The Internal Revenue Service recently issued proposed regulations under Section 409A of the Internal Revenue Code (“Section 409A”) in an effort to clarify and modify parts of the current final regulations (issued in 2007) and proposed income inclusion regulations. For the most part, the proposed regulations are consistent with how most practitioners have been interpreting and applying the final regulations. The proposed regulations do provide some helpful new guidance as well. However, the revisions to the proposed income inclusion regulations limit the ability to make changes to unvested amounts without incurring Section 409A penalties.
Some of the proposed changes include:
- Modification of the short-term deferral exception to permit a delay in payments to avoid violating federal securities laws or other applicable law. This change will make it much easier for plan sponsors to address the inherent conflicts between avoiding the imposition of excise taxes under Section 409A and the violation of federal securities laws.
- Clarification of issues related to stock rights. The proposed regulations clarify that a stock right (e.g., an option) structured to be exempt from Section 409A (e.g., it has an exercise price per share equal to the fair market value of a share on the date of grant, no deferral feature) will not be treated as being subject to Section 409A solely because the amount payable under the stock right upon an involuntary termination for cause, or the occurrence of a condition within the employee’s control, is based on a measure that is less than fair market value.
- Revision of the rules to allow pre-employment equity grants to be exempt from Section 409A. The proposed regulations modify the definition of “eligible issuer of service recipient stock” to include a corporation (or other entity) for which a person is reasonably expected to begin, and actually begins, providing services within 12 months after the grant date of a stock right. Accordingly, options and stock appreciation rights granted to employees prior to employment commencement can still qualify for an exemption under Section 409A.
- Clarification of Involuntary Separation Pay Exception. The proposed regulations provide that separation pay plans intended to be exempt from Section 409A under the involuntary separation pay exception can still meet this exception even where an employee had no compensation from the employer during the year preceding the year of termination (generally, to utilize this exception, an employer must be able to calculate the employee’s prior year compensation). The proposed regulations clarify that where an employee has no compensation for the prior year, for purposes of this exception, the employee’s annualized compensation for the year of termination may be used.
- Modification of the rules regarding recurring part-year compensation. In response to complaints by educational institutions that the guidance in IRS Notice 2008-62 did not sufficiently address issues related to part-year compensation for some teachers, including college and university faculty, the proposed regulations provide that an arrangement under which an employee receives recurring part-year compensation that is earned over a period of service is not subject to Section 409A if the arrangement does not defer payment of any of the recurring part-year compensation to a date beyond the last day of the 13th month following the first day of the service period for which the recurring part-year compensation is paid, and the amount of the employee’s recurring part-year compensation (not merely the amount deferred) does not exceed the annual compensation limit under Section 401(a)(17) ($265,000 for 2016) for the calendar year in which the service period commences. This is a significant liberalization of the guidance in Notice 2008-62 which applies only if the arrangement does not defer from one year to the next year the payment of more than the applicable dollar amount under Section 402(g)(1)(B) ($18,000 for 2016).
- Addition of a rule regarding when payment has been made. The proposed regulations add a generally applicable rule to determine when a payment has been made for all provisions of the regulations under Section 409A. Under the guidance, a payment is made, or the payment of an amount occurs, when any taxable benefit is actually or constructively received. In addition, the proposed regulations provide that the inclusion of an amount in income under Section 457(f)(1)(A) of the Internal Revenue Code (governing the taxation of nonqualified deferred compensation of tax exempt entities) is treated a payment for all purposes under Section 409A. The proposed regulations also clarify that a transfer of property that is substantially non-vested to satisfy an obligation under a nonqualified deferred compensation plan is not a payment for purposes of Section 409A unless the recipient makes an election under Section 83(b) to include in income the fair market value of the property (less any amount paid for the property).
- Clarification and modification of the rules applicable to amounts payable following death. The proposed regulations clarify that the rules applicable to amounts payable upon the death of an employee also apply to amounts payable upon the death of a beneficiary. In addition, as the time periods for the payment of amounts following death in the final regulations often are not long enough to resolve certain issues related to the death (for example, confirming the death and completing probate), the proposed regulations provide that an amount payable following the death of an employee, or following the death of a beneficiary who has become entitled to payment due to the employee’s death, will be considered timely paid if it is paid at any time during the period beginning on the date of death and ending on December 31 of the first calendar year following the calendar year during which the death occurs.
- Clarification of certain rules permitting payments in connection with the termination and liquidation of a plan not made in connection with a change in control. The proposed regulations clarify that the acceleration of a payment pursuant to this special acceleration rule is permitted only if the employer terminates and liquidates all plans of the same category that the employer sponsors, and not merely all plans of the same category in which a particular employee actually participates. The proposed regulations also clarify that under this rule, for a period of three years following the termination and liquidation of a plan, the employer cannot adopt a new plan of the same category as the terminated and liquidated plan, regardless of which employees participate in the plan.
- Limitation on ability to make corrections of unvested amounts under the proposed income inclusion regulations. Proposed Treasury Regulation Section 1.409A-4(a)(1)(ii)(B) includes provisions which allow employers to make changes to nonqualified deferred compensation plans before amounts under the plans are vested without causing penalties to be incurred under Section 409A. However, due to perceived abuses, the revised proposed regulations curb the ability to make corrections. These revised proposed regulations may not be used to make changes to plan provisions that are already compliant with Section 409A. In addition, any corrections made under these revised proposed regulations must be made in accordance with existing guidance regarding corrections (e.g., IRS Notice 2010-6) to the extent possible. Thus, employers who have corrected Section 409A failures using the proposed income regulations in the past, should review these new proposed regulations before making similar changes/corrections going forward.
The proposed regulations amending the final regulations are proposed to be applicable on or after the date on which they are published as final regulations, but taxpayers may rely on these proposed regulations immediately. However, certain clarifications made in the proposed amendments are not intended as substantive changes to the current requirements under Section 409A. In connection with these clarifications (set forth in the preamble to the proposed regulations), taxpayers are now precluded from taking certain positions under the final regulations.
Until the Treasury Department and the IRS issue further guidance, taxpayers may rely on the proposed income inclusion regulations, as modified by these new proposed regulations, for purposes of calculating Section 409A penalties.