May 25, 2007

IRS Issues Final Deferred Compensation Rules: Tax-Exempt Compliance Countdown

3 min

Internal Revenue Code Section 409A dramatically changed the landscape for deferred compensation arrangements.  Recently issued final IRS rules require that any arrangement that is now treated as deferred compensation be brought into compliance by December 31, 2007.  If it is not, the affected individuals (not the employers) face draconian tax penalties.

The new rules change how deferred compensation arrangements must be structured, documented and administered.  Also, there is a new definition of just what such arrangements are.  This new definition sweeps in many existing arrangements not previously thought to be deferred compensation.  The key concept to remember is that any compensation "earned" in one year and paid in another year is considered deferred compensation.  So, for example, under 409A both executive and rank-and-file severance plans can be deferred compensation.  The same is true for post-termination expense reimbursement arrangements of all types – those that cover medical expenses as well as those that cover club dues and travel.

For tax-exempt employers, these new rules are in addition to the Section 457 rules that already apply to tax-exempt deferred compensation arrangements. Tax-exempt employers, therefore, will have to ensure that their deferred compensation arrangements comply with both sets of rules, and this can have some surprising results. 

For example, many tax-exempt employers do not consider either executive or rank-and-file severance arrangements to be deferred compensation because the Section 457 rules exempt bona fide severance plans.  Under Section 409A, however, any severance arrangement that promises compensation in one year but pays in another is deferred compensation unless an exemption applies. Therefore, all existing severance arrangements must be reviewed for Section 409A compliance.

Given the complexity of the rules and compliance deadline, tax-exempt employers should begin their compliance countdown now.  Key steps are as follows: 

  • Appoint a person or team to inventory and review all arrangements, including informal arrangements, that might be considered "deferred compensation" under Section 409A, including:

    • Voluntary Deferred Compensation Plans, Agreements or Arrangements
    • Supplemental Retirement or "Wraparound" Plans, Agreements or Arrangements
    • Excess Benefit Plans
    • Employment and Independent Contractor Agreements
    • Severance Plans, Agreements or Arrangements
    • Change of Control, Retention and Severance Plans, Agreements or Arrangements
    • Short and Long-Term Incentive or Bonus Plans, Agreements or Arrangements
    • Policies or Arrangements for Reimbursement or Coverage of Certain Expenses Post-Termination

  • Working backwards from December 31, 2007, make a compliance calendar.  Remember that plan amendments will require approval and that negotiations with affected individuals could take time.

  • Review each arrangement for Section 457 compliance.  The IRS has stated that it hopes to issue new guidance under Section 457 that is expected to clarify certain provisions and explain how Section 409A will apply.

  • Review each arrangement to determine if it must comply with Section 409A, if it qualifies for a special exemption, or if it is "grandfathered" out of the Section 409A rules.  Do this review even if the arrangement was reviewed only last year.  There are significant changes in the final Section 409A rules, and this is the last opportunity for change. 

  • For arrangements that must comply with 409A, document the arrangement, if necessary, or change existing documents, including related election forms and employee communications.

    • Identify required changes in key terms (e.g., new definitions for "disability," "separation from service," "change of control," "performance based compensation").
    • Identify changes for deferral elections (e.g., restrictions on ability to change elections).
    • Identify changes for distribution elections (e.g., restrictions on ability to change elections).
    • Identify other changes (e.g., elimination of impermissible distribution events, acceleration rights and "haircuts").
    • Review any related service provider agreements (e.g., recordkeeper, TPA) and assemble your documentation in order to demonstrate good faith compliance from 2005 through 2007.

This article is not intended to provide legal advice or opinion and should not be relied on as such.  Legal advice can only be provided in response to specific fact situations.