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Impending Deadline - Dec. 31, 2008: Mandatory Compliance with Section 409A Requirements and Cafeteria Plan Requirements

December 5, 2008

This is a reminder of two very important deadlines that will take place on December 31, 2008 dealing with (1) the new Internal Revenue Code Section 409A ("Section 409A") requirements as to deferred compensation arrangements, and (2) the new cafeteria plan requirements.  Failure to satisfy either of these separate deadlines could result in severe penalties to the participants and the employer. 

Section 409A Compliance

It is critical that every employer thoroughly review its deferred compensation arrangements as soon as possible in order to ensure documentary compliance with Section 409A.  This comprehensive review is necessary in order to adequately determine whether the written documents that relate to each of the employer's deferred compensation arrangements are drafted to comply with, or satisfy the exceptions with respect to, Section 409A.  Any necessary amendments or restatements to deferred compensation arrangements to comply must be adopted no later than December 31, 2008.  The written documents for each deferred compensation arrangement must properly designate the form and timing of each payment under the arrangement subject to Section 409A (unwritten arrangements subject to Section 409A will no longer be permitted after December 31, 2008).

Violations of Section 409A, either non-compliant in written documentation or operation, will invoke the following penalties to the service provider (usually the employee):  (1) a 20% excise tax (in addition to normal income taxes), (2) immediate income inclusion (usually on the date of vesting), and (3) interest at an increased rate from the date of vesting.  The employer will have reporting and withholding obligations and will be subject to penalties for any failure to properly satisfy such obligations (as well as all of the service provider's penalties, if the employer has an obligation to indemnify the service provider).  If Section 409A penalties are incurred with respect to one type of payment (e.g., a separation payment, equity compensation payment, etc.), these penalties could also apply to similar types of payments under other deferred compensation arrangements with respect to which the service provider participates that are subject to Section 409A—even if the other deferred compensation arrangements are compliant with Section 409A.

Section 409A has been interpreted by the IRS to apply to a very broad range of compensation arrangements.  Generally, Section 409A will apply to deferred compensation arrangements that provide a legally binding right to a payment in a future year, unless certain exceptions apply.  Under the IRS' guidance on Section 409A, the following are examples of deferred compensation arrangements that are or may be subject to Section 409A:

  • Employment or consultant agreements with any of the following features:
      • established salary over a period of years
      • reimbursement of service provider expenses (e.g., tax return preparation, financial planning fees)
      • termination pay (including pay conditioned on signing of a release) 
      • indemnification of service provider
      • relocation make-whole agreements
  • Severance payments or benefits (under either a severance arrangement or an employment agreement)
  • Performance/bonus pay
  • Change of control payments or benefits 
  • Retention payments 
  • SERPs
  • Excess benefit plans
  • Post-retirement benefits
  • In-kind benefit arrangements
  • Discounted stock options (i.e., options with an exercise price less than the fair market value of the stock at the time the option was granted)
  • Stock appreciation rights and phantom stock awards
  • Performance units
  • Split-dollar life insurance
  • 457(f) arrangements (i.e., promises to pay compensation to employees of public schools and non-profit organizations who remain employed until a target date)

Cafeteria Plan Compliance

On August 6, 2007, the IRS released new proposed regulations under Section 125 of the Internal Revenue Code pertaining to cafeteria plans that are generally scheduled to go into effect beginning on or after January 1, 2009.  Although final regulations were expected to have been released, such regulations have not yet been issued by the IRS and no release date for such final regulations has been projected.  It is possible that the regulations may not be finalized until after 2009, or that the Treasury Department may extend the effective date for some or all of the final rules.  Until then, plan sponsors, their administrators and their advisors are required to comply with the new regulations by adopting the required amendments and operating their cafeteria plans in accordance with such new requirements no later than December 31, 2008 for calendar year plans (or, with respect to non-calendar year plans, no later than the day prior to the first day of the plan year beginning on or after January 1, 2009). 

The new regulations emphasize that cafeteria plans are the exclusive way for an employer to allow employees to choose between taxable and nontaxable benefits without the choice itself resulting in gross income to employees.  Some of the new requirements of these regulations deal with nondiscrimination testing, permissible benefits, elections, substantiation, group term life insurance, health savings accounts, and flexible spending accounts.

As the proposed regulations now constitute the primary regulatory guidance on the administration of cafeteria plans, compliance with these new regulations is of utmost importance.  Failure to comply with the rules could lead to plan disqualification, resulting in taxable income to plan participants in an amount equal to the taxable benefit with the greatest value that an employee could have elected to receive.