On September 29, 2005, the IRS issued an advance copy of proposed regulations regarding the application of Internal Revenue Code Section 409A to nonqualified deferred compensation plans and arrangements (“nonqualified plans”). Under Section 409A, which generally is effective for amounts deferred on and after January 1, 2005, all amounts deferred under a nonqualified plan are subject to current income taxation unless the plan complies with the election, distribution, and acceleration requirements of Section 409A. If a nonqualified plan fails to comply with these requirements at any time during a year, all amounts deferred under the plan for that year and all preceding years, by any participant to whom the failure relates, are included in the participant’s gross income to the extent vested and not previously included in income. Further, such amounts are subject to an additional 20% penalty tax plus interest on the tax underpayments.
This alert highlights some of the many important issues addressed in the proposed regulations.
Deadlines Extended. The proposed regulations extend certain deadlines provided in the previous transitional relief for one additional year, to December 31, 2006:
- Plan Amendments and Operation. The deadline for amending nonqualified plans to comply with Section 409A, and the “good faith” compliance period, is extended to December 31, 2006.
- Change in Payment Elections. Participants have until December 31, 2006 to make changes to the time and form of their payment elections without violating Section 409A’s acceleration and distribution rules. Importantly, however, during 2006 a participant cannot change a payment election with respect to payments the participant would otherwise receive during 2006, or cause payments to be made in 2006. Thus, any action with respect to such 2006 payments should be taken before the end of 2005.
- Distributions Controlled by Qualified Plans. Many nonqualified plans provide that distributions start or are paid in the same form as distributions from a related qualified plan. The proposed regulations authorize the continued use of such provisions until December 31, 2006, provided certain requirements are met. Such “linked” distribution provisions must be eliminated eventually, however.
Deadlines Not Extended. The proposed regulations do not extend the transitional relief deadlines for the following items:
- Plan Terminations. Generally, an amendment to terminate a nonqualified plan and distribute the deferred compensation to plan participants must be adopted by December 31, 2005, to avoid dealing with Section 409A.
- Termination or Cancellation by Participants. Similarly, any amendment to enable a participant to terminate participation in a nonqualified plan or to cancel an outstanding deferral election must be made by December 31, 2005.
Severance Pay Arrangements. The proposed regulations exempt from the requirements of Section 409A certain severance arrangements that provide for separation pay upon an actual involuntary separation from service or under a window program only if the following requirements are met: (1) the amount of the payments do not exceed the lesser of two times the employee’s annual compensation or two times the applicable Code Section 401(a)(17) limit ($210,000 for 2005); and (2) the payments are completed by December 31 of the second calendar year after the year in which the separation from service occurred.
Termination of Deferral Election After a Hardship Distribution. Under the proposed regulations, a nonqualified plan may provide for the termination of a participant’s deferral election if the participant obtains a distribution from the nonqualified plan due to an unforeseeable emergency or obtains a hardship distribution from a 401(k) plan. Previously, it was unclear whether deferral elections could cease due to a participant’s hardship distribution.
Post-Employment Reimbursement Arrangements. The proposed regulations provide that certain reimbursement arrangements related to a termination of employment are not covered by Section 409A, to the extent the reimbursement arrangement covers only expenses incurred and reimbursed before the end of the second calendar year following the year in which the termination occurred.
If you have any questions about Section 409A or the proposed regulations, please contact a member of Ogletree Deakins’ Benefits Group.
Note: This article was published in the October 5, 2005 issue of the Benefits eAuthority.