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Deferred compensation for executives under sec. 409A.


* Sec. 409A treats almost every compensation deferral arrangement as a nonqualified deferred compensation plan, unless it is specifically excluded.

* Due to the scope of Sec. 409A, Treasury has issued, and will continue to issue, lengthy guidance on a number of questions.

* A plan is deemed to defer an item of compensation if the service provider has a legally binding right to the funds, but the compensation is payable in a subsequent tax year.

Sec. 409A regulates virtually every form of compensation earned, but not received, in the same tax year. Part I of this two-part article discusses the introduction of Sec. 409A and the definitions of compensation deferral and nonqualified defined compensation plan.


Sec. 409A, enacted in October 2004 as part of the American Jobs Creation Act of 2004, imposed a new set of ground rules for taxation of deferred compensation.

This two-part article discusses how Sec. 409A and the current proposed regulations apply to deferred compensation arrangements. Part I, below, covers the introduction of Sec. 409A and the plans and types of deferred compensation subject to it. Part II, in the August 2006 issue, will address how Sec. 409A applies to stock arrangements, distributions and the election to defer compensation.

A failure of a specific deferral transaction (such as a stock option grant) to meet Sec. 409A requirements can mean immediate income recognition as of the date on which the individual's right to the compensation is no longer subject to a substantial risk of forfeiture. Under Sec. 409A(a) (1) (B), the tax on such income is increased by interest at the underpayment rate plus 1%, and a penalty, denominated an additional tax, of 20% of the deferred compensation.

As is the case for many tax laws, the impetus for enactment was not merely to collect more revenue, but to try to stop--or at least restrict--certain types of behavior by American businesses. For example, according to the February 2003 Report of the Joint Committee on Taxation, (1) Enron paid its executives approximately $53 million in accelerated distributions from deferred compensation plans in the weeks preceding bankruptcy. (2) That same report included in its recommendations that the existence of certain specific devices, such as an acceleration of distributions, disqualify any plan from deferral treatment.

New Statute's Coverage

Sec. 409A does not regulate those forms of deferral that are already highly regulated, such as qualified plans and incentive stock options (ISOs), or employee benefits such as vacation and sick pay. In addition, Sec. 409A is not intended "to prevent the inclusion of amounts in gross income under any other provision of this chapter or any other rule of law earlier than the time provided in this section." (3) (Emphasis added.)

Effective Date

Although Sec. 409A became effective on Jan. 1, 2005, taxpayers were initially given some transition relief, extending until Dec. 31, 2005, the deadline by which all plans and agreements had to be brought into conformity with all of its requirements. (4) A condition of this relief was that even if existing plans and arrangements were not immediately amended to conform to the statute and regulations, the parties had to act in good faith as if such amendments had been made. In September 2005, the corporate documentation and "good faith" compliance period was further extended to Dec. 31,2006.

In March 2006, Treasury granted transition relief for deferred compensation arrangements for offshore funding mechanisms and/or financial health triggers for distributions. (5) In general, for arrangements that were already in place as of March 21,2006, no amendment to bring them into compliance with Sec. 409A has to be adopted before Dec. 31, 2007. However, any transaction entered into after March 21, 2006, which constitutes the placement of funds overseas or activates a mechanism to provide for distributions on a change in the service recipient's financial health, will immediately be subject to the prohibitions of Sec. 409A. (6)

Additional Guidance

The reach of Sec. 409A is broad and deep, regulating not merely abusive rabbi trusts but all types of deferred compensation, equity-based and otherwise. As a result, Treasury has had to issue--and will continue to issue--lengthy and detailed proposed regulations on a number of issues and areas, including:

* Blocking structures seen as abusive, while permitting some types of deferral entered into as part of normal retirement planning and/or incentive compensation;

* Determining which equity-based compensation plans trigger immediate taxation on grant, vesting or on some other future event;

* Enabling service providers to preserve the right to defer taxation on compensation for earned services, while avoiding unintentional premature recognition of taxable income before such payments;

* Providing some guidance on the specific times, procedures and reporting of elections;

* Coining and defining some new terms (e.g., unforeseeable events legally binding right) and redefining some old ones (e.g., substantive risk of forfeiture); and

* Designing a practical safe harbor for change-of-control distributions.

Although Treasury has worked hard to fit Sec. 409A into the existing world of taxation and reporting of compensation income, the limited time available to date for this task has meant that two of the major areas that were the original reason for enactment are yet untouched--namely, parking of deferred compensation offshore and provision of so-called "financial health" triggers. In effect, taxpayers are given no guidance on whether or where there might be some flexibility in crafting plans to include one or both of these provisions in some measure. Moreover, some problems may be intractable. Certain rules depend on the existence of true arm's-length dealing between service providers and service recipients (not always the case in some corporations).

Background of Deferred Compensation

To understand how and why Congress acted, one should look at the more common nonqualified deferred compensation arrangements and how they were regulated under pre-Sec. 409A law: stock options, stock appreciation rights (SARs), phantom stock units, restricted stock and deferred bonuses.


There is no tax consequence to either the employee or the company at the time of grant of a nonqualified stock option (NQSO), unless the option itself has an ascertainable fair market value (FMV), which usually means that it can be traded. On exercise, the employee will recognize compensation income equal to the current value of the shares received less any amount paid (the exercise price), and the employer will receive a tax deduction for compensation equal to the amount of the income recognized by the employee. On sale of the stock, the employee will have capital gain (or loss) equal to the difference between the net sales proceeds and the value of the shares on the exercise date.

Under Financial Accounting Standards Board (FASB) Statement No. 123, Accounting for Stock-Based Compensation (October 1995) and the FMV-based method of FASB Statement No. 123(R), Share-Based Payment (revised 2004), the total compensation cost to the employer is measured as of the grant date and recognized over the service period (usually the vesting period). The FMV for stock options is determined by means of an option-pricing model that takes into account the price at the grant date, the exercise price, the option's expected life (the term of the option adjusted for anticipated terminations), the volatility of the underlying stock, the expected dividends and the interest rate over the expected life of the option.


Because a SAR is not considered property under Sec. 83, the grant of a SAR is ordinarily not a taxable event. Instead, it is treated as an unfunded and unsecured promise to pay an amount, either in the form of cash or in stock. When the SAR, is exercised and cash or stock is delivered, the company may deduct the full value as compensation expense and the grantee will recognize the full value of the property received as gross income.

During the period in which a SAR is outstanding, the ultimate amount of compensation inherent in the right is indeterminate. Accounting Principles Board Opinion No. 25 and FASB Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans, require interim calculations of the compensation amount. The more difficult problem involves determining the appropriate periods for purposes of recognizing compensation expense measured to date. If the service period for the SAR is not otherwise defined in the plan or the award is not for past service, FASB Interpretation No. 28 provides that the service period will be presumed to be the vesting period.

Phantom Stock

The difference between a phantom stock plan and SARs is that the grantee of a phantom stock unit typically receives, as part of the grant, the full value of a share of stock, while the grantee of a SAP. receives only the appreciation over a period of time. The tax treatment of phantom stock grants is similar to that of SARs.

Phantom stock plans have the same accounting effects as SARs. The amount of compensation to be recognized will be determined when the employee receives the amount representing the current market value of the phantom stock unit.

Deferred Bonus Compensation

This category includes transactions in which an employer promises to pay certain amounts of cash or stock at a determinable point in the future.

Example 1: At the beginning of 2006, employer A decides to award a bonus of up to $100,000 to an employee, E, on achievement of a 15% increase in net sales during the fiscal year. After the end of the year, with the milestone met, A earmarks $100,000 of its cash for eventual payout to E. Although A holds the bonus funds and the interest earned thereon for E's benefit (the employee has a legal right to the funds), E has no right to delivery of the cash before the occurrence of one of the triggers for payout, such as retirement, change of control of the company or a date selected by the employee. Until such a trigger event, no income tax is payable by E on the bonus, and A cannot deduct such amount as compensation.

In a common variation on the above plan, the employer establishes a formal grantor trust to hold the funds (the above plan would constitute a constructive trust in any event).When the amount of deferred compensation is actually paid, the amount is taxable to E, and A may take a compensation deduction.

For financial statement purposes, A's liability to pay the $100,000 accrues during the period when the employee has earned the bonus. Thus, the company should accrue a charge for the discounted present value of the total estimated future payments during such earning period.

Performance-Based Stock Plans

Stock performance plans involve the award of bonuses in the form of common stock to employees on the achievement of certain goals. They are similar to cash bonus plans, except that the award is in stock. Unlike a stock option arrangement, no cash investment is required by the employee. In a typical performance plan, a predetermined number of shares is designated for payment if specific performance levels are attained (e.g., an increase in net sales of 15%). The measurement date of a stock performance plan is determinable only on the ultimate issuance of the shares, and compensation is measured by the number of shares ultimately awarded at the then current market price of the stock, similar to phantom stock units.

In a performance plan, the number of shares to be awarded is not known as of the date of the establishment of the plan. Thus, for financial statement purposes, the company estimates the (1) number of shares that Hill be issued and (2) market appreciation from the date of the establishment of the plan, and then takes a charge against earnings over the period of service.

Restricted Stock Variation

A variation on the performance based stock plan is for the company to add a second hurdle--and a second level of incentive--by issuing restricted stock. Under a restricted stock performance plan, the stock is issued to the employee and entitles him or her to certain ownership fights, which may include voting rights and the right to receive dividends. In this case, failure to meet the performance criterion would result in forfeiture of the restricted stock. This difference affects the accounting for these plans. The nature of the restriction results in the compensation cost being measured at the date when the number of shares to be awarded is known.

One major accounting difference between this plan and a regular stock performance plan is that in the latter, the shares are not actually issued until the performance criteria have been met. In a restricted stock performance plan, stock is actually issued and must be recorded in the company's capital account at FMV on issuance.

Perceived Abuses

Pre-Sec. 409A Rules for Cash-Basis Taxpayers

Constructive receipt (a meaningful concept only to a cash-basis taxpayer) means: If a taxpayer has it or can get his or her hands on it, it is taxable. (7) Specifically, "... a mere promise to pay, not represented by notes or secured in any way, is not regarded as a receipt of income within the intendment of the cash receipts method ..." (8) The same rule applies even when the promise to pay is accompanied by some limited control by the service provider. Examples of these controls include certain escrow arrangements when (1) there is a bona fide, arm's-length agreement calling for deferred payment, (2) the promisee receives no present beneficial interest from the funds while in escrow and (3) the escrow agent does not act under the exclusive authority of the taxpayer. (9)

Having Cake and Eating It, Too

The service provider has to draw a sometimes delicate balance. It is not difficult to postpone tax on deferred compensation, but the amounts not distributed must remain the property of the company and subject to claims by the company's creditors. By the same token, it is not difficult to provide some safeguards for the service provider, but the price to be paid may be immediate taxation on all amounts deferred.

Rabbi Trust

In 1980, the Service ruled on a deferred compensation plan involving an irrevocable trust that became a template for countless similar arrangements over the next 25 years. (10) In this case, the employer funded an irrevocable trust with cash and made distributions from time to time to the employee. On the death, disability, retirement or other termination of the employee, the principal and accumulated income were to be paid to the employee. The employee had no right to change the timing or other terms of the distributions. Although the employer could not amend the terms of the trust, the trust assets were made specifically subject to the claims of the employer's creditors in the same manner as for any of the employer's other assets.

In its decision, the Service considered the effect of the "economic benefit" doctrine, which provides, among other things, that the creation of a fund in which the taxpayer has an interest and which is controlled not by the employer but by an independent third party, will result in immediate inclusion by the taxpayer of the amount funded. (11) Because the facts did not suggest such an arrangement, the Service then considered whether the funds were "constructively received" by the taxpayer within the meaning of Regs. Sec. 1.451-2(a). Because the assets of the trust were subject to the claims of the employer's creditors, the Service ruled that the funding of the trust did not constitute a taxable event for the employee.

The IRS Model Trust

This ruling was followed eventually by a published ruling that actually provided a form of model trust. (12) Terms include the establishment of an account at an unrelated financial institution (with or without a formal trust document), deposit of funds in that account and arranging for all funds to be subject to the claims of the employer's creditors. (13)

Return of the Cake

The response of taxpayers, naturally, was to endeavor to expand the limits of this safe harbor. To provide more assurance for the service provider that the funds would actually be available at the time of the scheduled distribution (i.e., retirement or other termination), trusts were formed that automatically removed the provision reserving the funds for the employer's creditors if and when the employer suffered certain financial reverses, a sort of insolvency early-warning provision. The funds would become immediately taxable to the employee, but at least they were secure. (14)

In a second variation, the arrangement might provide that no funds were to be distributed until termination except in "emergency" circumstances, with those circumstances being defined very generously, so that the employee really had the power to get access to the funds at any time. A third type was a "haircut" trust, in which the employee had the power to demand part or all of the funds at any time as long as he or she accepted a percentage discount of the total otherwise payable. A fourth variation involved an otherwise standard form of common-law trust that was settled under the laws of a foreign tax-haven jurisdiction, with the funds deposited in a local bank in that tax haven. In theory, this met the standards of the model mast in Rev Proc. 92-64,(15) but in practice the added difficulty for a creditor to reach assets of such a trust gave the employee added security without subjecting him or her to current tax.

Sec. 409A

Definition of a Nonqualified Deferred Compensation Plan

The new law consists of three principal elements: Sec. 409A, Notice 2005-1 (16) and proposed regulations. (17) Sec. 409A(d) treats as a "nonqualified deferred compensation plan" every arrangement of compensation deferral unless it is specifically excluded. Excluded are certain plans and other arrangements that one would expect on their face not to involve significant abuse. (18) These are:

* Qualified retirement plans governed by Sec. 401;

* Annuity plans governed by Sec. 403(a);

* Annuity contracts governed by Sec. 403(b);

* Simplified employee pensions, as defined in Sec. 408(k);

* Certain plans governed by Sec. 457(b) (19);

* Excess benefit arrangements governed by Sec. 415(m);

* Accumulated vacation and sick pay;

* Certain plans in which contributions are made on behalf of individuals that are nontaxable by reason of a bilateral U.S. tax treaty;

* Participation in any plan sponsored by a foreign entity on behalf of certain nonresident aliens (20);

* Participation by certain U.S. persons in certain plans sponsored by non U.S. entities to the extent of non-elective deferrals of foreign-source earned income, if the deferred amounts meet the individual limitation rules of Sec. 415 (21); and

* Participation in plans governed by certain totalization agreements entered into with any foreign country or mandatory contributions to a foreign country's Social Security system (or equivalent). (22)

Determination of the existence of a plan is made separately for each service provider, and all such arrangements of a similar type, such as all of the account-based plans for a service provider, are aggregated into one master plan for purposes of governance by Sec. 409A. In some circumstances, however, separate determinations may be made for services by one person as an employee and as an independent contractor on other hand. (23) Although a plan or other arrangement by itself may initially be oral only, it must be written to satisfy Sec. 409A. (24)

Definition of Deferral of Compensation

In general, a plan is considered to defer an item of compensation if the (1) service provider has--either by means of providing services or otherwise--a legally binding right to the funds during the current tax year and (2) compensation is payable in a subsequent tax year. Under the proposed regulations, a taxpayer may have a legally binding right to compensation that is nevertheless subject to a substantial risk of forfeiture. (25) There is no such deferral if the service provider's right to the income is subject to reduction or elimination by the service recipient after the services have been performed. This would be the case of a bonus payable at the absolute discretion of the service recipient. (26)

Payments subject to conditions: If the amounts were payable on the presence or absence of an objectively measurable particular condition, there would still be no deferral of compensation within the meaning of Sec. 409A, unless the condition were more illusory than real.

Example 2: A consultant, P, to a company, is entitled under the terms of his service contract entered into in 2005, to receive $200,000 on completion of the services and an additional $300,000 after two years if the company exercises its sole discretion to pay it.

Example 3: The facts are the same as in Example 2, except P had a legally binding right to the $300,000 as long as he completed two years of additional service (with provisions in the agreement in case of bad faith termination by the company).

In Example 2, there would be no deferral; in Example 3, there would be deferral within the meaning of Sec. 409A. (27)

A more serious issue would exist if the agreement provided that the company would pay the bonus unless Halley's Comet were to return to the solar system 55 years ahead of schedule. In this case, the proposed regulations would treat this "discretion" as illusory, on the basis that the discretion lacked "substantive significance." The difficulty here is that it would be a simple drafting exercise to design an agreement that gives the company absolute discretion to award the bonus, while circumstances exist that would make the failure to make the award extremely uulikely. What would be the result if P is a recently retired executive officer whose opinions command respect from the board of directors and who is sought out frequently for his wise counsel? Or if P's continued services are critical to the financial well-being of the company? (28)

Short-term scheduled or unscheduled deferrals: Payments of compensation are not treated as deferred solely became they are paid after the end of the tax year in which the compensation was earned, as long as the funds are paid by the company within 30 days after the end of such tax year and are paid in accordance with the company's normal payroll schedule. In addition, the proposed regulations do not treat certain short-term postponements of payments (such as year-end bonuses) to a subsequent tax year as deferral of compensation when the payments are made within 2 1/2 months of the subsequent year. (29) The proposed regulations allow for an unspecified grace period in the case of payments made after the 2 1/2-month period if due to "unforeseeable" events affecting the company's financial solvency. (30)

Substantial Risk of Forfeiture

Assuming that a service provider earns income to which he or she has a legally binding right, there still may be no amounts subject to Sec. 409A until and unless the parties agree that such income is to be paid after the tax year in which it is no longer subject to a "substantial risk of forfeiture." While the definition of this term in the proposed regulations is similar to that in Sec. 83 and the regulations thereunder, there are important differences. For example, unlike Sec. 83, Prop. Regs. Sec. 1.409A-1(d) provides that a noncompetition condition does not create a substantial risk of forfeiture. The proposed regulations are much stricter in considering the facts and circumstances surrounding the condition that appears to create the risk of forfeiture. For example, if the service provider is the chief executive officer and a major stockholder of the company imposing the condition, it is less likely that the condition will be treated as a substantial risk of forfeiture under Prop. Regs. Sec. 1.409A-1(d)(3).

Financial Health Triggers and Placement of Funds Overseas

The proposed regulations do not provide any substantive guidance on deferred compensation arrangements providing either for distributions on the service recipient's poor financial condition or for accumulating cash in a trust managed by an offshore bank. Thus, practitioners are cautioned to avoid any such arrangements completely, at least for the present. (31) One should also avoid any provisions for guarantees of payment of deferred compensation by third parties which have a legal or de facto relationship to the service recipient.


Part II, in the August 2006 issue, will cover applicability of Sec. 409A to stock arrangements, permitted distributions and the election to defer compensation.

(1) "Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation Issues and Policy Recommendations," Joint Committee on Taxation, JCS 3-03 (February 2003), Vol. I, p. 12-15.

(2) These payouts were part of a much larger program of compensation for top management. In 1998, top executives recognized income of approximately $125 million from exercising stock options, and $24 million from removing restrictions from stock grants. For 2000, these numbers were $1.5 billion and $132 million respectively; see Joint Committee Report, note 1 supra, at p. 41.

(3) Sec. 409A(c).

(4) Notice 2005-1, IRB 2005-2, 274.

(5) Notice 2006-33, IRB 2006-15, 754.

(6) See id. and Sec. 409A(b).

(7) See Secs. 61 and 451(a); Regs. Sec. 1.451-1 and Rev. Rul. 60-31, 1960-1 CB 174, as modified by Rev. Rul. 70-435, 1970-2 CB 100.

(8) Rev. Rul. 60-31, note 7 supra.

(9) J.E. Reed, 723 F2d 138 (1st Cir. 1983). By contrast, see Example 4 in Rev. Rul. 60-31, note 7 supra, which involved an athlete's signing bonus that was placed into escrow, to be payable, with interest, over five years. This was held to be taxable immediately to the athlete, because the money was irrevocably delivered to the escrow agent and the employer's discretion had ended.

(10) Because the service provider in this case was a rabbi and the service recipient his congregation, this type of arrangement became known as a "rabbi trust"; see IRS Letter Ruling 8113107 (12/31/80).

(11) E. T. Sproull, 16 TC 244 (1951), aff'd, 194 F2d 541 (6th Cir. 1952).

(12) Rev. Proc. 92-64, 1992-2 CB 422.

(13) One variation was a provision in the trust that if and when the employer otherwise became insolvent, all funds would automatically revert to the employer's accounts for its general funds.

(14) Of course, if the automatic trigger occurred too close in time to actual insolvency, the employee ran the risk that the payment would constitute a fraudulent conveyance. Such a trust was sometimes referred to as a "rabbicular trust" (hybrid rabbi/secular trust).

(15) See note 12, supra.

(16) See note 4, supra.

(17) REG-158080-04 (10/4/05). These proposed regulations will probably be supplemented during the last half of 2006 and may become final as of Jan. 1, 2007.

(18) See Sec. 409A(d)(1) and (2) and Prop. Regs. Sec. 1.409A-1(a)(2) and (3).

(19) One has to distinguish between Sec. 457(b) arrangements and those under Sec. 457(f). As of the Economic Growth and Tax relief and Reconciliation Act of 2001, amounts held in a Sec. 457(b) plan for the benefit of employees are taxable either when paid or "first made available" under the terms of the particular plan. For this purpose, "first made available" means the date, after termination, on which the plan authorizes actual distributions to commence. By contrast, compensation owed to an employee under a Sec. 457(f) plan (also referred to as an ineligible plan) is taxable in the full amount of benefits that are vested (or, expressed another way, for which there is no longer any "substantial risk of forfeiture"). Sec. 409A does cover Sec. 457(f) arrangements.

(20) For this purpose, "certain" means (1) nonresident aliens and (2) persons who are classifiable as resident aliens solely by reason of the "substantial presence" test; see Prop. Regs. Sec. 1.409A-1(a)(3).

(21) See Prop. Regs. Sec. 1.409A-1(a)(3)(iii).

(22) See Prop. Regs. Sec. 1.409A-1(a)(3)(iv).

(23) See Prop. Regs. Sec. 1.409-1(c)(2)(ii).

(24) See Prop. Regs. Sec. 1.409-1(c)(3)(i).

(25) Preamble II-A, REG-158080-04, note 17 supra.

(26) See Prop. Regs. Sec. 1.409A-1(b)(1).

(27) See Notice 2005-1, note 4 supra, Q&A-4; and Prop. Regs. Sec. 1.409A-1(b)(1).

(28) "However, if the facts and circumstances indicate that the discretion to reduce or eliminate the compensation is available or exercisable only upon a condition, or the discretion to reduce or eliminate the compensation lacks substantive significance, a service provider will be considered to have a legally binding right to the compensation. Whether the negative discretion lacks substantive significance depends on the facts and circumstances of the particular arrangement" (Prop. Regs. Sec. 409A-1(b)).

(29) Notice 2005-1, note 4 supra, Q&A-4; and Prop. Regs. Sec. 1.409A-1(b)(3) and (4).

(30) See Prop. Regs. Sec. 1.409A-1(b)(4).

(31) The statute provides some relief for circumstances in which a service provider actually performs services in a foreign jurisdiction. Under Sec. 409A(b)(1), the compensation payable from those services may be placed in a trust and/or bank account located in that same jurisdiction.

Author's note: The author acknowledges the kind assistance on a number of accounting question of Melody Thornton, Tax Manager, and James Ledwith, Audit Palmer, in the San Diego, CA, office of J.H. Cohn, LLP.

Stuart R. Singer

Of Counsel

Jenkens & Gilchrist LLP

Los Angeles, CA
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Title Annotation:part 1
Author:Singer, Stuart R.
Publication:The Tax Adviser
Date:Jul 1, 2006
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