409A Update and Tidbits - James Bristol (Wller Lansden)
Representatives from the IRS and the Treasury Department have been
making rounds in recent weeks to talk about compliance with section
409A of the Internal Revenue Code transitional guidance. The
presentations have been conversational in tone and have included deep
drilling on technical niceties that make for dense reading. The
following notes include information provided by Treasury in May to the
AICPA National Conference on Employee Benefit Plans in Las Vegas and
the ABA Section of Taxation conference in Washington, D.C.
Who Bears The Penalty? 409A compliance rests on the
shoulders of the employer. The penalty for 409A errors falls, however,
on the employee. In many cases, there is a 20 percent additional tax on
top of immediate taxation of amounts that were intended to be deferred.
The employer gets a tax deduction (hardly a penalty). It is odd that
the penalty for noncompliance falls on those who may have no role in
achieving compliance.
Transition Election. 409A generally does not permit
acceleration of a distribution. A participant may extend the deferral
date in some circumstances. Until the end of 2008, however,
participants can change a previous distribution election. For example,
if a plan provides for ten-year installment payments at age 65, a new
election could be permitted for a lump sum payment on termination of
employment. This is known at the IRS as a “19C” election.
Dividend Equivalents on Stock Options. Generally
not allowed. Typically, these give the employee a cash payment on
option exercise. In 409A, this has the effect of lowering the exercise
price, making the option exercise price less than market value on the
grant date. It seems to make no difference if dividends are paid
periodically, upon vesting or upon exercise.
Grandfathered Deferrals. Amounts deferred before
2004 are not subject to section 409A but are grandfathered under prior
deferred compensation rules. Grandfathering is lost if there is a
material modification of the agreement. There appear to be many
opportunities to materially modify an agreement. For example, making
the transition distribution election described above is a material
modification.
Plan Documents. 409A requires a written plan
document that includes certain specified language. The plan document
need not be a single piece of paper. For example, a deferral agreement
coupled with one or more “plan” documents will be considered a single
plan and will be taken together to determine if the plan contains the
language needed for 409A compliance.
409A Correction Program. IRS Notice 2007-100
provides a limited correction program for inadvertent operational
failures. A permanent and more extensive program is possible/likely in
the near future.
Restricted Stock and 409A. Section 409A does not
apply to compensation that is taxed under section 83 of the Internal
Revenue Code. So, what happens when there is a compensation deferral
election and the form of payment is restricted stock? Answer: since the
restricted stock payment is taxed under section 83, the deferral
election to receive restricted stock is not subject to 409A. This is
also true if the employee can elect among two or more forms of payment
that are subject to section 83. There is not yet an IRS position on
whether the employee can elect to get cash or restricted stock. One
Treasury official stated that it was a close call, but that his
personal opinion was that the choice between cash and restricted stock
should not trigger 409A.
Two Years/Two Times Pay Exception. Generally,
deferred compensation payments to “key employees” cannot begin prior to
six months following separation from service. There are a few
exceptions to this rule, including a payment that is no more than two
times annual salary and paid within two years of separation.
Apparently, the IRS was focused on early retirement windows. While
acknowledging that this could be used for a payment under an individual
separation agreement, the IRS reiterated that this exception only
applies to funds that would not otherwise be payable under any other
program.
Toggling. It is okay to for distributions to be
triggered by different events, but the triggers can’t be subject to
timing manipulation. For example, it is okay for a plan to provide
payment upon the separation from service, age 65 or a change in
control—whichever comes first. Impermissible “toggling” would occur if
an employee could choose among these events. The IRS is making a point
that toggling can occur in less obvious circumstances, such as a choice
between payment at age 55 with 10 years of service or at age 65 with
five years of service.
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