On Sept. 29, the Treasury Department and the IRS issued proposed regulations for implementing the new deferred compensation provisions under Internal Revenue Code Section 409A, enacted by the American Jobs Creation Act of 2004. Section 409A generally provides that unless certain requirements are met, amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includable in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income.

In addition to immediate taxation on the deferred income, Section 409A levies a tax of 20% of the amount included in income, plus interest calculated at 1% above the underpayment rate. See the Winter 2005 Tax Edge for a Section 409A summary.

Which types of plans are not affected?

Section 409A does not apply to qualified retirement plans, tax-deferred annuities, simplified employee pensions or SIMPLEs, nor to certain welfare benefit plans such as vacation leave, sick leave, compensatory time, disability pay and death benefits. 

Distributions from nonqualified deferred compensation plans are allowed only for: payments made at a fixed dated or pursuant to a fixed schedule; separation of service; death; disability; change in ownership or effective control of a corporation; or an unforeseeable emergency.

The new proposed regulations incorporate the initial guidance provided in Notice 2005-1 issued in November 2004, and provide substantial additional guidance.

Regulations set new reporting requirements

Some of the new regulations will require payroll and human resource departments to collect information not previously required to be reported to the IRS. Note that the new reporting requirements apply to nonqualified plans for both employees and non-employees. As a result, this will affect both forms W-2 and 1099 issued for 2005 and future years. A welcome provision of the new proposed regulations is a one-year extension of the deadline for documentary compliance. Taxpayers now have until Dec. 31, 2006 to amend plans to provide for new payment elections without violating the deferral and anti-acceleration rules. This allows taxpayers time to consult their advisors and review the plans to confirm they are compliant with the new law.

Not all deadlines have been extended

Many—but not all—transition rules for applying the proposed regulations have been extended. Be careful not to inadvertently miss any of the requirements that must be met by Dec. 31, 2005. For example, the proposed regulations do not extend the deadline for deferral elections or plan participation termination. 

The proposed regulations identify which plans and arrangements are covered under Section 409A, outline operational requirements for deferral elections and explain permissible timing for deferred compensation payments made under the rules. Major provisions in the proposed regulations include timing of elections to defer, valuation issues for nonpublicly traded stock, performance-based compensation, stock options stock appreciation rights (SARs) for both public and privately held companies and severance plans.

Note that some deferred compensation plans may not be subject to the requirements of Section 409A if certain requirements are met. These plans may include short-term deferral and severance payments. 

The proposed regulations also place a limitation on plan terminations. Terminating a plan can now result in a violation of the anti-acceleration provisions of Section 409A. If this happens, an employer cannot establish another plan for five years after terminating a plan of the same type. Previously, employers were not restricted in terminating a plan as long as contractual obligations were met.

Blackman Kallick recommends that you review your compensation agreements for provisions that might be noncompliant under the new law. The new rules are very complex and must be met to be in compliance and to avoid potential penalties.

     Questions about Section 409A?
     Contact Brian Whitlock at 312/980-2941.
     Contact Javier Castaneda at 312/980-3212.

©2005 Blackman Kallick

Blackman Kallick Bartelstein LLP is located in Chicago, IL See their website at www.bkadvice.com and phone 312-207-1040.