Tax Article - IRS Issues Final Regulations on Tough Restrictions for Non-Qualified Deferred Compensation Arrangements - 409(A)

Congress enacted tough restrictions regarding non-qualified deferred compensation arrangements (“NQDC”) as part of the American Jobs Creation Act of 2004. Failure to comply with these rules can result in some very harsh consequences such as a 20% penalty on the amount of the deferred compensation. These penalties are applied at the employee/independent contractor recipient level. For example, something as simple and straight forward as a $100,000 deferred bonus could result in a $20,000 penalty if not structured properly. 

In most cases, it will be necessary to amend NQDC plans to bring them into compliance with these rules. Prior to issuing final regulations, there was sufficient uncertainty regarding the necessary amendments to existing plans that the deadline to make these amendments was extended pending the issuance of final regulations. The IRS recently issued these final regulations and has set a deadline of December 31, 2007, to amend NQDC plans and bring them into compliance.

Although this deadline may seem a long way off, there can be considerable work to do in many cases to bring plans into compliance with these new rules. Unfortunately, the IRS declined to provide model language for plans to adopt so it will be up to knowledgeable practitioners to ensure that the plan complies with all aspects of the operative section of the tax law, section 409A. Although comfort may be obtained by submitting a NQDC plan to the IRS within the private letter ruling process now that final regulations have been issued, there may not be sufficient time or IRS resources to accommodate the ruling process by the deadline. 

For the most part, the final regulations stick fairly closely to the previously issued proposed regulations and provide much needed guidance. Specifically exempted from the definition of deferred compensation are “short-term deferrals.” A short-term deferral requires payment to the employee by the 15th day of the third month following the later of the employer’s or employee’s year-end in which there is no substantial risk of forfeiture. 

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For example, a bonus awarded with immediate vesting and no substantial risk of forfeiture by a calendar year employer on November 1, 2007, to a calendar year employee must be paid by March 15, 2008. If the employer’s year end is October 31, 2007, and the award is made on November 1, 2007, the compensation must be paid by January 15, 2009. 

However, the plan will not constitute a short-term deferral if the bonus plan provides that any payment will be made on or after any date or occurrence of any event that will or may occur later than the short-term deferral date of March 15, 2008 (or January 15, 2009, in the case of the October 31, 2007, fiscal year end). If that is the case and the plan is not in compliance with these rules, the employee is exposed to a 20% penalty on the deferred compensation. For example, a bonus arrangement that provides for payment to an employee upon separation from service will not qualify as a short-term deferral, even if the payment is by March 15, because separation from service may occur and payment may be made subsequent to March 15. 

The regulations also provide additional guidance and relief in the case of separation pay. Unlike the proposed regulations where separation pay is excluded from deferred compensation only where the total separation pay was no more than two times compensation, the final regulations exempt two times compensation and only the excess is treated as deferred compensation. In addition, although the separation pay provisions only apply to involuntary terminations, the final regulations clarify when a voluntary termination for good reason can be treated as an involuntary termination. A good reason can qualify an otherwise voluntary termination where the termination is a result of an adverse change in the employment relationship, such as a reduction of pay or responsibility.

The final regulations also provide much needed guidance in the case of stock appreciation rights and stock options as well as providing much greater flexibility for the valuation of the underlying stock. Importantly, the valuation consistency requirement in the proposed regulations was eliminated such that different valuation methods for the option at grant and at exercise are allowed.

Although a more in-depth discussion of these final regulations is beyond the scope of this article, the important message here is to determine whether a non qualified deferred compensation plan exists and, if it does, to contact a qualified advisor to make the appropriate changes to ensure the plan is in compliance with section 409A. The downside in not doing this or attempting to short-cut the process can be a disaster given the broad scope and harsh penalties under 409A. 

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