Editor’s Notes: Deborah B. Andrews is a member of the Business and Tax Practice Groups at Ward and Smith, P.A.
The compliance deadline of December 31, 2008, has passed and all deferred compensation arrangements now either should comply with Internal Revenue Code Section 409A ("Section 409A") or be exempt from its application. Given the complexity and expansive scope of the Section 409A rules, businesses soon may discover violations despite their good faith efforts to comply. In some cases, arrangements requiring Section 409A compliance may have been overlooked or not properly identified as involving deferred compensation. In other cases, an arrangement may have been properly identified as deferred compensation, but the documents detailing such arrangement have not been amended to include all of the necessary requirements and modifications necessary for compliance with Section 409A. In all cases, even a minor or innocent mistake can trigger a huge tax liability for the taxpayer. However, some relief may be available.
Section 409A contains detailed operating rules and written requirements for arrangements that defer compensation to future years other than a qualified employer plan (such as a 401(k) plan), vacation leave, sick leave, compensatory time, disability pay, or a benefit plan. In general, "deferred compensation" is any arrangement under which a service recipient promises to pay a service provider compensation and the payment of the compensation is made in a year after that in which the promise is made. Although this article uses the terms "employer" and "employee," the rules technically apply to "service providers" which include not only employees, but also directors and certain independent contractors. "Service recipients" include all types of employers, whether public, private, or nonprofit.
The first step in complying with Section 409A is to properly identify arrangements that involve deferred compensation. It may be easy to identify traditional deferred compensation plans, such as supplemental executive retirement plans. However, there are numerous "nontraditional" arrangements that may fall within the purview of Section 409A, such as employment and severance agreements, stock option arrangements, and certain types of fringe benefits. All documents setting forth the terms of a deferred compensation arrangement to which Section 409A applies must contain certain terms and conditions and exclude certain others in order to comply.
After several extensions, the Internal Revenue Service ("IRS") set December 31, 2008, as the final deadline for employers to comply with Section 409A. If the deadline was missed, employees of those businesses could face severe tax consequences in the form of a triple tax, described below.
The Triple Tax
The IRS proposed regulations addressing the calculation of the tax payable by an employee whose deferred compensation plan violates Section 409A are complicated. In general, the employee of a business that fails to comply with Section 409A may be liable for three separate tax amounts (the "triple tax"):
• Immediate Tax on Vested Amount – Payment of income tax on all amounts that are deferred and vested to the extent not previously included in the employee’s income;
• Excise Tax – Payment of a penalty in the amount of 20% of the compensation included in the employee’s income as a result of the Section 409A violation; and,
• Premium Interest Tax – Payment of interest by the employee at the IRS underpayment rate plus one percentage point.
The end result is that an employee who is expecting to pay the usual 35% of the deferred compensation amount in federal taxes could end up paying more than double that amount. In fact, the amount of the triple tax could be greater than the amount of deferred compensation if the compensation has been vested for many years. To make matters worse, the triple tax is due in the year the violation occurs. So, the employee could end up owing tax on compensation that is not received until future years.
The following example is a simple illustration of how easy it is to violate Section 409A and the resulting tax consequence:
In an effort to retain its chief executive officer ("CEO"), XYZ Company ("XYZ") established a salary continuation plan (the "Plan"). Under the Plan, if the CEO remained employed with XYZ until the CEO reached age 60, the CEO would be entitled to receive $10,000 a month for 60 months upon a disability or separation from service from XYZ. The Plan defines the term "disability" as the CEO’s inability to perform as CEO due to a physical or mental illness as determined by a physician. On June 15, 2010, the CEO turns 60, retires from XYZ, and begins to collect the monthly payments under the Plan. It is discovered later that the Plan’s definition of disability does not comply with Section 409A.
Although the payments were triggered by the CEO’s separation from service and not as a result of a disability, the former CEO will be subject to the triple tax because of the Plan’s noncompliant definition of "disability." As a result, in 2010 (the year the deferred compensation vested), the former CEO must pay (i) tax on the entire deferred amount of $600,000 ($10,000 x 60 months); (ii) an additional excise tax of $120,000 ($600,000 x 20% penalty); and (iii) the premium interest tax.
Avoiding the Triple Tax Upon A Documentary Failure
The above example clearly shows that the net effect of a violation of Section 409A can be devastating to an employee, and the IRS has established a limited correction program to address certain operational failures. For example, if a plan that otherwise complies with Section 409A becomes noncompliant due to unintentional practices or operations of an employer, relief may be available to the employee to avoid the triple tax.
Unfortunately, the IRS has not yet provided any relief for documentary failures of Section 409A, although the IRS is considering doing so. Despite the lack of a currently applicable relief program, there may be a limited opportunity to fix certain documentary failures with respect to non-vested amounts under the current IRS proposed regulations.
The proposed regulations provide that if a deferred compensation arrangement fails to comply with Section 409A at any point during a taxable year, the deferred amount is includible in the employee’s income for such year to the extent the amount is vested and was not included in income in a prior year. The tax liability for a Section 409A violation is determined independently each year. Therefore, if a deferred compensation arrangement is amended to comply with Section 409A prior to the beginning of the tax year in which the deferred compensation vests, the triple tax may be avoided.
In the above example, if the Plan is amended in 2009 to modify the definition of "disability" to fall within the meaning of Section 409A, the violation would be overlooked since the deferred compensation does not vest until 2010 (when the CEO turns 60.) Based on the proposed regulations, as long as the plan complies with Section 409A as of the beginning of 2010, the former CEO would escape the triple tax.
Formal relief under a correction program currently is not available for deferred compensation arrangements that fail to meet the documentary requirements of Section 409A. Although the IRS is considering such a program, the timing and scope of any future relief for documentary failures is unclear. In the meantime, employers should act quickly and work diligently with legal counsel to identify deferred compensation arrangements, in particular those that may not appear at first glance to be a deferred compensation arrangement, and determine whether it is necessary to amend the corresponding documents. For now, taxpayers may rely on the proposed regulations until the final regulations are issued. However, the Section 409A rules are still unfolding and the final regulations may restrict the ability to fix documentary failures with respect to non-vested amounts. Taxpayers and employers should stay tuned to see how the Section 409A story ends.
©2009, Ward and Smith, P.A
Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. Deborah Andrews is a member of the Business and Tax Practice Groups where she advises businesses, individuals, and tax-exempt organizations on complex tax matters and compliance. Comments or questions may be sent to email@example.com.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.