Act Now to Ensure that Non-Qualified Deferred Compensation Plans Comply with Section 409A by December 31, 2008 to Avoid Negative Tax Consequences

After December 31, 2008, all non-qualified deferred compensation plans must be in writing and their terms must comply with the requirements of Section 409A of the Internal Revenue Code and the regulations issued under it.

Generally speaking, a nonqualified deferred compensation plan (a “plan”) is any agreement or arrangement in which an employee or certain independent contractors (a “service provider”) has a binding right to compensation in one year but the compensation is not payable until a later year. This definition includes arrangements that cover only one service provider or only a limited number of service providers.

The broad definition of a plan can include a number of arrangements that employers might not ordinarily consider to be deferred compensation plans, including:

• Employment agreements with provisions deferring compensation;
• Independent contractor agreements with provisions deferring compensation;
• Bonus and commission agreements with provisions deferring compensation;
• Severance agreements with provisions deferring compensation;
• Restricted stock;
• Stock options (other than options under qualified incentive stock option plans and employee stock option plans); and
• Phantom stock, stock appreciation rights, and other compensation arrangements based on equity equivalents.

In order for a plan to comply with Section 409A, it must be in writing, and meet Section 409A’s requirements, which include:

• Restrictions on when service providers can elect to defer compensation and change their elections;
• Distributions of deferred compensation only upon:
  o A service provider’s separation from service;
  o A service provider’s death;
  o A service provider’s disability;
  o A specified time or according to a fixed schedule;
  o A change in ownership or control of a corporation; or
  o An unforeseeable emergency; and
• Prohibitions against accelerating the distribution of deferred compensation.
  

If a plan does not meet the requirements of Section 409A, all of the service provider’s income that is deferred under the plan after the year 2004 is taxable in the first year that the plan fails to comply with Section 409A (unless there is a substantial risk that the deferred compensation could be forfeited), even if the compensation has not actually been distributed to the service provider at that time. The service provider will also be required to pay an excise tax of 20% of the amount of deferred compensation that should have been included in income and interest on the deferred compensation from the time it should have been included in income. Although these negative consequences primarily affect employees and other service providers, employers are required to report and withhold taxes on income that is taxable to employees and other service providers under defective plans.

With the deadline for compliance looming, you should begin identifying non-qualified deferred compensation plans now in order to make any required amendments before the December 31st deadline. If you need assistance in identifying plans that are subject to Section 409 or in amending plans to comply with Section 409A, please contact us as soon as possible.