409A: are your deferred compensation plans in compliance?

(And Watch Out for Those Stock Options!)

For those of you who only read the first paragraph of these types of articles, here are your takeaway items: All of your company's deferred compensation plans must be reviewed to ensure that they are in compliance with Section 409A of the Internal Revenue Code of 1986, as amended (the "Code"). Documentary compliance must be completed no later than December 31, 2007. If your company's plans run afoul of 409A, your employees will not only be taxed currently on what they thought was deferred income, but they will also be subject to an additional 20% penalty tax. In essence, your employees will be subject to a tax rate of up to 55% on income they have not yet received, Oh, and by the way, stock options can be considered deferred compensation plans. (Perhaps you want to read on.)

Code Section 409A was added by the American Jobs Creation Act of 2004. Prior to its enactment, the law concerning deferred compensation plans was largely embodied in case law, revenue rulings and private letter rulings. Congress believed that companies were improperly using these informal rules to defer income and provide too much flexibility as to when the deferred raceme could be received. It therefore adopted a set of specific requirements to permit deferral and imposed a draconian 20% penalty tax on the employee to secure performance. Unfortunately, the new rules raised so many unanswered questions that it took until April 10th of this year for the IRS to issue an almost 400 page regulation project to provide guidance to taxpayers. Although it took the IRS two and a half years to formulate the rules, taxpayers must have all of their documentation in compliance with these rules in less than seven months. Note also that, although document compliance is required by year-end, plans need to have been operated in accordance with Code Section 409A since January 1,2005.

The starting point of the analysis is the determination of whether you have a "deferred compensation plan." This term is defined very broadly, but is subject to certain significant exceptions.

A deferred compensation plan means any agreement, method, program or other arrangement that, under its terms and the relevant facts and circumstances, gives a service provider a legally binding right to compensation during one taxable year that is or may be payable in a later taxable year. This definition, of course, covers what most businesses consider deferred compensation plans, such as plans whereby the employee can elect to have a portion of his or her salary or bonus deferred to a later year and he or she receives a greater amount than the original deferred amount in that later taxable year because the company provides "interest" or "invests" the amount in stocks for the participant.

What is not generally known is that this definition also includes many arrangements that one does not intuitively think of as a deferral of income. For instance, the regulations treat any stock option granted to a service provider with an exercise price that is less than the fair market value of the underlying stock on the date of grant as a deferred compensation plan subject to the provisions of Code Section 409A. Certain modifications to stock options that were originally granted at fair market value but have appreciated at the tinge the modification is made may also cause a previously exempt stock option to become a deferred compensation plan. Similarly, negotiated severance and other separation pay plans, if they are not limited solely to payments upon involuntary separation from service, can also be considered deferred compensation plans. Now the good news is that certain short-term deferrals are not subject to Code Section 409A. Short-term deferrals are generally deferrals to no later than the 15th day of the third month after the end of the later of the employee's or the employer's taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture.

Assuming you have a deferred compensation plan, how can you prevent your employees from being subject to current taxation and the penalty tax? By following certain specific rules and pay-out dates Generally, pay-out can only occur upon separation from service, death, retirement, disability, a specifically defined "change in control," a date certain or a specifically defined "unforeseen financial emergency." Remember that "in-the-money" stock option that is considered a deferred compensation plan? If you limit exercise to a date certain, it will still be a deferred compensation plan but it will be in compliance with Code Section 409A. Of course, no one writes stock options in this manner--but don't tell the IRS.

This is only the tip of the iceberg. There are all sorts of complex rules dealing with the timing of deferral elections, the deferral of performance based compensation, how new plans and new participants are treated, and permissible distribution methods (and when changes to such methods can be made). Also, there are rules as to how trusts established to "secure" the participants' benefits must be drafted. Finally, there are rules regarding how deferred compensation must be reported on an employee's Form W-2 or a non-employee's Form 1099-MISC.

The most important point is, every company must (i) determine what plans it has and (ii) get those plans into compliance by year-end. The time for action has come. And your employees will thank you for it. (Alternatively, imagine their reaction when they are audited and told they are subject to tax and a penalty tax because the company did nothing to protect them against it....)

Mike Fernhoff is a partner in the Los Angeles office of Kaye Scholer LLP, where he chairs the Los Angeles Tax Practice Group. Mr. Fernhoff has substantial experience in all aspects of federal income tax planning for companies and their employees, including the planning and structuring of executive compensation arrangements, and can be reached at 310.788.1374 or [e-mail]