New Proposed Regulations Issued Under Section 409A
July 11, 2016
The U.S. Treasury Department and Internal Revenue Service (IRS) recently issued new proposed regulations1 (the Proposed Regulations) under Internal Revenue Code Section 409A, which help clarify certain provisions of—and make some modest but welcome changes to—existing regulations under Section 409A.
This WSGR Alert highlights the key clarifications and changes made by the Proposed Regulations that employers will find most useful in connection with the administration of their nonqualified deferred compensation plans (NDCPs).
Overall, the Proposed Regulations add more flexible options for plan administration and should help ease certain aspects of employers' administration of their NDCPs. For the most part, we expect that employers will not need to amend current arrangements to comply with the Proposed Regulations or to benefit from the added flexibility offered.
The IRS says that taxpayers may rely on this new guidance until applicable final regulations are published and, in the meantime, it will not assert any positions that are contrary to the guidance.
Section 409A provides a complex regime of requirements that apply to NDCPs, the violation of which can result in unintended early taxation of compensation arrangements and an extra 20 percent federal income tax, as well as interest penalties and potential tax withholding and reporting obligations on the employers that sponsor the NDCPs.2 Since the enactment of Section 409A over 10 years ago, the IRS has issued several sets of implementing guidance,3 most notably the final regulations issued in April 2007 (the "Current Final Regulations"), which, among other things, set forth strict rules for deferral elections and for the time and form of payments under NDCPs. In December 2008, the IRS issued more regulations in proposed form, which provide guidance on calculating amounts includible in income and the federal penalty taxes and interest charges that apply in the case of NDCPs that fail to comply with Section 409A rules (the "Current Income Inclusion Regulations").4
Key Clarifications and Changes to Current Final Regulations
1. Short-Term Deferral Exemption Expanded
Current Final Regulations. The Current Final Regulations generally provide that a payment made under an NDCP is considered a "short-term deferral" and not deferred compensation subject to Section 409A if the payment by its terms is not permitted to be made later than, and actually is made no later than, the 15th day of the third month following the later of the end of the service provider's first taxable year or the end of the service recipient's first taxable year in which the right to the payment no longer is subject to a substantial risk of forfeiture.
The Current Final Regulations also permit certain delays in making payments of otherwise short-term deferral amounts (e.g., if the payments are delayed beyond the applicable two-and-a-half-month period because it is administratively impracticable for the service recipient to make the payments within that period and payment is in fact made as soon as administratively practicable).
Proposed Regulations. The Proposed Regulations expand the short-term deferral exemption in the Current Final Regulations by permitting additional circumstances in which a delay may be made in making a payment of an otherwise short-term deferral amount. If a service recipient reasonably anticipates that paying an otherwise short-term deferral amount during the applicable two-and-a-half-month period would violate federal securities laws or other applicable law, and such payment actually is made as soon as reasonably practicable following the first date on which the service recipient reasonably anticipates that the payment would not cause such violation, then the payment nevertheless may continue to be exempt from Section 409A as a short-term deferral. However, causing inclusion in income or the application of a penalty provision or other provision in the Code does not constitute a violation of applicable law for purposes of this exemption.
2. Stock Rights Exemption Clarified
Current Final Regulations. The Current Final Regulations provide that certain stock rights (generally non-discounted stock options or non-discounted stock appreciation rights) granted with respect to qualifying "service recipient stock," which contain no additional deferral feature ("Exempt Stock Rights"), do not provide for deferred compensation subject to Section 409A. "Service recipient stock" for this purpose generally means, as of the stock right's grant date, common stock of a corporation that is an eligible issuer of the stock (an "Eligible Issuer"). Service recipient stock generally does not include, among other things, any stock subject to a mandatory repurchase obligation (other than a right of first refusal) or permanent put or call right, if the stock price under such right or obligation is based on a measure other than the stock's fair market value.
Proposed Regulations. The Proposed Regulations clarify that an otherwise Exempt Stock Right will not be treated as providing for deferred compensation subject to Section 409A solely because the amount payable under such right upon an involuntary separation from service for cause or the occurrence of a condition within the service provider's control (e.g., a violation of a noncompetition or nondisclosure agreement) is based on a measure that is less than fair market value.
3. New Hire Inducement Awards
Current Final Regulations. The Current Final Regulations provide that an Eligible Issuer (as generally defined above) means the corporation or other qualifying entity for which the service provider provides direct services on the date of grant of an otherwise Exempt Stock Right.
Proposed Regulations. Some commentators had asserted that the definition of an Eligible Issuer could hinder employment negotiations by preventing service recipients from granting otherwise Exempt Stock Rights to service providers before they are actually employed by the service recipient. In response, the Proposed Regulations provide that a corporation or other qualifying entity nevertheless will be considered an Eligible Issuer if it is reasonably anticipated that a person will begin providing services to the corporation or other entity within one year after the grant date of the otherwise Exempt Stock Right, and the person actually starts providing such services within one year after the grant date (or, if services do not begin within that period, such right will be forfeited).
Accordingly, at least for purposes of Section 409A, service recipients may grant Exempt Stock Rights as inducement awards to potential service providers, as described above. However, companies considering such grants should first confirm that the grants are permitted by the applicable equity plan and that securities law exemptions are available.
4. Separation Pay Plan Exception Clarified and Modified
Current Final Regulations. The Current Final Regulations provide that certain qualifying separation pay plans that provide for payment only upon an involuntary separation from service or pursuant to a window program are exempt from Section 409A (the "Separation Pay Plan Exception"). One of the requirements of this exception is that the applicable separation pay generally may not exceed two times the lesser of (1) the service provider's annualized compensation for his or her taxable year immediately preceding the year of separation, or (2) the limit under Code Section 401(a)(17) for the year of separation (the "Two Times Rule").
Proposed Regulations. Some commentators had expressed concerns about whether the Two Times Rule prohibits the use of the Separation Pay Plan Exception for a terminated service provider who had not been employed by, and did not receive any compensation from, the service recipient for the taxable year immediately preceding the year of separation (an "Applicable Service Provider"). In response, the Proposed Regulations clarify that the Separation Pay Plan Exception is available for Applicable Service Providers, assuming the requirements of the exception otherwise are met. The Proposed Regulations further provide that an Applicable Service Provider's annualized compensation for the year of separation is to be used for purposes of applying the Two Times Rule.
5. Added Flexibility for Payments Due to Death
Current Final Regulations. The Current Final Regulations provide that deferred compensation under an NDCP may be paid only at a specified time or upon specified events, including upon the death of a service provider.
The Current Final Regulations also provide that a payment nevertheless will be considered made upon a date specified under the NDCP (including the time a specified event occurs) if the payment is made on that date or on a later date within the same taxable year of the service provider or, if later, by the 15th day of the third calendar month following the date specified under the NDCP, provided that the service provider is not permitted to designate the taxable year of the payment.
Proposed Regulations. The Proposed Regulations clarify that the rules in the Current Final Regulations that apply to amounts payable upon a service provider's death, as described above, also apply to amounts payable upon the death of a beneficiary of the service provider.
Some commentators had expressed concerns about the administrative impracticability of making timely payments of death benefits (e.g., the specified time periods often are not long enough to resolve certain issues related to the death). The Proposed Regulations add payment timing flexibility by providing that an amount payable due to the death of a service provider or his or her beneficiary that is to be paid at any time during the period beginning on the date of death and ending on December 31 of the calendar year immediately following the year of death (the "Death Payment Period") will be treated as timely paid for purposes of Section 409A if it is paid at any time during this period. The Proposed Regulations also provide that an NDCP does not need to specify any particular date within the Death Payment Period as the payment date and may rely on this new rule if the NDCP provides that the applicable amount will be paid sometime during such period, upon death without specifying the period for payment following death in any other manner, or on a date within the Death Payment Period determined at the discretion of the beneficiary.
The Proposed Regulations further provide that an NDCP that already provides for payment of a death benefit at any time during the specified Death Payment Period may be amended to provide for payment of that amount (or payment of that amount may be made without amending the NDCP) at any other time during the Death Payment Period without violating the otherwise applicable deferral election or permissible payment rules of the Current Final Regulations.
6. Changes in Status from Employee to Independent Contractor or Vice Versa
Current Final Regulations. The Current Final Regulations include language that seems to suggest that a service provider whose status changes from employee to independent contractor or vice versa will not be considered to have incurred a separation from service for purposes of Section 409A until he or she ceases to provide services in both capacities. That is, this dual termination language could be read, as some commentators had suggested, to provide that an employee who becomes an independent contractor for the same service recipient and whose anticipated level of services as an independent contractor will be 20 percent or less than the average level of services performed over the immediately prior 36-month period would not have a separation from service until the complete termination of the contractual relationship with the service recipient. This resulted in an inconsistency with the more specific rule in the Current Final Regulations that an employee will have a separation from service if it is reasonably anticipated that the level of services to be performed after a certain date (whether as an employee or independent contractor of the same service recipient) permanently would decrease to no more than 20 percent of the average level of services performed (whether as an employee or independent contractor) over the immediately prior 36-month period.
Proposed Regulations. In order to resolve the inconsistency, the Proposed Regulations eliminate the potentially confusing dual termination language described above. The Proposed Regulations further clarify that an employee who becomes an independent contractor for the same service recipient but does not have a separation from service upon such change in status (based on the 20 percent test that applies to employees as described above) will have a separation from service in the future when the contractual relationship with the service recipient terminates (which is the separation from service rule in the Current Final Regulations that applies to independent contractors).
7. Added Flexibility for Payments to Beneficiaries upon Death, Disability, or Unforeseeable Emergency
Current Final Regulations. The Current Final Regulations provide that a payment under an NDCP resulting from the addition of death, qualifying disability, or unforeseeable emergency of a service provider as a potentially earlier alternative payment event for a previously deferred amount is not a prohibited acceleration of the payment under Section 409A (the "Acceleration Exception").
Proposed Regulations. The Proposed Regulations expand the Acceleration Exception so that it also applies to the payment of deferred amounts upon the death, qualifying disability, or unforeseeable emergency of a beneficiary who has become entitled to payment due to a service provider's death.
The Proposed Regulations also clarify that a schedule of payments that already has begun before a service provider's or beneficiary's death, qualifying disability, or unforeseeable emergency may be accelerated upon any such event.
8. Other Clarifications and Changes to Current Final Regulations
The Proposed Regulations also include some other clarifications and changes to the Current Final Regulations, as described below:
- Reimbursement of Legal Fees and Expenses: Provides that a plan under which a service provider has a right to payment or reimbursement of reasonable attorneys' fees and other reasonable expenses incurred to enforce a bona fide legal claim against the service recipient with respect to the service relationship does not provide for deferred compensation subject to Section 409A.
- Deemed Asset Sales: Clarifies that a stock purchase treated as a deemed asset sale under Code Section 338 is not a sale or other disposition of assets for purposes of determining whether a service provider has incurred a separation from service for purposes of Section 409A.
- Plan Terminations and Liquidations: Clarifies that the provisions in the Current Final Regulations that permit acceleration of payments upon the termination and liquidation of an NDCP require a termination and liquidation of all plans of the same type sponsored by the service recipient and all members of its controlled group. The Proposed Regulations also clarify that a new plan of the same type may not be adopted for at least three years following any such plan termination and liquidation.
- Foreign Ethics or Conflict-of-Interest Laws: Expands the foreign ethics or conflict-of-interest exception to the general prohibition on the acceleration of payments in the Current Final Regulations to permit the accelerated payment of all types of deferred compensation (and not just certain types of foreign earned income) if the acceleration is reasonably necessary to comply with bona fide foreign ethics or conflict-of-interest laws.
- Exempt Stock Rights Eligible for Transaction-Based Compensation Rules: Clarifies that the special payment rules in the Current Final Regulations for transaction-based compensation payments also may apply to incentive stock options and other Exempt Stock Rights.
- Federal Debt Collection Laws: Expands the rule in the Current Final Regulations that permits the acceleration of the time or schedule of payments, or permits payment to be made under a plan, as satisfaction of a service provider's debt to the service recipient to include payments reasonably required to comply with federal debt collection laws.
- "Payment" Definition: Provides a rule that is generally applicable to determine when a "payment" has been made for purposes of Section 409A.
- Code Section 457A Interaction: Clarifies that NDCPs under Code Section 457A (e.g., NDCPs sponsored by certain non-U.S. entities) also may be NDCPs for purposes of Section 409A, and that the rules of Section 409A would apply to such plans separately and in addition to any Code Section 457A rules that apply to the plans.
- "Service Provider" Definition: Clarifies that a "service provider" for purposes of the Current Final Regulations may be an entity, as well as an individual.
- Part-Year Compensation: Modifies and explains the exemption rule for recurring part-year compensation arrangements, which typically affects service providers such as teachers.
Key Changes to Current Income Inclusion Regulations
Current Income Inclusion Regulations. The Current Income Inclusion Regulations provide, among other things, that corrections generally can be made to NDCP provisions that are not compliant with Section 409A's requirements while the applicable amounts are still subject to a substantial risk of forfeiture without including the amounts in income or incurring penalty taxes, subject to a specified anti-abuse rule (e.g., a correction may not be made if the facts and circumstances indicate that a service recipient has a pattern or practice of permitting impermissible changes in the time or form of payment with respect to nonvested deferred amounts and an impermissible change applies to the applicable amount) (the "Old Anti-Abuse Rule").
Proposed Regulations. The Proposed Regulations withdraw the Old Anti-Abuse Rule and replace it with a more stringent anti-abuse rule (the "New Anti-Abuse Rule"). The IRS notes that the New Anti-Abuse Rule is intended to preclude service recipients from (a) changing time or form of payment provisions that otherwise meet the requirements of Section 409A in a manner that fails to so comply; (b) creating errors in their NDCPs with respect to nonvested amounts with the intention of using those errors as a pretext for establishing or changing the time or form of payment in a manner that fails to comply with Section 409A; or (c) making other changes of a similar nature.
The New Anti-Abuse Rule generally provides that, in order for otherwise nonvested deferred amounts to be treated as nonvested for purposes of the Current Income Inclusion Regulations, (a) if a change is made by a service recipient in an NDCP provision that is not otherwise permitted under Section 409A and the Current Final Regulations and that affects the time or form of payment of an applicable amount, there must be a reasonable, good-faith basis for concluding that the original provision was noncompliant and the change is necessary to bring the NDCP into compliance; (b) the facts and circumstances surrounding the change must not indicate a pattern or practice of permitting impermissible changes in the time or form of payment with respect to nonvested deferred amounts under one or more NDCPs; (c) to the extent generally applicable guidance regarding the correction of Section 409A failures prescribes a particular correction method for a type of failure, such prescribed correction method must be used in order to correct the failure with respect to the nonvested deferred amount;5 and (d) substantially similar failures affecting nonvested deferred amounts must be corrected in substantially the same manner.
Takeaways from the Proposed Regulations
The Proposed Regulations provide some needed clarifications and flexibility, which are always welcome in what some have called the "harsh" and "unforgiving" world of Section 409A. As noted above, for most companies, we expect that no action will be needed to comply with the Proposed Regulations or to benefit from the added flexibility offered.
For More Information
For practical and cost-effective assistance navigating the complex laws, regulations, and guidance that govern deferred compensation plans impacted by Section 409A, including the Proposed Regulations, please contact any member of the employee benefits and compensation practice at Wilson Sonsini Goodrich & Rosati.
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