Don’t Bite the Hand Don’t Bite the Hand That Feeds You!That Feeds You!

New Compliance Requirements for

Deferred Compensation Programs

By Kristi Cook, JD

For:

1-800-433-1828

ALSO…Please Don’t Shoot the Messenger!

Law passed at end of 2004 as part of American Jobs Creation Act of 2004– IRS issued a Notice 2005-1 that provided

some guidelines– But, regulations not issued until the end of

September, 2005 Created a new Section 409A which

establishes new requirements for deferred compensation arrangements

Surprise…Surprise!!!

Effective for all compensation deferred after December 31, 2004

Until 12/31/05, employers were permitted to terminate ongoing arrangements provided that all assets were distributed by 12/31/05

Must operate in “good faith” compliance with new requirements until programs are amended to conform to new requirements

Have until 12/31/06 to amend current programs to conform to new requirements

What is §409A?

A new section added to the federal income tax code establishing requirements for all deferred compensation arrangements – There are certain exemptions available under

§409A– But any arrangement not exempted must

satisfy the requirements of §409A

New §409A Regulations

Impose new rules on all deferred compensation arrangements

Impose annual 20% excise tax on employee on arrangements that fail to meet requirements– Plus 1% over “underpayment interest rate– BUT, employer must report properly

PLUS amounts are taxable when no longer subject to substantial risk of forfeiture– NOT when received by the employee

What Arrangements are Affected?

Affects any plan, arrangement or agreement (whether written or not) between an employee and employer that defers compensation into a future year– Exception for qualified retirement plans and certain

bona fide welfare plans.– However, most severance pay programs, accumulated

leave programs, early retirement incentive programs and split dollar insurance plans are affected by these new regulations

What is Deferred Compensation?

A plan provides deferred compensation if – the employee has a legally binding right to

compensation– that is not received during the current tax year

and – is payable to (or on behalf of) the employee in

a later year

Statutory Exemptions from §409A

Short Term Deferrals Qualified Plan Contributions Separation Pay Safe Harbor Bona Fide Welfare Plans

Short Term Deferrals

Any amounts paid to the employee within 2½ months of the end of the year in which the benefit is no longer subject to a “substantial risk of forfeiture” – For most K-12 employers, the year of severance is the

applicable year Plan should require payment within the 2½

month period – Amounts paid after 2 ½ month period may be

exempted if due to unforeseeable administrative issues or solvency problems if paid as soon as practicable

What is a Substantial Risk of Forfeiture?

Entitlement to the compensation is– conditioned on the performance of substantial future

services or – the occurrence of a condition related to the purpose of

the compensation, and – the possibility of forfeiture is substantial

Specifically rejects “noncompete” arrangements, “rolling risks of forfeiture,” post employment consulting agreements– Also extending deferrals of salary unless related to a

“material” increase in compensation

Qualified Plans

Amounts paid into qualified plans are excluded from definition of “deferred compensation”

Applies to contributions into 401(a), 403(b), 401(k) and 457(b) programs

Health reimbursement and medical reimbursement accounts are also excepted

Separation Pay Exceptions

Three types of separation payments are excluded from deferred compensation, including payments for– Certain involuntary terminations of

employment– Certain “window” programs– Certain payments under collectively bargained

plans

Involuntary Separations and Window Programs

Excluded if:– Payments do not exceed the lesser of

• 2X the employee’s compensation or• 2X the 401(a)(17) limit on compensation; and

– Payments are not made later than December 31 of the second calendar year following the year of separation from service

“Window” period cannot exceed 12 months

Collectively Bargained Plans

Window plans and involuntary termination plans that are collectively bargained through arms length negotiations are not subject to the limits on the amount of the benefit or on the duration of the payouts.

NO exception for programs that provide benefits for voluntary terminations or are offered under “windows” that are open for more than 12 months

Bona Fide Welfare Plans

Programs structured as “wage replacements” for – Vacation leave – Sick leave– Compensatory time, – Disability pay, or– Death benefit plan

Severance pay plans are NOT excluded as bona fide welfare plans

Sabbatical leave plans are not exempted

Review of §409A Coverage

Any arrangement that defers compensation to a future year unless there is a substantial risk of forfeiture

Exemptions for:– Short term deferrals– Qualified plan contributions– Separation Pay “Safe Harbors,” and – Bona fide welfare plans

What Should You Do Now? Examine all compensation arrangements

– Individual employment contracts, collective bargaining agreements, Act 93 agreements and similar agreements

Determine if compensation earned in the current year is payable in a future year– If yes, are any exemptions available to exclude the benefit

from 409A? Can the benefit be restructured to avoid inclusion

under 409A?– If yes, open contracts and restructure– If not?

What Does 409A Require? Establishes requirements for written

documentation, valid deferral elections, timing of distributions and tax reporting– Plan must be evidenced in writing– Must report in year of deferrals AND in year of

payments• Different reporting codes

“Deferral Elections”

Deferrals may be “elective” or “nonelective” Elective deferrals occur when employee

voluntarily elects to defer compensation into a future year

Nonelective deferrals occur if the payment for the benefit is based on contractual obligations or similar binding agreement– Accumulated leave payments, ERIPs, severance pay,

etc.

Elective Deferral Elections

Elections must include the amount of the deferral, the form of payment to be received and the timing of the distributions

Elections must be completed in year preceding year in which the services are provided to the employer– In initial year, election must occur within 30 days of

eligibility Elections are irrevocable

– Unforeseeable emergency withdrawals are permitted

Nonelective Deferrals

This type of compensation is considered earned in the year in which the employee has a legally binding right to the compensation– Generally, the year in which benefits first

become payable to employee– Treated as an “initial year” election

Distribution Restrictions

Arrangement must limit distributions to the occurrence of one of the following events: – Severance from service– Disability– Death– Specified time or fixed schedule– Unforeseeable emergencies

Cannot accelerate distributions

Can Employees Change Previous Distribution Elections? Distribution elections may be changed by

employees provided that the change occurs at least 12 months prior to the date the distribution would otherwise have occurred, AND

Payment must be deferred for at least another 5 years

NOTE: this does not defer taxation on the distribution to employee

Employer Tax Reporting

Employers must report all deferrals in the years when made and when no longer subject to forfeiture– All deferrals plus earnings in Box 12 on Form

W2 using Code Y– Amounts includable in income are reported in

Box 12 with Code Z Reporting requirements applicable to 2006

tax year

Best Solutions for §409A Issues

Short Terms Deferral Exemption– Pay all benefits within 2½ months of end of year in

which severance from service occurred• Requirement for timing of payment should be included in

written arrangement

Qualified Plan Exemption– Structure deferred compensation around employer

403(b) contributions• 6 year payout limitation

– Year of severance from service plus the next 5 years

Strategies?

Try to avoid application of §409A– Review all current compensation arrangements – Identify any that defer compensation after 12/31/2004,

plus• ALL §457(f) plans• Most split dollar plans• Many “traditional” benefits

– Severance benefits – ERIs– Retirement bonuses– Accumulated leave programs

Strategies…continued

Determine if any exemptions apply– Short term deferral for accumulated leave type

benefits– Contributions into 403(b) plans to replace

benefits• Restructure to avoid 409A

– Window plans • Remember 12 month limitation• More helpful for CBA ERIPs

More Strategies

Remember the issue when crafting future compensation programs

Try to keep it simple– Complicated arrangements lead to missed

payments– Acceleration of taxes, excise tax and reporting

problems

Questions?Questions?

Thank You