Background
As we have previously alerted, Section 409A was adopted in 2004 partially in response to Enron and partially in response to what the IRS considered to be abuses by small and mid-sized companies with respect to deferred compensation. Section 409A and the applicable regulations that have since been implemented under it provide a very complex web of regulation with respect to non-qualified deferred compensation arrangements. Over the years since adoption, the effects of 409A have been phased in via IRS Notices, proposed Regs and final Regs. Presumably, IRS Notice 2010-6, published earlier this year, represents the final opportunity to deal with non-compliant documentation problems in existing arrangements in a manner that avoids, or at least partially avoids in certain circumstances, the dramatically adverse consequences of being taxed under Section 409A.
Section 409A impacts certain deferred compensations arrangements between a service provider and the recipient of those services (including employees and employers), Section 409A defines deferred compensation as being any right to payment that arises in a particular tax year, but payment of which is not made until a later year. There are many arrangements, oral and written, in which 409A concerns can arise. They include among many others, deferred compensation arrangements, rabbi trusts, employment agreements, severance packages, uninsured disability programs, phantom stock and other phantom equity plans, stock option and other equity option plans, bonus programs including annual bonus plans that pay bonuses earned in one year in the early part of the following year.
Additional Taxes Imposed
If any deferred arrangement is not expressly exempted from Section 409A or otherwise does not meet Section 409A compliance requirements, Section 409A provides that the non-qualified deferred compensation becomes currently includable in gross income, even though not currently payable under the terms of the arrangement, and subject to tax at ordinary income rates plus an additional 20% tax plus interest from the date the right to receive the payment first arises at the Internal Revenue Code underpayment rate plus 1%. Section 409A thus generates a very hefty tax burden in the event of non-compliance. This burden is increased by the fact that the taxes due are payable at a time when the taxpayer likely has not received any portion of the deferred payment and thus must use other resources to cover the tax. While these tax burdens belong to the service provider (generally an employee) it is not difficult to recognize that the service provider will look to the service recipient that put the program in place to aid in the resolution of the tax problem. Further, the service provider is obligated to report noncompliant Section 409A deferred compensation to the IRS. The result is a tax and morale headache for both parties to the deferral arrangement.
Review and Amendment Again Advised
Against this background, we are advising all clients to re-examine their compensation and other payment arrangements with service providers and former service providers against Section 409A requirements to be sure to take full advantage of IRS Notice 2010 6 to avoid, to the maximum extent possible, the pitfalls of any Section 409A problems that continue to exist in their arrangements. This review should take place even if one was done earlier when Section 409A was initially adopted. Since the early days of life under Section 409A, government decision making as part of the process of crafting and implementing regulations, further guidance given by the government agencies involved and the evolution of certain “best practices” either require or support the need to consider additional plan amendments under certain circumstances as well as provide merit for tweaking previous amendments in a manner that may now be necessary to conform to the regulatory framework that has evolved and/or to address best practices.
Notice 2010 6 Relief
IRS Notice 2010-6 is complex. For purposes of this alert only an oversimplified overview is practical. IRS Notice 2010 6 provides for the opportunity to correct ambiguous plan terms, correct impermissible definitions of payment events such as impermissible definitions of separation from service, change of control of the service recipient, and disability of the service provider. The ability to correct impermissible payment events is also possible. The Notice also allows for correction of impermissible payment periods. Other corrective actions are also permitted.
Taking advantage of IRS Notice 2010 6 before the end of the year will allow, in a number of circumstances, the avoidance of any Section 409A tax problems. In other circumstances, amendments are permitted to correct problems and avoid Section 409A taxes, provided that a specified waiting period in which an event triggering payment of deferred compensation under the deferral arrangement, if not amended, does not arise. In many circumstances, the Notice provides that if such a pre-amendment payment requirement were to arise in the waiting period, a reduced portion of the deferred compensation will be subject to the consequences of 409A.
We are recommending that all reviews be completed by October 31st in order to provide ample time for any amendments to be crafted and implemented prior to year-end. Of course, in cases where correction involves a waiting period, the earlier the review and amendment the better.
If you desire assistance in performing the audit suggested by this alert, please get directly in touch with your principal contact at our firm, or contact Attorneys Henry Beck, Jr. or Matthew Teich. If you would like to undertake your own review, we have provided electronic links below to the Code Section, the applicable Regulations and Notice 2010-6.
Section 409A
409A Regulations and Guidance
Notice 2010-06