IRS Notice 2007-86 extended the deadline for employers to bring documents into compliance with the final regulations of Section 409A of the Internal Revenue Code (the "Code") until December 31, 2008. With less than six months remaining in the year, we strongly encourage all employers to now take action to implement a Section 409A review process in order to allow for sufficient time to assess compliance alternatives and prepare amendments to implement any necessary changes. Because the amendment process may generally require Board action and employee consent, advance planning for the steps that need to be taken before the end of the year becomes even more crucial.
Code Section 409A addresses "nonqualified deferred compensation" and violations of 409A can stem from either operational failures or by having non-compliant documents. Employers that have not yet fully implemented a 409A document review and compliance process should do the following:
- STEP ONE: Identify the types of arrangements that could potentially be subject to Code Section 409A. 409A has a very broad purview and arrangements subject to its requirements can include, among other things: equity compensation plans including stock option and restricted stock unit awards, bonus and incentive compensation plans, nonqualified deferred compensation or retirement plans, employment agreements and offer letters, severance arrangements, change in control agreements, and any other agreement or obligation that gives a service provider a legally binding right to compensation that is or may be payable in a later year. Certain exceptions to Code Section 409A may apply, but for purposes of this first step it is prudent to be over-inclusive rather than under-inclusive.
- STEP TWO: Review the identified arrangements for 409A compliance and prepare and adopt written amendments not later than December 31, 2008 for all non-compliant arrangements. To the extent any unwritten arrangements are subject to Code Section 409A, those arrangements must be reduced to writing by December 31, 2008 as well.
- STEP THREE: Assess operational procedures. Because operational and document compliance go hand-in-hand, employers should also focus on reviewing and ensuring that their payroll and operating procedures can satisfy the requirements of Code Section 409A on an on-going basis. Establishing 409A-compliant operational procedures is also important because it can enable employers to rely on methods for correcting certain 409A operational failures under the transition relief and proposed correction program described in Notice 2007-100, the purposes of which are to limit the harshness of 409A penalties.
Act now! Employers have a one-time opportunity to implement changes provided by the transition relief provisions that will no longer be available after 2008. The negative consequences for failing to comply with Code Section 409A are severe and can result in an acceleration of income of amounts intended to be deferred and the imposition of an excise tax of 20%, paid by the employee, over and above the income tax owed. States (such as California) may impose their own additional tax for 409A violations, and penalties and interest may also apply. Moreover, 409A compliance prevents employers from having to deal with unhappy employees who may demand to be made whole as a result of the imposition of a 409A tax. Achieving 409A compliance in both form and operation can also facilitate the consummation of a corporate merger, acquisition or financing transaction since employers are regularly being asked to provide representations and warranties regarding 409A compliance.
ANY TAX ADVICE HEREIN WAS NOT INTENDED OR WRITTEN BY THE AUTHOR TO BE USED, AND IT CANNOT BE USED BY ANY RECIPIENT, FOR THE PURPOSE OF AVOIDING ANY TAX PENALTIES THAT MAY BE IMPOSED ON ANY PERSON. THERE IS NO LIMITATION IMPOSED ON A RECIPIENT HEREOF BY THE AUTHOR HEREOF ON DISCLOSURE OF THE TAX TREATMENT OR TAX STRUCTURE OF ANY TRANSACTION. EXCEPT WITH PRIOR WRITTEN CONSENT OF THE AUTHOR, NOTHING HEREIN MAY BE USED OR REFERRED TO IN PROMOTING, MARKETING OR RECOMMENDING A PARTNERSHIP OR OTHER ENTITY, INVESTMENT PLAN OR ARRANGEMENT TO ANY PERSON.