IRS Issues Proposed Regulations Addressing Application of Section 409A to Nonqualified Deferred Compensation Plans

June 24, 2016

On June 21, 2016, the Internal Revenue Service ("IRS") issued proposed regulations clarifying or modifying a number of provisions of the final regulations under Internal Revenue Code ("Code") section 409A.  The IRS also withdrew one provision from previous proposed regulations regarding the calculation of amounts includible in income under section 409A(a)(1) and replaced it with revised proposed regulations.  The proposed regulations do not have any specific focus, but rather address various concerns raised by taxpayers over interpretive issues since the current regulations were finalized in 2007. 

Background

Section 409A was added to the Code in 2004 and addresses the taxation of amounts deferred under nonqualified deferred compensation plans ("NQDC plans").  The Treasury Department and the IRS issued final regulations under section 409A in 2007, addressing section 409A issues and setting forth the requirements for deferral elections and for the time and form of payments under NQDC plans.  The Treasury Department and the IRS then issued additional proposed regulations in 2008, providing guidance on the calculation of amounts includible in income under section 409A(a)(1) and the additional taxes imposed by section 409A regarding service providers participating in certain NQDC plans and other arrangements that do not comply with section 409A(a).  It has been rumored for years that the proposed regulations will be issued in final form "soon".

Overview of Provisions

Some of the key clarifications and modifications under the proposed rules include:

• Clarifying that Code section 409A’s rules apply to NQDC plans separately and in addition to the rules under Code section 457A.  Code section 457A provides that compensation deferred under a nonqualified entity’s NQDC plan is includible in gross income when there is no substantial risk of forfeiture of the rights to the compensation.  Nonqualified entities include (i) certain foreign corporations and (ii) partnerships where substantially all income is allocated to non-taxpayers.  The Treasury Department is expected to issue proposed regulations under section 457A of the Code relatively soon.
• Modifying the definition of "eligible issuer of service recipient stock" to include a corporation or 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.  This addresses complaints that the current definition hinders employment negotiations by preventing service recipients from granting stock rights (i.e., stock options and stock appreciation rights) to prospective service providers before they actually commence employment.
• Clarifying 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 employment status change, 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.  The final regulations provide various presumptions in this regard (e.g., if the person is expected to work at a level below 20% of the average level over the prior 36 months, there is a presumption a separation from service has occurred).
• Providing a rule that is generally applicable to determine when a "payment" has been made for purposes of section 409A.  Under the proposed regulations, a payment is made or occurs when any taxable benefit is actually or constructively received.  The proposed regulations include examples of payments (e.g., a transfer of cash or a transfer of property includible in income under section 83) and when payments are made (e.g., upon the transfer or reduction of an amount of deferred compensation in exchange for benefits under a welfare plan). 
• Modifying the rules applicable to amounts payable following death.  The proposed regulations clarify that the rules applicable to amounts payable upon the death of a service provider also apply to amounts payable upon the death of a beneficiary, and provide guidelines on when such payments are treated as timely paid. 
• Clarifying rules permitting accelerated payments in connection with the termination and liquidation of a NQDC plan.  The proposed regulations clarify that the acceleration of payments is permitted only if the service recipient terminates and liquidates all plans of the same category that the service recipient sponsors and not just those in which the service provider actually participates.
• Clarifying and modifying the anti-abuse provisions under 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 where section 409A is violated.  There was some concern that taxpayers could intentionally create noncompliant NQDC plans for additional flexibility and then "fix" them at a later date.

The proposed regulations will become final 90 days after publication of the final regulations in the Federal Register.  However, taxpayers may rely on the proposed regulations until that time.