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Don’t Bite the Hand Don’t Bite the Hand That Feeds You!That Feeds You!
New Compliance Requirements for
Deferred Compensation Programs
By Kristi Cook, JD
For:
1-800-433-1828
ALSO…Please Don’t Shoot the Messenger!
Law passed at end of 2004 as part of American Jobs Creation Act of 2004– IRS issued a Notice 2005-1 that provided
some guidelines– But, regulations not issued until the end of
September, 2005 Created a new Section 409A which
establishes new requirements for deferred compensation arrangements
Surprise…Surprise!!!
Effective for all compensation deferred after December 31, 2004
Until 12/31/05, employers were permitted to terminate ongoing arrangements provided that all assets were distributed by 12/31/05
Must operate in “good faith” compliance with new requirements until programs are amended to conform to new requirements
Have until 12/31/06 to amend current programs to conform to new requirements
What is §409A?
A new section added to the federal income tax code establishing requirements for all deferred compensation arrangements – There are certain exemptions available under
§409A– But any arrangement not exempted must
satisfy the requirements of §409A
New §409A Regulations
Impose new rules on all deferred compensation arrangements
Impose annual 20% excise tax on employee on arrangements that fail to meet requirements– Plus 1% over “underpayment interest rate– BUT, employer must report properly
PLUS amounts are taxable when no longer subject to substantial risk of forfeiture– NOT when received by the employee
What Arrangements are Affected?
Affects any plan, arrangement or agreement (whether written or not) between an employee and employer that defers compensation into a future year– Exception for qualified retirement plans and certain
bona fide welfare plans.– However, most severance pay programs, accumulated
leave programs, early retirement incentive programs and split dollar insurance plans are affected by these new regulations
What is Deferred Compensation?
A plan provides deferred compensation if – the employee has a legally binding right to
compensation– that is not received during the current tax year
and – is payable to (or on behalf of) the employee in
a later year
Statutory Exemptions from §409A
Short Term Deferrals Qualified Plan Contributions Separation Pay Safe Harbor Bona Fide Welfare Plans
Short Term Deferrals
Any amounts paid to the employee within 2½ months of the end of the year in which the benefit is no longer subject to a “substantial risk of forfeiture” – For most K-12 employers, the year of severance is the
applicable year Plan should require payment within the 2½
month period – Amounts paid after 2 ½ month period may be
exempted if due to unforeseeable administrative issues or solvency problems if paid as soon as practicable
What is a Substantial Risk of Forfeiture?
Entitlement to the compensation is– conditioned on the performance of substantial future
services or – the occurrence of a condition related to the purpose of
the compensation, and – the possibility of forfeiture is substantial
Specifically rejects “noncompete” arrangements, “rolling risks of forfeiture,” post employment consulting agreements– Also extending deferrals of salary unless related to a
“material” increase in compensation
Qualified Plans
Amounts paid into qualified plans are excluded from definition of “deferred compensation”
Applies to contributions into 401(a), 403(b), 401(k) and 457(b) programs
Health reimbursement and medical reimbursement accounts are also excepted
Separation Pay Exceptions
Three types of separation payments are excluded from deferred compensation, including payments for– Certain involuntary terminations of
employment– Certain “window” programs– Certain payments under collectively bargained
plans
Involuntary Separations and Window Programs
Excluded if:– Payments do not exceed the lesser of
• 2X the employee’s compensation or• 2X the 401(a)(17) limit on compensation; and
– Payments are not made later than December 31 of the second calendar year following the year of separation from service
“Window” period cannot exceed 12 months
Collectively Bargained Plans
Window plans and involuntary termination plans that are collectively bargained through arms length negotiations are not subject to the limits on the amount of the benefit or on the duration of the payouts.
NO exception for programs that provide benefits for voluntary terminations or are offered under “windows” that are open for more than 12 months
Bona Fide Welfare Plans
Programs structured as “wage replacements” for – Vacation leave – Sick leave– Compensatory time, – Disability pay, or– Death benefit plan
Severance pay plans are NOT excluded as bona fide welfare plans
Sabbatical leave plans are not exempted
Review of §409A Coverage
Any arrangement that defers compensation to a future year unless there is a substantial risk of forfeiture
Exemptions for:– Short term deferrals– Qualified plan contributions– Separation Pay “Safe Harbors,” and – Bona fide welfare plans
What Should You Do Now? Examine all compensation arrangements
– Individual employment contracts, collective bargaining agreements, Act 93 agreements and similar agreements
Determine if compensation earned in the current year is payable in a future year– If yes, are any exemptions available to exclude the benefit
from 409A? Can the benefit be restructured to avoid inclusion
under 409A?– If yes, open contracts and restructure– If not?
What Does 409A Require? Establishes requirements for written
documentation, valid deferral elections, timing of distributions and tax reporting– Plan must be evidenced in writing– Must report in year of deferrals AND in year of
payments• Different reporting codes
“Deferral Elections”
Deferrals may be “elective” or “nonelective” Elective deferrals occur when employee
voluntarily elects to defer compensation into a future year
Nonelective deferrals occur if the payment for the benefit is based on contractual obligations or similar binding agreement– Accumulated leave payments, ERIPs, severance pay,
etc.
Elective Deferral Elections
Elections must include the amount of the deferral, the form of payment to be received and the timing of the distributions
Elections must be completed in year preceding year in which the services are provided to the employer– In initial year, election must occur within 30 days of
eligibility Elections are irrevocable
– Unforeseeable emergency withdrawals are permitted
Nonelective Deferrals
This type of compensation is considered earned in the year in which the employee has a legally binding right to the compensation– Generally, the year in which benefits first
become payable to employee– Treated as an “initial year” election
Distribution Restrictions
Arrangement must limit distributions to the occurrence of one of the following events: – Severance from service– Disability– Death– Specified time or fixed schedule– Unforeseeable emergencies
Cannot accelerate distributions
Can Employees Change Previous Distribution Elections? Distribution elections may be changed by
employees provided that the change occurs at least 12 months prior to the date the distribution would otherwise have occurred, AND
Payment must be deferred for at least another 5 years
NOTE: this does not defer taxation on the distribution to employee
Employer Tax Reporting
Employers must report all deferrals in the years when made and when no longer subject to forfeiture– All deferrals plus earnings in Box 12 on Form
W2 using Code Y– Amounts includable in income are reported in
Box 12 with Code Z Reporting requirements applicable to 2006
tax year
Best Solutions for §409A Issues
Short Terms Deferral Exemption– Pay all benefits within 2½ months of end of year in
which severance from service occurred• Requirement for timing of payment should be included in
written arrangement
Qualified Plan Exemption– Structure deferred compensation around employer
403(b) contributions• 6 year payout limitation
– Year of severance from service plus the next 5 years
Strategies?
Try to avoid application of §409A– Review all current compensation arrangements – Identify any that defer compensation after 12/31/2004,
plus• ALL §457(f) plans• Most split dollar plans• Many “traditional” benefits
– Severance benefits – ERIs– Retirement bonuses– Accumulated leave programs
Strategies…continued
Determine if any exemptions apply– Short term deferral for accumulated leave type
benefits– Contributions into 403(b) plans to replace
benefits• Restructure to avoid 409A
– Window plans • Remember 12 month limitation• More helpful for CBA ERIPs
More Strategies
Remember the issue when crafting future compensation programs
Try to keep it simple– Complicated arrangements lead to missed
payments– Acceleration of taxes, excise tax and reporting
problems
Questions?Questions?
Thank You