Client Bulletin #371 - For PDF version of this Client Bulletin, click here.
The Internal Revenue Service ("IRS") and the Department of the Treasury have issued the long-awaited final regulations implementing the restrictions and penalties under Section 409A of the Internal Revenue Code ("Code") on certain nonqualified deferred compensation arrangements ("NDCAs"). These regulations were released on April 10, 2007, and will be effective on January 1, 2008.
Prior to Section 409A's effective date of January 1, 2005, NDCAs were subject to very few rules. As long as the arrangement was not taxable under the constructive receipt rules (or in the case of tax-exempt and governmental employers, under the forced accrual provisions of Code Section 457), almost anything was permissible. A typical NDCA would cover senior managers or executives, and could involve arrangements such as deferred compensation provisions in an employment contract, severance packages, supplemental executive retirement plans, excess benefit plans, or nonqualified stock options. It was typical that the participant and the employer would negotiate specific terms in the NDCA that gave the participant great flexibility over the form and timing of payment of the benefits.
With the advent of Section 409A, however, significant limitations have been imposed on NDCAs. There is much less flexibility regarding elections by participants as to the time or form of payment, and payments themselves can only be triggered by certain events specified in the statute. Certain funding arrangements designed to protect a participant's benefit in the event the employer experiences financial difficulty are now prohibited, and it is generally impermissible for a participant and the employer to negotiate an accelerated payout of the benefit.
Failure of a NDCA to meet the requirements of Section 409A will result in substantial adverse tax consequences to the participant. All amounts that have been deferred under the noncompliant NDCA (and possibly under all other similar arrangements covering the participant) become immediately taxable, deemed interest is added to the amount of the tax, and the participant must also pay a nondeductible 20% penalty tax on the amount of the deferrals included in income. This is a draconian result, and one that must be avoided.
Since January 1, 2005, NDCAs have been required to operate in "good faith" compliance with Section 409A, but were not required to be amended to formally comply with Section 409A. The IRS previously set the amendment deadline to be December 31, 2007, anticipating that the final regulations would be out in time for NDCAs to be conformed to those regulations. With the issuance of the regulations this week, it is extremely unlikely that the December 31, 2007 amendment deadline will be pushed back. Further, the automatic "good faith" reliance that NDCAs currently have if they are operated in accordance with either previous IRS administrative guidance on Section 409A, or with the proposed Section 409A regulations that were issued in October, 2005, will come to an end on December 31, 2007. After that date, NDCAs will be required to conform with the new regulations in both form and operation.
The final Section 409A regulations are quite lengthy (almost 400 pages) and extremely complex. While they generally follow the proposed regulations, there are numerous differences between the earlier guidance and the final regulations. It is critical that employers begin now to identify all NDCAs that are subject to Section 409A, and to review those arrangements to determine what amendments must be made to them before the December 31, 2007 deadline.
Constangy, Brooks & Smith, LLC will be preparing a summary of the final regulations, and will provide additional information on the significant differences between the regulations and the prior guidance. In the meantime, if you have any questions regarding compliance with Section 409A, please contact Dana Thrasher (205-226-5464), Dave Pearson (813-222-1367), Rebecca Amthor (205-226-5460) or Bob Ellerbrock (205-226-5462).
Constangy, Brooks & Smith, LLC has counseled employers, exclusively, on labor and employment law matters since 1946. The firm represents Fortune 500 corporations and small companies across the country. More than 100 lawyers work with clients to provide cost-effective legal services and sound preventive advice to enhance the employer-employee relationship. Offices are located in Georgia, South Carolina, North Carolina, Tennessee, Florida, Alabama, Virginia, Missouri, and Texas. For more information about the firm's labor and employment services, visit www.constangy.com, or call toll free at 866-843-9555