Rules Of Conduct For The New World Of Deferred Compensation
The end of 2008 was also the end of the good faith reliance period for bringing deferred compensation plans into operational and documentary compliance with Code section 409A. It also ended the transitional guidance that permitted certain changes to existing plans without violating section 409A. This means that options are limited for correcting noncompliance, as well as for amending existing arrangements or designing new arrangements. This article offers some suggestions for operating under the new regime.
Get It In Writing
To be in documentary compliance the material terms regarding rights to deferred compensation subject to section 409A were required to be in writing by December 31, 2008. While there may be more than one document that sets forth the material terms of the plan, such as a plan document and an election form, they must be in writing and the writing must meet the terms of section 409A on its face. This also means it is important to know what documents make up the plan and what documents do not, to ensure a plan is not inadvertently amended in a manner that violates section 409A.
Many employers have individual deferred compensation agreements with individual employees. Employers should consider the administrative efficiencies that may be realized from centralizing such agreements into one plan document.
Follow Instructions
Operational compliance means following the terms of the 409A-compliant document. An operational failure occurs when the plan is operated in a manner different than set forth in its document. For example, if a plan participant elects to defer 10% of compensation but the employer defers a different amount, there is an operational failure.
To Err Is Human, To Correct Divine
As section 409A is written, even minor documentary or operational failures can cause severe adverse tax consequences to employees. Recognizing this, the IRS developed a correction program for certain unintentional and inadvertent operational failures. The gist of the program is that if a qualifying operational failure is corrected within 2 years after the year in which it occurred, the employee will escape the full tax consequences of a section 409A violation (i.e., paying income tax on the entire vested deferred compensation plus an additional 20% penalty and interest at an increased rate). In general, if a qualifying operational failure is corrected within the same tax year as it occurred, it is treated as if it had not occurred. Qualifying failures of non-insider employees can also be corrected by the end of the year after the year in which the failure occurs without incurring the 20% penalty or interest. There is a transitional rule that permits taxpayers to treat 2009 as the year after the failure for any failure occurring before 2008.
Other operational failures, including those involving amounts not exceeding the annual limit on 401(k) elective deferrals ($16,500 for 2009), can be corrected by the end of the second taxable year after the year it occurred by paying only income tax and the 20% penalty on the amount involved in the failure.
Given the consequences of missing the opportunity to correct an operational failure, employers should consider periodic operational audits of their plans to catch and correct any inadvertent and unintentional failures in a timely fashion. In addition, employers should consider hiring a third-party administrator to administer their deferred compensation programs.
It should be noted that at this time there is no correction program for a documentary failure. However, the IRS is considering adopting one and has asked for public comment on the scope of such a program.
Play It Close To The Vest
The IRS issued proposed regulations on calculating the tax and penalty when a plan fails to meet section 409A late last year. The proposed regulations apply the adverse tax consequences for a compliance failure to amounts deferred in the year in which the failure occurs and all previous taxable years; however, amounts are taxable and subject to the 20% penalty only to the extent such amounts are not subject to a substantial risk of forfeiture (i.e., vested) and have not previously been included in income (see, Section 409A Gift From The Treasury: A Second Chance to Comply Especially for Government And Exempt Employers, link right).
Therefore, if an employee's right to the deferred compensation is subject to a substantial risk of forfeiture and the plan has a documentary failure, it could still be amended to become compliant without adverse tax consequences to the employee if brought into compliance before the beginning of the year in which the employee's right vests.
Remember The New Math
Section 409A's new deferral rule makes adding new payment elections to a deferred compensation arrangement more difficult. Generally, any new form of distribution must be added at least a year before the existing distribution could be made and cannot be paid to the participant until 5 years after the previous payment election would begin. For example, if a plan provides for a lump sum payment at age 65 and the employer wishes to add the right to elect 10 installment payments beginning at age 65, in order for a participant to receive installments, he or she must elect such payment at least a year before turning 65 and could not begin receiving payments until age 70.
Likewise, section 409A's prohibition on acceleration of payment prevents a deferred compensation plan from simply being voluntarily terminated and benefits distributed. For example, if an employee has an arrangement that calls for compensation to be deferred and paid only when he or she reaches age 65 — but the employee is terminated at age 55 — the arrangement cannot simply be terminated and the employee paid due to separation from service. The plan could be terminated provided all similar arrangements of the employer that would be aggregated as a single plan under section 409A were also terminated, no benefits were paid for a year, all benefits were paid to all participants within 2 years, and the employer did not adopt a similar plan for at least 3 years.
These consequences make it imperative that deferred compensation arrangements be considered whenever an employer is contemplating terminations of affected employees such as when down-sizing or due to a reorganization.
Respect Your Grandfather
Deferred compensation arrangements in existence before 2005 are grandfathered from section 409A's requirements to the extent that the rights to the deferred compensation are vested on December 31, 2004. If an arrangement that existed on October 3, 2004 was materially modified after that date, it will become subject to section 409A. Therefore, if the arrangement does not meet the requirements of section 409A and the employer and employee wish to keep the arrangement exempt from section 409A, care must be taken to ensure that the grandfathered arrangement is not materially modified in writing or in operation.
Be Careful Out There
Section 409A has made nonqualified deferred compensation plans similar to qualified retirement plans in that if certain requirements are not met the tax advantages of deferring income are lost. Even harsher, section 409A violations result in an additional 20% penalty tax. Given the high stakes involved in the new world of deferred compensation, employers need to ensure they follow the new rules.