The IRS has issued proposed regulations (REG-123854-12) upon which taxpayers may rely addressing issues related to nonqualified deferrred compensation arrangements subject to IRC §409A. These rules generally update and clarify provisions that are found in the existing regulations under §409A.
Specifically the preamble specifies the following 19 areas that are addressed.
(1) Clarify that the rules under section 409A apply to nonqualified deferred compensation plans separately and in addition to the rules under section 457A.
(2) Modify the short-term deferral rule to permit a delay in payments to avoid violating Federal securities laws or other applicable law.
(3) Clarify that a stock right that does not otherwise provide for a deferral of compensation will not be treated as providing for a deferral of compensation solely because the amount payable under the stock right upon an involuntary separation from service for cause, or the occurrence of a condition within the service provider's control, is based on a measure that is less than fair market value.
(4) Modify the definition of the term “eligible issuer of service recipient stock” to provide that it includes a corporation (or other entity) for which a person is reasonably expected to begin, and actually begins, providing services within 12 months after the grant date of a stock right.
(5) Clarify that certain separation pay plans that do not provide for a deferral of compensation may apply to a service provider who had no compensation from the service recipient during the year preceding the year in which a separation from service occurs.
(6) Provide that a plan under which a service provider has a right to payment or reimbursement of reasonable attorneys' fees and other expenses incurred to pursue a bona fide legal claim against the service recipient with respect to the service relationship does not provide for a deferral of compensation.
(7) Modify the rules regarding recurring part-year compensation.
(8) Clarify that a stock purchase treated as a deemed asset sale under section 338 is not a sale or other disposition of assets for purposes of determining whether a service provider has a separation from service.
(9) Clarify that a service provider who ceases providing services as an employee and begins providing services as an independent contractor is treated as having a separation from service if, at the time of the change in employment status, the level of services reasonably anticipated to be provided after the change would result in a separation from service under the rules applicable to employees.
(10) Provide a rule that is generally applicable to determine when a “payment” has been made for purposes of section 409A.
(11) Modify the rules applicable to amounts payable following death.
(12) Clarify that the rules for transaction-based compensation apply to stock rights that do not provide for a deferral of compensation and statutory stock options.
(13) Provide that the addition of the death, disability, or unforeseeable emergency of a beneficiary who has become entitled to a payment due to a service provider's death as a potentially earlier or intervening payment event will not violate the prohibition on the acceleration of payments.
(14) Modify the conflict of interest exception to the prohibition on the acceleration of payments to permit the payment of all types of deferred compensation (and not only certain types of foreign earned income) to comply with bona fide foreign ethics or conflicts of interest laws.
(15) Clarify the provision permitting payments upon the termination and liquidation of a plan in connection with bankruptcy.
(16) Clarify other rules permitting payments in connection with the termination and liquidation of a plan.
(17) Provide that a plan may accelerate the time of payment to comply with Federal debt collection laws.
(18) Clarify and modify § 1.409A-4(a)(1)(ii)(B) of the proposed income inclusion regulations regarding the treatment of deferred amounts subject to a substantial risk of forfeiture for purposes of calculating the amount includible in income under section 409A(a)(1).
(19) Clarify various provisions of the final regulations to recognize that a service provider can be an entity as well as an individual.
IRC §409A, added to the IRC back in 2004, provides for punative taxation on employee and service providers if they are participants in a nonqualified deferred compensation plan (other than those specifically excluded from §409A treatment) unless the plan complies at times during the taxable year both in terms of plan documentation and plan operation with the requirements of §409A.
Some specific details on certain of these provisions are found below.
The proposed regulations would create a consistent rule for what is treated as “payment” under the provisions of §409A, clarifying the matter. As the preamble notes:
These proposed regulations add a generally applicable rule to determine when a payment has been made for all provisions of the regulations under section 409A. Under these proposed regulations, a payment is made, or the payment of an amount occurs, when any taxable benefit is actually or constructively received. Consistent with the final regulations, these proposed regulations provide that a payment includes a transfer of cash, any event that results in the inclusion of an amount in income under the economic benefit doctrine, a transfer of property includible in income under section 83, a contribution to a trust described in section 402(b) at the time includible in income under section 402(b), and the transfer or creation of a beneficial interest in a section 402(b) trust at the time includible in income under section 402(b). In addition, a payment is made upon the transfer, cancellation, or reduction of an amount of deferred compensation in exchange for benefits under a welfare plan, a non-taxable fringe benefit, or any other nontaxable benefit.
As well, the proposed regulations would clarify whether receipt of property which itself is subject to a substantial risk of forfeiture would constitute a payment, as noted in the preamble:
These proposed regulations also clarify that a transfer of property that is substantially nonvested (as defined under § 1.83-3(b)) to satisfy an obligation under a nonqualified deferred compensation plan is not a payment for purposes of section 409A unless the recipient makes an election under section 83(b) to include in income the fair market value of the property (disregarding lapse restrictions), less any amount paid for the property.
The preamble notes that the proposed regulations will make some liberalizing changes in when a payment is deemed to be a death related payment, since the time frames generally required for a payment related to an event under §409A may not be long enough due to the issues often found in dealing with the death of an individual:
Also, some commenters have indicated that the time periods for the payment of amounts following death often are not long enough to resolve certain issues related to the death (for example, confirming the death and completing probate). In view of the practical issues that often arise following a death, these proposed regulations provide that an amount payable following the death of a service provider, or following the death of a beneficiary who has become entitled to payment due to the service provider's death, that is to be paid at any time during the period beginning on the date of death and ending on December 31 of the first calendar year following the calendar year during which the death occurs is treated as timely paid if it is paid at any time during this period. A plan is not required to specify any particular date within this period as the payment date and may rely on this rule if the plan provides that an amount will be paid at some time during this period, including if the plan provides that payment will be made upon death without defining the period for payment following death in any other manner, and including if the plan provides that payment will be made on a date within this period determined in the discretion of the beneficiary.
These proposed regulations further provide that a plan providing for the payment of an amount at any time during this specified period may be amended to provide for the payment of that amount (or the payment of that amount may be made without amending the plan) at any other time during this period (including a time determined in the discretion of a beneficiary) without failing to meet the requirements of the deferral election provisions of § 1.409A-2 or the permissible payment provisions of § 1.409A-3, including the prohibition on the acceleration of payments under § 1.409A-3(j). For example, a plan that provides for a payment to be made during the first calendar year beginning after the death of a service provider may be amended to provide for the payment of the amount (or the payment may be made under the plan without such amendment) at any time during the period beginning on the date of death and ending on December 31 of the first calendar year following the calendar year during which the death occurs.
The proposed regulations also address the problem for those in education that the IRS had originally attempted to solve via Notice 2008-62. The problem was that educators who have a portion of the year in which they are not performing services (think summer vacation) traditionally had been given the option to be paid their salary only during the portion of the year that services were actually performed or to have that salary spread over an entire twelve months, most often making the choice at the beginning of the school year.
That created a deferral that ran afoul of the allowed provisions in the original §409A regulations which the IRS addressed in that notice, allowing such a program did not run afoul of §409A if the following requirements were met:
The arrangement does not defer payment of any of the recurring part-year compensation beyond the last day of the 13th month following the beginning of the service period, and
The arrangement does not defer from one taxable year to the next taxable year the payment of more than the applicable dollar amount under section 402(g)(1)(B) in effect for the calendar year in which the service period begins ($18,000 for 2016).
The IRS had received complaints about the fact that the second requirement blocked relief in some cases, leading to the IRS proposing the following revision as outined in the preamble:
Commenters have expressed concerns that Notice 2008-62 would not adequately address some teaching positions, such as college and university faculty members. They have noted that, depending on several variables (such as the calendar month in which a service provider commences service or the length of the service period), the dollar limitation in the notice may result in adverse tax consequences to service providers with annual compensation as low as $80,000. Commenters have further observed that some of these arrangements are nonelective, and therefore some service providers cannot opt out of a recurring part-year compensation arrangement.
In recognition that service recipients in the field of education frequently structure their pay plans to include recurring part-year compensation and that the main purpose of this design is to provide uninterrupted cash flow for service providers who do not work for a portion of the year, these proposed regulations modify the recurring part-year compensation rule. These proposed regulations provide that a plan or arrangement under which a service provider receives recurring part-year compensation that is earned over a period of service does not provide for the deferral of compensation if the plan does not defer payment of any of the recurring part-year compensation to a date beyond the last day of the 13th month following the first day of the service period for which the recurring part-year compensation is paid, and the amount of the service provider's recurring part-year compensation (not merely the amount deferred) does not exceed the annual compensation limit under section 401(a)(17) ($265,000 for 2016) for the calendar year in which the service period commences. A conforming change is being made for purposes of section 457(f) under proposed section 457(f) regulations (REG-147196-07) that are also published in the Proposed Rules section of this issue of the Federal Register.
Under the current regulations, the amount taxable for a beneficiary of a plan that is noncompliant at any time during the year is the excess of the total amount deferred under the plan reduced by the the total of the amounts previously subject to tax plus any amounts subject to a substantial risk of forfeiture. Thus, generally, if a participant is not vested in his/her benefits by the end of a tax year, an “impermissible” amendment to the plan can be made without tax consequences.
The IRS is concerned that some taxpayers have been abusing this rule, regularly changing the rules right up until the year the participant vests under the program. Thus, the preamble notes:
Although these rules permit the correction of certain plan provisions that fail to comply with the requirements of section 409A(a) while amounts are nonvested without including the amounts in income or incurring an additional tax, they were not intended to allow service recipients to change time or form of payment provisions that otherwise meet the requirements of section 409A(a) in a manner that fails to comply with section 409A(a), and they were not intended to permit service recipients to create errors in nonqualified deferred compensation plans with respect to nonvested amounts with the intention of using those errors as a pretext for establishing or changing a time or form of payment in a manner that fails to comply with section 409A(a). Accordingly, these proposed regulations clarify and modify the anti-abuse rule under § 1.409A-4(a)(1)(ii)(B) of the proposed income inclusion regulations to preclude changes of this nature.
First, these proposed regulations clarify that a deferred amount that is otherwise subject to a substantial risk of forfeiture is treated as not subject to a substantial risk of forfeiture for a service provider's taxable year during which there is a change in a plan provision (including an initial deferral election provision) that is not otherwise permitted under section 409A and the final regulations and that affects the time or form of payment of the amount if there is no reasonable, good faith basis for concluding that the original provision failed to meet the requirements of section 409A(a) and that the change is necessary to bring the plan into compliance with the requirements of section 409A(a).
Second, these proposed regulations provide examples of the types of facts and circumstances that indicate whether a service recipient has a pattern or practice of permitting impermissible changes in the time or form of payment with respect to nonvested deferred amounts under one or more plans. If the service recipient has such a pattern or practice that would affect a nonvested deferred amount, that amount is treated as not subject to a substantial risk of forfeiture. The facts and circumstances include: Whether a service recipient has taken commercially reasonable measures to identify and correct substantially similar failures promptly upon discovery; whether substantially similar failures have occurred with respect to nonvested deferred amounts to a greater extent than with respect to vested deferred amounts; whether substantially similar failures occur more frequently with respect to newly adopted plans; and whether substantially similar failures appear intentional, are numerous, or repeat common past failures that have since been corrected.
Third, these proposed regulations provide that, to the extent generally applicable guidance regarding the correction of section 409A failures prescribes a particular correction method (or methods) for a type of plan failure, that correction method (or one of the permissible correction methods) must be used if a service recipient chooses to correct that type of a failure with respect to a nonvested deferred amount. In addition, these proposed regulations provide that substantially similar failures affecting nonvested deferred amounts must be corrected in substantially the same manner.
A service recipient correcting a plan failure affecting a nonvested deferred amount is not required, solely with respect to the nonvested deferred amount, to comply with any requirement under generally applicable guidance regarding the correction of section 409A failures that is unrelated to the method for correcting the failure, such as general eligibility requirements, income inclusion, additional taxes, premium interest, or information reporting by the service recipient or service provider. Accordingly, a service recipient may amend a noncompliant plan term in a manner permitted under applicable correction guidance even though the failure may not have been eligible for correction under that guidance (for example, due to applicable timing requirements). In addition, the portion of the nonvested deferred amount that is affected by the correction is not subject to income inclusion, additional taxes, or applicable premium interest under section 409A(a)(1), and neither the service recipient nor the service provider is required to notify the IRS of the correction. For a description of the currently available corrections methods, see Notice 2008-113 (2008-51 IRB 1305), Notice 2010-6 (2010-3 IRB 275), and Notice 2010-80 (2010-51 IRB 853).
These regulations were published as proposed regulations, but no similar temporary regulations were issued at the same time. Rather the IRS provides the following in the discussion of the general effective date of the proposed regulations:
The provisions of these proposed regulations amending the final regulations are proposed to be applicable on or after the date on which they are published as final regulations in the Federal Register. For periods before this date, the existing final regulations and other applicable guidance apply (without regard to these proposed regulations). The applicability date for the existing final regulations in § 1.409A-6(b) is accordingly amended to reflect extension of certain transition relief through 2008 under Notice 2007-86, 2007-46 IRB 990. Taxpayers may, however, rely on these proposed regulations before they are published as final regulations, and until final regulations are published the IRS will not assert positions that are contrary to the positions set forth in these proposed regulations.
However the IRS warns that certain positions in these regulations are not intended to represent changes in the law, thus positions contrary to these portions of the temporary regulations are deemed to be a violation of the existing regulations (and thus a major problem for the plan participant):
(1) That the transfer of restricted stock for which no section 83(b) election is made or the transfer of a stock option that does not have a readily ascertainable fair market value would result in a payment under a plan; (2) that a contribution to a section 402(b) trust includible in income under section 402(b) to fund an obligation under a plan would not result in a payment under a plan; (3) that a stock purchase treated as a deemed asset sale under section 338 is a sale or other disposition of assets for purposes of determining when a service provider separates from service as a result of an asset purchase transaction; or (4) that the exception to the prohibition on acceleration of a payment upon a termination and liquidation of a plan pursuant to § 1.409A-3(j)(4)(ix)(C) applies if the service recipient terminates and liquidates only the plans of the same category in which a particular service provider participates, rather than all plans of the same category that the service recipient sponsors.
With regard to the part-year compensation rules applicable generally to educators, the IRS provides the following options:
The rules set forth in these proposed regulations regarding recurring part-year compensation are proposed to be applicable on and after the date on which these proposed regulations are published as final regulations in the Federal Register. However, taxpayers may rely on either the rules in these proposed regulations or the rules in Notice 2008-62 relating to recurring part-year compensation for the taxable year in which these proposed regulations are published as final regulations and all prior taxable years.