The American Jobs Creation Act of 2004 added Section 409A to the Internal Revenue Code. Such section provides that amounts deferred under a nonqualified deferred compensation plan (“NQDC”) for all taxable years are currently included in gross income to the extent that they are not subject to a substantial risk of forfeiture and not previously included in gross income. Section 409A does not apply to a NQDC if certain requirements are met.
On April 10, 2007, the IRS published its final regulations providing rules and additional guidance on Section 409A requirements. The effective date of the final regulations is January 1, 2008. A NQDC will not be treated as violating 409A if the plan is operated in reasonable, good faith compliance with the provisions of 409A and applicable IRS guidance. In addition, the NQDC plan must be amended on or before December 31, 2007 to conform with the requirements of the final regulations. Additionally, amounts deferred and vested in taxable years beginning before January 1, 2005 are generally not subject to 409A as long as the NQDC was not materially modified after October 3, 2004. (Such plans are referred to as “Grandfathered Plans”). Failure to comply with the newly issued regulations under 409A may result in early taxation of the NQDC as well as an additional tax penalty and interest.
Generally, a plan provides for deferral of an employee’s compensation if, under the plan and the relevant facts and circumstances, the employee has a legally binding right during a taxable year to compensation that is or may be payable to the employee in a later taxable year. Section 409A applies to many compensation arrangements that a company might not realize is a deferred compensation plan. For example, 409A may apply to some stock option and bonus arrangements and other employment-related agreements with deferred payment rights. 409A does not, however, apply to arrangements that have special status under federal tax law or to welfare benefit arrangements such as vacation, sick leave and death benefit plans.
The final regulations provide guidance on the numerous requirements placed on a NQDC by 409A.
Given the issuance of final regulations, companies that have deferred compensation arrangements should review those arrangements to avoid possibly unfavorable tax consequences for those plans not in compliance with the regulations.