an event that "could" occur after the year in which the legally binding right to the payment arises, the agreement will generally be considered to provide for a deferral of compensation (unless such arrangement is excluded from section 409A under a specific exception, such as the short-term deferral rule described below).

   A deferral of compensation is generally defined under the final regulations in the context of a legally binding right to a payment of compensation in a future taxable year. For purpose of the regulations, a legally binding right includes a contractual right that is enforceable under the law governing the contract. Although an employee is not considered to have a legally binding right to compensation that can be reduced or eliminated by the employer after the services giving rise to the compensation have been performed, the final regulations make it clear that a legally binding right can exist even if the right can be reduced or eliminated by application of a nondiscretionary, objective provision creating a substantial risk of forfeiture.

2. Short-Term Deferrals

   The "short-term" deferral rule provided under the final regulations is a very useful and important exception to the expansive rules defining a deferral of compensation. Under this rule, a deferral of compensation does not occur if:

   * the arrangement under which the compensation is paid does not provide for a deferred payment of compensation, and

   * the compensation payment is includible in income no later than 2 1/2 months after the end of the first year in which the legally binding right to the payment arises or, if later, the first year in which the compensation is no longer subject to a substantial risk of forfeiture (the "2 1/2 month period").

   1. Operation of Short-Term Deferral Rule

      There are several important rules provided in the final regulations illustrating the operation of the short-term deferral rule, as follows:

      * The right of an employee to make a deferral election with respect to compensation will not preclude the application of the short-term deferral rule to such compensation provided that the employee does not make the deferral election and payment is actually made within the 2 1/2 month period.

      * If a plan provides for payment on or after an event or date that will or "may" occur after the end of the 2 1/2 month period, the plan will be considered to provide for a deferral of compensation, regardless of whether the amount is actually paid as a result of the occurrence of such payment event or date during the 2 1/2 month period.

      ** For example, assume an employer awards a bonus to its employee on November 1, 2008, and the employee has a legally binding to such payment as of such date. Under the bonus plan (i) the employee will forfeit the bonus unless the employee continues performing services through December 31, 2010 (thus, the employee's right to such bonus is subject to a substantial risk of forfeiture until December 31, 2010) and (ii) the bonus is scheduled to be paid as a lump sum on July 1, 2011. Because the specified payment date is after the 2 1/2 month period (March 15, 2011, in this example) the bonus plan will be considered to provide for a deferral of compensation and will not qualify for the shortterm deferral rule regardless of whether the bonus is paid on or before March 15, 2011. (2)

      ** Further, based on the facts of the above example, assume (i) the legally binding right to the bonus that the employee acquires on November 1, 2008, is not subject to a substantial risk of forfeiture, and (ii) instead of a scheduled payment date of July 1, 2011, the bonus is scheduled to be paid as a lump sum upon the employee's separation from service. Under these facts, because separation from service is an event that may occur after the 2 1/2 month period (March 15, 2009, in this example), the bonus plan will be considered to provide for a deferral of compensation and not qualify for the short-term deferral rule. This is so even if the employee separates from service and the bonus is paid on or before March 15, 2009. (3)

      * If a plan does not specify a payment date or payment event, payments made within the 2 1/2 month period will qualify for the short-term deferral rule. If in this case payment is made outside of the 2 1/2 month period, however, section 409A will generally be violated because of the failure to pay upon a specified date or event.

      * If the plan specifies a payment date within the 2 1/2 month period and payment is not made within such period but is made within the same year in which the payment date occurs, such payment, though now subject to section 409A, will generally comply with section 409A. Often, bonus plans or similar arrangements do not provide for a specified payment date. Thus, it is important that those arrangements that are intended to fall within the short-term deferral rule specify a March 15 payment date (or any earlier date within the 2 1/2 month period) to prevent inadvertent violations of section 409A.

   2. Certain Delayed Payments

      Under the final regulations, payments that otherwise qualify for the short-term deferral rule that are made outside of the 2 1/2 month period may still qualify as a short-term deferral under the following circumstances:

      * The delay in payment was due to an unforeseeable administrative delay.

      * The making of the payment within the 2 1/2 month period would have jeopardized the ability of the employer to continue as a going concern.

      * The delay in payment was necessary to prevent the loss of a deduction under section 162(m) (which generally disallows the deduction of compensation in excess of $1 million).

3. Stock Options and Stock Appreciation Rights

   Compensatory stock options and stock appreciation rights (collectively, "stock rights") are, in general, subject to the requirements of section 409A, unless they come within a safe harbor provided under the final regulations. Stock rights will be within the safe harbor if they incorporate the following elements: (i) they must be granted on stock of the employer; (ii) the exercise price (or, with respect to stock appreciation rights, the price by reference to which any appreciation is determined) must never be less than the fair market value of the underlying shares at the time of grant; and (iii) the stock right must not include additional deferral features such as, for example, a provision for the deferral of the delivery of shares or other payment after exercise. In addition to those stock rights covered by the safe harbor, incentive stock options that...