The Department of the Treasury (Treasury) and Internal Revenue Service (IRS) issued proposed regulations (REG-123854-12) (Proposed Regulations) that would clarify and modify certain provisions of the Section 409A final regulations issued in 2007. The Proposed Regulations would also modify the proposed regulations relating to the calculation of amounts to be included in income under Section 409A issued in 2008.

For the most part, the Proposed Regulations would make technical corrections or provide clarifications to the Section 409A final regulations and are consistent with most practitioners' current interpretations of the rules. Certain aspects of the proposed changes, however, are more substantive; some of these changes provide taxpayers with greater flexibility, while others may restrict current practices. This Alert discusses the most noteworthy provisions.

The Proposed Regulations will apply on the date the final regulations are published in the Federal Register, but taxpayers may rely on the Proposed Regulations immediately. Certain provisions, as noted below, are effective immediately. Comments are due on the Proposed Regulations by September 20, 2016.

Background

Section 409A governs nonqualified deferred compensation plans and imposes requirements regarding the timing of elections to defer compensation and the timing of distributions of compensation previously deferred. If the requirements of Section 409A are not satisfied, all compensation deferred under the plan is includible in a participant's gross income at the time that the legally binding right to the compensation arises or, if later, at the time the compensation is no longer subject to a substantial risk of forfeiture (sometimes referred to as the "vesting date"). In addition, the service provider must pay an additional 20% tax and, in some cases, a premium interest tax on the deferred compensation amount required to be included in income.

In 2007, Treasury and the IRS issued final regulations under Section 409A that set forth the definitions for what constitutes nonqualified deferred compensation, certain exceptions from those definitions (including the exemptions for short-term deferrals and for stock rights), the requirements for deferral elections, and the requirements for the time and form of payments under nonqualified deferred compensation plans.

In 2008, Treasury and the IRS issued proposed regulations that provide guidance on the calculation of amounts includible in income under Section 409A(a)(1) and the additional taxes imposed on service providers participating in a noncompliant deferred compensation plan. (These proposed regulations are referred to as the "proposed income inclusion regulations").

Proposed regulations

Noteworthy changes to the Section 409A final regulations and the proposed income inclusion regulations may be grouped in four general categories: (i) the definition of deferred compensation; (ii) the definition of a payment and when a payment is considered to be made; (iii) when an acceleration of a payment is permissible; and (iv) when an amount is included in income under Section 409A and when the terms of an unvested payment may be amended without being included in income.

A. Definition of deferred compensation

Stock rights. Stock options and stock appreciation rights (collectively, stock rights) are not considered deferred compensation and are exempt from the application of Section 409A if specific requirements are satisfied. This includes a requirement that the stock option must relate to service recipient stock, as defined by Section 409A, or for a stock appreciation right, the value of that stock. The Proposed Regulations would clarify that an employer's right to call a stock right, for a service provider who is terminated involuntarily for cause or violates a non-compete agreement for an amount that is less than the spread between the exercise price and the fair market value of the underlying stock, will not cause the stock right to fall out of the stock right exemption. In addition, the proposed rules would clarify that exempt stock rights may be granted by a future employer up to 12 months in advance of the service provider's commencement of employment.

Short-term deferrals. The Section 409A final regulations provide that payment of compensation within 2½ months after the year within which the right to the payment is no longer subject to a substantial risk of forfeiture is considered a "short-term deferral" that is exempt from Section 409A. The Proposed Regulations would clarify that a delay of settlement of a payment (e.g., a payment of a restricted stock unit) beyond this 2½-month period to comply with federal securities laws will not cause the payment to fall out of the short-term deferral exemption.

Sections 457(f) and 457A. The Proposed Regulations would clarify that nonqualified deferred compensation under a plan maintained by a tax-exempt or governmental employer that is subject to Section 457(f) is also subject to Section 409A and that the Section 409A rules apply separately and in addition to Section 457(f). At the same time that the Proposed Regulations were issued, the IRS also issued Section 457 proposed regulations. (For more on REG-147196-07, see Tax Alert 2016-1182.) Under Section 457(f), a deferred compensation amount is includible in income at the time that a substantial risk of forfeiture first lapses (i.e., in the first year that the individual vests in the deferred compensation on the basis of a performance of services). For the most part, this means that deferred amounts are short-term deferrals under Section 409A because the amounts are includible in income at vesting and this inclusion is treated as a payment for purposes of Section 409A, even if the amount is not actually distributed from the plan. (See discussion later in Section B on what constitutes a "payment" under Section 409A.) Future earnings in a Section 457(f) plan on the deferred amounts, however, are treated as nonqualified deferred compensation under Section 409A because the earnings are not includible in income until actually paid or made available to the recipient.

This analysis, however, depends upon the definitions of a substantial risk of forfeiture for purposes of Section 457(f) inclusion and for purposes of the Section 409A short-term deferral exemption being the same, which is not always the case. The definition of substantial risk of forfeiture is also relevant for determining when an arrangement meets certain other exemptions under Section 409A (e.g., as a bona fide separation pay plan). As such, there are a number of circumstances in which a nonqualified deferred compensation arrangement maintained by a tax-exempt or governmental employer must comply with both the Section 457(f) and the Section 409A requirements. These employers will need to carefully design and operate their nonqualified deferred compensation plans to avoid a Section 409A compliance failure.

Similarly, the Proposed Regulations would clarify that nonqualified deferred compensation plans subject to Section 457A (e.g., deferred compensation arrangements maintained by employers in jurisdictions that do not have a comprehensive income tax) will need to ensure that the arrangement also complies with the Section 409A requirements. Section 457A was enacted after the Section 409A regulations were finalized. The Proposed Regulations request comments on whether rules related to Section 457(f) plans, such as the payment timing rules, should also apply to deferred compensation arrangement subject to Section 457A.

Recurring part-year compensation. The Proposed Regulations include a helpful rule for educational organizations that regularly pay teachers, professors and other employees over 12 or 13 months, even though the employee may work only 9 or 10 months during the year. The Proposed Regulations provide that such recurring compensation arrangements are not considered deferred compensation, provided the annual compensation paid does not exceed the Section 401(a)(17) limit ($265,000 for 2016) and other requirements are satisfied. This rule is also incorporated in the Section 457(f) proposed regulations.

B. Definition of a payment and when a payment is considered to be made

General rule. A significant clarification made by Proposed Regulations is to the rule addressing when an amount is treated as a payment. The Proposed Regulations would clarify that an amount is treated as paid for all purposes of Section 409A when a taxable benefit is actually or constructively received and is included in gross income. This includes amounts included in income upon a transfer of cash, upon a transfer of property under Section 83, when deferred compensation vests under Section 457(f), or when the receipt of an interest in a non-grantor trust vests under Section 402(b).

Some practitioners had taken the position that the Section 409A final regulations would permit a service provider to elect to receive a payment of deferred compensation as a transfer of restricted stock, which would not be included in income under Section 83 until a future year in which those restrictions lapsed. In effect, this approach would allow further deferral of income while still arguably complying with the Section 409A payment provisions. The Proposed Regulations would make clear that a transfer of restricted stock is not considered a payment for Section 409A purposes, unless a Section 83(b) election is made, resulting in immediate taxation, notwithstanding the restrictions on the stock. Therefore, a service recipient's election to receive cash or restricted shares would not satisfy the Section 409A rules under the Proposed Regulations, unless the service provider's election to receive the restricted shares satisfied the Section 409A subsequent deferral rules. Similarly, the transfer of a compensatory stock option not having a readily ascertainable fair market value (and thus not subject to income inclusion upon grant) would not be considered payment for purposes of Section 409A.

The preamble to the Proposed Regulations provides that this amendment of the final regulations (clarifying that a payment does not include a transfer of restricted stock for which no Section 83(b) election is made or a transfer of a stock option that does not have a readily ascertainable value) is not intended to be a substantive change to the Section 409A final regulations. Therefore, taxpayers may not take the position under the existing final regulations that such transfers are payments for Section 409A purposes.

Payment upon death. Death of the service provider is one of the Section 409A permissible deferred compensation payment events. The Proposed Regulations provide that following the death of a service provider, a deferred compensation payment that is made any time during the period beginning on the date of death and ending on December 31 of the first calendar year following the calendar year during which the death occurs is treated as timely paid.

Transaction-based compensation. In the case of certain changes in control of the service recipient, the Section 409A final regulations provide that payments of certain stock-based compensation will comply with the payment timing rules if the payments are on the same schedule and under the same terms and conditions as apply to all shareholders. The Proposed Regulations provide that these special payment rules for transaction-based compensation also apply to an exempt stock right (such as stock options and stock appreciation rights) without causing the exempt stock rights to lose the Section 409A exemption.

C. Determining when acceleration of a payment is permissible

Plan terminations. Under the Section 409A final regulations, the payment of deferred compensation may be accelerated if the plan is terminated and liquidated. One requirement of this provision is that all plans of the same type in which the service provider participates must be terminated. The Proposed Regulations would clarify that a service recipient must terminate and liquidate all plans of the same category that the service recipient maintains, not just all plans of the same category in which a particular service provider actually participates.

The preamble to the Proposed Regulations provides that the amendment of the final regulations related to the termination and liquidation of a plan is not intended to be a substantive change to the Section 409A final regulations. Instead, the amendment is designed to clarify the rule set forth in the existing regulations. Therefore, the rule articulated in the amendment currently applies under the final regulations.

Payment to a beneficiary. In the case of a beneficiary who is entitled to a payment under a nonqualified deferred compensation plan due to an employee's death, the Proposed Regulations provide that it is permissible to add to the plan the possibility of an accelerated payment upon that beneficiary's death, disability or unforeseeable emergency.

D. Determining when an amount is included in income under Section 409A and when terms of an unvested payment may be amended without being included in income

Perhaps the most significant provision in the Proposed Regulations is the modification of the proposed income inclusion regulations restricting the ability to correct a Section 409A error in the year prior to vesting of the nonqualified deferred compensation.

The proposed income inclusion regulations provide that a Section 409A violation in one year that results in adverse tax consequences to a service provider generally will not continue in subsequent years, provided that a violation does not also occur in a subsequent year. In addition, the proposed income inclusion regulations provide that amounts that are unvested as of the end of the year in which the violation occurs are not subject to Section 409A income inclusion and the additional 20% tax. Some taxpayers may have utilized these rules to change the time and form of an unvested nonqualified deferred compensation payment in a manner normally not permissible under Section 409A without incurring liability for the additional tax as a result of a Section 409A violation.

The Proposed Regulations would modify the proposed income inclusion regulations to limit the ability to change the time and form of payment for these unvested amounts. To change the time and form of payment for an unvested benefit, the following requirements apply:

— The employer must make a reasonable, good faith determination that the deferred compensation would not comply with Section 409A absent the amendment.

— The employer may not have a pattern or practice of permitting impermissible changes in the time or form of payment with respect to unvested amounts.

— The employer must follow existing Section 409A correction guidance, if any, to correct the failure related to the unvested amount. (In these circumstances, however, other requirements in the existing Section 409A correction guidance relating to eligibility, income inclusion, and information reporting do not apply.)

If an amendment did not meet these requirements, the relating deferred amounts would not be treated as being subject to a substantial risk of forfeiture. As such, these amounts would be subject to income inclusion as the result of the Section 409A violation and subject to the additional 20% tax, even if the amounts are in fact unvested as of the end of the year.

Implications

For the most part, the Proposed Regulations would clarify the application of Section 409A in ways that are not surprising or unexpected. There are, however, certain types of plans — including those sponsored by tax-exempt organizations and governmental entities subject to Section 457(f) — that will need further review to consider the application of Section 409A. The Proposed Regulations' limitations on the ability to amend the payment terms of unvested amounts also puts further emphasis on structuring nonqualified deferred compensation plans to comply with Section 409A from inception.

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