Proposed Regulations on Deferred Compensation Under Section 409A

by Norman J. Misher, David E. Kahen
Published: December 09, 2005
Source: R&H Letter to Clients and Friends

Proposed Regulations on Deferred Compensation Under Section 409A The IRS recently issued proposed regulations regarding deferred compensation under section 409A. These proposed regulations and related preamble (covering 238 pages) expand upon guidance issued at the end of 2004 in IRS Notice 2005-1. We highlighted the provisions and requirements of this new legislation, which was added by the American Jobs Creation Act of 2004 (the "2004 Act"), in an article we distributed in November, 2004, entitled “A Revolution in the World of Deferred Compensation,” which you may find on our Website,, under the subject Executive Compensation. As described more fully in that article, the essential thrust of section 409A is to require all nonqualified deferred compensation arrangements to be in writing, and to meet highly specific requirements relating to the timing of deferral elections and the timing and manner of distributions. The scope of this new provision is extremely broad, and includes various types of compensatory arrangements, including "plain vanilla" stock options, stock appreciation rights, and bonus and severance arrangements, which have not historically been viewed as deferred compensation. If an arrangement is subject to section 409A and fails to comply with the requirements of that section, the employee will be subject to several onerous provisions, including: (i) inclusion of the deferred compensation in income in the year in which the requirements were violated, (ii) an interest charge based on a deemed underpayment of tax from the time of the deferral, and (iii) an additional tax equal to 20% of the compensation required to be included in income. The regulations are scheduled to become effective for taxable years beginning on or after January 1, 2007, and, until the regulations are finalized, taxpayers may rely upon the proposed regulations and Notice 2005-1. The primary purpose of this letter is to alert you to certain effective dates and transitional rule provisions under which action may be required by December 31, 2005, or, in some cases, during 2006. 1. In general, the new rules apply to amounts deferred after December 31, 2004. They also apply, in general, to a deferral arrangement that was in existence on October 3, 2004, if the arrangement is materially modified after that date. The Notice and the proposed regulations provide guidance as to when an amount is considered to have been deferred under these rules and when an arrangement is considered to have been "materially modified" in a manner that will cause the new rules to apply to a pre-2005 deferral. Thus, these rules will need to be analyzed in any situation where consideration is being given to changing or modifying a pre-2005 arrangement. 2. Notice 2005-1 provided that, in general, an arrangement adopted before December 31, 2005, would not be treated as violating section 409A if the arrangement was operated in "good faith compliance" with section 409A during 2005 and the arrangement was amended to comply with the requirements of section 409A by the end of 2005. This transitional relief has been extended for an additional year, to December 31, 2006. Similarly, Notice 2005-1 permitted employers to allow employees to make new payment elections with respect to amounts previously deferred on or before December 31, 2005, without being considered to have violated the section 409A rules; that right has been extended as well (subject to certain limitations) so as to end on December 31, 2006. 3. Notice 2005-1 also provided that participants in a deferred compensation arrangement could be given the right to terminate their participation, or to cancel a deferral election previously made under the arrangement, on or before December 31, 2005, provided that (i) the amendment was adopted and made effective on or before that date and (ii) the amounts subject to termination or cancellation would be includible in each affected participant's income in calendar year 2005 or, if later, the year in which such amounts became earned and vested. This transitional relief has not been extended. Accordingly, an employer that does not want to amend a pre-existing arrangement subject to section 409A so as to comply with the new requirements, and prefers instead to accelerate all distributions under this special transitional rule (and trigger in 2005 the related income taxes imposed on the employees, but without any interest, addition to tax or other penalty), must act before the end of this year. The new rules substantially limit, after 2005, the flexibility employers have traditionally had to terminate such arrangements. 4. A "short-term deferral," pursuant to which compensation is paid no later than 2-1/2 months after the end of the taxable year in which the employee is first entitled to such compensation is not a deferral of compensation subject to the requirements of section 409A. Thus, for example, amounts earned in 2005 that are paid by March 15, 2006, will not, in general, be subject to the new rules. Many employers are revising their historical incentive compensation arrangements to come within this exception for short-term deferrals and thereby avoid the complexities and uncertainties associated with the application of section 409A. 5. With respect to deferrals of compensation that do not come within the short-term deferral exception and that are subject to the new rules, section 409A requires that most elections to defer compensation expected to be earned in 2006, including elections to defer bonus or incentive compensation that does not meet the specified requirements for "performance-based" compensation, be made by December 31, 2005. Elections to defer calendar 2006 compensation that is "performance-based" will generally have to be made by June 30, 2006. 6. Notice 2005-1 provided initial guidance regarding reporting by employers on Forms W-2 and 1099 of amounts includible in income by reason of section 409A and of all deferrals under nonqualified plans as required by the 2004 Act. In Notice 2005-94 (released December 8, 2005), the IRS announced that those reporting requirements were being suspended for information returns required to be filed by employers for calendar year 2005. However, employees remain required to file tax returns and pay any tax due with respect to amounts includible in income for 2005 by reason of section 409A. Notice 2005-94 also states that future published guidance may require employers to file corrected information returns for 2005 that report any previously unreported amounts that are includible in income under section 409A. If you have any questions regarding section 409A and its application to nonqualified deferred compensation arrangements, please contact Norman J. Misher at (212) 903-8733, David E. Kahen at (212) 903-8763, Allen J. Erreich at (212) 903-8769, or any of our other attorneys.