New IRS Rules Affecting Deferred Compensation - Section 409A
by Rehan K. Hasan

On April 10, 2007 the IRS issued its final regulations regarding section 409A. Section 409A deals with non-qualified deferred compensation plans such as certain stock option plans, non-compete agreements, and other equity based compensation. Common provisions under the old rules such as acceleration of distributions at the discretion of the plan administrator or granting options below fair market value have been substantially altered under the new rules.

Section 409A applies to amounts deferred in the taxable years after December 31, 2004. An amount is treated as deferred once it is earned and vested. Deferred compensation is any compensation that an employee or independent contractor has a legally binding right to during a taxable year that has not been actually or constructively received in gross income and is payable to or on behalf of the employee or independent contractor in a later tax year.

The basic requirements of section 409A include, but are not limited to:

• Timing of deferrals elections;
  
• Selection of form and timing of distributions;
  
• Restrictions on the timing of distributions;
  
• Prohibition against acceleration of deferred compensation payment (except in prescribed circumstances);
  
• Funding restrictions.

A “plan” is any written document that sets forth material terms including the amount (or method or formula) of deferred compensation, payment schedule or payment triggering events, the time by which any deferral election is required to be irrevocable and the conditions under which they may be made. A plan that provides for a deferral of compensation and does not fall within an exception must comply with Section 409A requirements.

Plans that are excluded from the requirements of Section 409A include, but are not limited to:

• Qualified employer plans
  
• Section 457 plans
  
• Restricted property such as stock
  
• Incentive stock option plans and employee stock purchase plans
  
• Short term deferrals
  
• Fair market value stock options plans and stock appreciation rights

Certain plans will be “grandfathered”, and thus not mandated to comply with the requirements of Section 409A. Grandfathered plans are those in which benefits were earned and vested before January 1, 2005. Benefits are considered vested for grandfather rule purposes if they are not subject to a substantial risk of forfeiture and do not require any performance of future services. Also, in order to fall under the grandfather rule, no material modifications must have been made after October 3, 2004. A material modification is any addition or enhancement of a benefit or right.

The most alarming feature of the final regulations is the consequences for failure to comply with the above listed requirements. These consequences include current income recognition of the deferred compensation, 20% excise tax, potential interest penalties at underpayment rate plus 1%, as well as state tax consequences.

Although an existing plan may appear to be excluded from the requirements of Section 409A, the IRS has handed down no guidance outside of the rules themselves to illustrate what features of a plan may invalidate an excluded plan. Thus, best practices at this time are to have all plans looked at and modified to comply with the requirements of Section 409A.

This Article is published for general information, not to provide specific legal advice. The application of any matter discussed in this article to anyone's particular situation requires knowledge and analysis of the specific facts involved.

Copyright © 2008, Fairfield and Woods, P.C.,
ALL RIGHTS RESERVED.

Comments or inquiries may be directed to:
Rehan K. Hasan