Did You Know?
By: THOMAS W. GARTON
September 2007
This is the first article in a series containing reminders about tax traps for the unwary and information about new or developing income tax rules.
Code Section 409A; The Big Gorilla Walks into the Room on January 1, 2008
After postponements, but unfortunately before many technical questions have been answered, the final regulations under Internal Revenue Code Section 409A were issued in April, 2007. They are slated to be effective January 1, 2008. This gorilla cannot be ignored. Section 409A applies to just about any compensation plan that involves a deferral of receipt (and therefore recognition) of compensation income. So what’s the big deal?
If the plan or agreement fails to comply with the rules, the executive, employee, or director who receives the benefits could be subject to income tax, interest and a 20 percent penalty on the deferred payments. At best this will result in a very unhappy executive, and at worst it may be the basis for a cause of action by the executive against the employer for not observing the new rules.
No longer can we “wait and see” how this will shake out. It’s time to take action.
“Deferred Compensation” is very broadly defined for purposes of Section 409A. Not surprisingly, it includes standard and familiar unfunded deferred compensation arrangements. Surprisingly (unless you have been monitoring the progress of the regulation-making process), it also includes almost any arrangement that creates a deferral of payment of compensation beyond the date that is 2-1/2 months after the end of the tax year in which the benefit vests. Statutory stock options (ISO’s) granted under Code Sections 422 and 423 are not included in this definition. However, if an ISO is modified, it could become deferred compensation subject to Section 409A. And speaking of traditional stock options, the method of setting the value of option stock (and therefore the exercise price) is more stringent under Section 409A than under the basic stock option rules of the Code.
December 31, 2007 is the last date for the service provider and the payer of the compensation to amend noncomplying plans and for certain new elections to be made by the service provider.
Employers, with the guidance of benefits counsel or consultants, should take the following steps as soon as possible:
- Identify all possible deferred compensation plans in place. These may include such arrangements as salary continuation plans, severance plans, performance bonus programs, taxable fringe benefits, phantom stock plans, stock options and other equity incentive plans, and change of control agreements.
- Check for qualification for certain limited grandfathering provisions of 409A.
- Amend plans or arrangements that are not grandfathered and that are not in compliance with the new requirements. Remember, the deadline for this is December 31, 2007.
- Implement the Form W-2 reporting that is now required under Section 409A. This should be coordinated with your payroll services vendor.
Don’t let the gorilla surprise you and your key employees. Start preparing now for its December 31, 2007 arrival.
Takeaway
It’s time to start preparing for the new deferred compensation rules, effective January 1, 2008.