IRS Proposes Amendments to Section 409A Deferred Compensation Regulations
The Internal Revenue Service recently proposed amendments to the regulations under Code Section 409A. The unexpected new proposals add to the reams of 409A rules and guidance that have piled up since 2004, but only modestly.
In what passes for good news under 409A, the proposals serve mainly to clarify a few points that were not much in doubt and loosen up a few rules. These amount to small, technical improvements to the highly technical 409A rules. To the extent the proposals would tighten up any rules, the issues are narrow and the effect is small. The proposed new rules are certain to be adopted, and they can be relied on immediately.
The focus of this Client Alert is on the practical impact of the proposals. Parts of the proposals dealing with rarely seen events or affecting only not-for-profit entities or government employees are not discussed here. If you believe that these items may effect you please don’t hesitate to call us to discuss your specific situation.
Payments Following Death
A very helpful change adds flexibility to payments upon death. Under the current rules, the timing of payments triggered by death must be spelled out with the same precision – and the same limitations – as apply to other events that trigger a payout. This creates problems, because plan administrators must coordinate with the estate of the deceased, which in some cases can result in delays and in other cases can create a need for faster settlement. The new rules will allow a plan administrator to pay out deferred compensation at any time between the date of death and December 31 of the year following death, and the administrator can coordinate with the estate on the time of payment (a marked contrast to the harsh 409A rules forbidding this type of collaboration). The new rules add similar flexibility in the event a beneficiary dies before receiving all payments.
Although not well known, the 409A rules already offer flexibility to change the payout terms of existing deferred balances upon death. The rules provide for such flexibility on the theory that, if a plan does not accelerate payment for death, that was probably an oversight. The proposed rules not only confirm this flexibility (resolving some doubts as to how far it goes), but also would allow for reliance on the new, flexible payout rules upon death (distribution any time through the end of year following death) even if those rules are not written into the plan. We believe, however, that plan documentation should be revised to expressly incorporate the new rules, so that all parties are aware of the rules, and so that beneficiaries cannot complain that the plan administrator’s actions contravene written plan terms and past deferral elections.
Delayed Payouts for Stock Options/SARs Following a Change in Control
One proposal deals with treatment of equity awards following a change in control. It would allow a payout relating to stock options and stock appreciation rights (“SARs”) to be delayed, with the ultimate payout to align with delayed payments to stockholders. The existing rules allow this for certain forms of deferred compensation, so this change broadens the rules to give similar treatment to stock options and SARs.
Delayed Payouts of Short-Term Deferrals
Compensation that is paid in the same year it is earned or within 2.5 months after year-end is a “short-term deferral” that avoids many onerous 409A requirements (although other, more limited requirements must be met – nothing is easy under 409A). The existing rules permit short-term deferral payments to be delayed past the deadline in very limited cases – if administratively impractical, if payment would jeopardize the company’s ability to continue as a going concern or if payment would cause a loss of tax deductibility under Code Section 162(m). The proposals add one more: Delayed payment is permitted if necessary to comply with federal securities or other applicable laws.
Stock Option/SAR Grants to Prospective Employees
The proposals would allow stock options or SARs to be granted to a person who is not yet an employee or otherwise providing services. While it is common for plans to authorize this, it is not common in practice because it can raise a number of legal and practical issues. Nevertheless, if a new hire believes that the stock price may rise before the agreed upon start date of employment, she may negotiate for the grant to occur earlier. This proposal eliminates a 409A impediment to this practice.
Repurchase of Shares Acquired by Exercise of Stock Options/SARs
For stock options and SARs, the 409A rules limit terms allowing the company to repurchase shares at a price other than fair market value. The proposed rules would allow terms that call for repurchase at a price below the fair market value of the shares in the case of a termination for “cause” or upon a breach of a non-competition or non-solicitation covenant.
Severance Pay for Employee Fired in the Same Year as Hired
The 409A exemption for severance pay for an involuntary termination is based on the employee’s salary level at the end of the year prior to termination. The proposed rules provide that, if the employee both started work and was fired in the same year, the level of compensation in that year is annualized to determine the exemption for severance pay.
Reimbursement of Legal Expenses
The exemption for payment of legal fees is expanded from a limited number of specific types of claims to now cover all types of bona fide claims relating to employment. This is only a minor improvement, because complying with the old rule – treating the reimbursements as potential 409A deferrals – did not pose a difficult problem. The far bigger issue is how far a company should go in committing to pay a former employee’s legal expenses, lest the provision encourage unnecessary and wasteful litigation.
Corrections to 409A Violations Where the Deferral is Not Yet Vested
The proposals tighten up existing rules that allow for changes to the distribution times for non-vested deferred compensation where those changes correct a 409A violation. Non-vested deferred compensation means a compensation arrangement that is a full-fledged 409A deferral (not an exempt short-term deferral) that remains subject to a substantial risk of forfeiture at the time it is amended. The existing regulations contain an “anti-abuse” rule that is triggered if the company has a pattern or practice of making corrections. The IRS apparently is concerned that this rule is not enough, so the proposals add some teeth to the anti-abuse rule:
- Correction is allowed only if there is a reasonable, good faith basis for believing that correction is needed under 409A and the correction is effective to fix the problem.
- The company cannot take action to introduce a problem as a pretext for then changing the distribution terms to fix the problem.
- The proposal lists factors to be considered in assessing whether the facts and circumstances demonstrate abuse of the corrections rule and requires that corrections of this kind be carried out in a manner consistent with the more extensive guidance on correcting 409A problems for fully vested deferred compensation.
Code Section 409A imposes a complex regulatory scheme on a very wide range of compensation practices, with potentially large tax penalties payable if the precise 409A requirements are not met, in both word (documentation) and deed (operation of plans). Although 409A now profoundly shapes the design of elective deferred compensation plans, it also has surprising effects on the design of equity awards and severance and other post-termination compensation under employment agreements and separation policies. It does not appear that the IRS has yet ramped up its audit capabilities in this area, but we expect that that could be coming at some point, as it would potentially reap a bounty of tax penalties for technical violations.
We urge companies to pay very close attention to Section 409A in the design and implementation of compensation arrangements, both those that constitute 409A deferrals and those that are intended to be exempt from 409A. If you have any questions please don’t hesitate to contact us to discuss the specifics of your company’s program as well as compliance challenges and remedies.
Steven C. Root