409A Overview

UPDATE ON 409A REGULATIONS
April 10, 2006
The U.S. Treasury Department and Internal Revenue Service continue to formulate regulations for Section 409A of the Internal Revenue Code ("409A") which governs non-qualified deferred compensation programs for employees, directors, and other service providers.
 
Because there has been a wide array of public comments on these complicated issues, final regulations are now not expected until the fall of 2006.  Practitioners are continuing to advise their clients to wait until after the regulations are final before they complete their plan amendments.
 
Many are trying to persuade the IRS and Treasury Department to specifically address split-dollar life insurance arrangements.  This is because the proposed 409A regulations are creating confusion and uncertainty with established 2003 regulations that grandfathered split dollar arrangements.  The Todd Organization supports these advocacy efforts.
 
On March 27, 2006, the IRS issued Notice 2006-33 which clarified restrictions on the use of offshore trusts or employer financial health triggers in rabbi trusts.  As The Todd Organization has consistently refrained from recommending these approaches, we believe this will impact few, if any, of our clients.
 
Notice 2005-94, issued on December 8, 2005, temporarily suspended the deferred compensation reporting requirements imposed under 409A for calendar year 2005.  According to Stephen Tackney, attorney with the Executive Compensation Branch, Tax Exempt and Government Entities Division of the IRS, after the regulations are finalized the IRS will develop guidance on how to determine the most appropriate amounts to report on Form W-2, box 12 Codes Y and Z.
 
We will continue to monitor the proposed regulations as well as related developments and keep you informed.  For additional information, please contact your Todd representatives or e-mail us here.

 

PROPOSED non-qualified DEFERRED COMPENSATION RULES PROVIDE IMPORTANT CLARITY AND GUIDANCE
October 13, 2005
On September 29, 2005, the U.S. Treasury Department and Internal Revenue Service announced proposed regulations under section 409A of the Internal Revenue Code ("409A"), which governs non-qualified deferred compensation programs for employees, directors, and other service providers.
 
In general, the new proposed regulations provide a reasonable and acceptable framework under which companies will continue to use non-qualified deferred compensation agreements as cost effective tools to retain and attract high quality executives.  While nearly every plan will require some modifications to comply with the new regulations, these changes should be manageable, especially with the significant transition time allowed under the proposed regulations.
 
Transition Relief
The most dramatic change is that the proposed regulations generally provide a full year extension, until December 31, 2006, for companies to bring their non-qualified deferred compensation plan documents into compliance with 409A.  This change impacts many areas. 
 
For example, many companies have linked qualified and non-qualified provisions, whereby the plan participant receives distributions at the same time from both plans.  While such provisions were expected to be eliminated by the end of 2005, companies are being allowed additional time, through the end of 2006, to unravel these connected elections.
 
Under the proposed 409A regulations, participants will have until December 31, 2006 to revise the time and form of distribution elections without needing to meet additional requirements.  In most cases, however, elections to defer 2006 compensation will need to be made by December 31, 2005.
 
It is important to remember that while final documentation may be delayed, plans must continue to be administered in compliance with 409A.  The recently issued regulations include a proposed effective date of January 1, 2007.  However, by relying on these proposed regulations, and starting to assess changes now, companies will be able to demonstrate good faith compliance with 409A. 
 
Notable Key Changes
In addition to the changes mentioned above, this section summarizes some of the most noteworthy provisions.
Performance-Based Compensation - Statutory language in 409A provides that performance-based deferred compensation decisions must be based on at least a 12-month earnings period and that the individual's initial deferral decision must be made no later than six months before the end of this period.  The proposed 409A regulations allow the performance criteria to be established within 90 days after the start of the performance period, provided the performance outcome is not substantially known at that time. 
 
To qualify as performance-based compensation, the compensation must depend upon the satisfaction of pre-established organizational or individual performance criteria.  It is permissible to make payments based upon subjective performance criteria, as long as the criteria relate to the individual's (or the individual's business unit's) performance and the individual does not determine for himself that the criteria has been met.  Performance-based compensation does not include any amounts that would be paid regardless of performance or amounts based on a level of performance that is substantially certain to be met at the time the criteria is established.
 
Changes in Time and Form of Payments - Under 409A, changes are permitted in the time and form of deferred compensation payments if the following three conditions are met:

  • The election change may not take effect until at least 12 months after the date on which the initial election is made;
  • The payment with respect to which the election is made must be deferred for a period of at least five years; and
  • The election may not be made less than 12 months before the date on which the first payment is scheduled to be made.

The proposed regulations clarify that each separately identified amount to which a plan participant is entitled to payment on a determinable date is a separate payment.  Life annuities, however, will always be treated as a single payment as will installment payments in most instances.  This treatment allows participants to change their form of payment for each separately identified amount, independently, as long as the change meets the three conditions outlined above.
 
The proposed regulations were also fairly liberal in providing that certain changes would not impermissibly accelerate payment to participants.  A plan can provide that an intervening event which qualifies as a permissible payment event under 409A may override an existing payment schedule, even if payments have already commenced.  For example, this could include accelerating installment payments to pay a death benefit in a lump sum.  In addition, elections to receive a benefit in installments can be changed to fewer installments or a lump sum payment without creating an impermissible accelerated distribution as long as the timing rules outlined above are met.
 
Alternative Payment Times - Under the proposed regulations, a plan may provide for payments based upon the earlier of, or later of, two or more specified events or times frames.  In addition, plans may provide that a different form of payment be elected for each potential event.
 
Distributions to Specified Employees - Section 409A stated that any specified employee of a public corporation may not receive any distributions following separation from service (not counting distributions due to death, disability, a change in control or upon an unforeseeable emergency) within six months following termination.  A specified employee is defined as a key employee under Code Section 416(i), without regard to paragraph 5 thereof.  Under that section, a key employee is an officer earning more than $135,000 per year (indexed, and limited to the top 50 employees), a 5% owner, or a 1% owner with compensation greater than $150,000.
 
The proposed regulations further clarify that a specified employee for purposes of 409A is one who meets the above definition at any time during the 12-month period ending on an identification date.  The plan sponsor may establish any date as the identification date, although December 31 will be used if no date is formally designated.  The plan sponsor then has three months to determine who the specified employees were as of that date.  Beginning with the first day of the fourth month thereafter (April 1 if a December 31 identification date is used) and for the following 12-month period, those specified employees will be subject to this rule.  Who falls within the definition of specified employee will be reexamined annually using this method.  Plan sponsors could also consider delaying any payments to be made during this six-month period to all participants to ensure compliance.
 
Permissible Accelerations

  • When Plan Terms Are Linked to Qualified Plan: Under the terms of some non-qualified deferred compensation arrangements, the amount deferred under the plan is determined under the qualified employer plan formula or is determined as an amount offset by some or all of the benefits provided under the qualified employer plan.  In both instances, the proposed regulations provide that these calculations do not constitute an acceleration of a payment under the non-qualified deferred compensation arrangement even though this may result in a decrease of the amount deferred under the non-qualified deferred compensation plan.
  • Payment Upon Plan Termination: While 409A generally does not allow plan sponsors to accelerate benefit payments, the proposed regulations added some additional exceptions to those contained in Notice 2005-1.  Of particular importance is the ability to terminate a deferral arrangement without causing an impermissible acceleration.  At the plan sponsor's discretion and under the terms of the arrangement, all aggregated plans (all account balance plans or all nonaccount balance plans) may be terminated as long as no payments are made within 12 months but all payments are made within 24 months of the termination and the plan sponsor does not adopt a new arrangement that would be aggregated with the terminated plans within five years following the plan termination.  Plans may also be terminated following a change in control or following a corporation's dissolution or bankruptcy.

Clarification on Material Modifications - The proposed regulations clarify that the suspension or termination of a grandfathered plan is not considered a material modification.  Also, if a company mistakenly amends a grandfathered plan so as to create a material modification, this can be rescinded before the end of the calendar year in which the modification occurred, so long as no one took advantage of the modification.
 
Provisions for Split-Dollar Life Insurance Arrangements - While the proposed regulations do not specifically address split-dollar life insurance arrangements, these are specifically discussed in the preamble to the regulations.  In general, the preamble indicates that endorsement method split-dollar will probably be treated as deferred compensation while collateral-assignment split-dollar plans that opted to adopt loan treatment will not.
 
The Treasury Department and the IRS have requested additional comments as to the scope of changes to split-dollar arrangements that may be necessary to comply with, or avoid the application of, 409A and under what conditions those changes not be treated as a material modification for purposes of the split-dollar regulations.  Comments are due by January 6, 2006, and a hearing date on comments is scheduled on January 25, 2006.
 
Short-Term Deferrals - The proposed regulations retain the 2 1/2 month rule.  As such, amounts paid within 2 1/2 months after the end of the year in which the employee obtains a legally binding right to the compensation is not considered deferred compensation and is not subject to 409A.
 
Separation Pay Arrangements - Severance plans, referred to in the proposed regulations as separation pay arrangements to avoid confusion with other Code provisions, fall under 409A but many of these plans will be able to take advantage of one of the three exceptions:

  • The separation pay arrangement is exempt from 409A if the total of all payments to an employee does not exceed two times the employee's annual compensation (up to the 401(a)(17) limit on compensation for qualified plan purposes) for the year prior to termination and all payments are made by the end of the second calendar year following the year in which the employee terminates employment.
  • If an employee is involuntarily terminated, the arrangement can be structured to take advantage of the short-term deferral exception discussed above.
  • Reimbursement arrangements that cover amounts that are otherwise excludable from gross income are exempt from 409A, as long as all amounts reimbursed are incurred and reimbursed by the end of the second calendar year following the calendar in which the employee terminates.

Severance plans that are not exempt from 409A can still comply with 409A if separation pay becomes payable upon an involuntary termination and the parties engage in bona fide, arms length negotiations to determine the amount of pay.  In that event, the terminating employee may elect the time and form of payment at any time before the terminating employee has a legally binding right to the payment.
 
General Provisions Relating to Section 409A and the Propose Regulations
Below is additional information about numerous provisions in 409A and the proposed regulations.
Proposed and Key Effective Dates - The regulations are proposed to be generally applicable for taxable years beginning on or after January 1, 2007.  As discussed above, plan sponsors and participants may rely on these proposed regulations until the effective date of the final regulations.
 
Section 409A is effective for taxable years beginning after December 31, 2004 and for amounts deferred before that if the plan has been materially modified after October 3, 2004 or if the plan sponsor chooses to bring amounts previously deferred into compliance with 409A.
 
non-qualified Deferred Compensation Plan - After specifying a wide variety of qualified plans that do not come under the following definition, the Treasury Department and IRS define a non-qualified deferred compensation plan as being in place, if, under the terms of the plan and the relevant facts and circumstances, the participant has a legally binding right during a taxable year to compensation that has not been actually or constructively received and included in gross income, and that, pursuant to the terms of the plan, is payable to (or on behalf of) the participant in a later year. 
 
Plans Must be in Writing and Can Be Any Size - Plans must be in writing and can include one or more individuals.  The proposed regulations extended the effective date of the requirement in Notice 2005-1 that the material terms of all deferral arrangements be set forth in writing on or before December 31, 2005, to December 31, 2006. 
 
Deferral Elections -non-qualified deferred compensation plan elections must be irrevocable during the service period.  Plan elections also need to include a time and form of payment.  Evergreen elections are permitted, but must be irrevocable during the relevant service year.  Generally, elections must be made prior to the earnings period.
 
During the first year of eligibility, elections must be made within 30 days after eligibility is established.  In the first year of eligibility, any bonus deferral will be calculated as total bonus multiplied by a ratio of the number of remaining days in the performance period over the number of days in the performance period.
 
Performance-based compensation may be deferred up to six months before the end of the performance period.  Commissions are treated as providing services in the year the customer remits payment to the company.
 
Calculation of Grandfathered Amounts -For account balance plans, the proposed 409A regulations need not apply to amounts deferred and vested by December 31, 2004, unless a material modification has been made. Future earnings on the grandfathered amount will also be grandfathered.
 
For nonaccount balance plans, 409A does not apply to the present value of the benefits as of December 31, 2004, calculated as if the participant voluntarily terminated on December 31, 2004 and received the maximum value available from the plan on the earliest date allowed.  The grandfathered amount may increase in subsequent years to equal the present value of the benefit without regard to further services rendered by the participant after December 31, 2004.
 
Unforeseeable Emergencies - The proposed regulations include the 409A definition of an unforeseeable emergency and the procedure to use to claim one.  In addition, they permit cancellation of a participant's deferral election upon a payment for an unforeseeable emergency.
 
Disability - Besides incorporating the definition of disability contained in 409A, the proposed regulations permit plan sponsors to rely upon a determination of disability made by the Social Security Administration.
 
Going Forward
The Todd Organization will be reaching out to all of our clients in the near future to review plan provisions and determine the optimal strategies for making sure that your plan will continue to work effectively in light of the proposed regulations.  It is important to develop time lines to review plan provisions and implement possible changes.  Through an industry association, we will also be closely tracking public comments on these proposed regulations and seeking clarification on various provisions that may appear ambiguous or which do not take into account likely plan scenarios.
 
For additional information, please contact your Todd Executive Benefit Consultant and others on your Service Team.
 
To the best of our knowledge, this Tmail provides accurate and authoritative information in regard to the subject matter covered.  However, we provide the information with the understanding that The Todd Organization is not rendering legal, accounting or tax advice.  Individuals must rely upon their own legal, accounting and tax advisors to review specific situations.