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Meeting the Section 409A Deadline

By Frederick D. Lipman, Barry L. Klein and Wilhelm L. Gruszecki
October 30, 2007

With a last-minute extension by the IRS, the final regulations adopted under Section 409A of the Internal Revenue Code now impose a hard Dec. 31, 2008 deadline on making necessary amendments to deferred compensation arrangements for employees, directors, and certain independent contractors of private, not-for-profit, and public companies in order to avoid federal excise taxes at a rate of 20% (plus retroactive interest). Such employees, directors and independent contractors are referred to in the 409A regulations and in this article as 'service providers' and the entities for which they provide services are referred to as 'service recipients,' but it may be easier if you think about 'employees' and 'employers.' The extension to Dec. 31, 2008 should not dissuade employers from immediately beginning (or continuing) the task of reviewing, redesigning and formally amending their deferred compensation plans. This is painstaking work and requires participation of the Board, Human Resources and individual executives.

'Good faith' compliance with Section 409A has been required since Jan. 1, 2005, but with the publication of several hundred pages of final regulations in April 2007 and subsequent guidance, the IRS has set a Dec. 31, 2008 deadline for full compliance with the statute and regulations, in form and operation. If you fail to act by this deadline, service providers, including your senior executives, will be subject to the punitive and confiscatory taxes and penalties imposed by Section 409A: Deferred compensation that is subject to Section 409A will be taxed at vesting (not at payment), will be subject to an excise tax penalty of 20%, and will be subject to interest from the date of non-compliance retroactive to the date of vesting. Failure to comply with Section 409A can result in total federal income and excise taxes on deferred compensation at a rate as high as 55% (plus retroactive interest), namely a maximum federal income tax rate of 35% plus the 20% excise tax penalty. Moreover, there is an additional 20% state penalty if the service provider resides in California, resulting in a combined federal and state tax rate as high as 85% (before the effect of federal tax deductions for state income taxes) plus retroactive interest.

Common types of arrangements that may be subject to Section 409A include (but are not limited to) the following:

  • employment agreements, which may include formal agreements, letter agreements or offer letters, expatriate agreements and retention agreements;
  • all severance or separation pay provisions or agreements;
  • annual and multi-year bonus and commission plans;
  • traditional deferred compensation plans, including so-called 'SERPS';
  • any agreement with a change-in-control provision;
  • split-dollar life insurance arrangements;
  • corporate transaction 'earn-out' arrangements;
  • stock options, SARs, phantom stock plans, and other equity awards (excluding restricted stock, which is generally exempt, tax-qualified incentive stock options and tax-qualified employee stock purchase plans);
  • 457(f) deferred compensation arrangements for non-profits;
  • reimbursement arrangements covering multi-years;
  • back-to-back private equity deferral arrangements;
  • foreign retirement arrangements covering U.S. employees; and
  • any other nonqualified deferred compensation plan.

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