New Proposed 409A Regulations May Impact Nonqualified Deferred Compensation Arrangements

On June 21, 2016, the IRS issued proposed 409A regulations intended to (a) clarify certain provisions of the final 409A regulations that were published in 2008, (b) withdraw and replace provisions in those earlier regulations that addressed income inclusion upon a violation of 409A, and (c) address certain issues pertaining to recurring part-year compensation by revising Notice 2008-62. The proposed regulations become effective only when the regulations are finalized, but taxpayers may rely on the proposed regulations immediately, and the IRS has stated that they will take no positions contrary to the proposed regulations prior to their effective date.

Clarifications to the Final Regulations

The IRS has proposed clarifications and, in some cases, modifications to the regulations in an effort to facilitate compliance with Internal Revenue Code section 409A (referred to as “409A” throughout). Like the original 409A regulations, these proposed regulations are complex and are not easily summarized. The clarifications and modifications are as follows:

  • Short Term Deferrals. A payment that otherwise qualifies as a short-term deferral under 409A but that is made after the applicable 2-1/2 month payment window will continue to qualify as a short-term deferral if (a) it was administratively impracticable for the service recipient (generally, the employer) to make the payment, (b) payment would have jeopardized the service recipient’s ability to function as a going concern, or (c) the service recipient reasonably anticipated that a deduction for the payment would not be permitted under Code section 162(m); so long as, in all three instances, the payment is made as soon as practicable or as soon as the payment would no longer have such effect.
  • Payments for Stock at Less Than Fair Market Value. When payment for stock is made to a service provider (generally, the employee) as the result of an involuntary termination for cause or the occurrence of a condition within the service provider’s control (such as the violation of a non-compete clause), the amount payable may be based on a measure that is less than the fair market value of the stock without violating the general 409A requirement that payment be based on a fair market value measure.
  • Plan termination and liquidation. In order to terminate a plan pursuant to the applicable 409A regulations, a plan sponsor, under the 409A aggregation rules, must terminate all like-type nonqualified plans in the plan sponsor’s controlled group, not just like-type plans in which a single service provider participates. Note that this change could have a big impact when determining which deferred compensation plans must be terminated when any plan subject to 409A is terminated.
  • Eligible Issuers of Service Recipient Stock. The term “eligible issuer of service recipient stock” includes a corporation or entity for which it is reasonably anticipated the service provider will provide services within 12 months of the date of a grant of stock rights, and the service provider does in fact begin providing services for that corporation or entity within 12 months of the grant date. In other words, stock rights under 409A may be granted prior to the start date of an employee’s employment.
  • Separation Pay Plans. If a service provider’s employment begins and ends during the same taxable year, the service provider’s annualized compensation for that year may be used to determine if the separation pay plan exception to 409A applies.
  • Reimbursement for Attorneys’ Fees. The 409A exception for reimbursement or payment for reasonable attorneys’ fees and other expenses incurred by the service provider to enforce a claim against the service recipient with respect to actions based on wrongful termination, employment discrimination, the Fair Labor Standards Act, or workers’ compensation statutes, is expanded to include, more broadly, any claims that relate to the service relationship.
  • Status Change from Employee to Independent Contractor. The regulations have been clarified so that an employee who becomes an independent contractor will have a separation from service at that time if his or her anticipated level of services as an independent contractor will be 20% or less of the average level of services provided as an employee over the immediately preceding 36-month period. If a separation from service does not occur at that point (because the level of services is anticipated to exceed the 20% threshold), a separation from service will not occur thereafter until a complete termination of the independent contractor’s services for the service recipient has occurred.
  • Payments under Code section 457(f). The inclusion in income of amounts paid under Code section 457(f)(1)(A) will be treated as a payment for all purposes under 409A, not just for purposes of the short-term deferral rule. New rules applicable to 457(f) plans are addressed in the proposed 457 regulations that were also issued on June 21, 2016 (see subsequent Client Advisory on those proposed regulations).
  • Timing of Payments. As a general rule, a payment is considered to have occurred under 409A when a taxable benefit is actually or constructively received, including: transfers of cash; events that result in inclusion in income under the economic benefit doctrine; transfers of property under Code section 83(b); contributions includible in income under Code section 402(b); and payments upon the transfer, cancellation, or reduction of nonqualified deferred compensation amounts in exchange for benefits under a welfare plan, non-taxable fringe benefit plan, or other non-taxable benefits.
  • Deemed Asset Sales. Unlike an actual asset sale, a service provider may not be treated as separated from service under 409A in a deemed asset sale under Code section 338 (relating to stock transactions that are treated as asset transactions).
  • Acceleration of Payments.
    • The exception to the 409A anti-acceleration restriction for payments due to the death, disability, or unforeseeable emergency of a service provider is also applicable to payments due to the death, disability, or unforeseeable emergency of a beneficiary who is entitled to payment from a deferred compensation plan subject to 409A due to the death of a service provider. In addition, a series of payments (including payments treated as a single payment) that commences prior to a service provider’s or beneficiary’s death, disability or unforeseeable emergency may be accelerated upon the occurrence of the service provider’s or beneficiary’s death, disability or unforeseeable emergency.
    • The exception to the anti-acceleration restriction for payments made to comply with foreign ethics or conflicts of interest law is expanded to permit the acceleration of any nonqualified payments subject to 409A, not just foreign earned income from sources within the applicable country.
  • Payment upon Death.
    • The 409A rules generally applicable to payments due to the death of a service provider are also applicable to payments due to the death of a beneficiary of a service provider.
    • Payments following the death of a service provider (or the beneficiary of a service provider) will be treated as timely if they are made at any time beginning on the date of death and ending on the December 31 of the year following the year of death. Plans need not specify a particular date during this period by which payment is to be made, and may provide generally that payment will be made during this period, including at a date determined at the beneficiary’s discretion. Plans that provide for payment at a particular time during this period (e.g., within 60 days after death) may make such payment at any other time during this expanded period without violating 409A, with or without amendment to the plan.
  • Transaction-Based Compensation. The special rules for transaction-based compensation payments (generally related to an employer’s purchase of stock or stock rights held by a service provider in connection with a change in control) are extended to apply to statutory stock options or stock rights that did not otherwise provide for deferred compensation before a purchase of (or agreement to purchase) the stock rights.
  • 457A Plans. Non-qualified plans under Code section 457A (which was enacted after the issuance of the final 409A regulations, and which applies to nonqualified plans sponsored by certain foreign corporations or partnerships whose income is substantially allocated to foreign persons or organizations) may be considered non-qualified plans under 409A, and the rules of 409A will apply to a Code section 457A plan separately and in addition to the requirements of Code section 457A.
  • Permissible Acceleration. Plans may accelerate the timing of payments to comply with federal debt collection laws.
  • Entities as Service Providers. A service provider under 409A may be an entity (e.g., a corporation, a subchapter S corporation, or a personal service corporation) as well as an individual.

Rules with Respect to Income Inclusion for 409A Violations.

The proposed regulations modify the rules with respect to determining a service provider’s taxable income when there has been a 409A violation to include certain anti-abuse provisions. In particular, amounts that are otherwise subject to a substantial risk of forfeiture will be treated as not subject to substantial risk of forfeiture, and will be included in income, if the employer engages in a pattern or a practice of permitting impermissible changes in the time or form of payment with respect to nonvested deferred amounts. Whether an employer has engaged in such a pattern or practice is a facts and circumstances determination.

To prevent employers from changing time and form of payment provisions that otherwise comply with 409A, or from creating errors with the intent of using the errors as a pretext to change the time and form of payment provisions, the proposed regulations provide that deferred amounts that are subject to a substantial risk of forfeiture will be treated as not subject to substantial risk of forfeiture when there is a change in a plan provision related to the time and form of payments that is not otherwise permitted under 409A if there is no reasonable, good faith basis to conclude that (a) the original provision failed to satisfy the 409A requirements and (b) the change is necessary to bring the plan into compliance with 409A.

With respect to establishing whether there is an abusive pattern or practice with respect to permitting impermissible changes in the time and form of payments with respect to nonvested amounts, the regulations include examples and provide a list of the generally applicable facts and circumstances to be taken into consideration. In addition, a plan sponsor must correct substantially similar failures affecting nonvested deferred amounts in a substantially similar manner.

Changes Impacting Recurring Part-Year Compensation.

IRS Notice 2008-62 provides an exception to 409A for the deferral of recurring part-year compensation (typically payments to educators who receive salary over a 12-month period although working fewer than 12 months) as long as the deferral arrangement does not extend beyond the end of the 13th month following the beginning of the service period and the deferral amount does not exceed the annual dollar limit under Code section 402(g) (the 402(g) limit, currently $18,000). Many educators have not been able to make use of this exception when electing to average their pay over a full 12-month period because the amounts being deferred exceed the 402(g) limit (or, in some cases, where the deferral arrangement is non-elective). The proposed regulations revise this 409A exception to remove the 402(g) limit requirement and replace it with a requirement that the total amount of recurring part-year compensation not exceed the annual compensation limit under Code section 401(a)(17) (currently $265,000).

What Does This Mean to You?

The proposed regulations may impact plan operation, plan design, and document language for plans subject to 409A. Accordingly, sponsors of nonqualified deferred compensation arrangements subject to 409A are encouraged to proactively review the plan administration and document provisions of those arrangements to determine whether modifications to either or both are advisable, either now or when the proposed regulations become final.  If you have any questions about this advisory or any other employee benefit plan matter, please contact a member of our Employee Benefits Group.


Sherman & Howard has prepared this advisory to provide general information on recent legal developments that may be of interest. This advisory does not provide legal advice for any specific situation and does not create an attorney-client relationship between any reader and the Firm.

©2016 Sherman & Howard L.L.C.                                                                                   July 5, 2016