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Randall B. Weill

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Employers Who Defer Paying Employee Compensation Must Follow New IRS Rules

On April 10, 2007, the IRS and the Treasury Department issued final regulations for Internal Revenue Code Section 409A.  The final regulations set out rules governing elections to defer compensation, the permissible acceleration of payments, and methods for funding these benefits.  The regulations also significantly restrict the ways in which compensation can be deferred and paid without being taxed prior to actual or constructive receipt.  All but a limited number of deferred compensation arrangements must comply with the new regulations by December 31, 2007, in order to avoid significant tax consequences, interest, and penalties.

What is Section 409A?

Section 409A was enacted as part of the American Jobs Creation Act of 2004 in response to executive compensation abuses by large public corporations.  It became effective on January 1, 2005.  However, Section 409A applies to all types of employers, including privately owned companies and non-profit organizations, which defer the payment of compensation that is earned or vested on or after that date. 

What qualifies as a "deferred compensation" arrangement?

A plan or arrangement provides for the deferral of compensation if an employee has a "legally binding right" to compensation earned in one tax year that is or may be payable in another tax year.  Deferred compensation arrangements that must, with limited exceptions, be brought into compliance with Code Section 409A may be found in:

• executive employment agreements
• separation pay agreements
• bonus or incentive plans
• equity compensation arrangements
• consulting agreements
• director compensation agreements
• change of control agreements
• reduction in force programs
• fringe benefits arrangements
• split-dollar life insurance
• deferred compensation arrangements for government or tax exempt organizations
• supplemental executive retirement plans
• excess benefit plans
• termination or severance payments. 

Who will be impacted by Code Section 409A?

These rules apply not only to employees but also to independent contractors and other non-employee service providers, for example, directors.  Code Section 409A does not apply to tax qualified retirement plans.

What types of penalties apply for non-compliance?

Violating the new rules can result in serious tax consequences and penalties to employees. For example, if a deferred compensation plan does not comply by the deadline, the employee must:

• include the full amount of deferred compensation benefit in his or her income, even if the employee won't receive the money until later, perhaps at retirement.
• pay a 20 percent penalty, in addition to income taxes, on the improperly deferred compensation.
• Pay interest on any unpaid tax due on the improperly deferred amount. The IRS will charge an interest rate that is one percent higher than the normal rate on late tax payments. 

Act quickly!

Since there are less than six months left until the year-end compliance deadline, employers should act quickly to have any arrangement, written or oral, that involves the deferral of compensation carefully reviewed to determine whether it needs to comply with Code Section 409A.