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Impending December 31, 2008 Deadline: Mandatory Compliance with Section 409A

September 2, 2008

It is critical that every employer thoroughly review its compensation arrangements as soon as possible in order to ensure documentary compliance with Section 409A of the Internal Revenue Code. This comprehensive review is necessary in order to adequately determine whether the written documents that relate to each of the employer's compensation arrangements are drafted to comply with, or satisfy the exceptions with respect to, Section 409A. Any necessary amendments or restatements to compensation arrangements to comply must be adopted no later than Dec. 31, 2008. The written documents for each 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 Dec. 31, 2008). 

Violations of Section 409A in the form of the written arrangement or the operation of the written arrangement will invoke the following penalties to the service provider: (1) a 20 percent excise tax (in addition to normal income taxes), (2) immediate income inclusion (usually on the date of vesting), and (3) interest 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 also apply to all similar types of payments under other compensation arrangements with respect to which the service provider participates that are subject to Section 409A—even if the other 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 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 compensation arrangements that are or may be subject to Section 409A:

  • Deferred compensation arrangements
  • Employment or consultant agreements with any of the following features:

(a) established salary over a period of years
(b) reimbursement of service provider expenses (e.g., tax return preparation, financial planning fees)
(c) termination pay (including pay conditioned on signing of a release)(d) indemnification of service provider
(e) 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)

Additionally, new elections as to the timing and form of payment with respect to compensation arrangements subject to Section 409A may be made no later than Dec. 31, 2008 with respect to payments to be made after Dec. 31, 2008 pursuant to the current terms of the arrangements.

Again, since the process to ensure Section 409A compliance could take some time and will ultimately require approval by the appropriate party charged with adopting any necessary amendments or restatements no later than Dec. 31, 2008, a thorough review of your employer's compensation arrangements should be completed as soon as possible.

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If you have any questions related to Section 409A or would like assistance in ensuring compliance with the Dec. 31, 2008 deadline, please contact one of the attorneys listed on the upper right-hand side of this page.