2016-Issue 23 – In 2004, Congress enacted Section 409A of the Internal Revenue Code, which places strict requirements on nonqualified deferred compensation plans. Since that time, the IRS has issued numerous pieces of guidance. Most recently, on June 22, 2016, the IRS issued new proposed revisions to the final regulations under Section 409A. This edition of Tax Advisor Weekly will summarize some of the changes.
- Under the final 409A regulations, a payment is deemed made on a specified date or event, even if it is delayed for one of several reasons. One permissible reason is a delay that is required in order to comply with federal securities laws and regulations or other applicable law. A similar exception, however, was not provided for “short-term deferrals” — payments that are made within a short period following the end of the taxpayer’s taxable year. The proposed regulations will allow delay of short-term deferrals in order to comply with federal securities regulations without causing the payment to cease to qualify as a short-term deferral, therefore maintaining the exemption of such payments from 409A under those circumstances.
- The final regulations provide exemptions for certain stock-based awards (i.e., options, stock appreciation rights, etc.), provided certain requirements are met, if the stock underlying such awards qualifies as “service recipient stock.” The definition of service recipient stock was previously limited to entities for which a service provider is providing services (or upstream entities). Recognizing that in many cases, executives will be given “inducement grants” to accept a position before they actually commence employment, the proposed regulations provide that service recipient stock includes stock of any entity (or parent entities) even if the recipient of such awards is not currently employed, provided the service provider actually commences employment within 12 months of the date of grant.
- The final regulations under Section 409A provide an exception for certain separation pay, provided that the pay satisfies certain requirements and does not exceed a multiple of annualized pay earned in the calendar year preceding the year of termination. For employees who were terminated in the same year as they were hired and received severance, the exception under the final regulations could not apply, because such employees would have had no earnings in the year preceding the year of termination. To resolve this issue, the proposed regulations will now allow the exception to be applied based on annualized pay earned in the year of termination, in circumstances where the terminated employee had no earnings in the immediately preceding calendar year.
- The final regulations provided for an exception for reimbursement of certain legal fees, provided that the fees were payable to an employee in connection with certain specified labor-related actions (i.e., wrongful termination, employment discrimination, FLSA or workers’ compensation proceedings). The exception did not apply where an employee had a right to reimbursement of legal expenses for other types of claims. The proposed regulations resolve this issue by expanding the exception to apply to any reimbursement of legal fees and expenses incurred to enforce a claim by the service provider against the service recipient relating to the service relationship, without regard to the type of claim.
- Under the final regulations, when a service recipient entered into an asset transaction, the service recipient could elect whether to treat employees affected by the asset sale as “separated from service” for purposes of 409A, thereby allowing distributions from the plan. The proposed regulations clarify that certain transactions that qualify as “deemed” asset sales under Section 338 of the Internal Revenue Code do not qualify for this relief. Thus, in such transactions, the service provider may not elect whether or not to treat employees affected by such a transaction as separated from service.
- The final regulations provide that a “separation from service” occurs, with respect to employees, when the level of services is expected to drop below 20 percent of the average level of services over the preceding three years. On the other hand, independent contractors are deemed to have separated from service when the contractual relationship has ended and it is reasonably expected that the contractor will provide no additional services to the service recipient. Under the final regulations, practitioners have struggled with these rules when an employee transitions from employee to independent contractor status — which is quite common in situations where an executive terminates employment but continues to provide services as a consultant to the service recipient. The proposed regulations clarify that where an employee becomes an independent contractor (and services are expected to exceed the 20 percent threshold), any separation from service after such time will be determined based on the rules applicable to independent contractors. Thus, an employee who becomes an independent contractor, but who does not experience a separation from service, will not subsequently experience a separation from service until the contractual relationship terminates and it is reasonably expected that he or she will provide no additional services to the service recipient (and not when the level of services provided as a contractor drops below 20 percent of the level of services provided as an employee).
- Under the final regulations, payments may generally be made upon a service provider’s death, even if such payment results in an acceleration of payment or a change in the form of payment. No similar provision was included in the regulations for beneficiaries of a participant. The proposed regulations clarify that the provisions relating to payments made upon death of a service provider apply equally to beneficiaries of a service provider. In addition, 409A will also allow payments to beneficiaries upon their disability or in the event of an unforeseeable emergency. Previously, these provisions were only explicitly applicable to service providers.
- The final regulations provide that in the event of bankruptcy, a service recipient may terminate a deferred compensation plan, provided that all plans of the same type are terminated at the same time. Previously, it was unclear whether this rule was applied on a participant-by-participant basis (i.e., a plan could be terminated if all plans of the same type in which there were common participants were terminated) or if it would be applied employer-wide. The proposed regulations clarify that this rule would be applied on an employer-wide basis. Thus, if a service recipient maintains multiple plans of the same type that cover different unique employee populations, all such plans must be terminated if the service provider wishes to use the bankruptcy rule to terminate one or more such plans — even though no employee participates in more than one such plan of the service provider.
- Under the final regulations, nonqualified deferred compensation could be subject to a limited offset ($5,000) for amounts owed by the employee to the service recipient, without such offset being considered an impermissible acceleration of payment. The proposed regulations expand this rule to permit offset, without regard to the amount of such offset, where the offset is reasonably determined to be necessary to comply with federal laws regarding debt collection.
- Finally, the proposed regulations clarify that, in addition to the requirements existing under Section 457 of the Internal Revenue Code, the requirements of Section 409A will also apply to noncompliant plans maintained by nonprofit and governmental entities that are subject to Section 457(f) of the Code.
Alvarez & Marsal Taxand Says:
Although Section 409A of the Internal Revenue Code was passed almost 12 years ago, the law and regulations surrounding the statute continue to evolve. Please contact your A&M professional if you have any questions regarding the design or administration of your nonqualified deferred compensation plan, as violation of the applicable laws and/or regulations can lead to significant unanticipated tax liabilities.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisers. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisers before determining if any information contained herein remains applicable to their facts and circumstances.
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