July 1, 2008
Dear Client:
We are writing to update you on the latest deadlines for compliance with the Code Sec. 409A rules for nonqualified deferred compensation (NQDC) plans and to let you know what action is now required by you.
The IRS issued final regulations under Section 409A in April, 2007 which did not require nonqualified deferred compensation plans (NQDC) to be in compliance until December 31, 2008. These regulations transform the tax treatment of all NQDCs. These rules affect all companies and their employees who have a deferred compensation plan. As you know, you have a deferred compensation plan in place for all your physician/employees which governs the payout of the accounts receivable of the company.
These rules are important to you in that the penalties for not complying with them are severe. According to IRC Section 409A, a nonqualified deferred compensation plan (NQDC) fails if at anytime during a taxable year, it fails to meet the requirements of (1) distributions, (2) acceleration of benefits, and (3) elections, or is not operated in accordance with any of these three requirements. Noncompliance with the new rules will result in that not only will all compensation deferred under the NQDC plan for the tax years be includable in income in the year of failure, but all includable compensation is subject not only to interest but also an excise tax of 20%. The excise tax and interest are generally payable by the employee.
Therefore, noncompliant plans would subject the physician/employee to income taxation on the deferred amount of compensation, an excise tax of 20% of the amount of the deferred compensation amount and interest on both amounts. Deferred compensation may be considered constructively received by the physician unless the payments are subject to a "substantial risk of forfeiture" set of rules. The rules also restrict under what circumstances payments of deferred compensation may be made to the recipient, when and in what form. Deferred elections (or provisions provided in the deferred compensation contract) must also follow a stricter regime than in prior years.
An NQDC has three main requirements:
Distributions. The plan must provide that compensation deferred under it may not be distributed earlier than (1) separation from service (with special rules for certain "specified" key employees); (2) the date a participant becomes disabled; (3) death; (4) a time specified under the plan; (5) to the extent provided in the regulations?see Treas. Reg. § 1.409A-3(i)(5)-a change in the ownership or effective control of the organization; or (6) an illness, accident, casualty loss or other unforeseeable emergency that creates a financial hardship for the participant.
Acceleration of benefits. The plan may not permit the time or schedule of any payment to be accelerated except under specified circumstances; for example, to comply with a domestic relations order. Such exceptions, however, must be beyond the discretion of the employee.
Elections. Compensation may be deferred at the participant's election only if the election is made not later than the close of the taxable year proceeding the taxable year in which the employee performs the services. For example, an election to defer a portion of one's salary for 2009 must be made before December 31, 2008. Within 30 days of becoming eligible to participate in the plan, an employee may elect to defer compensation for subsequent services. There are special deferral election rules for performance-based compensation.
Subsequent elections to delay or change the form of a distribution may not take effect until at least 12 months after the election. For an election related to a payment that is not made upon disability or death or due to an unforeseeable emergency, the plan must require the payment to be deferred for at least five years. Any election related to a payment made under a fixed schedule may not be made sooner than 12 months before the first scheduled payment.
Section 409A is generally looking for an arrangement that provides for the deferral of the compensation owed to a ?service provider? into a later year. Note that NQDC rules do not apply to qualified retirement plans or individual retirement accounts.
Short-term deferral exception. There is a short-term deferral exception to the NQDC rules. Under this rule, if the deferred compensation is paid out in full within 2 ½ months after the year of vesting and is no longer subject to a substantial risk of forfeiture, the arrangement is deemed never to have constituted a Section 409A deferral. This is relevant for annual bonuses determined on the basis of productivity. Note, it is very important that all annual productivity bonuses that do not meet the terms of a Section 409A be paid within 2 ½ months of the year-end of the corporation.
You should also note that the short-term deferral exception is one mechanism to avoid the Section 409A penalties. If all deferred compensation arrangements are paid within 2 ½ months from the year end and the deferred benefits are continually subject to a substantial risk of forfeiture, then the excise penalty and current income inclusion rules will not apply. Even if the actual payments of the vested deferred compensation may be delayed many years, the arrangement does not constitute an NQDC plan under Section 409A because the complete payout will occur within 2 ½ months of the end of the vesting year as long as the plan had been continually subject to a substantial risk of forfeiture.
Separation from service. Payouts from an NQDC plan must not occur until there is a defined termination of employment. Separation from service requires permanent cessation of employment. Significant post-termination consulting would result in potential excise penalties. Payouts from an NQDC on retirement should be amended, because the employee could retire as a common-law employee, yet continue to render substantial post-retirement consulting services as an independent contractor.
Transition rule. Congress passed section 409A as part of the American Jobs Creation Act of 2004, and it has been in effect since the beginning of 2005. Deferrals of compensation earned and vested before 2005 are subject to prior law (grandfathered) unless the plan is materially modified after Oct. 3, 2004. Amounts deferred after 2004 have to comply "in good faith" with section 409A as provided in ongoing guidance.
In October 2007, the IRS issued Notice 2007-86, which extended the effective date of the final regulations through the end of 2008. Notice 2007-86 indicates, however, that taxpayers are required to operate any nonqualified deferred compensation plan in compliance with the plan's terms "to the extent consistent with section 409A and the applicable guidance." For plans adopted on or before Dec. 31, 2008, this also includes the requirement that such plans be amended on or before Dec. 31, 2008, to conform to section 409A and its final regulations.
Grandfathering. You will also have to decide whether to preserve grandfather
treatment for amounts deferred before 2005. You will need to evaluate how much money is at risk, because it is administratively more complicated to manage different buckets of money under different rules. Yet for payout in 2007 and 2008, grandfathering the prior rules may be a very beneficial plan feature.
Deferred compensation payments made in 2008. An election made in 2008 can apply only to amounts that wouldn't otherwise be payable in 2008. Therefore, if a deferred amount is payable in 2008, an employee can't defer it to a later year. The employee can only defer it from one post-2008 year to another, say from 2009 to 2010. Also, an election in 2008 may not cause an amount to be paid in 2008 that wouldn't otherwise be payable in 2008. Thus, an employee can't accelerate into 2008 an amount that is payable after 2008. An acceleration is only permissible from one post-2008 year to another, for example from 2010 to 2009.
Information reporting requirements. The new rules require that all deferrals for the year under an NQDC plan be separately reported on a Form W-2. The determination of the amount to include for an entity and arrangement like your company's is still an unresolved issue to which the IRS has not given any guidance.
Action Plan. We suggest that you do the following:
1. Examine all of your compensation plans and employee contracts to determine
whether such plans or contracts contain deferred compensation provisions.
2. If it is determined that Section 409A applies to a plan or contract, the next
step is to assure that the plan complies with the Section 409A requirements. We
strongly suggest that you have legal counsel review your plans and make the
appropriate revisions or rewrites as required by these new laws.
3. Obtain new payment elections from plan participants. Assure that all deferral
elections are appropriate and legally documented for each employee qualifying for
deferred compensation. An election to defer performance-based compensation
that is based on services performed over 12 months or more must be made no
later than six months before the end of the performance period.
4. Assure that the plan provides that all payments under a NQDC plan are made
at a fixed date, under a fixed schedule, or upon any of these five events:
(1) separation from service, (2) death, (3) disability, (4) change in ownership or
control of the corporation, or (5) unforeseeable emergency. Assure also that the
plan does not provide for accelerated payments of the deferred compensation.
5. Resolve "buy-in" issues with potential acceleration of deferred compensation
amounts when a new shareholder ?buys-in? to the accounts receivable/deferred
compensation plan with the reduction of salary for a period of time. This will most
likely require a different shareholder buy-in model.
If you would like additional assistance with consultation regarding the revision of your plans to ensure full and timely compliance with the new Section 409A law, please contact us at your convenience.
Very truly yours,
SOUKUP, BUSH & ASSOCIATES, P.C.
