Secction 409A of the Internal Revenue Code was added by the American Jobs Creation Act of 2004.1 On April 17, 2007,2 the Internal Revenue Service issued final regulations—nearly 400 pages in length—which took effect Jan. 1, 2008.3 Together, IRC Section 409A and the final regulations provide a comprehensive set of rules regulating the taxation of nonqualified deferred compensation (NDC). Since its enactment, Section 409A compliance has become a fundamental checklist issue for employee benefits lawyers who design NDC arrangements on behalf of service recipient organizations. Such arrangements must be carefully drafted to comply with Section 409A’s requirements and faithfully operated in accordance therewith. Estate planners don’t need to be experts in Section 409A, but they do need to be aware of and identify Section 409A issues when advising executives and professionals who participate in NDC arrangements, so that they can assist their clients in avoiding punitive taxation.4
Section 409A and the corresponding regulations apply to supplemental executive deferred compensation plans, as well as many other arrangements that provide for the deferral of compensation. Such arrangements generally cover employees, but may also cover independent contractors who aren’t in the business of providing services to unrelated service recipients (and similar personal service entities). They may provide or be based on equity positions in the service recipient organization, and they may be free-standing plans or features of employment agreements, severance pay agreements or business sale agreements. Moreover, service recipients may be almost any type of business, professional service organization, charity or other organization.
If you identify a possible deferral of compensation in an arrangement, there are, fortunately, several important exemptions to Section 409A’s requirements, including:
• traditional qualified deferred compensation arrangements (for example, IRC Section 401(a) qualified pension and profit-sharing plans and IRC Section 403(b) tax-deferred annuities);
• stock options with exercise prices equaling or exceeding fair market value (FMV) on the issue date (known as “non-discounted stock options”);
• broad-based foreign retirement plans similar to U.S. qualified plans based on foreign source income;
• U.S. Social Security and similar foreign social insurance programs;
• deferrals to early in the following year, based on the organization’s typical payment schedule; and
• Welfare benefit plans, such as those providing solely death or involuntary severance pay benefits.
Under temporary guidance issued prior to the final regulations, there’s also an exemption for partnership compensatory arrangements, for which the underlying compensation will be treated as guaranteed payments when paid to partners or former partners. The IRS hasn’t explicitly indicated that the partnership-guaranteed payments exemption is a long-term feature of the Section 409A scheme, but there’s been no indication to the contrary. Removing that exemption would necessitate close coordination of Section 409A and partnership taxation—a task we believe would be inordinately complex.
While service recipient organizations (whose advisors typically design the deferred compensation arrangements) usually wish to assure advantageous tax treatment for participating individuals, those organizations are impacted only indirectly by their wage withholding and compensation reporting responsibilities and/or having unhappy service providers.
When Section 409A applies to a deferred compensation arrangement and its requirements haven’t been met, amounts otherwise deferred under the arrangement are subject to gross income inclusion for the service provider on the date when the deferred compensation vests, which, typically, is the date when a service provider is no longer required to perform substantial additional services to be entitled to the benefits. In addition to gross income inclusion, the amounts deferred are subject to a 20 percent penalty tax, as well as interest from the original date of deferral. This punitive taxation, when applicable, would directly impact high income executives or professionals, many of whom would be clients of estate planners and advisors. Because Section 409A’s direct negative consequences apply only to the service provider individuals for whom Section 409A requirements aren’t met, advisors to such individuals need to be alert.
Section 409A’s general punitive taxation doesn’t apply if a deferred compensation arrangement (as applied to a particular individual) satisfies the requirements pertaining to each of five features of the arrangement:
(1) advance deferral elections;
(2) definite payment schedules;
(3) minimum deferrals for “specified employees”;
(4) limits on acceleration or additional deferral of payments; and
(5) prohibition on offshore funding.
Each of these sets of requirements is complex. Indeed, they comprise much of the almost 400 pages of the Section 409A final regulations. Nevertheless, a few observations may help advisors spot arrangements that deserve more complete review:
(1) Advance deferral elections—In general, to meet Section 409A requirements, deferrals must be made and be irrevocable on or before certain dates. For arrangements based on individual service provider elections, deferral elections generally must be made before the service provider’s taxable year in which the applicable services are performed. However, certain later elections are permitted: (a) for forfeitable deferrals, (b) in the first year the provider is eligible under the arrangement, (c) for certain short-term deferrals, and (d) for arrangements that operate on a fiscal year different from the provider’s taxable year.
Deferrals that aren’t made at the service provider’s election must be made before the service provider has a legally binding right to the compensation or, if later, the date that would have applied if the service provider had an election right.
(2) Definite payment schedules—A Section 409A-compliant arrangement will specify when, to whom and how payments will be made. Specifying dates for such payments is the most obvious definite payment schedule. However, schedules of payments on the occurrence of specific events also are permissible if specified in the governing documents, including:
• to beneficiaries after the service provider’s death;
• on the service provider’s total and permanent disability;
• on the change of control of the service recipient; and
• following the occurrence of an unforeseeable
(3) Minimum deferrals for “specified employees”—“Specified employees,” that is, certain key employees of publicly traded corporations, generally, may not be entitled to distributions until the employees have been separated from service for at least six months.
(4) Change in payment schedules—A Section 409A-compliant arrangement generally won’t allow changes to a previously established payment schedule. However, certain changes are permitted, including:
• The service provider may change beneficiaries, despite the effect that such change may have on life expectancy payments after the service provider’s death.
• Payments may be made to individuals other than service providers to comply with state domestic relations orders.
• Accelerated payments may be made to eliminate service providers’ ties to service recipients if they’re necessary to comply with state or federal ethics or conflicts-of-interest rules.
• Payments may be deferred for not less than five years beyond the original payment date if the new deferral election is made at least one year before the original payment date.
(5) Offshore funding—Section 409A taxes generally apply if assets to fund the deferred payment obligation are moved into a foreign trust or other offshore funding mechanism. Exceptions apply if the service providers are non-resident aliens who perform their services outside the United States.
As noted above, Section 409A concerns can arise when attorneys or others who aren’t necessarily versed in the nuances of avoiding Section 409A punitive taxation, draft or otherwise work on employment, severance or business sale agreements. For example, we’ve encountered a business sale contract that included an agreement to pay significant amounts of money to the owner of a selling entity over a period of several years in exchange for the owner’s provision of transition consulting services to the buyer. Because the transition period extended significantly beyond the consulting period and because the service provider wouldn’t then be in the business of providing similar services to other organizations, the service payments constituted deferred compensation subject to Section 409A taxation. The threat of Section 409A punitive taxation emerged as a result of the service provider’s desire to accelerate the service payments in the event of certain adverse circumstances pertaining to the buyer’s finances. The acceleration provision didn’t comply with Section 409A. Thus, to assure compliance, the parties had to negotiate a somewhat faster definite payment schedule that didn’t include the offending acceleration provision.
Recent Court Decision
On Feb. 27, 2013, the U.S. Court of Federal Claims in Sutardja v. United States5 affirmed the IRS’ position that Section 409A applies to discounted stock options (stock options granted with a per share exercise price that’s less than the FMV of the underlying stock on the date of grant) because such options constitute the “deferral of compensation.” In so affirming, the court held that the grant of a nonqualified stock option, although not itself a taxable event, is the grant of compensation to which the recipient has a legally binding right on exercise (for non-discounted stock options) or, importantly, vesting (for discounted stock options).
The court found that a genuine issue of material fact existed as to whether the stock option granted to plaintiff Sehat Sutardja was in fact discounted—a question to be addressed at a future trial. However, resolution of that factual question didn’t preclude resolution of the issues espoused by the IRS and Sutardja. Among those legal issues was Sutardja’s contention that, even if the option was discounted, any deferral of compensation would be exempted under Section 409A’s short-term deferral exemption because he exercised the option prior to the end of a two-and-a-half-month short-term deferral period. The court rejected this argument, noting that to satisfy the exemption, the stock option plan must not permit the exercise of a vested stock option after the short-term deferral period. It was insufficient that a particular option holder actually exercised his option within the short-term deferral period when the plan permitted a later exercise.
Sutardja illustrates the importance of well-documented FMV determinations to assure compliance with the non-discounted stock option exemption. To avoid inadvertently granting stock options at a discount and, by extension, the tax consequences of Section 409A, service recipient organizations should take care to: (1) enlist the services of a qualified appraiser before granting stock options, (2) provide that appraiser with all relevant data that will enable the appraiser to assess the underlying stock’s FMV, and (3) have a knowledgeable third party review the appraiser’s assessment for reasonableness. Further, the service provider’s advisors may wish to double check that those compliance measures are taken.
• On Jan. 11, 2010, the U.S. Tax Court filed T.C. Summary Opinion 2010-1,6 which addressed the tax consequences of events that occurred in the 2005 taxable year. In that year, Howard Slater, the sole owner and representative of a registered broker-dealer, entered into an agreement with an insurance company, which provided that the commissions he earned as a broker-dealer would be deposited into his annuity accounts. The contracts outlining the details of the arrangement included a surrender charge provision in the event that Slater withdrew amounts from his annuity accounts. The court’s analysis treats Section 409A as a provision that provides an opportunity for deferral of income, rather than as a provision that imposes punitive taxation on certain income that would otherwise be deferred. Based on that erroneous application of Section 409A, the court found that the surrender charges didn’t make the commissions subject to a substantial risk of forfeiture for purposes of Section 409A, nor did the record establish that the petitioner’s commission was conditioned on some future performance or occurrence. Thus, the court held that the commissions earned in 2005 were included in Slater’s gross income. The court didn’t discuss Section 409A’s
20 percent additional tax or interest.
• The IRS issued Revenue Ruling 2010-27, which provides guidance, in the form of examples, on what constitutes an unforeseeable emergency distribution for “eligible deferred compensation plans” under IRC Section 457(b). The principles set forth in that ruling apply to amounts deferred under NDC plans subject to Section 409A, which may be paid under the terms of the plan on the occurrence of an event constituting an unforeseeable emergency.
• The IRS issued companion Rev. Ruls. 2009-31 and 2009-32, which provide guidance on the tax consequences of amending a tax-qualified retirement plan to permit annual contributions of employees’ unused paid time off to the plan and post-retirement payment of such amounts. Under the facts presented in each ruling, the IRS concluded that the amendment of the retirement plan and the operation of the plan in accordance with the terms of the amendment didn’t cause the plan to fail to qualify as a bona fide sick and vacation leave plan for the purposes of the corresponding Section 409A exemption.
Other Tax Rules
Section 409A requirements are imposed along with existing deferred compensation rules, including:
• Possible earlier inclusion of deferred compensation in gross income based on the service provider having constructive receipt and/or an economic benefit.
• If the service recipient is a tax-exempt organization, there’s service provider gross income inclusion when benefits become non-forfeitable, even without constructive receipt or an economic benefit.
• Payments following the death of the service provider will be income in respect of a decedent; that is, the legatees or beneficiaries receiving the payments, generally, will include the deferred compensation in their gross income in the same manner as the service provider would have.
Section 409A, the final regulations and subsequent IRS and judicial guidance establish complex and detailed rules that must be followed to avoid punitive tax treatment of many arrangements that have the effect of deferring receipt of compensation for both employees and independent contractor service providers. Knowing those rules and properly designing arrangements to comply with them is primarily the responsibility of employee benefits attorneys advising employers and other service recipient organizations. However, advisors to executives and other service providers should be able to spot arrangements that need a second expert review, because it’s their clients who will be directly subject to the punitive taxes. In the end, if you have any questions, call an expert. The stakes are too high to do otherwise.
1. P.L. 108-357, enacted Oct. 22, 2004.
2. Final Treasury Regulations Sections 1.409A-1 through -6 to accompany Internal Revenue Code Section 409A were issued on April 17, 2007; there were 397 pages, including the preamble, in the version the authors printed.
3. Under the enacting statute, Section 409A is effective for amounts deferred after Dec. 31, 2004. The preamble to the final regulations states that the regulations apply to taxable years beginning on or after Jan. 1, 2008.
4. A “Section 409A Alert” by Thomas C. Foster was published in the September 2007 issue of Trusts & Estates. This article covers the material in the 2007 article and addresses subsequent developments.
5. Sutardja v. United States, No. 11-724T (Fed. Cl. Feb. 27, 2013).
6. Slater v. Commissioner, T.C. Summ. Op. 2010-1 (Jan. 11, 2010).