By Marc Stockwell.
Overview and Possible Plan Sponsor Action Steps
On June 21, 2016, the Internal Revenue Service (IRS) issued proposed regulations prescribing rules under Section 409A of the Internal Revenue Code (“Code”) that provide certain clarifications and modifications to the Section 409A final regulations and the proposed Section 409A income inclusion regulations. These proposed regulations are not intended to propose a general revision of the final regulations or the proposed income inclusion regulations.
Plan sponsors will want to act now, ahead of the publication of the proposed regulations as final regulations, to have their trusted advisors review existing plans and arrangements, which are or could be subject to Section 409A, in order to determine if their provisions present any compliance issues as to the proposed regulations. In addition, plan sponsors will want to decide if they will continue to rely on the current regulations or comply with the proposed regulations going forward. Sponsors should assess if any plan amendments are necessary or advisable, while ensuring that no changes are made to nonqualified plans that enjoy grandfathered status unless they are intended.
The proposed regulations discussed herein were accompanied by proposed regulations under Section 457 and, as discussed herein, the proposed regulations clarify and coordinate the provisions of Section 457 and Section 409A where appropriate. This summary recaps the Section 409A proposed regulations only, except where specific references are made to Section 457. A more detailed discussion of the proposed regulations under Section 457 is provided in a separate article.
Deferral of Compensation
Section 457(f) and Section 457A Plans
The Section 409A proposed regulations clarify that the rules under Section 409A apply to nonqualified deferred compensation plans separately and in addition to the rules under Section 457(f) (plans of tax exempt organizations which rely on a substantial risk of forfeiture to defer the compensation) and 457A (plans of certain nonqualified foreign entities). This is a technical but important clarifying change regarding the application of Section 409A to Section 457 plans.
Short-Term Deferral Rule
The current final Section 409A regulations provide rules that exclude from application of Section 409A payments made during a short-term deferral period, defined as the period beginning on the first day of the first month and ending on the 15th day of the third month following the end of the employer’s or employee’s tax year (whichever is later) (“Short-Term Deferral Period”). This has been a very helpful exclusion for many compensation plans. A payment that would otherwise be made within the Short-Term Deferral Period, but is delayed, may still qualify as a short-term deferral, and not subject to Section 409A, if it is established that:
- It was administratively impracticable for the employer to make the payment by the end of the Short-Term Deferral Period;
- Making a payment within the Short-Term Deferral Period would jeopardize the employer’s ability to continue as a going concern; or
- The employer reasonably anticipates that it will not be able to deduct the payment under the compensation deduction limits of Section 162(m).
The proposed regulations supplement these exceptions. Payments that would otherwise qualify as short-term deferrals but that are made outside the Short-Term Deferral Period are also not subject to Section 409A if the employer reasonably anticipates that making the payment during that period would violate federal securities or other applicable law and the payment is made as soon as reasonably practicable following the date the payment would not cause such a violation.
- Reduction in payments of service recipient stock rights due to bad behavior
Current regulations provide an exclusion from the application of Section 409A for certain stock options and stock appreciation rights granted with respect to “service recipient stock” (referred to in this article as (“employer stock”), which is generally common stock of a corporation the stock price of which is determined using a measure that is considered fair market value, if the stock is subject to a mandatory repurchase obligation or a permanent put or call right.
Employers that grant stock rights to employees as part of their compensation packages could not always take advantage of that exclusion. In order to discourage employees from engaging in “bad behavior” toward the employer, employers commonly reduced the amount that an employee would receive under a stock rights arrangement if the employee is dismissed for cause or violates a noncompetition or nondisclosure agreement. This type of reduction is generally barred by the final regulations, but it has been observed that such a reduction should not be prohibited given the statutory language and underlying policies of Section 409A.
The proposed regulations clarify that a stock price will not be treated as based on a measure other than fair market value, if the amount payable on an employee’s involuntary separation from service for cause or violation of a condition within the employee’s control (whether or not the condition is specified at the time the stock right is granted) is determined using a measure that is less than fair market value. Practically, this permits employers to reduce the amount an employee will receive under a stock right if the employee gets fired for cause or breaches a restrictive covenant obligation.
- Granting service recipient stock prior to actual employment
Current regulations define the term “eligible issuer of service recipient stock” (referred to in this article as “eligible issuer of employer stock”) to mean the corporation or other entity for which the employee provides direct services on the date of grant of the stock right and certain affiliated corporations or entities. It has been observed that this definition prevents employers from agreeing to grant stock rights to employees during employment negotiations, before the employees are actually employed and the stock right granted.
The proposed regulations provide that a corporation or other entity will be an eligible issuer of employer stock, if it can reasonably anticipate that an employee will begin providing services within 12 months after the date of the stock right grant, and the person actually does or, the stock right is forfeited if services do not begin within that period.
Separation pay plans – application to employees terminated in year of hire
Pursuant to the final regulations, separation pay plans that provide for payment only upon an involuntary separation from service or pursuant to a window program are excluded from application of Section 409A to the extent that they meet certain requirements. One of those requirements is that separation pay generally cannot exceed two times the lesser of:
- The employee’s annualized compensation based upon the annual rate of pay for the employee’s taxable year preceding the taxable year in which the separation from service occurs, or
- The limit under Section 401(a) (17) ($265,000 for 2016) for the year in which the employee separates from service.
The proposed regulations clarify that the separation pay plan exception is also available for employees whose employment begins and ends in the same taxable year. The employee’s annualized compensation for the taxable year in which the employee separates from service may be used for purposes of this exception provided that the employee had no compensation from the employer in the taxable year preceding the year in which the separation from service occurs.
Employment-related legal fees and expenses
Current regulations provide that an arrangement does not provide for a deferral of compensation (and is excluded from application of Section 409A) to the extent that it provides for amounts to be paid as settlements or awards resolving bona fide legal claims under circumstances enumerated in the regulations (e.g., wrongful termination or employment discrimination). The application of Section 409A to common provisions in employment agreements that provide for the reimbursement of attorneys’ fees in connection with employment-related disputes has never been clear. Current regulations do not provide clear rationale to distinguish between arrangements that provide for payment of reasonable attorneys’ fees and the legal claim expenses currently listed in the final regulations. The proposed regulations clarify that an arrangement is excluded from the application of Section 409A to the extent that it provides for the payment or reimbursement of an employee’s reasonable attorneys’ fees and other expenses if they are incurred to enforce a claim by the employee against the employer.
Recurring part-year compensation (e.g., teacher pay)
The final regulations appear to provide the potential for the application of Section 409A to employees who receive recurring part year compensation, such as teachers who may earn compensation over a 9 month period but choose to receive the compensation over a 12 month period. The proposed regulations offer a solution and provide that a plan or arrangement under which an employee receives recurring part-year compensation does not provide for the deferral of compensation, and is excluded from the application of Section 409A, if the plan does not defer payment of any of the recurring part-year compensation to a date beyond the last day of the 13th month following the first day of the service period for which the recurring part-year compensation is paid. In addition, the amount of the employee’s recurring part-year compensation must not exceed the annual compensation limit under Section 401(a) (17) ($265,000 for 2016) for the calendar year in which the service period commences. A conforming change is being made for purposes of Section 457(f) under concurrently proposed Section 457 regulations to protect teachers who work for tax exempt or governmental schools.
Separation from Service Definition
Asset purchase transaction
Final regulations permitted the parties to an asset sale agreement to determine if an employee for the seller of the assets would be treated as having experienced a “separation from service” when the employee was hired by the buyer of the assets as a result of the sale. The proposed regulations specify that a stock purchase transaction that is treated as a deemed asset sale under Section 338 of the Code is not a sale or other disposition of assets for purposes Section 409A. The proposed regulations observe that it would be inconsistent with Section 409A to allow deemed asset sale parties to treat employees as having separated from service as a result of the deemed asset sale.
Employee and independent contractor dual status and change in status from employee to independent contractor (or vice versa)
The proposed regulations clarify that a service provider, who performs services as an employee, and who becomes an independent contractor for the same employer, will have a separation from service only if, at that time, it is reasonably expected that the level of future services as an independent contractor will not exceed 20 percent of the average level of services performed as an employee over the immediately preceding 36-month period. If the level of services is expected to exceed 20%, the employee will have a separation from service in the future when a separation from service as an independent contractor occurs, i.e., upon the expiration of the contract (or, if applicable, all contracts) under which services are performed for the employer as long as the expiration is a good-faith and complete termination of the contractual relationship.
When a Payment is Made
A deferral of compensation does not occur for purposes of Section 409A if the employee actually or constructively receives a payment that is not a “deferred payment” on or before the 15th day of the third month following the end of the employee’s or the employer’s first taxable year (whichever is later) in which the right to the payment is no longer subject to a substantial risk of forfeiture (the “Short-Term Deferral Period”). A “deferred payment” is a payment that is or may be made outside the Short-Term Deferral Period. A payment is treated as actually or constructively received if the payment is includible in income, including under the economic benefit doctrine under Sections 83, 402(b) or 457(f).
The proposed regulations establish a general rule for when a payment is deemed to be made; that is, a payment is made when any taxable benefit is actually or constructively received. The proposed regulations go on to provide that the term “payment” includes the transfer of cash, any event that results in the inclusion of an amount in income under the economic benefit doctrine under Section 83, 402(b) or 457(f) (1) (A), and the transfer, cancellation or reduction of an amount of deferred compensation in exchange for benefits under a welfare plan, a non-taxable fringe benefit or any other nontaxable benefit. However, the occurrence of any of the following is not considered a payment:
- A grant of an option that does not have a readily ascertainable fair market value;
- A transfer of property that is substantially non-vested with respect to which the employee does not make a valid Section 83(b) election; or
- A contribution to a trust under Section 402(b) or a transfer or creation of a beneficial interest in such trust unless and until such amount is includible in income under Section 402(b).
The proposed regulations additionally clarify the coordination of Section’s 409A and 457’s income inclusion rules.
Current regulations provided that following a death, a plan must make payments by December 31 of the year in which the payment would otherwise be scheduled, or, if later, by the 15th day of the third month following the plan’s payment date. Reflecting far more flexibility, the proposed regulations provide that an amount payable following the death of an employee (or following the death of a beneficiary who became entitled to payment due to the death) is treated as timely paid if it is paid at any time during the period beginning on the date of death and ending on December 31 of the first calendar year following the calendar year during which the death occurs. A plan is not required to specify any particular date within this period as the payment date. In fact, the plan will fall within this rule even if it provides that an amount will be paid: (1) at some time during this period, (2) upon the employee’s death, without defining the period for payment following death in any other manner, or (3) on a date within this period determined in the discretion of the beneficiary.
Certain transaction-based compensation
Under the final regulations, transaction-based compensation payments are payments related to certain types of changes in control. The payments occur because an employer buys its stock or the employer or a third party buys stock rights from an employee. In addition, transaction-based payments are payments calculated by reference to the stock value of the employer stock. The final regulations also provide that if transaction-based compensation is paid on the same terms and according to the same time schedule applicable to payment to shareholders generally in connection with a change in control, the transaction-based compensation may be treated as a Section 409A-compliant. Additionally, if it is paid not later than five years after the change in control event, transaction-based compensation meeting the foregoing requirements will not fail to meet the requirements of the Section 409A’s initial or subsequent deferral election rules.
The proposed regulations clarify that the special payment rules, described above, for transaction-based compensation will also apply to a statutory stock option or a stock right that did not otherwise provide for deferred compensation before the purchase or agreement to purchase the stock right. Therefore, the purchase (or agreement to purchase) such a statutory stock option or stock right, in a manner consistent with the special payment rules, will not result in the statutory stock option or stock right being treated as providing for the deferral of compensation from the original grant date.
Prohibition on Acceleration of Payments
Payments to beneficiaries upon death, disability, or unforeseeable emergency
The final regulations provide that a prohibited acceleration of a payment does not result from adding death, disability, or unforeseeable emergency as a potentially earlier payment event for an amount already deferred. This exception, under the final regulations, applies only with respect to an employee’s (as opposed to a beneficiary’s) death, disability, or unforeseeable emergency. Under the proposed regulations, this exception will also apply to the payment of deferred amounts on account of the death, disability, or unforeseeable emergency of a beneficiary. These proposed regulations also clarify that a schedule of payments (including payments treated as a single payment) that has already commenced prior to an employee’s or a beneficiary’s death, disability, or unforeseeable emergency may be accelerated upon those events.
Compliance with Bona Fide Foreign Ethics or Conflicts of Interest Laws
Under the final regulations, to the extent reasonably necessary to avoid the violation of a Federal, state, local, or foreign ethics or conflicts of interest law, a plan may provide for acceleration of the time or schedule of a payment. However, this exception applies only to foreign earned income from sources within the foreign country with respect to a foreign ethics or conflicts of interest laws.
The proposed regulations, acknowledging that the requirements of foreign ethics or conflicts of interests law may affect payment of both foreign and United States earned income, permit the acceleration of any nonqualified deferred compensation if reasonably necessary to comply with a foreign ethics or conflicts of interest law.
Plan Terminations and Liquidations
Under the final regulations, to terminate a plan under Section 409A and accelerate payment of compensation deferred thereunder, the employer must terminate and liquidate all of its plans that, under Section 409A aggregation rules, would be aggregated with the terminated plan, if the same employee had deferrals of compensation under all such plans. In addition, for the three years subsequent to the plan termination, the employer was not permitted to establish a new plan that would have been aggregated with the terminated plan under the aggregation rules. The IRS interpreted the “same employee” requirement to be the “same hypothetical employee,” and rejected attempts to interpret the requirement otherwise.
The proposed regulations clarify that the acceleration of payments at plan termination is permitted only if the employer terminates and liquidates all plans of the same category (Section 409A regulations list nine categories) that the employer sponsors, and not only the plans of the same category in which a certain employee actually participates. In addition, for a period of three years following the termination and liquidation of a plan, the employer cannot adopt a new plan of the same category as the terminated and liquidated plan, regardless of which employees will participate in the plan.
Offset provisions to comply with Federal laws regarding debt collection
The proposed regulations create an exception to the prohibited acceleration of deferred compensation payments to allow offsets, to the extent reasonably necessary, of deferred compensation in the settlement of debt pursuant to Federal debt collection laws.
Amount Includible in Income under Section 409A
Under proposed regulations issued in December 2008, if a deferred compensation plan fails to meet the requirements of Section 409A at any time during the taxable year, the amount includible in income is comprised of all amounts deferred or paid during the year, less any amounts subject to a substantial risk of forfeiture. This has been interpreted to permit otherwise impermissible changes (time or form of payment) to amounts subject to a substantial risk of forfeiture.
The proposed regulations add an anti-abuse provision to this rule. Basically, if the facts and circumstances reveal a pattern or practice of permitting impermissible changes, such amounts may be considered as vested for the taxable year (potentially resulting in income inclusion immediately). The proposed regulations provide examples of the facts and circumstances that would be considered a pattern and practice of allowing impermissible changes to the form or timing of payment of unvested deferred amounts, including: (1) whether similar failures are numerous or appear intentional, (2) whether similar failures occur more often for unvested amounts rather than vested amounts in new plans, and (3) whether reasonable actions have been taken to identify and promptly correct similar failures. Additionally, the proposed regulations provide that failures in connection with unvested deferred amounts must be corrected under applicable IRS guidance regarding correction of the particular type of plan failure, without taking into consideration guidance unrelated to the failure such as requirements as to eligibility, income inclusion, premium interest, additional taxes and information reporting.
Individual and Entity Service Providers
The proposed regulations clarify various provisions of the final regulations to recognize that a service provider can be an individual as well as an entity, including a corporation, partnership, personal service corporation, qualified personal service corporation and a non-corporate entity that would be a personal service corporation or a qualified personal service corporation if it were a corporation.
Proposed Applicability Dates
General applicability date for amendments to Section 409A final regulations
The proposed regulations, which amend the final regulations, are intended to be applicable on or after the date on which they are published as final regulations. For periods before this date, the current final regulations and other applicable guidance apply, without taking into consideration the proposed regulations, keeping in mind that certain clarifications, such as plan termination rules, are not considered to be substantive revisions and are already effective. However, taxpayers may rely on the proposed regulations before they are published as final regulations.
General applicability date for amendments to Section 409A proposed income inclusion regulations
The proposed income inclusion regulations are intended to be applicable on or after the date on which they are published as final regulations. Until further administrative guidance is issued, taxpayers may rely on the 2008 proposed income inclusion regulations, as modified by the 2016 proposed regulations, in order to calculate the amount includible in income under Section 409A, including the identification and treatment of deferred amounts subject to a substantial risk of forfeiture, and to calculate additional taxes under Section 409A(a)(1).
Special applicability dates for amendments to recurring part-year compensation rules
The proposed rules regarding recurring part-year compensation are intended to be applicable on and after the date on which these proposed regulations are published as final regulations. However, for the taxable year in which the proposed regulations are published as final regulations and all prior taxable years, taxpayers may rely on either the proposed regulation rules or the rules in Notice 2008-62 relating to recurring part-year compensation.Findley Post, Human Capital