Complying With Deferred Compensation Tax Rules

Thursday, September 25, 2008

Jim Murphy & Matt Renaud, General Dynamics Corporation, http://

Abstracted from: The New Deferred Compensation Rules:
An Issue-Spotter's Guide To Tax Code Section 409A
By: Jim Murphy and Matt Renaud General Dynamics Corporation, Falls Church VA (JM); Jenner & Block, Chicago IL (MR)

ACC Docket - Vol. 26, No. 6, Pgs. 48-56

Taxing deferred compensation. Section 409A of the Internal Revenue Code regulates how executives and corporations time the receipt of the employee's taxable income to affect the year in which the income is subject to tax. After years of development, the IRS's final guidance on Section 409A runs almost 400 pages. Employees whose companies do not comply with the complex requirements, warn general counsel Jim Murphy and benefits attorney Matt Renaud, face a 20% excise tax. Section 409A applies only to “nonqualified deferred compensation,” a term that includes any legally binding arrangement for compensation earned currently but payable in a later year. A legally binding right must be legally enforceable but may be subject to a vesting schedule. However, if a company always pays a bonus to employees who retired the prior year, the IRS may take the position (depending on the facts and circumstances) that the employee's right is legally binding. The statute applies to employees, directors, and independent contractors who work substantially for one employer.

How to comply.
The authors outline the rules with which a deferred compensation plan must comply. For example, the plan must be in writing and must specify that payments may be made only upon death, disability, separation, or change in control, or upon a specified date that cannot be accelerated by the employee or the company. The timing and form of payment must be set out at the time the parties enter into the arrangement, and any deferrals must be made before the year in which the compensation is earned. Assets used to fund or secure a deferred compensation arrangement cannot be held offshore. Any post-employment expense reimbursement included in the arrangement must be payable only for a specified time, and unused portions cannot roll over to future years. For key employees, Section 409A payments that are attributable to separation from service may not be paid for at least six months after separation. Separation is determined based on the facts and circumstances and is usually considered the time when the employee no longer provides any services to the company. Aggregate similar arrangements, so any substitution of benefits will be subject to the same payment terms and timing as the original benefit.

Basic exemptions.
Deferred compensation plans are exempt from the Section 409A requirements, note the authors, if they are grandfathered, tax-favored, or covered by a regulatory exemption. A compensation arrangement is grandfathered if it was entered into on or before October 3, 2004, and was earned and vested by the last day of that year. A grandfathered benefit will lose protection if it is modified in a material way. Benefits that receive favorable tax treatment and paid time off­such as qualified retirement plans, retiree medical plans, medical and dependent care spending accounts, and vacation or sick leave and pay­also are exempt from the Section 409A rules. A short-term exemption exists for compensation that is paid within two-and-a-half months of the end of the year in which it is no longer subject to risk of forfeiture (usually March 15th of the year following vesting), if the arrangement does not allow deferral.

Other exemptions.
The authors review several other available exemptions from compliance with Section 409A. The so-called 2X/2Y exemption allows severance that is the lesser of two times the individual's compensation or two times an amount set out in the Code (currently 2 times $225,000) if the severance is paid by the end of the second tax year after the employee's service ends. A portion of a severance payment might meet the 2X/2Y requirements, and that portion would be exempt from the Section 409A rules. This exemption applies to involuntary terminations or terminations for good reason as well as to certain arrangements in the case of voluntary terminations. However, practitioners should pay particular attention to severance arrangements for voluntary terminations because they may allow the employee to manipulate the year in which income is taxed. A de minimis exemption covers payments that are less than the prior year's 401(k) contribution limit. Expense reimbursements after employment has ended are exempt if incurred by the end of the second taxable year after the year when employment ceased. Any post-employment expense reimbursements or benefits that are not taxable to the employer are also exempt.

Abstracted from ACC Docket
published by Association of Corporate Counsel
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