Funding Arrangements under Sec. 409A

Under Sec. 409A(a), deferred compensation arrangements must satisfy requirements relating to the timing of (1) elections to defer compensation, (2) changes in the time and form of payments and (3) distributions of deferred compensation. According to Sec. 409A(b), deferred compensation arrangements cannot be funded directly or indirectly in offshore trusts, unless the plan participant provides substantial services in the foreign jurisdiction in which the trust is located. Further, taxpayers cannot use a trust or other funding arrangement that restricts access to the assets by the employer’s creditors if the employer’s financial health declines (a so-called “springing trust”). Violations of the Sec. 409A rules trigger accelerated income tax, interest on the participant’s deferred compensation from the vesting date, and an additional 20% tax on such compensation.

Effective Date of Sec. 409A for Funding Arrangements

The restrictions on deferral elections and distributions apply to deferred compensation that becomes vested, or is granted, on or after Jan. 1, 2005. Under a technical amendment to Sec. 409A(b) included in the Gulf Opportunity Zone Act of 2005, the restrictions on foreign and offshore trusts apply to any assets in offshore trusts or springing trusts on or after Jan. 1, 2005. Thus, the trust provisions apply to deferred compensation funded on Jan. 1, 2005 even if the deferred compensation itself is grandfathered under Sec. 409A because the employee’s right to the compensation had vested before 2005.

In recent guidance, the IRS has applied its post-2004 definition of “deferred compensation”—essentially, any amount of compensation the right to which is vested in one tax year but which is paid in another—to define the types of assets subject to Sec. 409A(b) both before and after Jan. 1, 2005. This definition broadens Sec. 409A’s scope beyond what was traditionally considered to be deferred compensation, to include traditional bonus and salary deferral programs and supplemental executive retirement plans, as well as certain stock-based compensation, taxable fringe benefits and severance-pay arrangements.

Transition Rules for Grace-Period Assets

On March 21, 2006, the IRS issued Notice 2006-33, which gives transition guidance for offshore and springing trusts with respect to assets set aside as of March 21, 2006 (grace-period assets) and their related income. The notice creates a limited opportunity to correct such trusts. However, the guidance leaves practitioners with many questions on how to bring common foreign arrangements into compliance with the new law.

According to Notice 2006-33, grace-period assets can be used to pay nonqualified deferred compensation through Dec. 31, 2007 without triggering a violation. Thus, problematic trusts may be spent down by Dec. 31, 2007 without penalty, provided that the distribution otherwise is allowable under Sec. 409A.

The notice also provides that, as of a date on or before Dec. 31, 2007, if grace-period assets are no longer associated with the payment of nonqualified deferred compensation, either under the plan’s terms or through the dissolution of a trust or desegregation of assets, the plan will be treated as having complied with Sec. 409A(b) with respect to those assets. Thus, by the end of 2007, foreign assets can be moved to the U.S., and assets in springing trusts may be able to be moved to permissible rabbi trusts (or the trusts can be amended), and no penalties will be imposed on the plan participants.

Next Steps

Employers should identify all trusts with provisions that may violate Sec. 409A(b), and grace-period assets should be tracked in separate accounts. Employers should determine the amount of grace-period assets that can be used by Dec. 31, 2007 to pay deferred compensation, and should plan to do so. If there will be grace-period assets remaining after Dec. 31, 2007, employers should start planning now whether to amend arrangements to comply or to move those assets to permitted rabbi trusts.

Employers also must review ongoing deferred compensation arrangements to determine whether assets to be set aside for U.S. taxpayers must be held in the U.S. or, in the most extreme cases, whether U.S. taxpayers must be precluded from participating in certain arrangements.

From Susan Lennon, J.D., Washington, DC