The early part of the year is a time during which many companies and their compensation committees, management teams, and outside advisors are focused on both developing new compensation arrangements and reviewing existing compensation arrangements for executives and other employees. These arrangements must be structured and maintained in a way that not only meets the company’s desired business needs, but also complies with the complex and often counterintuitive rules contained in various applicable sections of the Internal Revenue Code.
Two sections of the Internal Revenue Code that continue to challenge both companies and their advisors in creating compensation arrangements are Section 409A, which governs the treatment of nonqualified deferred compensation arrangements, and Section 162(m), which limits the annual compensation deduction that a public company may take with respect to certain of its executive officers. This article highlights some of the key pitfalls and other traps for the unwary that can cause unintentional failures and result in unintended consequences and penalties under these two sections.
Section 409A
Section 409A contains a comprehensive set of requirements that govern the broadly defined universe of so-called nonqualified deferred compensation arrangements. Violations of Section 409A, whether documentary or operational, can result in significant monetary penalties for the employees and executives who are parties to these arrangements.
While many companies have gained significant familiarity with Section 409A over the past 10 years, the 2014 announcement by the Internal Revenue Service that it has begun auditing Section 409A arrangements has put enhanced pressure on the need to ensure that all arrangements are in compliance with Section 409A. This makes it even more critical that companies and their advisors place extra emphasis on developing procedures for identifying potential Section 409A risks and ensuring compliance with Section 409A rules, to avoid the taxes and penalties that can result from even innocent mistakes.
The following sets forth some of the main Section 409A compliance issues frequently encountered in practice.
General Application of Section 409A
One reason for many inadvertent violations of Section 409A is the failure to identify that the arrangement at issue is subject to its requirements. This happens because Section 409A applies to a wide variety of arrangements that may not be thought of as providing for deferred compensation. Section 409A covers not only traditional deferred compensation arrangements involving the deferral of salaries and bonuses, but also many employment, change in control, and severance arrangements, awards of phantom stock, deferred shares and restricted stock units, and bonus payments. In addition, and unlike some other sections of the Internal Revenue Code, Section 409A is not limited to public companies or certain high-ranking or highly paid executives. Rather, Section 409A applies to both private and public companies and to nearly all service providers, including executives and other employees, nonemployee directors, and most independent contractors. As a result, nearly every compensation arrangement must be examined to determine if it is potentially subject to Section 409A.
The application of Section 409A also is not limited solely to individuals providing services in the United States, but instead has a broad reach that extends to certain foreign deferred compensation arrangements. Section 409A applies to all income payable to United States taxpayers, regardless of the country in which the compensation is earned, unless an exemption applies. For this purpose, U.S. taxpayers include U.S. citizens, legal permanent residents (i.e., green card holders), and temporary residents (as determined by the “substantial presence” test under the Internal Revenue Code). However, for nonresident aliens, deferred compensation is generally subject to Section 409A only if the underlying services were performed in the United States.
In light of the potential reach of Section 409A to foreign arrangements, companies should take action to:
perform a thorough review of their employee population, to identify all employees who are U.S. taxpayers,
identify all foreign benefit arrangements applicable to U.S. taxpayers that could provide for deferred compensation under Section 409A, and
determine whether, in each case, an exemption applies to the particular foreign deferred compensation arrangement, such as arrangements that may be covered by a tax treaty.
Timing of Initial Deferral Elections
The initial election to defer the payment of nonqualified deferred compensation must be made in compliance with a detailed set of rules in Section 409A. In general, an initial election to defer compensation must:
be in writing,
be irrevocable,
specify a payment date or event that is permissible under Section 409A, and
be made prior to the beginning of the year in which the compensation is earned.
The final rule noted above regarding the timing of the election continues to create issues for companies and their advisors, because the timing deadline is often counterintuitive. For example, assume that
