Nonqualified Deferred Compensation (Code Section 409A): Potential Pitfalls And One Last Opportunity

Saturday, September 1, 2007 - 01:00

We now have a fair amount of guidance from the IRS in the area of nonqualified deferred compensation, including final IRS regulations issued earlier this year. Although Section 409A of the Internal Revenue Code (the "Code") was added by the American Jobs Creation Act of 2004 and initially became effective starting in 2005, the guidance on this provision has created a period of extended flexibility during which it is possible to analyze and (attempt to) correct those arrangements that are considered to be "nonqualified deferred compensation plans" in order to bring them into formal compliance with all of the requirements of Code Section 409A. Of course, all good things must end, and this transitional period will come to a close on December 31, 2007. Any arrangements that are considered to provide for deferred compensation on a nonqualified basis that are not in compliance with all of the various requirements of Code Section 409A as of January 1, 2008, will be subject to the unpleasant tax consequences of that noncompliance. Compliance failures (whether due to flaws in the documentation of an arrangement or due to a failure to follow the terms and conditions of a compliant set of documents) will result in taxes on the participant (i.e., on the executive). This may mean a tax liability on amounts not actually received (a type of "constructive receipt" of income), a significantly increased tax rate (the tax on noncompliant arrangements will be at the normal rate for ordinary income, currently up to 35 percent, plus an additional 20 percent tax, for an effective maximum tax rate of 55 percent), plus an "interest" charge on this tax liability (as though it constituted a late payment of taxes at the relatively steep interest rate equal to the rate charged by the IRS for underpayments of taxes, plus 1 percent, which would mean a 9 percent rate currently).

Since we are now faced with a need to comply with a new set of tax rules no later than the end of this year (which we may find somehow shows up a lot faster than it might seem during the heat of August), a number of areas of concern are worth considering while there is still at least some breathing room.There may also be a last chance to get rid of a deferred compensation plan that might otherwise be of limited value and increasingly cumbersome to operate. This is set out in more detail in the following discussion:

Finding The Nonqualified Deferred Compensation Plan (Or, As Jerry Maguire Might Have Said, "Show Me The Deferred Compensation!")

Each plan, contract or other arrangement that provides benefits in the nature of deferred compensation is potentially treated as a "nonqualified deferred compensation plan" that can be subject to Code Section 409A. Very broadly stated, almost any arrangement that purports to pay taxable compensation in a year after the year the services were actually performed is potentially going to be treated as a nonqualified deferred compensation plan for these purposes.

While many companies have plans that are actually called the "Company X Nonqualified Deferred Compensation Plan," or are executive retirement plans that are generally understood to be a type of deferred compensation, there are a host of other arrangements that are potentially subject to Code Section 409A. These include employment agreements, severance plans, bonus plans, equity-based compensation plans or arrangements, phantom equity plans and restricted stock unit plans, just to name a few. While it is generally difficult to bring a nonqualified deferred compensation plan into compliance with Code Section 409A, it will be impossible to do so if the parties involved fail to recognize that they have such a plan to begin with. The first and possibly most daunting task at hand is to identify those arrangements that may need to be addressed. Once identified, the process of making the modifications required to comply with Code Section 409A can then commence.

Change Of Control Severance Plans

Many companies (perhaps most publicly traded companies) have plans (or individual employment agreements) that contain special provisions related to a "change of control" of the company. These arrangements often provide benefits following a change of control of the company should the executive be terminated from his or her employment. This type of arrangement is intended to encourage the participants to continue to devote themselves to the company's success without being distracted by the possibility of a change of control. Such an arrangement can motivate key executives to act in the best interests of the company and its shareholders, working towards a successful change of control transaction where appropriate, without seeking such a transaction where it is not. While it is possible for a severance benefit to be exempt altogether from the requirements of Code Section 409A, the arrangement would need to comply with the requirements of a special severance exception set out in final IRS regulations. If that exception is not applicable, the arrangement can become subject to Code Section 409A creating a possibility of very unfavorable tax treatment of the participant. Typical provisions that bring a change of control severance plan outside the severance exception include: the magnitude of the severance benefit; the period over which severance is paid; and the possibility that the severance pay is triggered under circumstances not deemed for these purposes to be an involuntary termination of employment. The IRS rules as to what "good reason" to quit is equivalent to an involuntary termination are not typically found in plans that pre-date the publication of these rules. Change of control severance plans, and any other severance plan, employment agreement or similar arrangement with a "good reason" to quit provision, should be reviewed for compliance with Code Section 409A.

Contractual "Setoff" Provisions

Where executives have deferred compensation benefits that are designed generally to comply with Code Section 409A going forward, contractual provisions that permit a company to set off amounts the executive may owe to the company by amounts owed to the executive under the deferred compensation arrangement may cause the deferred compensation arrangement to fail to comply with Code Section 409A. The IRS may interpret the setoff right as causing the event that gives rise to any repayment obligation to be treated as being immediately subject to the "setoff" right of the company, making the event (e.g., a loan) equivalent to an unscheduled withdrawal from the deferred compensation arrangement. This interpretation by the IRS would mean that the deferred compensation arrangement contains an accelerated payout provision (which violates the requirements of Code Section 409A), notwithstanding the fact that the deferred compensation arrangement is, in all other regards, in compliance with Code Section 409A.

Deferred Compensation Plan Design Issues

Many deferred compensation plans are designed so that in all events benefits are paid out upon termination of employment. This may be intended to address participant concerns (that they not be in a position of having to collect their benefits from a former employer long after they have terminated employment) or to address employer concerns (that relate to their interest in not carrying an obligation on a tax-deferred basis for a long time for former employees). In either case, Code Section 409A prohibits the immediate payment of deferred compensation benefits to certain "specified employees" of publicly traded companies where the payment is triggered by a termination of employment until a date that is at least six months after that termination. Another area of concern with payout upon termination of employment arises if a nonqualified deferred compensation plan permits participants to use the subsequent deferral rule of Code Section 409A. Although generally Code Section 409A requires any election as to time and manner of payment of deferred compensation to be made at the time of the initial deferral, the subsequent deferral rules provide an exception that permits a later change in this election so long as the modification is made, irrevocably, at least 12 months before the date the deferred compensation would otherwise have been paid and causes the payout to be deferred for a period of at least five years. Should a participant terminate employment after making such an election, immediate payment of the benefit (even though the plan is structured generally to pay benefits upon a termination of employment without regard to a contrary election of a later payment date) will not be permitted if this would be earlier than the date elected when making the subsequent deferral.

Terminating A Deferred Compensation Plan

Most deferred compensation plans contain provisions that generally permit the plan to be amended or terminated by the employer. A plan that is not valued by employees, or that is cumbersome or expensive to administer, might be viewed as something that should be eliminated. Normally, this is done unilaterally by the employer with an immediate payout of the accrued benefits to the participants. A termination of a deferred compensation plan and payment of benefits will generally be deemed to be an acceleration of payment of the deferred compensation, which normally is not permitted at all under Code Section 409A. Terminating a plan in violation of this prohibition on acceleration of payment not only triggers the normal tax on the income, but the penalty tax rate and "interest" charge described above.

Under the final regulations, it will still be possible to terminate a deferred compensation plan without causing a bad tax result for participants, but only if certain requirements are satisfied. Briefly, the requirements for a plan termination are: the plan being terminated can only be terminated if all other plans of a similar type (i.e., that are required to be aggregated with the terminating plan under the IRS final regulations) are also terminated; the payments to participants as a result of the plan termination are not made until at least 12 months after action to terminate the plan is taken; all of these payments must be completed within 24 months of the date of that action; and no new plan of the same type may be adopted within three years following the date the action to terminate the plan was taken. The significant opportunity that still exists for only a limited time is a plan termination consistent with the currently applicable transitional rules. In general, if action to terminate a nonqualified deferred compensation plan is taken now, and payment of plan benefits as a result of that termination is made at any time after the end of the year (e.g., in January 2008), the termination will not trigger any of the detrimental tax consequences of Code Section 409A. While such a termination would not be permitted under the final regulations once applicable, employers have one last chance to implement such a termination now under the currently applicable transitional rules. Action of this type would need to be taken no later than December 31, 2007.

Warren E. Fusfeld is a partner at WolfBlock and chair of the firm's Employee Benefits Practice Group. His practice is primarily in the area of employee benefits and taxation, including executive compensation and deferred compensation (both qualified and nonqualified).

Please email the author at wfusfeld@wolfblock.com with questions about this article.