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Section 409A
IRC Section 409A
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What is IRC Section 409A?

Enacted by the American Jobs Creation Act on October 22, 2004, IRC Section 409A sets forth new guidelines for “nonqualified deferred compensation plans”. Along with the new statutory requirements and restrictions, the section also imposes severe penalties for violations.

Section 409A is very broad and covers far more than traditional nonqualified deferred compensation plans. The statute defines a nonqualified deferred compensation plan as, “any arrangement that provides for the deferral of compensation, unless it is otherwise excepted”. This definition can often encompass individual agreements and benefit arrangements that are not intended to be nonqualified plans. Consequently, it is important to understand what section 409A covers, as well as the statutory requirements and restrictions.


What types of deferred compensation arrangements are subject to Section 409A?

Section 409A essentially defines a "nonqualified deferred compensation plan" as any plan that provides for the deferral of compensation that is not a qualified plan or exempted as a welfare benefit. This broad definition includes, but is not limited to the following plan arrangements:

      • Supplemental executive retirement plans (SERPs, SCPs)
      • Supplemental deferral or “excess” benefit plans
      • Elective and non-elective salary or bonus deferral plans
      • Phantom stock plans
      • Discounted stock options (options issued at less than FMV)
      • Discounted SARS (exercise price is less than FMV on date of grant)
      • Certain severance arrangements
      • Employment agreements that provide change of control benefits or other future payments
      • Other compensation that an individual earns in one year, but receives in a future tax year


What types of deferred compensation is exempt or “excepted” from Section 409A?

The following benefits generally do not meet the definition of nonqualified deferred compensation, and are not subject to the requirements of Section 409A:

      • Qualified employer plans, such as 401(k)
      • Welfare benefits (e.g. sick leave, vacation, disability pay, and medical benefits)
      • Bonus plans paid within 2 ˝ months following the end of the year in which the participant is vested.
      • Statutory stock options
      • Restricted stock


When did the Section 409A rules take effect?

IRC Section 409A technically became effective January 1, 2005; however, due to the delayed release of the final regulations, the complexity of the new statute, and the significant changes required for new and existing plan agreements, transition relief has been extended for several years. Prior to the issuance of the final regulations, taxpayers had been required to operate in good faith compliance with the statute and the proposed regulations that were issued in late-2004.

The final regulations were issued in April 2007 and were to take effect on January 1, 2008; however, due to the sheer volume of plan documents requiring modification, the IRS later extended its compliance deadline to December 31, 2008. As of January 1, 2009, all nonqualified deferred compensation arrangements should be in full operational and documentary compliance with Section 409A.


What are the key provisions and/or changes relating to Section 409A?

1) Limited Distributions. Distribution of deferred compensation is restricted to the following events:

      • Separation from service
      • Disability
      • Death
      • Specified date or fixed schedule specified under the plan
      • Change of Control
      • Unforeseeable emergency

2) No acceleration of benefits. The following transactions are prohibited.

      • No haircuts (i.e. no reduced benefits in exchange for an earlier payout)
      • No accelerations of benefits due to plan termination 
      • No changing to an earlier distribution date
      • No changing from an installment to a lump sum payment structure

3) Deferral elections must be made no later than the close of the preceding calendar year.

4) Limits the ability for participants to further defer payments.


Does Section 409A apply to all nonqualified deferred compensation plans?

No. Section 409A includes grandfather rules and transition provisions that exempt certain amounts deferred on or before December 31, 2004. In general, deferrals and earnings earned and vested prior to January 1, 2005 are exempt from section 409A, provided the following conditions are met:

      • The participant had a legally binding right to the deferral amounts as of December 31, 2004;
      • The amounts were not subject to a “substantial risk of forfeiture”, as defined in section 83; and
      • The plan had not been “materially modified” after October 3, 2004.

Although pre-2005 deferrals and the earnings with respect to the pre-2005 deferrals are generally exempt (grandfathered), the deferral amounts remain subject to the “constructive receipt” and “economic benefit” doctrines.
 

Does Section 409A apply to all amounts deferred under a deferred compensation plan?

No. In general, Section 409A applies to: (i) deferred compensation that was earned or became vested on or after that date; (ii) amounts deferred before January 1, 2005, if “materially modified” after October 3, 2004; and (iii) plans established after October 3, 2004 that constitute a “material modification.”

In general, a “material modification” is a change that enhances or adds an existing benefit or right, and such material enhancement or addition affects amounts earned or vested prior to January 1, 2005.

Does Section 409A only apply to employee-employer benefit arrangements?

No. Section 409A applies to benefit arrangements with any individual that provide services to the employer; or “service providers”. The definition of a “service provider” includes arrangements with directors, consultants, independent contractors, and other non-employees.
 

Who is affected by Section 409A?

Both the service recipient (the employer or plan sponsor), and the service provider (the employee or plan participant are affected by Section 409A; however, compliance with the statute is ultimately the participant’s responsibility. In the event of a violation or administrative error, the participant bears the expense of the failure, regardless of who is at fault. The participant is responsible for the payment of back taxes, as well as any penalties and interest that may due on an erroneous deferral or distribution.

What if an unscheduled deferral or early distribution occurred in error?

For administrative mistakes, such as unscheduled deferrals or early distributions from a nonqualified plan, the IRS offers a correction program for inadvertent and unintentional operational errors.

For errors are identified and corrected in the same tax year, there is generally no accelerated taxation or penalty provided that the employee repays the erroneous amount and the employer takes “reasonable steps” to avoid repeating the failure. For errors identified and corrected in a subsequent year, the mistake is generally taxable under Section 409A; however, the taxable amount is limited to the amount of the failure rather than all deferrals under the plan. The amount is also subject to the 20% penalty, but not the enhanced interest rate.

It is important to note that the correction program under Notice 2008-113 is only for operational failures. It does not provide relief for plan terms and provisions that fail to meet the requirements of Section 409A.


Are there special reporting or disclosure requirements for Section 409A?

Yes. The IRS set forth new reporting requirements enabling agents to track nonqualified deferred compensation. Employers are required to report nonqualified deferrals and taxable distributions under Section 409A on Federal Form W-2 or Form 1099 (for non-employees). Deferrals, plus earnings attributed to those deferrals are identified by entering code Y in box 12 of Form W-2, or box 15a of Form 1099-MISC. Taxable distributions (i.e. amounts from a plan that does not comply with Section 409A) are identified by entering code Z in box 12 of Form W-2 or box 15a of Form 1099-MISC. Retiree payments from a plan that complies with Section 409A are not coded.

Note: The IRS suspended certain reporting/coding requirements during 2005, 2006, 2007 and 2008 due to unclear reporting and computation provisions. The reporting of nonqualified deferrals effectively commenced on January 1, 2009. Reporting and wage withholding requirements for taxable distributions commenced on January 1, 2007.


What is the penalty for a Section 409A violation?

Failing to satisfy to the strict requirements of Section 409A is severe. The smallest violation can result in immediate taxation of all vested amounts under the plan and similar plans, plus an additional 20% penalty on the amount includible in income, and interest at the IRS underpayment rate plus 1%. For the interest component, interest is applied to the tax year in which the amounts were deferred, or if later, the year in which the amounts became vested.

Note: The income tax, penalty and interest are imposed on the individual participant, not the employer.
 
 

What if we didn’t know about Section 409A and didn’t update our plans by the deadline?

 

In January 2010, the IRS granted welcomed relief to taxpayers with documentary failures. Previous correction programs were offered for operational errors; however, plan documents errors were never covered.  The newest correction program enables employers and participants to fix plan provisions that were not in compliance by the December 31, 2008 deadline.  The correction program is subject to limitation; however, it is the first and probably the last opportunity to update plan documents without incurring significant penalties.