New 409A Deferred Compensation Rules  
By Bruce Delbecq
Community Bank Advisor, 2008 Winter

Most arrangements that defer compensation from one tax year to another are affected by the new 409A rules. Late in 2007, the deadline to amend plans to comply with the new rules was extended to December 31, 2008.

The types of arrangements affected by the 409A rules are broad. They include deferred compensation plans, severance arrangements, deferred employment contract benefits, and even stock option plans. Legislation passed in 2004 created these new rules that were generally effective beginning in January 2005. The basic requirements are reflected in section 409A of the Internal Revenue Code, and have been nicknamed the “409A” rules ever since. Plans are currently operating under a “good faith compliance” standard; the IRS has provided a continual stream of guidance, and final design and document changes must be in place by December 31, 2008.

Participant elections to defer a portion of their own compensation generally must be made before the beginning of the year in which the compensation is earned. In certain circumstances, an election by a participant to defer a performance bonus may be made as late as six months before the end of the performance period.

The 409A restrictions are broad in scope but center on limiting the time and form of benefit payments. Payments are allowed at a fixed time, or pursuant to a fixed schedule, upon separation from service, death, disability, unforeseeable emergency or change in control. The rules provide specific definitions for when separation of service, disability, and change in control occur, and they differ from the language currently contained in most plans.

The ability to postpone distribution timing is very limited and generally requires at least a five-year delay in the time of payment. Generally, benefit payments cannot be accelerated; however, in many instances a special transition rule will allow an election in 2008 to accelerate a payment to as early as January 2009.

The new rules impose additional restrictions on officers of publicly traded institutions, which the rules refer to as “specified employees,” and force a six-month delay in benefit payments under certain circumstances. In addition, the rules require stock options to have an exercise price no less than the fair market value of the underlying shares of stock on the date of grant. Most banks will want to position their stock option program so that the exercise price is determined under one of the safe harbors described in the IRS regulations. Often, this will cause changes in pricing methodology, especially for closely held banks and those traded on the “pink sheets.”

Most businesses find they must make minor or moderate changes to their plans in order to comply with the new rules. However, the basic plan design and most plan features tend to be retained, as long as they still meet the needs of the business.

The consequences of noncompliance are stiff and are assessed to plan participants. Previously untaxed amounts must be included in income upon becoming vested, interest at the federal underpayment rate plus one percent is imposed, and amounts includable in income will be subject to an additional 20 percent penalty tax.

Typically, the first step to compliance is a review of all documents that may contain a promise, or contingent promise, of deferred compensation and related administrative practices. Next, an assessment should be made to determine whether the detailed plan provisions meet the 409A requirements and whether the program design is still aligned with organizational goals and participant needs.

We recommend that a review of all plans commence as soon as possible since most organizations have found that the process of implementing changes takes more time than they originally thought.