Sec. 409A: where do taxpayers stand?

One of the more burdensome aspects of the American Jobs Creation Act of 2004 (AJCA) is Sec. 409A, which deals with taxation of nonqualified deferred compensation (NQDC) and is rather restrictive in its timing of taxation of such plans. Simply put, it requires including any NQDC in a recipient's income, unless it is subject to a substantial risk of forfeiture. The law was imposed due to recent abuses by top employees of various companies. Accordingly, the AJCA House Report (H Rep't No. 108-548 (Part 1), 108th Cong., 2d Sess. (2004)) noted:

The Committee is aware of the popular use of deferred compensation arrangements by executives to defer current taxation of substantial amounts of income. The Committee believes that many nonqualified deferred compensation arrangements have developed which allow improper deferral of income. Executives often use arrangements that allow deferral of income, but also provide security of future payment and control over amounts deferred. For example, nonqualified deferred compensation arrangements often contain provisions that allow participants to receive distributions upon request, subject to forfeiture of a minimal amount (i.e., a "haircut" provision).

Purpose

Before Sec. 409A, the available NQDC guidance was rather lenient, with a lot of potential for creativity, often leaving taxpayers to rely on case law and IRS rulings. Sec. 409A was designed to eliminate the uncertainty, as well as to restrict potential abuses. Its rules do not overrule other Code provisions, however. For example, if Sec. 83 applies, it might preempt Sec. 409A. Indeed, Sec. 409A's provisions will often interact not only with Sec. 83, but also with Sec. 451 and the constructive receipt rules, as well as other Code provisions.

Failure to Comply

Sec. 409A imposes severe penalties for noncompliance. If an NQDC plan fails to qualify under its deferral provisions, all previously deferred amounts that are no longer subject to a substantial risk of forfeiture have to be included in the taxpayer's income in the year the failure to comply occurs; see Sec. 409A(a)(1)(A).

Further, failure to comply triggers a penalty of 20% of the compensation deferred. Interest at the underpayment rate, plus 1 percentage point on the underpayments that would have occurred had the deferred compensation been includible in gross income for the tax year in which first deferred (or, if later, the first tax year in which such deferred compensation is not subject to a substantial risk of forfeiture), will be added; see Sec. 409A(a)(1)(B). Clearly, with such onerous penalties, understanding and complying with the new rules should be a high priority. Thus, IRS guidance on applying the new rules would seem to be a main concern.

Notice 2005-1

Initially, the regulations were required to be issued for Sec. 409A within 60 days of enactment; see Conf. Rep't No. 108-755, 108th Cong., 2d Sess (2004). Because such regulations were not issued by that deadline (Dec. 20, 2005), the IRS issued Notice 2005-1, to provide guidance in lieu of, and until, regulations were issued. It was part of a "series of guidance with respect to the application of [section] 409A," according to its "Purpose and Overview." Thus, the notice was intended to establish issues related to Sec. 409A, even though it does state that Treasury and the IRS intend to incorporate such principles into future guidance. Additionally, the notice points out that although it does not provide comprehensive guidance under Sec. 409A, if future regulations are more restrictive than the notice in a certain area, the former will apply prospectively only.

Notice 2005-1 focused on (1) definitions and coverage, (2) nonstatutory stock options and stock appreciation rights (SARs), (3) change in control events, (4) payment acceleration, (5) effective dates and transition relief and (6) application of information reporting and wage withholding requirements. It contains 38 specific questions and answers. (For a discussion, see Adkins, Tax Clinic, "Nonqualified Deferred Compensation Plans: New Rules under the AJCA," TTA, February 2005, p. 69.)

Many of the notice's questions are general in nature, such as, "what does Sec. 409A provide?" "What are the tax consequences of noncompliance?" "What is an NQDC plan?" "What constitutes a deferral?" "When does Sec. 409A become effective?" "What is covered?" "Who is a service recipient?" Other questions are more specific, such as partners dealing with partnership issues and SAILs, as well as stock options, bonus compensation and wage reporting.

Prop. Regs.

On Sept. 29, 2005, Prop. Regs. Sec. 1.409A-1 through -6 were issued (REG-158080-04), and extend many of Sec. 409A'S transition rules. However, some rules were not extended. The proposed regulations are effective for tax years beginning after 2006.

The good-faith compliance rules and Notice 2005-1, Q&A-19's deadline to amend a plan have been extended for one year, until Dec. 31, 2006. Note: Compliance with the proposed regulations is not required until 2007. They should be applied in conjunction with Notice 2005-1. According to the preamble, the proposed rules "do not affect the applicability of other guidance issued ... including Notice 2005-1." Although the proposed regulations are a cumbersome 200+ pages, a review of them in relation to Notice 2005-1 is critical and prudent for taxpayers with NQDC, stock options and other such plans.

Going Forward

Tax advisers are left to deal with the notice and the proposed regulations. From the two, it appears that the Service has indicted the direction in which the final rules are headed. Based on the proposed regulations, relying on Notice 2005-1 seems reasonable when the two conflict.

FROM KEVIN C. HILL, CPA, ELDREDGE, FOX & PORRETTI, LLP, CANANDAIGUA, NY