Coping With the Strict New Rules on Non-Qualified Deferred Compensation
Author: Scott A. Dondershine, attorney
New Section 409A and the accompanying Prop. Regs. substantially tighten the tax rules governing non-qualified deferred compensation. Failure to comply with these rules can cause immediate taxation of the amount deferred, plus interest and penalties.
The American Jobs Creation Act of 2004 1 contained a startling new provision that has turned the world of non-qualified deferred compensation planning upside down. The newly-enacted provision, codified in IRC Section 409A, has caused practitioners to rethink their understanding of the rules of constructive receipt. Proposed Regulations 2 were issued on 9/29/05, allowing for a more in-depth analysis of the changes.
This article examines the impact of Section 409A on some of the more popular non-qualified deferred compensation plans adopted by closely held, for-profit companies for the benefit of cash-basis workers. Unaddressed here are some of the exceptions and nuances applicable to publicly held companies and plans of non-profit companies.
Constructive receipt. Compensation not subject to Section 409A generally is taxed under the rules of “constructive receipt.” 3 An amount is generally considered constructively received during the tax year in which a payment is credited to a worker’s account, set aside for him, or otherwise made available to him.
New rules – Basic tests
Section 409A shifts the focus on the timing of taxation from an inquiry into “constructive receipt” toward a study of certain mechanical and design features of a plan. In order to avoid the immediate inclusion of deferred compensation in gross income, a plan must now comply with the (1) distribution, (2) acceleration of benefits, and (3) election tests.
Distribution test. The distribution test is met if the plan does not allow the payment of deferred compensation earlier than (1) the date of the participant’s separation from service, (2) death or disability, (3) a specified time (or pursuant to a fixed schedule) specified in the plan, (4) a change in the ownership or effective control of a corporation or in the ownership of a substantial portion of the corporation’s assets, or (5) the occurrence of an unforeseeable emergency. 4
Acceleration of benefits test. The acceleration of benefits test is met if the plan does not permit the acceleration of the time or schedule of any payment under the plan. 5 Accelerating benefits does not fail the test under certain circumstances specified in the Regulations, such as if needed to meet specific obligations including paying certain taxes and complying with a domestic relations order. 6
Election test. A plan providing for deferred compensation must meet certain requirements regarding the ability of a participant to “elect” the deferral of compensation. 7 In broad generalities (because the Regulations provide for a number of different nuances), compensation for services performed during a taxable year may be deferred by the worker’s election only if the election is made by the close of the worker’s preceding tax year. 8 For instance, Energetic Corporation has a plan pursuant to which Joe Elector, an employee of the corporation, may elect to defer a percentage of his salary. Joe must elect to defer a percentage of salary otherwise due for services in 2008 no later than 12/31/07.
In the case of performance-based compensation based on a performance period of at least 12 months, a worker may make the election no later than six months before the end of the performance period. 9 A plan may also permit subsequent elections to delay or change the form of payments in certain circumstances.
Failure to comply with tests. If one of the above tests is not met, any amount that would otherwise have been deferred is included in the affected worker’s gross income immediately unless the amount is subject to a “substantial risk of forfeiture.” The tax on the included compensation is increased by interest on the portion of the compensation that was deferred in prior years. An additional income tax of 20% of the compensation is also assessed, effectively acting as a penalty. 10 A worker’s rights to compensation are subject to a substantial risk of forfeiture and thus not currently taxed if his rights are conditioned on the future performance of substantial services. 11
Application of new rules to specific types of plans
The new rules apply to any plan (even if for just one person) that provides for the deferral of compensation except any “qualified employer plan” or bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan. 12 Examples of common plans that may be subject to the new rules include non-statutory stock option plans, stock appreciation right plans, phantom stock plans, and certain compensation arrangements deferring the payment of compensation. The following discussion addresses each of these types of plans.
Stock option plans. Stock options generally come in two types – options that comply with Section 422, known as incentive stock options (“ISOs”) and options that do not comply with Section 422, known as non-statutory stock options (“NSOs”).
ISOs are not subject to Section 409A 13 and instead continue to receive tax treatment that generally is favorable to employees and unfavorable to employers. 14 NSOs generally are covered under the new rules unless (1) the exercise/strike price may never be less than the fair market value (“FMV”) of the underlying stock on the date of grant and the number of shares subject to the option is fixed on the date of grant, (2) the option is taxed under the Section 83 rules described below, and (3) the option does not provide for any additional deferral of income. 15
NSOs based on preferred stock or stock that is subject to a mandatory repurchase obligation or put/call rights at a price other than FMV are also subject to the Section 409A rules. 16 This means that practitioners should review shareholder agreements to determine whether the obligations trigger a problem with Section 409A, even if the options exercised to acquire the underlying stock would otherwise be exempt from Section 409A.
In the case of NSOs not subject to Section 409A, taxation occurs pursuant to Section 83 – i.e., the difference between the exercise price and the FMV of an underlying share on the date of exercise will be taxed on the exercise date. 17 For instance, assume that on 1/1/07, Betty receives an option to acquire ten shares of stock for $1 each, which she can exercise if she continues to be employed by XYZ Company through 12/31/08. If Betty exercises the option on 1/1/09 when the FMV of a share is $11, she would recognize $100 (($11 – $1) × 10) of ordinary income.
If an NSO is subject to Section 409A, taxation would occur sooner – presumably (there is not a lot of guidance on this point) on the date of vesting, even if the option is not exercised at that time. For instance, if the exercise price of the option granted to Betty in the above example is $.01 per share and on the date of grant XYZ Company shares were valued at $1 per share, then the option would be subject to Section 409A. If the shares are worth $1.01 per share on the date of vesting, Betty would recognize $10 of ordinary income (($1.01 less $.01) × 10) on 12/31/08 even if she did not exercise the option at that time. Needless to say, Betty would be disappointed with such result and, therefore, it is vital to structure NSOs to avoid the application of Section 409A.
The most difficult of the three tests to pass to avoid Section 409A is setting the exercise price at or above the FMV of an underlying share on the date of grant. Although the Proposed Regulations provided some guidance on how one must establish FMV, 18 recently-issued IRS Notice 2006-4 19 made the rules more favorable. Pursuant to the Notice, for stock rights subject to Section 409A and issued before 1/1/05, an issuer merely has to have made a good-faith attempt to set the option price at or more than FMV. For stock rights issued on or after 1/1/05, any reasonable valuation method may be used to establish FMV. While an appraisal may not necessarily be required, an issuer should discuss the applicable valuation factors with an expert in order to implement a reasonable method and comply with the rules. The final Regulations, when issued, should provide additional guidance.
Stock appreciation rights. Generally, stock appreciation rights (“SARs”) provide workers with the right to share in the appreciation in the value of stock of a business (between the date of grant and the date of exercise of such right), without owning actual stock. For instance, suppose that a share of stock in Growth Corp. rises from an FMV of $1 on 1/1/08 (date of grant) to an FMV of $11 on 12/31/09 (the date the right is exercised). In this situation, Penny Wise, an employee of the corporation, would receive (after paying the exercise price of $1) a cash payment of $100 if she owned ten SARs ($11 – $1 × 10), with the right to receive appreciation that occurred during 2008 and 2009.
Penny would be able to defer recognition of the $100 until receipt if the SAR is not subject to Section 409A. A SAR is not subject to Section 409A if (1) the compensation payable under the right is not greater than the difference between the FMV of the stock on the date of grant and the FMV on the date the right is exercised, (2) the SAR exercise price may not be less than the FMV of the underlying stock on the date the right is granted, and (3) the SAR does not include any additional feature for the deferral of income. 20
Phantom stock plans. Phantom stock plans are similar to SARs but may have features that provide for greater value than the mere appreciation provided by a SAR. For instance, it is possible to structure the benefit to equal the entire value of an underlying share of stock. A worker’s phantom stock account can also be credited with the amount of distributions that would have been received had the worker owned real stock.
Phantom stock plans are generally subject to the rules of Section 409A unless structured carefully to comply with the distribution, acceleration of benefits, and election tests described earlier. Deferral elections are also possible under the rules discussed above.
If the rules of Section 409A are successfully navigated, taxation generally occurs upon payment of cash to a worker. If the rules of Section 409A are not successfully navigated, the amount deferred under the plan presumably would be taxed on vesting.
Other deferred compensation arrangements. One tool in the arsenal of an employer seeking to motivate/reward employees for performance but yet require future services is deferring payment of bonuses until vesting at a later point. For instance, in response to good work, calendar year-end Generous Corp. agrees on 11/1/08 to provide Johnny Joe with $1,000. Generous Corp. then puts the $1,000 into a “rabbi trust,” ensuring that Johnny will receive the payment (subject to the claims of Generous Corp.’s creditors). The corporation distributes the $1,000 from the trust to Johnny on 3/1/10.
Under the rules of constructive receipt without taking Section 409A into account, Johnny Joe generally would not be taxed on the $1,000 until receipt of that amount in 2010, because the $1,000 is subject to the claims of Generous Corp.’s creditors (even though it is placed in a rabbi trust). 21 Section 409A applies to a plan that (except if a valid deferral election is made by the worker) pays compensation after the later of (1) 2-1/2 months following the worker’s first taxable year in which the amount is no longer subject to forfeiture, or (2) 2-1/2 months following the end of the company’s first taxable year in which the amount is no longer subject to forfeiture. Therefore, under Section 409A, the compensation would have to be paid on or before 3/15/09, unless a valid deferral election is made. 22
Timing of new rules. In general, the new section applies to amounts that are “deferred” in taxable years beginning after 12/31/04, and to amounts “deferred” in taxable years beginning before 1/1/05 if the deferral plan is materially modified after 10/3/04. 23 An amount is considered “deferred” before 1/1/05 if before such date: (1) the employee had a legally binding right to be paid the amount deferred and (2) the right to the amount was earned and vested. For example, Unlucky Lou would suddenly have to be concerned about the rules with respect to any “discounted” NSO (regardless of when issued), which he did not have a vested right to exercise as of 1/1/05.
Going forward. Fortunately, many plans can be structured or amended to avoid application of the new rules. The new law provides that existing plans must be operated in good faith compliance with the new rules starting from 1/1/05 through 12/31/06, and must be amended prior to the end of 2006 in order to comply with the rules and to preserve any intended deferral. 24 We strongly recommend that, if a client has any plan providing for a deferral of income (including the plans discussed in this article), the client contact his professional advisor to determine if revision is needed.
Section 409A may well prove to be a key landmark in the development of deferred compensation tax laws. The laws now move away from a “constructive receipt” analysis and toward a study of mechanical tests relating to the circumstances in which benefits are (1) distributed, (2) accelerated, or (3) extended through elections. Failure to comply with the Section 409A rules can cause immediate taxation of the amount of deferred compensation, plus interest and penalties. Practitioners must be aware of Section 409A and its application to a variety of compensation schemes. Existing plans should be reviewed for compliance and revised if necessary.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, any U.S. federal tax information in this article is not intended, or written to be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code, or (2) promoting, marketing or recommending to another party any transaction or matter contained in this article.
Section 409A shifts the focus on the timing of taxation from an inquiry into ‘constructive receipt’ toward a study of certain mechanical and design features of a plan.
1 Pub. L. No. 108-357 (10/22/04).
2 REG-158080-04, 70 Fed. Reg. 57930-57984 (10/4/05).
3 Section 451.
4 Section 409A(a)(2).
5 Section 409A(a)(3) .
6 Prop. Reg. 1.409A-3(h).
7 Section 409A(a)(4).
8 Prop. Reg. 1.409A-2(a)(2).
9 Prop. Reg. 1.409A-2(a)(7).
10 Section 409A(a)(1).
11 Section 409A(d)(4).
12 Section 409A(d)(1).
13 Prop. Reg. 1.409A-1(b)(5)(ii).
14 See Section 421.
15 Prop. Reg. 1.409A-1(b)(5)(i)(A).
16 Prop. Reg. 1.409A-1(b)(5)(iii)(A).
17 Reg. 1.83-7.
18 Prop. Reg. 1.409A-1(b)(5)(iv).
19 2006-3 IRB 307.
20 Prop. Reg. 1.409A-1(b)(5)(i)(B).
21 Reg. 1.83-3(e).
22 Prop. Reg. 1.409A-1(b)(4)(i).
23 Prop. Reg. 1.409A-6(a).
24 Section XI.B of the Preamble to the Proposed Regulations.
© Copyright 2006 RIA. All rights reserved.
SCOTT A. DONDERSHINE is an attorney and CPA who practices business, tax and estate planning law with the firm of David, Brody & Dondershine LLP in Reston , Virginia . Mr. Dondershine has previously written extensively on business and tax law issues, and he can be reached at (703) 264-2220 and [email protected]
This Article appears in the June 2006 issue of Estate Planning. 33 Estate Planning 31, June 2006.