Employee Benefits Law Alert: Overview of Key Provisions of the Section 409A Proposed Regulations
1/1/2006

Section 409A, which was added to the Internal Revenue Code in October 2004, imposes onerous penalties on nonqualified deferred compensation that fails to meet strict new rules. Although Congress enacted Section 409A in response to well-publicized abuses by highly paid public company executives, the broad scope of the legislation will have a wide-ranging impact on compensation generally.

The Internal Revenue Service (IRS) has provided preliminary guidance regarding Section 409A in Notices 2005-1 and 2006-4 and in proposed regulations issued in September 2005. This Client Alert highlights certain key provisions of the proposed regulations, and is one of a series of Client Alerts prepared by Stoel Rives LLP that explain the substantive provisions of the proposed regulations. Links to the other Client Alerts are provided at the end of this Alert.

Section 409A Overview

Section 409A operates by specifying the nonqualified deferred compensation arrangements that are subject to its rules and by setting out detailed rules that must be satisfied with respect to (1) the timing of elections to defer compensation and (2) the timing of distributions of amounts treated as deferred. To the extent these rules are not met, Section 409A taxes compensation earlier than pre-Section 409A rules (generally at the time of vesting rather than at the time of payment) and imposes an additional twenty percent penalty tax on the amount included in income and an additional interest charge on amounts deferred at the IRS's interest rate for underpayments, plus one percent.

As a result, Section 409A requires companies to determine whether a particular compensation arrangement is nonqualified deferred compensation covered by Section 409A, and if so, what deferral elections and distribution events must be followed to avoid the acceleration of tax and penalty taxes imposed on arrangements that do not comply with Section 409A.

Nonqualified Deferred Compensation Subject to Section 409A

Section 409A applies to amounts deferred under a nonqualified deferred compensation plan. That term refers to any plan that provides for the deferral of compensation, unless a specific exception applies. These plans can involve compensation payable to employees or to independent contractors, including certain corporations or partnerships. Section 409A and the proposed regulations refer to these collectively as "service providers," and to the persons or entities for whom the services are provided as "service recipients." Because the focus in the majority of cases will likely be on employees and employers, this Client Alert uses those terms instead of "service providers" and "service recipients," except when that use does not make sense.

Short-Term Deferrals. Plans that fit within the "short-term deferral" exception are not subject to Section 409A. Under this exception, no deferral of compensation generally occurs if payment is made to the employee by the later of (1) 2½ months after the end of the employee's taxable year in which the amount becomes vested, or (2) 2½ months after the end of the employer's taxable year in which the amount becomes vested. The regulations also protect against inadvertent violations by permitting extensions of the 2½-month deferral period when payment by the deadline is administratively impracticable or would jeopardize the employer's solvency, and the circumstances causing the delay were not foreseeable at the time.

Planning Tip: There is no requirement that a plan specify in writing that payments must be made by the short-term deferral deadline to avoid application of Section 409A. However, employers should consider specifying a date or year of payment in the plan, even if payment will be made within the short-term deferral period. If the plan specifies a date or year of payment, no violation of Section 409A occurs if the deadline is missed as long as payment ultimately is made by the end of the calendar year in which the short-term deferral period ends or, if later, within 2½ months after the end of that calendar year.

Stock Options and Stock Appreciation Rights. The proposed regulations provide that nonqualified stock options will not be treated as deferred compensation subject to Section 409A unless they are granted at a discount or have other deferral features. Notice 2005-1 provided similar relief for stock appreciation rights (SARs), but only for SARs settled in publicly traded securities. The proposed regulations do not incorporate these restrictions on SARs, providing instead that a nondiscounted SAR (including a cash-settled SAR and a SAR settled in stock of a private company) will be subject to Section 409A only if it has other deferral features. A more detailed discussion of the equity compensation provisions in the proposed regulations is contained in our Client Alert, "Equity Compensation Provisions in the Section 409A Proposed Regulations." A link to that Client Alert is provided at the end of this Alert.

Severance Arrangements. The proposed regulations generally exempt severance arrangements under which benefits are paid only upon involuntary separation from service (or voluntary separation from service pursuant to a "window" program), and the arrangement provides that (1) the aggregate severance payments do not exceed two times the lesser of the employee's annual compensation or the Section 401(a)(17) annual compensation limit applicable to qualified retirement plans ($220,000 for 2006), and (2) all payments are made by the end of the second calendar year following the year in which separation from service occurs. A more detailed discussion of the severance provisions in the proposed regulations is contained in our Client Alert, "Severance Provisions in the Section 409A Proposed Regulation." A link to that Client Alert is provided at the end of this Alert.

Foreign Deferred Compensation Arrangements

The proposed regulations clarify the circumstances in which arrangements maintained by non-U.S. employers will be excluded from coverage under Section 409A. Arrangements excluded by the proposed regulations include the following:

• Arrangements Covered by U.S. tax treaties. Plan contributions are exempt from Section 409A to the extent they are exempt under a U.S. tax treaty, and benefits are exempt to the extent they would have been exempt under a U.S. tax treaty when first vested.

• Non-U.S. Source Income. Deferred compensation of a nonresident alien is exempt to the extent the compensation would have been exempt from U.S. income tax when first vested.

• De Minimis Amounts. Deferred compensation of a nonresident alien is exempt if the compensation is derived from the performance of services within the United States, the amounts deferred do not exceed $10,000 per year, and the compensation is deferred under a plan maintained by a non-U.S. employer.

• Foreign Earned Income. Deferred compensation of U.S. citizens and U.S. residents is exempt from Section 409A to the extent the compensation, when added to all other foreign earned income of the individual during the year in which the individual's right to the deferred compensation first vests, does not exceed the exclusion for foreign earned income under Section 911 (currently $80,000).

• Broad Based Foreign Retirement Plans Maintained by Non-U.S. Employers. Amounts deferred under a "broad based foreign retirement plan" maintained by a non-U.S. employer are exempt from Section 409A coverage to the extent the plan covers non-resident aliens and U.S. residents without a "green card." If the plan covers U.S. citizens and U.S. residents with a green card, the exclusion applies to such individuals only if they are ineligible to participate in a U.S. tax-qualified plan, and only to nonelective deferrals of foreign earned income that do not exceed the dollar limit under Section 415 for a similar U.S. tax-qualified plan (i.e., defined contribution or defined benefit).

Initial Deferral Election Rules

General Rules. Section 409A and the proposed regulations generally require that an employee must make a deferral election, including an election as to the time and form of payment under a plan that does not permit the employee to elect the amount of the deferral (a nonelective plan), in the taxable year before the taxable year in which the services giving rise to the compensation are performed. Evergreen elections (i.e., elections that remain in place for subsequent years until changed or revoked) will satisfy the general rule.

SERPs. For supplemental executive retirement plans ("SERPs") (and other nonelective plans) to avoid application of the initial deferral requirements, the plan must not permit the employee to exercise any discretion as to the amount of the deferral and the time and form of payment. The amount of the deferral and the time and form of payment must be set before the end of the taxable year preceding the taxable year during which the services giving rise to the compensation are performed.

First Year of Eligibility. An initial deferral election may be made up to 30 days after an employee first becomes eligible to participate in the plan, but only with respect to compensation earned after the date of the election. For purposes of this rule, however, the term "plan" is defined to include all plans of the same type (i.e., account balance, non-account balance, etc.). Thus, for example, employees who participate in an account balance plan and who become eligible to participate in another account balance plan will not be eligible to use this rule to make a mid-year election under the second plan.

Performance-Based Compensation. If deferred compensation is based on a performance period of at least 12 months, the initial deferral election must be made no later than six months before the end of the applicable performance period, and before the amount of the compensation is readily ascertainable and the right to receive the compensation is substantially certain. As with the rules under Section 162(m) (dealing with the $1 million limit on deducting pay to certain executives), the proposed regulations also permit the performance criteria to be established within 90 days after the beginning of the performance period, as long as the outcome is not substantially certain at the time the criteria are established.

Distribution Rules

Section 409A generally requires that payments be made no earlier than a fixed date or under a fixed schedule, or upon any of the five following events: (1) separation from service, (2) death, (3) disability, (4) change in control, or (5) unforeseeable emergency. The proposed regulations permit payment to be made as a result of one of these five events if the plan designates an objectively determinable date or year following the event (e.g., 30 days following separation from service). In addition, payments will be treated as made upon a designated date if they are made by the later of (i) the end of the calendar year containing the designated date or (ii) the 15th day of the third month following the designated date. Payments may also be delayed in certain other cases without violating Section 409A (e.g., when required to comply with the $1 million deduction limit for executive pay under Section 162(m) or securities laws). The proposed regulations also make clear that a plan may provide for payments to be made upon the earlier of, or the later of, two or more specified permissible payment events or times, and that a different form of payment may be elected for each potential payment event.

Six-Month Delay for Specified Employees. Section 409A requires that nonqualified deferred compensation payable upon separation from service to "specified employees" (generally defined as officers, five percent owners or certain one percent owners of the employer who are treated as key employees under the top-heavy rules that apply to tax-qualified retirement plans) of public companies be delayed at least six months following the date of separation. Plans may meet this requirement by providing that all payments otherwise due within the six-month period be delayed until the end of the six-month period, or that each scheduled payment that becomes payable pursuant to a separation from service is delayed six months after the date it was otherwise payable.

Plan Terminations. The proposed regulations permit an employer to terminate a plan and make distributions to participants without violating the prohibition under Section 409A against accelerating payment of benefits. This is permitted: (1) when the employer ceases providing a certain category of nonqualified deferred compensation plans altogether (e.g., account balance plans) and terminates all such plans with respect to all participants, (2) during the 30 days preceding or 12 months following a change in control of a corporation (but only if all substantially similar arrangements of the employer are terminated), or (3) in the case of certain corporate dissolutions or with the approval of a bankruptcy court.

Tax Withholding and Reporting Rules

Section 409A, as interpreted by Notice 2005-1, generally requires that employers report the total amount of deferral under a nonqualified plan in box 12 of Form W-2 using code "Y." Employers must also treat amounts that are taxable under Section 409A as wages subject to wage withholding, and report them in box 1 of Form W-2 as taxable wages, and also in box 12 of Form W-2 using code "Z." Service recipients must similarly report deferrals of non-employees in box 15a of Form 1099-MISC, and must report Section 409A income as non-employee compensation in box 7 of Form 1099-MISC.

On December 8, 2005, the IRS issued Notice 2005-94, which suspends the obligation of an employer or other service recipient to report and withhold on Section 409A deferrals for calendar year 2005. Until superseded by future published guidance, employers are not required (1) to report Section 409A deferrals for calendar year 2005 in box 12 of Form W-2 using code "Y" or on box 15a of Form 1099-MISC, as applicable, or (2) to include in wages amounts includible in gross income under Section 409A that the employee has not actually or constructively received during calendar year 2005. Thus, employers can exclude such amounts from wages for income tax withholding purposes and are not required to report such amounts as wages paid in box 2 of Form 941 or box 1 of Form W-2. Similarly, service recipients need not report other similar compensation amounts paid to non-employees in box 7 of Form 1099-MISC or as Section 409A income in box 15b of Form 1099-MISC.

Although the IRS provided this relief for the 2005 calendar year, it is merely a suspension of the requirements imposed under Section 409A, and consequently, future guidance from the IRS may require employers to file corrected information returns and furnish corrected payee statements for calendar year 2005. In addition, employees and other service providers must file returns and pay any taxes due relating to amounts includible in gross income under Section 409A for calendar year 2005.

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This Client Alert is a brief summary of certain of the provisions of the proposed regulations. In the interest of brevity, many details and issues have been omitted. If you have any questions or would like more information, please telephone one of the following attorneys:

IRS Circular 230 Notice: Any tax advice contained herein was not intended or written to be used, and cannot be used, by you or any other person (i) in promoting, marketing or recommending any transaction, plan or arrangement, or (ii) for the purpose of avoiding penalties that may be imposed under federal tax law.