On October 22, 2004, President Bush signed into law the American Jobs Creation Act that introduced Section 409A of the Internal Revenue Code. Section 409A brought about sweeping changes to the tax treatment of nonqualified deferred compensation (“Deferred Compensation”). The enactment of Section 409A was in large part a visceral reaction by Congress to the actions of corporate executives at Enron who accelerated their own Deferred Compensation benefits while leaving a majority of its employees with worthless securities in their 401k plans. While well intentioned, the impact of Section 409A and the proposed treasury regulations have left many closely held companies struggling to understand and apply these new rules.
Section 409A generally prohibits Deferred Compensation plans from accelerating distributions and restricts distributions to be no earlier than: separation from service; death; disability; a specified time; change in control; and unforeseeable emergency. Section 409A also provides for strict timing requirements for initial and subsequent deferral elections.
For tax years beginning on or after January 1, 2005, unless the Deferred Compensation complies with 409A , is excluded or exempt, all amounts deferred are includible in gross income of the employee to the extent not subject to a substantial risk of forfeiture and not previously included in his or her gross income. If the requirements are not satisfied, in addition to income inclusion, the employee is charged with interest at the underpayment rate plus 1% and an additional 20% penalty.
Section 409A specifically exempts qualified plans, tax-deferred annuities, 457(b) plans, SEPs, SIMPLEs, and qualified governmental excess benefit arrangements under Section 415(m). Bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plans are exempt under the statute as well.
Deferred Compensation can generally be grouped into two categories. The first is compensation arrangements that are in the form of stock or securities of the employer. The second is compensation in the form of incentive bonuses.
With respect to the first category, stock rights, options and phantom stock arrangements must now conform to Section 409A, unless otherwise excluded. For example, non statutory stock options (“NSO”) may be excluded from the rules of Section 409A if: (i) the exercise price of the option equals or exceeds the fair market value of the stock on the date the option is granted; and (ii) the option otherwise is subject to taxation under Section 83 (which provides the basic tax rules for NSOs).
A stock appreciation right (“SAR”) must also conform to Section 409A. However, a SAR may be excluded from 409A if the SAR provides for (i) the payment of an amount based on the appreciation in the value of the stock over an amount not less than the fair market value on the date of the grant; (ii) a fixed number of shares are issued before the grant date; and (iii) no there is no further deferral feature. The IRS has recently issued guidance stating that a good faith attempt is all that is needed to set a fair market value exercise price for an option or a SAR granted before January 1, 2005. However, until various valuation techniques are challenged by the IRS and reviewed by the courts, it may be prudent to use an existing valuation technique already accepted by the IRS.
The second category of Deferred Compensation – not related to stock of the employer - are incentive or performance based bonuses. Annual bonus arrangements and severance payments are subject to Section 409A rules to the extent that the payments are deferred beyond 2½ months from the date they are earned. Until further guidance is provided, deferral of greater than 2½ months - unless subject to a substantial risk of forfeiture – must conform to the Section 409A rules discussed above.
The adverse income tax consequences of Section 409A should not cause owners of closely held companies to abandon their Deferred Compensation plans. Deferred Compensation is still among the best methods from both a tax and economic perspective to incentivize key employees. Moreover, there are efficient ways to structure Deferred Compensation to avoid adverse tax consequences to key employees. If it is determined that an existing Deferred Compensation plan or employment contract triggers Section 409A, then it may be necessary to revise those agreements. Fortunately, there are transition rules that permit employers to modify existing agreements through December 31, 2006, which is an avenue of relief to adjust a Deferred Compensation plan.
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