IMPORTANT: Compliance Required with Section 409A before December 31, 2008
June 12, 2008
December 31, 2008, looms as a crucial deadline for employers to comply with Section 409A of the Internal Revenue Code and the final Section 409A regulations (Section 409A). Further, employers must reduce unwritten arrangements that are subject to Section 409A to written plans/agreements by December 31, 2008.
It is unlikely that the IRS will extend the December 31, 2008, deadline for Section 409A compliance. Therefore, we are reminding all employers who have not done so already to perform an immediate inventory of all compensation-related arrangements that could be subject to Section 409A (see the list below of common arrangements that are usually within the purview of Section 409A). Afterwards, we urge employers to contact legal counsel to determine which arrangements will require amendment before the end of 2008 to comply with Section 409A.
Previously, we distributed WSGR Alerts detailing various aspects of the final Section 409A regulations, including action items, highlights, stock rights, separation pay arrangements, and traditional nonqualified deferred compensation plans. In this alert, we focus on the importance of the 2008 year-end deadline and the arrangements that will need to be reviewed, and potentially amended, in order for employers to comply with Section 409A by the deadline and in the future.
Importance of the December 31, 2008, Deadline
The December 31, 2008, deadline for complying with Section 409A is critical for the following reasons:
- Violations are extremely costly for employees, particularly in California, which imposes an additional 20 percent state penalty tax atop the 20 percent federal penalty tax (thus, the effective tax rate on amounts includible into income as a result of a Section 409A violation can range up from 80-90 percent or more).
- Employers usually make representations and warranties regarding Section 409A compliance in acquisition and financing documents.
- Section 409A disproportionately affects key management and sales employees, who are more likely to participate in arrangements subject to Section 409A.
- Noncompliance with Section 409A can permeate through broad-based employee benefit plans (e.g., stock plans and severance policies) and, as a result, employers can encounter pressure to "make whole" many employees from the costly tax ramifications of Section 409A.
- If an employer's plans/agreements are subject to Section 409A, internal business administration (e.g., human resources, payroll, and legal departments) will need to monitor various aspects of compliance with Section 409A.
Amounts that are subject to and violate Section 409A must be reported by employers to the IRS on Forms W-2 or 1099, and, if applicable, proper withholding of income taxes must take place. Further, if employers fail to modify non-compliant arrangements subject to Section 409A before December 31, 2008, they will not be able to avail themselves—as a threshold matter—of the correction program and limited tax relief that the IRS publicized in IRS Notice 2007-100 for Section 409A errors and mistakes.
Identify Arrangements Subject to Section 409A
Employers should review all compensation-related arrangements to identify those that are subject to Section 409A. Common types of arrangements that may be subject to Section 409A are listed below.
- Traditional deferred compensation plans (e.g., top-hat plans and supplemental executive retirement plans for a select group of employees, and director fee deferral programs)
- Employment agreements and offer letters
- Change-in-control plans and agreements, including management "carve-out" plans
- Severance agreements and severance policies
- Discount stock options and discount SARs
- Restricted stock units, performance share awards, phantom stock, and other equity awards (other than restricted stock, which generally is exempt from Section 409A)
- Annual and multi-year bonus and commission plans
- Deferred salary arrangements (these are common for start-up companies)
- Reimbursement arrangements covering multiple years (e.g., COBRA reimbursements, personal allowances, and in-kind benefits)
- Split-dollar life insurance policies
- Tax "gross-up" arrangements
Amend for Documentary Compliance
By December 31, 2008, arrangements subject to Section 409A must be in writing. Therefore, certain plan documents, agreements, and amendments will need to be adopted by the corporate body with the authority to adopt and/or amend the relevant arrangement (e.g., the compensation committee or shareholders). Amendments also might require the consent of affected employees and, for public companies, the filing of forms with appropriate government authorities.
Prepare for Future Operational Compliance
To the extent that an employer has or will have an arrangement that is subject to Section 409A, the employer should coordinate its internal business administration to allocate responsibility for compliance with Section 409A. The list below includes likely business administration departments that are affected by Section 409A.
- Human resource department personnel will need to establish systems to maintain the plans subject to Section 409A in operational compliance with the rules of Section 409A.
- Payroll department personnel or the outside payroll administrator should establish the proper codes and processes for reporting and withholding compensation that is subject to Section 409A, regardless of whether the arrangement is in compliance with Section 409A or not.
- Retirement plan administrators should be contacted and review the "compensation" definition for purposes of 401(k) and retirement plan deferrals.
- Legal departments and/or outside counsel always should be contacted before new plans/agreements are executed or existing plans/agreements are amended. In addition, Section 409A always should be considered prior to terminating any employee that is party to an agreement that is subject to Section 409A.
For More Information
This WSGR Alert is only a general summary of the steps required to comply with the final Section 409A regulations by the 2008 year-end. We strongly advise you to seek professional assistance with respect to your specific issues.
If you have any questions regarding this WSGR Alert, please contact any member of Wilson Sonsini Goodrich & Rosati's employee benefits and compensation practice:
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Circular 230 Compliance: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this memorandum is not intended or written to be used, and cannot be used, for the purpose of (a) avoiding penalties under the Internal Revenue Code, or (b) promoting, marketing, or recommending to another party any transaction or matter addressed herein.