Often referred to as the “409A rules” after the corresponding section of the Internal Revenue Service code, these new rules affect a wide variety of deferred compensation plans, in which compensation earned in one year is paid in a subsequent year.
Beginning with the 2008 tax year, employers must provide full documentation of their compliance with the new rules for all affected deferred compensation arrangements, which include the following:
- Deferred cash payment plans
- Employment or severance/termination agreements
- Deferred employment benefits
- Supplemental executive retirement plans
- Delayed bonus payments
- Reimbursement agreements
- Change in control agreements
- Stock option plans
The 409A rules were originally enacted in 2004, but confusion over how to implement them led the IRS to delay the compliance deadline to the 2008 tax year.
A Look at the Details
Code Section 409A contains several new rules. For example, to qualify for deferred taxation, the decision to take deferred compensation generally must be made in writing on a designated date prior to the beginning of the year in which the deferred compensation will be earned. There are exceptions, however: A performance bonus may be deferred six months before the end of the relevant performance period. Also, the deferred compensation cannot be paid earlier than the date agreed to in the deferral without incurring tax and penalties.
Valuation of deferred noncash compensation, such as stock options, is also under much tighter scrutiny. Under 409A, stock options can no longer be issued with exercise prices that are lower than the fair market value on the date they are granted. Reasonable methods for determining valuation must be used prior to issuing a stock option and must include all available information that relates to the value of the company’s common stock, including the value of tangible and intangible assets, the present value of future cash flows, and the market value of common stock issued by similar companies.
In some cases, it may be easier for a company to simply alter its compensation package to avoid 409A deferred-compensation rules, for instance, switching to granting stock outright instead of issuing stock options that vest at a later date.
Not conforming to the new deferred compensation rules results in strict penalties. If a deferred compensation arrangement does not meet the requirements, the individual whose income was deferred will owe taxes on the income in the current year, and at a high rate of interest. In addition, a 20 percent penalty tax is added. The employee who agreed to the deferral pays these penalties, so at the risk of losing valued employees, it’s especially important to stay on top of the issue.
Business owners may need to take action in two areas:
- If you have made any deferred compensation plans with employees or independent contractors, review your plan to make sure it complies with 409A rules.
- If you have entered into any deferred compensation plans as a sole proprietor or other business form, working as an independent contractor for a client, confirm that the agreement you entered into conforms to 409A. Otherwise your business could end up owing tax and penalties in the current tax year on money you haven’t yet received.
For more information on IRS Code Section 409A, go to the IRS Web site or contact your tax specialist.