Corporations have been holding their breath for almost two years waiting for the IRS to produce final regulations interpreting Section 409A. This code affects the tax treatment of a wide range of deferred compensation arrangements for any person who provides services to a corporation, including employees, directors, independent contractors and partners.
Unfortunately, the IRS's announcement Oct. 4 that it was extending the compliance deadline from Dec. 31, 2006, to the end of 2007 gives corporations little time to catch their breath. With final regulations also not expected until the end of this year, they will still have onlyabout a year to bring their plans into written compliance.
"The business community has been on pins and needles for almost two years, and it will remain in that state until we see the final regulations," says Sandra Cohen, partner in Osler, Hoskin & Harcourt's pensions and benefits practice in New York.
But even the release of the long-awaited final regulations may not relieve the pain.
Enacted Jan. 1, 2005, as part of the American Jobs Creation Act of 2004, 409A requires corporations that wish to avoid current income taxation for payments under their deferred compensation plans to amend the plans to conform with the legislation. Exceptions exist for 401(k) and other tax-qualified plans, as well as stock options granted at fair-market value. Deferred amounts that do not fall within the exceptions or fail to meet 409A requirements become subject to a 20 percent tax penalty.
"Section 409A extends well beyond traditional executive compensation arrangements and affects most forms of severance agreements, multiyear bonuses, long-term incentive plans, stay bonuses, settlement agreements and supplemental retirement plans," Cohen says. "Generally speaking, a deferred compensation arrangment exists whenever someone obtains a legally binding right in one year to receive compensation that is paid in a future year."
The IRS did issue proposed regulations in 2005, at which time it also extended the time for formal compliance through 2006. The difficulty was that the proposed regulations were 240-pages long.
"Not only are they long, but they're way too complicated," says Marian Tse, chair of Goodwin Proctor's ERISA and employee benefits practice.
Indeed, 409A rules impose a significant administrative burden on corporations.
"Quite apart from the pure legal issues and decisions, compliance will be a major concern for a company's payroll and IT systems," says Marjorie Glover, chair of Chadbourne & Parke's executive compensation and employee benefits practice.
Unfortunately, there are no indications the IRS will change either the structure or complexity of the regulations in the final version. The agency may even add more "clarifying" rules.
"The proposed regulations are very sweeping and go to the core of the employment relationship," says Elizabeth Drigotas, a principal at the Washington, D.C., office of Deloitte Tax LLP, a subsidiary of Deloitte & Touche USA. "They affect the way in which employers craft employment and termination agreements, as well as the way in which they grant stock options."
Most importantly 409A imposes significant restrictions on deferred compensation distributions and employees' elections to extend deferrals, effectively removing employers' discretion in these matters. For the most part, the IRS will permit distribution only after the employee stops working for the company; at a time specified under the plan; in connection with an "unforeseeable emergency;" or when there is a "change in control" of the corporation.
One of the most troublesome rules is the restriction on distributing deferred compensation until after an employee stops working for the company. "That's where we find many of the implementation pressure points," Drigotas says.
For example, a publicly traded corporation may not distribute deferred compensation to a "key employee" until six months after separation from service. Key employees include up to 50 officers having annual compensation greater than $130,000 (adjusted for inflation).
But it's unclear just what comes under the "compensation" rubric. "Do health benefits, perks, pension plans and stock options come into the equation?" Cohen asks. "No one knows the answer yet."
Other important points include how the IRS will calculate the 20 percent penalty and how employers should report the existence of deferred compensation in Box 12 on W-2 forms. While the IRS has suspended the reporting requirements for 2005 and 2006, there has so far been no guidance on exactly what employers have to report.
"Deciding what to put in Box 12 can be very complicated, especially when you're dealing with deferred compensation that doesn't meet the requirements of section 409A, such as discounted stock options," Cohen notes.
Still, despite the complexities and uncertainties, corporations would be well advised to ensure they are in good-faith compliance as soon as possible.
When Congress enacted 409A, the IRS granted taxpayers transitional relief from formally bringing their plans into written compliance until the end of 2005. In the interim, however, sponsors had to operate their plans in reasonable good-faith compliance with 409A and any guidance the agency issued.
"Although the final regulations when released will not be effective until Jan. 1, 2008, operational good-faith compliance with the proposed regulations or other interim guidance provides a safe harbor," Cohen says.
To that end, Drigotas suggests employers take steps to identify all existing arrangements that may provide deferred compensation, particularly share-unit plans, retirement compensation arrangements, bonuses and severance agreements. Employers should also identify any stock options and stock appreciation rights they granted to employees at an exercise price below fair market value, as they are not exempt from 409A. In the case of arrangements that don't currently satisfy 409A, employers should take prompt action regarding 2006 deferrals.
For her part, Cohen recommends employers use caution when making payments that result from termination of employment agreements for any taxpayer earning more than $140,000 (roughly $130,000 adjusted for inflation since 2005).
"Even if an existing agreement says otherwise, it may be in the employee's interest to agree to a six-month delay to avoid the 20 percent surtax," she notes.
With the final regulations promised, though not guaranteed, for delivery at year's end, corporations that stay with a wait-and-see approach may find that a year is not enough time to formally comply with the weight of the complex and burdensome 409A regime.