Closely Held Employers
and Sec. 409A

Sec. 409A potentially affects every nonqualified deferred- compensation arrangement (NQDCA). This article analyzes Sec. 409A’s particular applicability to the types of NQDCAs more commonly maintained by closely held employers.

Mark P. Altieri, J.D., LL.M., CPA
Associate Professor
Kent State University
Kent, OH

For more information about this article, contact Dr. Burton at
Prof. Altieri at maltieri@kent.edu.

Executive Summary   

• Sec. 409A’s definition of NQDCAs is extremely broad and potentially ensnares employment, severance and bonus arrangements.

• Most deferral arrangements are subject to Sec. 409A, unless specifically excluded.

• A tax adviser must determine whether an NQDCA is subject to a substantial risk of forfeiture or inherently suffers from a plan failure.

Most practitioners are aware that a new and sweeping provision, Sec. 409A, was added to the Code by the American Jobs Creation Act of 2004. Its rules potentially affect every “nonqualified” arrangement that defers the receipt of compensation income to a year later than that in which earned.¹ Generally, the Sec. 409A rules apply to compensation deferred under a nonqualified deferred-compensation arrangement (NQDCA) after 2004. Since the advent of Sec. 409A in October 2004, the IRS and Treasury have provided clarifying notices and proposed regulations, as discussed below.

Business publications have been awash with summaries of the Sec. 409A rules, but little in the literature separates the many detailed rules more applicable to the publicly traded employer from those of particular interest to the closely held employer. This article explains the application of the Sec. 409A rules to NQDCAs likely to be maintained by closely held employers for key employees and highlights any necessary amendments.

Noncompliance Penalty

In general, Sec. 409A imposes a tax acceleration and a significant penalty to the extent that an NQDCA experiences a “plan failure” (described below) so that plan benefits to be paid in the future are not subject to a “substantial risk of forfeiture” (SROF). For example, a contractual requirement to render substantial future services before benefits vest constitutes an SROF. On a plan failure, absent an ongoing SROF, not only will all deferred compensation (plus income attributable to it) be accelerated into income, but a 20% penalty tax will be imposed in that year.

Relevant Authority

A number of primary and secondary authority sources help to understand Sec. 409A’s breadth. In addition to Sec. 409A, there is a helpful narrative in the legislative history embodied in the House Report.² The IRS has provided guidance in notices; Notice 2005-1,³ issued in December 2004, is the most helpful and relevant.  In responding to public comments on Notice 2005-1, and to provide additional and new guidance, Treasury issued proposed regulations in October 2005 (proposed regulations).⁴ Final regulations should be issued in the near future and are expected to be virtually identical to the proposed regulations.

Intent

Sec. 409A is generally applicable to NQDCAs maintained by closely held employers. However, the true abuse that Sec. 409A was intended to correct occurred with more sophisticated NQDCAs; manipulation as to the initial deferral decision and the timing of benefit payments was common before 2005. For NQDCAs maintained by closely held employers that are traditional nonqualified plans, the new rules typically will not require substantial amendments. The terms of these closely held plans may already largely follow the requirements laid out under the Sec. 409A rules (i.e., payments under the plans will not occur until a specified date, separation from service, death or disability, and there is no mechanism to either accelerate or further defer payment of the scheduled deferred compensation). Still, a closely held NQDCA will need to conform its definition of these triggering events to those required under the Sec. 409A rules. Additionally, as noted below, the definition of an NQDCA is extremely broad and goes well beyond traditional NQDCAs to potentially ensnare employment, severance and bonus agreements. These latter agreements are a potential trap for the unwary adviser of the closely held employer, even if he or she is somewhat well-versed in the Sec. 409A implications as to traditional NQDCAs.

Compliance Timeframe

Sec. 409A generally applies to income deferred after 2004, or prior to 2005 that vests after 2004. Notice 2005-1 originally required amendments to bring NQDCAs into conformity with Sec. 409A to be made before 2006. The proposed regulations had extended the amendment deadline to the end of 2006.⁵ However, a few areas required attention during 2005. These included timing rules for “elective” deferrals and the cancellation of outstanding deferral elections or the termination of an NQDCA before it became subject to Sec. 409A. Neither of these areas were typically of interest to NQDCAs maintained by closely held employers. Lastly, Notice 2006-79⁶ extended the amendment deadline to Dec. 31, 2007.

Multi-Pronged Analysis

Comprehension of Sec. 409A is made particularly difficult by a required three-pronged analysis. The first step is to determine whether an arrangement to defer compensation is an NQDCA under Sec. 409A. The second step is a determination whether benefits are subject to an SROF. If not, the final determination is whether the NQDCA, at the first time it is not subject to an SROF, inherently suffers from a “plan failure.” The convergence of these three events invokes Sec. 409A’s income acceleration and penalties; amounts deferred under the NQDCA for the current and all preceding tax years subject to Sec. 409A are includible in gross income and are subject to an additional penalty of 20% of the compensation required to be included in gross income. Interest is also added at the underpayment rate plus 1% from the year in which the amount was deferred.⁷

What Is an NQDCA?

Generally: An NQDCA under Sec. 409A may be an individualized arrangement (e.g., an employment agreement) or a more formal and broader plan (e.g., a nonqualified supplemental retirement plan in which all management-class employees participate). Notice 2005-1 and the proposed regulations specifically state that Sec. 409A is potentially applicable regardless of whether the arrangement constitutes an Employee Retirement Income Security Act of 1974 (ERISA) pension plan.⁸ Sec. 409A is generally looking for an arrangement that provides for the deferral of the compensation owed to a “service provider” (in which he or she has a “legally binding” right to the deferred compensation) into a later year. Sec. 409A(d)(1) excludes from the definition of an NQDCA a (1) “qualified” retirement plan (i.e., a tax-qualified pension, profit-sharing or Sec. 401(k) plan, a Sec. 403(b) tax-deferred annuity or an eligible Sec. 457(b) plan for state, government or tax-exempt employees); or (2) bona fide vacation, sick leave, disability pay or death-benefit plan. The latter exception is, by analogy, the same as that for such arrangements under the wage-withholding regulations.⁹

Except for these excluded plans and arrangements, any and all compensatory scenarios that defer income into a future year require scrutiny to determine if Sec. 409A applies. According to Notice 2005-1, Q&A-8, and Prop. Regs. Sec. 1.409A-1(f) and (g), the employee or independent contractor providing the services is referred to as the “service provider” (employee). The entity to whom the service provider renders services is the “service recipient” (employer).

Legally binding right to deferred compensation: A Sec. 409A deferral exists only if the employee has a legally binding right to compensation that has been deferred into a future year. If the employer may unilaterally reduce or eliminate that right, it is not legally binding. However, Notice 2005-1, Q&A-4(a), notes that if an employer would be unlikely to reduce or eliminate the deferred compensation, the employee would be deemed to have a legally binding right to it. The proposed regulations take the legally binding right to compensation a step further by stating that, if the facts and circumstances indicate that the employer’s discretion to reduce or eliminate compensation is available only on a condition, the employee is considered to have a legally binding right to it. Prop. Regs. Sec. 1.409A-1(b)(1) specifically states that, even if the employee’s right to the deferred compensation is subject to an SROF, he or she is deemed to have a legally binding right to it and there is an NQDCA under Sec. 409A.¹⁰

Example 1: D is a newly hired professional employee of P, Inc. In addition to his regular salary and bonus compensation, P provides D an additional fringe benefit in the form of a nonelective deferred-compensation arrangement (contractual differences be-tween elective and nonelective arrangements are discussed below). However, D’s rights to the deferred compensation are subject to an SROF that he maintain his status as a full-time P employee for the next 10 years, to vest. Even though D is an at-will employee and could be fired by P at any time, thus losing his deferred compensation, he is deemed to have a legally binding right to it. The nonelective deferred-compensation arrangement is an NQDCA under Sec. 409A. Absent application of the short-term deferral exception noted below, the NQDCA must be in writing and otherwise comply with Sec. 409A’s requirements.

Short-term deferral exception: The short-term deferral exception of Prop. Regs. Sec. 1.409A-1(b)(4) is a significant exception to the characterization of an arrangement as an NQDCA. Under it, if deferred compensation is paid out in full within 2½ months after the year of vesting, the arrangement is deemed never to have constituted a Sec. 409A deferral. This is relevant not only for annual bonuses determined on the basis of productivity, but also for long-term deferrals when the payout occurs shortly after the SROF lapses.

Example 2: The executives of a hospital (A) (a Sec. 501(c)(3) employer) participate in an NQDCA with A. Because the employer is a tax-exempt entity, the arrangement must conform to Sec. 457, in addition to Sec. 409A.¹¹ Because of the amounts of deferred compensation, the arrangement is structured as an “ineligible” Sec. 457(f) plan. Under such a plan, to avoid current income taxation under Sec. 457, the deferred benefits must be continually subject to an SROF. The plan provides that the executives will vest in the deferred benefits on attaining age 62 while still in A’s full-time employ and will be paid in a lump sum within 60 days of vesting.

Although the actual payments of the vested deferred compensation may be delayed many years, the arrangement does not constitute an NQDCA under Sec. 409A, because the complete payout will occur well within 2½ months of the end of the vesting year (before the vesting date, the deferred compensation had been continually subject to an SROF).

Separation-pay arrangements: Under the general definition of an NQDCA noted earlier, post-termination severance-pay arrangements would generally constitute NQDCAs. Prop. Regs. Sec. 1.409A-1(b)(9), however, excepts certain severance-pay arrangements from being initially defined as NQDCAs.

There are two severance-pay exceptions of potential interest to closely held employers.¹² The first applies to severance arrangements payable in the event of an involuntary termination of employment if the severance cannot be greater than two times the lesser of the (1) employee’s annual taxable compensation for the calendar year prior to the year of separation from service or (2) compensation limit under Sec. 401(a)(17) for qualified retirement plans ($225,000 for 2007). Roughly corresponding to the ERISA definition of a severance-pay arrangement,¹³ all payments under this exception must be made no later than December 31 of the second calendar year following the year of separation from service, according to Prop. Regs. Sec. 1.409A-1(b)(9)(iii).

The second exception deals with so-called “window” programs. This is the only exception under the severance-pay rules for voluntary, as opposed to involuntary, terminations. Prop. Regs. Sec. 1.409A-1(b)(9)(v) requires that the availability of a window program continue for only a limited period and, in no event, for more than one year. Additionally, window programs have to comply with the dollar limits just noted in the prior exception.

The problem with window programs is that this exception is difficult to fashion on an individual basis. The proposed regulations require that the window program be left open for less than one year for employees who separate from service during that period under specified circumstances (for example, as a short-term early retirement incentive). If the employer establishes a pattern of repeatedly providing for similar separation pay in similar situations for substantially consecutive periods, the program would not be deemed a window program.

If the severance-pay arrangement fails to fit into either of these exceptions, and is not otherwise covered by the short-term deferral exception noted earlier, it generally constitutes an NQDCA and must comply with Sec. 409A. However, such severance-pay arrangements are treated as a separate class of NQDCA under Sec. 409A (i.e., treated as distinct from account-balance NQDCAs (defined-contribution NQDCAs), nonaccount-balance NQDCAs (defined-benefit NQDCAs) and other Sec. 409A NQDCAs (equity-based NQDCAs, as discussed in the next paragraph)). Generally, all plans in the same class are aggregated and treated as one plan.¹⁴ Thus, the separation-pay arrangement that constitutes an NQDCA may provide a different amount and form of deferred-compensation benefit than that payable to the employee on separation from service under other NQDCAs maintained for his or her benefit by the same employer. Post-termination employer reimbursement of employee expenses may also factor into the determination of whether the severance-pay arrangement constitutes an NQDCA, according to Prop. Regs. Sec. 1.409A-1(b)(9)(iv).

Stock options: Notice 2005-1 and the proposed regulations clarify a prior area of confusion under the new law. An option to purchase stock that is a nonstatutory stock option (NSO) may be deemed to be an NQDCA. Specifically, an NSO is an option other than an incentive (qualified) stock option described in Sec. 422. Thus, the typical stock option, being nonqualified, will constitute an NSO under the new law.¹⁵ An NSO will further constitute  an NQDCA subject to Sec. 409A if the amount required to purchase stock under the option is less than the fair market value (FMV) of the underlying stock on the date the option is granted. FMV refers to the true, objective FMV of the underlying stock, not necessarily what the grantor and grantee of the option deem to be the FMV. Notice 2005-1 had requested “comments on appropriate techniques for valuation of stock subject to options or stock appreciation rights where the value of such stock is not established by and in an established securities market, in order to ensure that such valuation reflects the actual fair market value of the stock.” Prop. Regs. Sec. 1.409A-1(b)(5)(iv) looks for a consistent and reasonable valuation method and adds certainty in this analysis. Safe harbors (e.g., independent appraisal at time of grant) are available. Certain widely used valuation formulas, such as book-value formulas, that do not necessarily equate to true FMV, are problematic.

Even when an NSO is an NQDCA under the new law, the arrangement (like any NQDCA) may avoid a plan failure and the resulting tax acceleration and penalty. For example, as is frequently the case with options involving closely held stock, specifying an exact exercise date, or providing an exercise period that is not more than 2½ months after the year in which the option vests, will avoid Sec. 409A tax acceleration and penalties.¹⁶

SROF

Having established that the arrangement is an NQDCA, the second step is to determine if it is subject to an SROF. Sec. 409A(d)(4) states that an employee’s right to deferred compensation is subject to an SROF if the compensation is conditioned on the future performance of substantial services by any individual. This is the same definition found in Sec. 83(c)(1) on transfers of property in connection with the performance of services. Indeed, the legislative history notes that an SROF is defined under Sec. 409A in the same way as it is under Sec. 83.¹⁷ However, Sec. 409A(e)(5) authorizes Treasury to issue regulations disregarding an SROF when needed to carry out the purposes of Sec. 409A. Following that lead, Prop. Regs. Sec. 1.409A-1(d) notes that certain arrangements that could possibly constitute an SROF under Prop. Sec. 1.83-3(c) (e.g., noncompete agreements) would not constitute an SROF for Sec. 409A purposes.¹⁸

Thus, an SROF for Sec. 409A purposes must be real and substantial. The proposed regulations also scrutinize the substantiality of an SROF if the employee owns (directly or indirectly) a significant amount of his or her employer (or an entity affiliated with the employer).¹⁹ Notice 2005-1 and the proposed regulations focus on the employee’s effective control and dominion over the employer, thus making any purported SROF less likely to be exercised by the employer. In the case of a closely held NQDCA that is providing a benefit to a controlling shareholder-employee, the tax adviser should presume that any nominal SROF would be ineffective and proceed in drafting the NQDCA in a way that would preclude a plan failure from its inception.

Plan Failures

Early Distributions

Plan failures under the new rules can take a variety of forms. The first would result from the possibility of an improper early distribution under the NQDCA. This is present if the plan could pay any benefits before the (1) date of the employee’s separation from service during life, (2) employee’s death, (3) employee’s disability, (4) time specified in the plan for payout, (5) time of a change in the employer’s ownership or effective control (or in the ownership of a substantial portion of its assets) or (6) occurrence of an unforeseen emergency. Only the first two points hinge on the employee’s termination of employment; the remainder are addressed in the proposed regulations in a way that presumes NQDCA payout regardless of the employee’s employment termination.

Separation from service requires permanent cessation of employment. Significant post-termination consulting would preclude a separation from service; leaves of absence do not generally constitute separation from service, according to Prop. Regs. Sec. 1.409A-1(h)(1). Payouts that occur on “retirement” (defined as mere termination of employment) should be amended, because the employee could retire as a common-law employee, yet continue to render substantial post-retirement consulting services as an independent contractor.

The NQDCA may also provide for deferred compensation to be paid to an in-service employee at a time and manner specified at the time of deferral. These rules are flexible, despite the statutory need for specificity. Under Prop. Regs. Sec. 1.409A-3(g), the specified time or fixed schedule of payments needs to be objectively determinable as to the amount and tax year of payment. For example, an NQDCA that provides that deferred compensation will be made in three annual payments on December 31 following the employer’s initial public offering would satisfy the requirement that the NQDCA provide for payments at specified times pursuant to a fixed schedule.²⁰

To the extent that an unamended pre-Sec. 409A NQDCA allows for a payout regardless of the employee’s separation from service on a change in control of the entity, it is likely that the change-in-control definition will have to be modified by amendment to comply with the rather unique Sec. 409A definition of “change in control” under Sec. 409A(a)(2)(A)(v).

With regard to an NQDCA payout for an employee’s disability, if the payout will occur regardless of separation from service, the definition under Sec. 409A must be met. A disability is defined by Sec. 409A(a)(2)(A)(vi) as a mental or physical impairment qualified for Social Security disability payments, or a disability expected to last for more than a year and (1) that prevents the employee from engaging in substantial gainful activity or (2) for which the employee is receiving disability income benefits under an employer disability plan for at least three months.

An “unforeseen emergency” is a severe financial hardship to the participating employee resulting from an illness or accident to the participant or his or her spouse or dependent, not compensated or reimbursed through insurance or otherwise. Under Sec. 409A(a)(2)(A)(vi), it also includes a loss of the participant’s property due to a casualty or similar extraordinary and unforeseeable circumstance.

Different payments for different distribution events: The legislative history notes that the NQDCA could allow participants different forms of payment (as long as objectively ascertainable) for different permissible distribution events. The NQDCA could provide, for example, that the employee would receive a lump-sum distribution on a Sec. 409A defined disability, but receive an annuity stream on separation from service.²¹ Thus, an NQDCA benefit payout on separation from service for any reason must provide the same amount at the same time, regardless of whether separation from service is due to retirement, disability or change in control. If, however, the parties want to provide a different benefit on disability or change in control, or if the employer wants to provide an NQDCA payout on disability or change in control regardless of separation from service, the plan would have to segregate that benefit from the separation-from-service scenario, with the triggering event conforming to the Sec. 409A definitions of those terms.

Lastly, before Sec. 409A, it was fairly common for NQDCAs to give the employer a unilateral right to change the form of deferred-compensation payments. For example, the employer, in its sole discretion, might have had a right to make an actuarially discounted lump-sum payment in lieu of monthly payments for 20 years. After Sec. 409A, such a provision would violate the requirement that the amount and time of NQDCA payments be objectively determinable at the time of deferral.

Subsequent Deferral

A plan failure also includes an ability to again defer payments due to be made under the NQDCA. The plan may permit subsequent elections to delay or change the form of payments if the new election cannot take effect until at least 12 months after it is made. Also, an election to defer further a distribution to be made after the participant’s separation from service, on a predetermined date or schedule or on a change in ownership of the employer, must defer the delayed payment for at least an additional five years, according to Sec. 409A(a)(4)(C).

Initial Deferral Election for Elective NQDCAs

Another major category of plan failure relates to the initial deferral election for elective NQDCAs (in which the deferral decision is initiated by the employee). An elective NQDCA is one in which the employee opts to receive less salary and/or bonus compensation than he or she would otherwise currently receive and to defer receipt of the reduced amount to a future tax year. The point is that the initiative behind the deferral comes from the employee. Because the employee is initiating the deferral of compensation that he or she would otherwise shortly earn and receive, it would be inappropriate to impose an SROF on the NQDCA benefits. Thus, an elective deferral would normally be fully vested from its inception.

Nonelective deferred compensation is a different scenario. It is not unusual for employers to provide a deferred-compensation benefit as a fringe benefit to key employees. It does not result in a reduction in salary and bonus compensation otherwise payable. Rather, the nonelective arrangement is typically in the nature of an add-on benefit. This is the so-called “velvet handcuff” mechanism for retaining key employees, and usually incorporates within the arrangement an SROF requiring a number of years of service before benefits become nonforfeitable.

Elective deferrals must specify the time and form of payment on deferral. Additionally, Sec. 409A codified the IRS’s prior position in Rev. Proc. 71-19,²² by requiring that a participant’s elective deferral is effective only if made before the tax year in which the deferred compensation will be earned (e.g., a salary-reduction agreement entered into before 2007, to defer 10% of compensation that would otherwise be earned and payable in the 2007 calendar year). If the electively deferred compensation is based on performance criteria or services performed over at least 12 months (e.g., bonus compensation based on a fiscal-year net profit increase), the election must be made no later than six months before the end of the measurement period. As to a new participant (e.g., a new officer hired mid-year), the election must be made within 30 days after the date the new participant becomes eligible to participate in the NQDCA to initiate deferrals for that year.²³ A deferral election that remains in place unless the em-ployee changes it (an evergreen election) is generally permissible, under Prop. Regs. Sec. 1.409A-2(a)(2).

A nonelective NQDCA does not have to contend with the specific timing rules just noted, but the underlying contract must be entered into before the deferred compensation is earned and the amounts and timing of the payout must be objectively determinable, under Prop. Regs. Sec. 1.409A-2(a)(13).

Funding Arrangements

Long before the advent of Sec. 409A, formally funding a nonqualified obligation accelerated the taxable event to the participating employee.²⁴ To the extent that the employee had a vested, nonforfeitable interest in any trusteed or escrowed money (a “secular” trust) used to satisfy the employer’s contractual obligation, the employee’s taxation on the deferred compensation was (and is) accelerated under Sec. 83.

An important and frequently used device to somewhat enhance the likelihood that deferred compensation will be paid without accelerating the taxable event is “informal” funding of the obligation in a “rabbi” trust. In a rabbi trust, the employer contributes money to a trust to satisfy the deferred-compensation obligations. That wealth remains subject to the employer’s general and secured creditors in the event of legal insolvency or bankruptcy. Because of this contingency, the IRS has long acknowledged that employee taxation is not accelerated.²⁵

The new law does not change this result, except in the rarest situations. Under Sec. 409A(b), employee taxation through the use of a rabbi trust is accelerated only if it is an offshore trust (thus providing a practical impediment to employer creditors reaching the trust assets), or if it is a “springing” arrangement under which a pre-existing rabbi trust would contractually flip to secular trust status (or would be first funded) on a negative change in the employer’s financial health short of legal insolvency or bankruptcy.

Conclusion

The closely held business adviser must scrutinize any arrangement (regardless of how labeled) for deferrals of income beyond the year in which earned by the benefited employee. To the extent such deferrals are not specifically excepted from the Sec. 409A rules (e.g., short-term deferrals, welfare benefit plans and certain involuntary severance-pay arrangements), it is likely that such arrangements are subject to Sec. 409A. The tax adviser must search for such deferrals in contractual arrangements other than traditional NDC plans, to ensure that deferred bonuses, rights to purchase equity, severance pay and other deferrals are contractually accounted for under Sec. 409A.