New Tax Rules May Affect Payments To Retiring Partners

One of the most important provisions of the American Jobs Creation Act of 2004 establishes a new regime for taxing deferred compensation. Newly created Section 409A of the Internal Revenue Code likely will affect every arrangement now in place or hereafter adopted that promises the payment of deferred compensation to current and former employees, directors and other service providers. Such an arrangement may well include a partnership's unfunded retirement program for its partners.

With designated exceptions ' a tax-qualified retirement plan or a bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan ' Section 409A requires that, in order to avoid adverse tax consequences, all compensation deferred under any plan or arrangement must meet several strict requirements, listed below. Deferred payments that fail to meet the new requirements will become fully taxable, and will also be subject to an extra 20% tax and interest, in the taxable year the amount vests.

Requirements to Avoid Taxation and Penalty

The four requirements a plan must meet to satisfy Section 409A are as follows:

1. Amounts deferred under the plan may not be distributed earlier than separation from service, disability, death, a time specified under the plan at the date of deferral, a change in control or an unforeseeable emergency;
2. No acceleration of the time or schedule of any payment under the plan may be permitted (except as the IRS may provide in regulations);
3. In the case of an elective deferral, the election to defer must be made before the year during which the associated services are performed or, in the case of the first year in which a person is eligible to participate, within thirty days after his or her eligibility date; and
4. In the case of any permitted subsequent election regarding the timing or form of payments from the plan:

Applicability to Partnerships

While Section 409A itself is silent on the subject, guidance issued by the Treasury on December 20, 2004 (Notice 2005-1) (revised 1/2005) confirms that Section 409A will apply to any arrangement between a partner and a partnership that provides for the deferral of compensation under a non-qualified deferred compensation plan.

For example, Notice 2005-1 makes clear that an arrangement providing for retirement payments to a partner that are described in Section 1402(a)(10) of the Code will be subject to the new rules. Section 1402(a)(10) describes partnership payments that are eligible to be excluded from self-employment income of a retired partner. These are payments received pursuant to a written plan that provides for periodic payments to partners (or to a class or classes of partners) on account of retirement, with the payments to continue at least until the partner's death, where:

• The partner renders no services to the partnership during the taxable year in which the amounts are received;
• No obligation exists from the other partners to such partner except with respect to the retirement payments under the plan; and
• The partner's share, if any, of the capital of the partnership has been paid to him or her in full before the close of the taxable year in which the payments are received.

Notice 2005-1 points out that Section 409A may also apply to payments covered by Section 707(a)(1) (payments to a partner not acting in his or her capacity as a partner), if the payments otherwise would constitute a deferral of compensation under a non-qualified deferred compensation plan. It excepts from Section 409A's rules, at least until further guidance is issued, payments from a partnership subject to Section 736 of the Code (other than payments described in Section 1402(a)(10), as noted above).

Effective Date and Limited Safe Harbor

These provisions of the new law apply generally to amounts deferred after Dec. 31, 2004. Amounts earned and vested prior to 2005 will not be subject to the new rules, unless the plan under which they are deferred, eg, a partnership agreement, is materially modified after Oct. 3, 2004, other than in conformity with anticipated IRS guidance.

For partners not vested in their retirement payouts prior to Jan. 1, 2005, Notice 2005-1 provides limited relief. It allows them an opportunity to avoid the adverse tax consequences of the new provision if the agreement under which they are entitled to receive their retirement payments is amended on or before Dec. 31, 2005 to provide for election and payment provisions that comply with the requirements outlined above. In the meanwhile, their agreement will not be treated as violating Section 409A so long as the agreement is operated in good faith compliance with the provisions of Section 409A and Notice 2005-1 during calendar year 2005 until the agreement is amended.

One of the most important provisions of the American Jobs Creation Act of 2004 establishes a new regime for taxing deferred compensation. Newly created Section 409A of the Internal Revenue Code likely will affect every arrangement now in place or hereafter adopted that promises the payment of deferred compensation to current and former employees, directors and other service providers. Such an arrangement may well include a partnership's unfunded retirement program for its partners.

With designated exceptions ' a tax-qualified retirement plan or a bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan ' Section 409A requires that, in order to avoid adverse tax consequences, all compensation deferred under any plan or arrangement must meet several strict requirements, listed below. Deferred payments that fail to meet the new requirements will become fully taxable, and will also be subject to an extra 20% tax and interest, in the taxable year the amount vests.

Requirements to Avoid Taxation and Penalty

The four requirements a plan must meet to satisfy Section 409A are as follows:

1. Amounts deferred under the plan may not be distributed earlier than separation from service, disability, death, a time specified under the plan at the date of deferral, a change in control or an unforeseeable emergency;
2. No acceleration of the time or schedule of any payment under the plan may be permitted (except as the IRS may provide in regulations);
3. In the case of an elective deferral, the election to defer must be made before the year during which the associated services are performed or, in the case of the first year in which a person is eligible to participate, within thirty days after his or her eligibility date; and
4. In the case of any permitted subsequent election regarding the timing or form of payments from the plan:

Applicability to Partnerships

While Section 409A itself is silent on the subject, guidance issued by the Treasury on December 20, 2004 (Notice 2005-1) (revised 1/2005) confirms that Section 409A will apply to any arrangement between a partner and a partnership that provides for the deferral of compensation under a non-qualified deferred compensation plan.

For example, Notice 2005-1 makes clear that an arrangement providing for retirement payments to a partner that are described in Section 1402(a)(10) of the Code will be subject to the new rules. Section 1402(a)(10) describes partnership payments that are eligible to be excluded from self-employment income of a retired partner. These are payments received pursuant to a written plan that provides for periodic payments to partners (or to a class or classes of partners) on account of retirement, with the payments to continue at least until the partner's death, where:

• The partner renders no services to the partnership during the taxable year in which the amounts are received;
• No obligation exists from the other partners to such partner except with respect to the retirement payments under the plan; and
• The partner's share, if any, of the capital of the partnership has been paid to him or her in full before the close of the taxable year in which the payments are received.

Notice 2005-1 points out that Section 409A may also apply to payments covered by Section 707(a)(1) (payments to a partner not acting in his or her capacity as a partner), if the payments otherwise would constitute a deferral of compensation under a non-qualified deferred compensation plan. It excepts from Section 409A's rules, at least until further guidance is issued, payments from a partnership subject to Section 736 of the Code (other than payments described in Section 1402(a)(10), as noted above).

Effective Date and Limited Safe Harbor

These provisions of the new law apply generally to amounts deferred after Dec. 31, 2004. Amounts earned and vested prior to 2005 will not be subject to the new rules, unless the plan under which they are deferred, eg, a partnership agreement, is materially modified after Oct. 3, 2004, other than in conformity with anticipated IRS guidance.

For partners not vested in their retirement payouts prior to Jan. 1, 2005, Notice 2005-1 provides limited relief. It allows them an opportunity to avoid the adverse tax consequences of the new provision if the agreement under which they are entitled to receive their retirement payments is amended on or before Dec. 31, 2005 to provide for election and payment provisions that comply with the requirements outlined above. In the meanwhile, their agreement will not be treated as violating Section 409A so long as the agreement is operated in good faith compliance with the provisions of Section 409A and Notice 2005-1 during calendar year 2005 until the agreement is amended.