Internal Revenue Code (IRC) Section 409A

No discussion of deferred compensation would be complete without touching on IRC Section 409A, which governs the treatment of deferred compensation. This provision was developed in response to Enron’s bankruptcy, one of the largest corporate bankruptcies ever. In the case of Enron, the company dismantled a deferred compensation plan, making payouts of large cash balances to participating executives right before the company’s bankruptcy filing. Meanwhile, rank-and-file employees were hurt badly when the stock price cratered.

Section 409A was enacted in an attempt to prevent similar situations by limiting the ability of executives to access deferred compensation balances. Since it became effective in 2005, implementing a deferred compensation program has become much more complicated and the risk to executives of unintentional noncompliance is now much larger. The bottom line is that if companies fail to comply with 409A, all deferred compensation can be subject to current taxation along with penalties and interest for late payment of the taxes. In addition, an executive can be penalized with a 20% non-deductible excise tax on the deferred compensation, which is due in addition to regular income and payroll taxes. As a result, with any form of deferred compensation (which can include non-qualified deferred compensation plans, SERPs, restricted stock unit plans, phantom equity plans, and long-term cash plans), the company should conduct careful analysis to identify whether the award will be subject to 409A and, if so, whether the award design and payment timing comply with its requirements.

Key things to keep in mind for Section 409A compliance include the following:

• Stock options and restricted shares are generally exempt from 409A.
• Performance plans that pay out before the 15th day of the end of the tax year are excluded from 409A due to the short-term deferral exception.
• Deferral elections generally need to be made prior to the beginning of the year of the award.
• Executives are limited in their ability to modify any deferral elections; re-deferrals must extend for at least five years beyond the originally scheduled payment date.

Under the 409A regime, effective plan administration has become critical to ensuring that employees who participate in deferred compensation schemes are not subject to tax penalties. Attorneys practicing tax law can point to numerous cases where 409A has been violated due to administrative errors in implementing the design. Simplicity of design and process can make administration easier. In reviewing these plans, it is critical to make sure that all parties agree that the company will be able to administer the design effectively.

Key Questions for Committee Members to Ask:

• Is this compensation arrangement subject to IRC Section 409A?
• Have appropriate legal/tax professionals reviewed the arrangement?
• Has the company ensured that the terms of the award and deferral elections comply with IRC Section 409A?