- IRS and Treasury Release Proposed Section 409A Income Inclusion Regulations and Related Guidance
- January 13, 2009 | Authors: Jeffrey R. Capwell; Robert Gordon Chambers; Robert M. Cipolla; Taylor W. French; Steven D. Kittrell; G. William Tysse
- Law Firms: McGuireWoods LLP - Charlotte Office ; McGuireWoods LLP - Charlotte Office ; McGuireWoods LLP - Richmond Office ; McGuireWoods LLP - Charlotte Office ; McGuireWoods LLP - Washington Office
On December 8, 2008, the Internal Revenue Service and Treasury Department issued proposed regulations for calculating amounts includible in income under Section 409A of the Internal Revenue Code of 1986, as amended (“Section 409A”), as well as the 20% penalty and interest that also apply.
Compensation deferred under a nonqualified deferred compensation plan that fails to comply with Section 409A in either form or operation is required to be included in the employee’s (or other service provider’s) gross income for income tax purposes, to the extent such amounts are: (i) not subject to a substantial risk of forfeiture (i.e., are vested), and (ii) have not previously been included in the employee’s income. Such amounts are also subject to:
- A 20% penalty tax; and
- An additional tax equal to the interest that would have accrued on the tax payable on such deferred compensation had it been included in the employee’s gross income in the later of the year in which the employee first earned the amounts or the amounts were no longer subject to a substantial risk of forfeiture.
Final regulations implementing the requirements of Section 409A take effect on January 1, 2009. As a result, Section 409A nonqualified deferred compensation plans must be brought into full operational and written compliance with those requirements by January 1, 2009.
As the January 1 effective date draws nearer, increasing attention is being focused on how to determine the tax impact of Section 409A failures. The proposed regulations provide some initial insight into how to determine this tax impact, although they are likely to be revised in certain respects. However, under IRS Notice 2008-115 (issued separately on December 10, 2008), the proposed regulations can be relied upon with respect to the calculation of income includible under Section 409A and the calculation of the additional taxes until the issuance of final regulations.
Violations Not Permanent
The proposed regulations clarify that a Section 409A violation is not “permanent”. This means that a violation would result in income inclusion and additional income taxes only with respect to amounts deferred under the plan for the year in which the violation occurs and all preceding years, and not with respect to amounts deferred in subsequent years as long as the plan complies in form and operation with Section 409A during such subsequent years). This is an important clarification because the statutory language of Section 409A could be read to trigger adverse tax consequences for all future years following the year in which a violation occurred.
The proposed regulations would also offer limited relief for certain impermissible changes to the time or form of benefit payments of amounts that have not vested and thus have not yet triggered tax. Such a change would not be treated as resulting in a Section 409A violation if the plan is made to comply with Section 409A in form and operation by the year in which the amount eventually vests.
Year End Calculation Date
Under the proposed regulations, the total amount to be included in income would be determined as of the last day of the employee’s taxable year (generally December 31) in which the Section 409A violation occurs. This amount would include deferrals made during the year before or after the violation, and would include any deemed investment earnings (net any investment losses) during the year. Any payments to the employee during the year (whether before or after the violation) would be included as well. Amounts that, as of the last day of the year, could still qualify for the short-term deferral exemption if paid within the applicable short-term deferral period following the end of the year would be excluded.
Specific Types of Plans
The proposed regulations would require income inclusion amounts to be calculated as follows for different types of plans:
- Account Balance Plans (e.g., 401(k) Excess or Supplemental Deferral Plans): The total amount to be included under an account balance plan would generally equal the aggregate balance of all accounts under the plan as of the close of the employee’s taxable year, plus any amounts paid from such plan during the year.
- Nonaccount Balance Plans (e.g., SERPs): The total amount to be included would generally equal the present value (using reasonable actuarial assumptions) as of the close of the employee’s taxable year of all amounts payable to the employee under the plan, plus all amounts paid to the employee during such year. If a deferred amount could be payable at more than one time or in more than one form of payment, the amount is treated as payable in the available time and form of payment that results in the highest present value. For this purpose, an employee is treated as having separated from service as of the last day of the taxable year in which the violation occurs.
- Stock Rights (e.g., Options or SARs): The total amount to be included would generally equal the spread of the option or SAR as of the last day of the employee’s taxable year. If the stock right is exercised during the year, the total amount to be included would equal the spread on the date of exercise.
- Separation Pay Arrangements (e.g., Severance Agreements): If the amount payable under the arrangement is payable solely on the employee’s involuntary separation from service, the amount is not required to be calculated unless and until the employee becomes entitled to the amount. At that point, the amount to be included would equal the present value of the payments.
There are also additional special rules for certain specialized types of plans, such as reimbursement arrangements and split-dollar life insurance arrangements.
Carving Out Nonvested and Previously Included Amounts
Amounts that are still subject to a substantial risk of forfeiture and amounts that have previously been included in the employee’s gross income are subtracted from the total amount to be included in the employee’s income as a result of the Section 409A violation. Whether an amount is subject to a substantial risk of forfeiture for this purpose is also measured as of the last day of the employee’s taxable year (generally December 31). If an amount is vested as of the last day of the year, it is included even if it didn’t vest until after the date of the violation.
Calculation of the 20% Penalty and Interest
The 20% penalty tax is simply applied to the total amount required to be included in income for an employee’s taxable year. The calculation of the additional interest tax is more complicated.
Initially, the amount required to be allocated to previous years for purposes of calculating the interest tax is the amount required to be included in income for the current year, regardless of the amounts actually deferred in the prior year or years. This amount is allocated to the prior taxable year or years in which the amount was either first deferred or was no longer subject to a substantial risk of forfeiture (but not before the year beginning January 1, 2005). Payments, deemed investment losses (or other forfeitures) and amounts previously included in income are then carved out and are generally attributed to the earliest deferrals for this purpose. A hypothetical tax underpayment is calculated based on the employee’s actual tax circumstances as though each allocated amount were actually paid to the employee during the applicable year, and the interest tax is calculated based on the hypothetical tax underpayment at the IRS underpayment rate plus 1%.
An amount required to be included in income under Section 409A is not required to be included in income again when the amount is actually paid. Amounts previously included under Section 409A automatically offset future payments from the same nonqualified deferred compensation plan (including any plans required to be aggregated with such plan) for purposes of determining the taxable amount of such payments. If an amount previously included in income under Section 409A is subsequently forfeited (because, for example, of the insolvency or bankruptcy of the service recipient, inaccurate assumptions or deemed investment losses), the employee is entitled to a deduction at the time the employee’s right to all deferred compensation under the plan is permanently forfeited or otherwise lost, equal to the excess of the amount previously included in income over the amount actually or constructively received by the employee. However, there is no recovery of the 20% penalty or interest tax. The service recipient may have a corresponding obligation to recognize additional income or reduce its net operating loss carryovers to the extent of the employee’s deduction.
Reporting and Withholding
The proposed regulations do not address the service recipient’s tax reporting or withholding obligations or how to calculate amounts includable in income because of violations of the special Section 409A rules on funding arrangements (such as the rules on funding triggers tied to the employer’s financial condition). However, these topics are addressed in IRS Notice 2008-115, which provides rules for income inclusion reporting and withholding for Section 409A violations that occur in 2008 and future taxable years until the final regulations become effective. Notice 2008-115 generally provides that:
- The proposed regulations may be relied on in their entirety (not on a piecemeal basis) for purposes of calculating income inclusion reporting and withholding amounts until the regulations become final; and
- The requirement to annually report employee deferrals on Form W-2 (or on Form 1099-MISC for other service providers) – the so-called “code y” reporting requirement – is waived until the Internal Revenue Service and Treasury Department issue future guidance.
The proposed regulations state that the Internal Revenue Service and Treasury Department expect that the “code y” reporting requirement will not be implemented until the final regulations become effective.
Notice 2008-115 is generally consistent with Internal Revenue Service and Treasury Department guidance on reporting and withholding requirements for Section 409A violations in taxable years prior to 2008. It provides that amounts includable in an employee’s compensation due to a Section 409A violation are subject to applicable withholding at supplemental withholding rates, regardless of whether the amounts have been paid to the service provider or the service provider has received other wage payments during the year. It also provides that the additional 20% tax and interest is not subject to withholding, pending future guidance.
Finally, Notice 2008-115 also addresses reporting and withholding requirements for violations of the special deferred compensation funding requirements under Section 409A(b). The notice generally provides that service recipients or other payers must make a reasonable, good-faith application of a reasonable, good-faith method to determine the amount includible in income for reporting and withholding purposes with respect to a Section 409A(b) violation.
The Internal Revenue Service and Treasury Department have not announced a proposed effective date for final regulations. However, there will likely be significant pressure next year for more definitive guidance.
Enhanced Correction Program
On the same date the proposed regulations were issued, the Internal Revenue Service and Treasury Department issued Notice 2008-113, describing an enhanced correction program for certain operational errors that occur under Section 409A. The program expands the prior corrections program in significant respects, including by allowing corrections for certain operational failures that are corrected in the subsequent taxable year.