Employee Benefits & Pensions
Sec. 409A provides election, distribution, and funding requirements with respect to nonqualified deferred compensation (NQDC) arrangements. If an NQDC arrangement fails to satisfy these requirements, amounts deferred under the plan during the current and all preceding tax years are includible in gross income to the extent not subject to substantial risk of forfeiture and not previously included in income. The amount included in income is subject to a 20% additional income tax and potentially a premium interest tax. This item provides an update on Sec. 409A guidance and discusses a recent case that addresses the valuation of payments that are subject to the Sec. 409A six-month delay on distribution of payments to specified individuals.
Changes to the Correction Programs
The IRS issued Notice 2010-80 on November 30, 2010, which modified certain provisions of the Sec. 409A correction programs provided under Notices 2010-6 and 2008-113.
Notice 2008-113 provides a correction program for certain Sec. 409A operational failures that are corrected during the same tax year as the failure, failures that are corrected in the tax year immediately following the tax year in which the failure occurred, and failures that are corrected by the end of the second tax year following the year in which the failure occurred. Taxpayers may rely on Notice 2008-113 for tax years beginning on or after January 1, 2009, and for tax years beginning before that date.
The IRS issued Notice 2010-6 on January 5, 2010. That notice provides methods for taxpayers to voluntarily correct certain types of failures to comply with the document requirements of Sec. 409A. This correction program is intended to encourage taxpayers to review the governing documents of their NQDC arrangements for Sec. 409A document failures. In some cases, plans may be corrected without service providers’ having to include amounts in income under Sec. 409A, while in other cases as much as 50% of the amount deferred under the plan must be included in income, subject to the 20% additional income tax rate (although not the additional premium interest tax). Correction under the notice isolates the document failure to the year of correction so that the document failure will not taint prior years. Taxpayers may rely on Notice 2010-6 for tax years beginning on or after January 1, 2009. Notice 2010-6 also made certain modifications to Notice 2008-113. These modifications are effective for service provider tax years beginning on or after January 1, 2010, but may be relied upon for service provider tax years beginning before that date.
Notices 2010-6 and 2008-113 apply only to inadvertent and unintentional failures to comply with Sec. 409A document and operational requirements. Taxpayers taking advantage of the programs must satisfy eligibility and notice requirements.
Notice 2010-80 provides for the following changes to the document and operational correction programs:
Linked plans and stock rights: Under Notice 2010-6, relief under the document correction program was not available to certain linked plans and stock rights. Linked plans are generally defined as NQDC plans under which the amount deferred is determined based on a formula under a qualified plan, and the amount payable under the nonqualified plan is offset by some or all of the benefits under a qualified plan. Linked plans that were not eligible for correction under the document correction program were plans that had document failures due to the amount deferred under the plan being determined by (or the time or form of payment being affected by) the amount deferred under (or the payment provisions of) one or more other NQDC plans or one or more qualified plans. Notice 2010-80 expanded eligibility for the document correction program to linked plans that provide that the amount paid under one plan is affected by the amount paid under the other plan, provided the time and form of payment under the first plan are not affected by the amount deferred under, or the payment provisions of, the other plan.
Stock rights that were intended to satisfy the stock right exception under Sec. 409A but that were granted with an exercise price less than fair market value on the date of grant are eligible for correction as an operational failure under Notice 2008-113, but no stock rights were eligible for relief under Notice 2010-6. Notice 2010-80 expanded eligibility for the document correction program to stock rights that are subject to Sec. 409A, meaning the rights do not satisfy the stock right exception under Sec. 409A. If a stock right provides that the right may be exercised only upon a fixed date or a period beginning and ending within one tax year (generally the calendar year for individual taxpayers) and/or upon a permissible payment event under Sec. 409A and its regulations (such as separation from service, death, disability, or change in control), a failure in the governing documents of the stock right is eligible for relief under the document correction program. For instance, relief under Notice 2010-6 would be available to a stock right that is subject to Sec. 409A and granted to an employee with a calendar tax year, provided that it may be exercised on the earlier of a fixed date or the period beginning with the employee’s separation from service and ending on December 31 of the year of the employee’s separation from service where the definition of separation from service complies with Sec. 409A and its regulations.
Payment periods dependent upon return of a release or other employment-related action: Notice 2010-6 provides an additional correction method for payment provisions that provide for a period of payment that is dependent upon employment-related action, including the service provider’s submission of an executed employment-related agreement, such as a release of claims or a noncompetition or nonsolicitation agreement. Arrangements that include such a payment provision may be corrected before the date of the event that triggers payment to remove the service provider’s ability to delay or accelerate the timing of payment as a result of the service provider’s actions. Notice 2010-6 provided two methods to correct these payment provisions. Notice 2010-80 expands the correction methods and provides for transition relief to correct such provisions.
Under Notice 2010-80, a payment provision that is dependent upon employment-related action is eligible for correction if the provision is corrected before the date of the event that triggers payment and the arrangement is amended to remove the service provider’s ability to delay or accelerate the timing of the payment as a result of the service provider’s action. If the arrangement provides for a designated period following the permissible payment event (such as separation from service, death, or disability) that is a permissible payment period (e.g., a 90-day period), except that the service provider’s action could affect the tax year of the payment, the amendment must provide for either (1) payment only on the last day of the designated period or (2) payment in the second tax year if in any event the designated period begins in the first tax year and ends in the second tax year.
If the provision does not provide for payment within a designated payment period that complies with Sec. 409A, the amendment must provide for either:
- Payment only upon a fixed date either 60 or 90 days following the occurrence of the permissible payment event; or
- Payment during a specified period not longer than 90 days following the occurrence of the permissible payment event, provided that if the specified period begins in one tax year and ends in a second tax year, the payment will be made in the second tax year.
This correction relief is available even if the plan was previously amended under the transition period provided under Notice 2010-6, Section XI, to correct a provision that allowed the service provider to delay or accelerate the timing of a payment as a result of the service provider’s action (this transition relief ended December 31, 2010). In any case, the amendment may not otherwise change the time or form of payment.
Notice 2010-80 also provides transition relief through December 31, 2012, for plans that contain payment provisions as of December 31, 2010, that are dependent upon an employment-related action. If a payment is made under the provision before March 31, 2011, it will not be treated as a Sec. 409A form or operational failure. If a payment is made under the provision after March 31, 2011, the provision will not be treated as a form failure for tax years beginning on or after January 1, 2009, and the payment will not be treated as an operational failure, provided that:
- Any amounts paid under the provision where the potential payment period begins in a service provider tax year and ends in a subsequent service provider tax year are paid in the subsequent tax year, or if paid in the first tax year are treated as an operational failure and corrected in accordance with Notice 2008-113; and
- If any amounts subject to the provision remain deferred after December 31, 2012 (other than a remaining installment, annuity, or other payment of an amount that has already become payable under such a plan provision), the plan provision has been amended in accordance with Notice 2010-6, as amended by Notice 2010-80, on or before December 31, 2012.
Plans that include a payment provision dependent upon employment-related action as of December 31, 2010, are eligible for the transition period with respect to individuals who commence participation after December 31, 2010.
Modifications to the notice requirements: The document and operational correction programs contain service provider and service recipient notice requirements that must be satisfied to be eligible for relief. Generally, a service recipient is required to provide information statements to service providers who are affected by the failure, and both the service recipient and service providers are required to attach this information to their tax returns. Notice 2010-80 revises the notice requirements related to the correction of payment provisions that are dependent upon employment-related actions and correction of such provisions made in accordance with the transition relief that ends on December 31, 2012, to eliminate (1) the requirement for service recipients to furnish information statements to affected service providers and (2) the requirement for affected service providers to attach the statements to their tax returns. The service recipient continues to be subject to the requirement to attach the information statement to its timely filed (including extensions) original federal income tax return for the year in which it corrects the failure and the tax return for the subsequent tax year, to the extent that a service provider is required to include an amount in income during such subsequent year.
In addition, Notice 2010-80 modifies the notice requirements under Notice 2008-113 for correction of operational failures in the same tax year in which the failure occurs. Notice 2010-80 provides that service recipients are no longer required to give affected service providers a statement describing the failure. In the event such a failure occurs, service recipients continue to be subject to the notice requirement to attach a statement to their timely filed (including extensions) original federal income tax return for the tax year in which the failure occurred.
Distributions Upon an Unforeseeable Emergency
The IRS issued Rev. Rul. 2010-27 on November 4, 2010. The ruling provides guidance on what events constitute unforeseeable emergency distributions from deferred compensation plans that are governed by Sec. 457(b). Although this ruling addresses the definition of unforeseeable emergency distributions under Sec. 457 plans, the ruling applies to plans that are subject to Sec. 409A. One of the permissible payment events under Sec. 409A is an unforeseeable emergency. The definition of “unforeseeable emergency” under Sec. 409A is substantially similar to the definition under Sec. 457. As a result, in the ruling the IRS provides that the principles and holdings set forth in the ruling apply to amounts distributed due to an unforeseeable emergency from an NQDC plan that is subject to Sec. 409A.
For purposes of Sec. 457, an unforeseeable emergency is defined as a severe financial hardship of the participant or beneficiary resulting from:
- An illness or accident involving the participant, the beneficiary, or the participant’s or beneficiary’s spouse or dependent (as defined in Sec. 152(a));
- The loss of the participant’s or beneficiary’s property due to casualty, including the need to rebuild a home following damage to a home not otherwise covered by homeowner’s insurance (e.g., as a result of a natural disaster); or
- Other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant or beneficiary (Regs. Sec. 1.457-6(c)(2)(i)).
Whether a participant or beneficiary has experienced an unforeseeable emergency is based on facts and circumstances. Regs. Sec. 1.457-6(c)(2)(ii) provides examples of events that may constitute unforeseeable emergencies, including foreclosure or eviction, the need to pay medical expenses, and the need to pay funeral expenses of a spouse or a dependent (as defined in Sec. 152(a)). A distribution due to an unforeseeable emergency may not be made to the extent that the emergency is or may be relieved through reimbursement or compensation from insurance or otherwise, by liquidation of the participant’s assets, to the extent the liquidation of such assets would not itself cause a severe financial hardship, or by cessation of deferrals under the plan. Distributions must be limited to the amount reasonably necessary to satisfy the emergency need, which may include amounts to pay federal, state, or local income taxes or penalties reasonably anticipated to result from the distribution (Regs. Sec. 1.457-6(c)(2)(iii)).
In the ruling, the IRS reviewed three fact patterns to determine whether each event constituted an unforeseeable emergency. One fact pattern involved the need to pay for repairs to the participant’s principal residence due to significant damage from a water leak in the basement. The second fact pattern involved a distribution to pay for funeral expenses for the participant’s adult son, who was not a dependent as defined in Sec. 152(a). The third fact pattern involved a distribution to pay accumulated credit card debt where the participant did not incur the debt as a result of any events that were extraordinary and unforeseeable circumstances that were beyond the control of the participant.
The ruling provides that the events in the first and second fact patterns were considered unforeseeable emergencies, even though the events did not fit within any of the specific examples provided in the regulations. The IRS determined that the repairs to the principal residence and the funeral expenses for a nondependent child were extraordinary and unforeseeable circumstances that arose as a result of events beyond the control of the participant and were substantially similar to the applicable examples provided in the regulations. It also determined that the event in the third fact pattern did not constitute an unforeseeable emergency because it did not fit within any of the specific examples provided in the regulations and was not due to circumstances that arose as a result of events that were beyond the control of the participant. With respect to the second fact pattern involving the nondependent adult child, this holding is an expansion in the interpretation of the definition of unforeseeable emergency. However, the circumstances under which the distribution was permitted are consistent with the purpose of the unforeseeable emergency distribution provision, which is to provide access to funds to pay for costs that occur due to events outside the control of the participant or beneficiary. Although the holding provides an expanded interpretation of the definition, plan administrators should carefully evaluate the facts and circumstances of each distribution to determine whether it is consistent with the regulations and guidance.
Valuation of Payments Subject to the Six-Month Delay
The Eleventh Circuit recently issued a decision in Graphic Packaging Holding Co. v. Humphrey, No. 10-12015 (11th Cir. 11/16/10), which addressed the valuation of amounts that are subject to the Sec. 409A six-month delay. Sec. 409A provides that amounts paid to a specified employee upon a separation from service may not be paid until six months after the date of separation from service. A specified employee is generally defined as a key employee of a public company. A key employee is generally defined as an officer whose annual compensation is greater than $160,000 for 2011 (this threshold amount is indexed for inflation).
In this case, Graphic Packaging sued Humphrey, the company’s former vice chairman, to recoup over $500,000 that the company alleged it overpaid to Humphrey. During his employment, Humphrey received restricted stock unit (RSU) awards that were payable half in cash and half in the company’s common stock. Humphrey was a specified employee for purposes of Sec. 409A and thus payments upon separation from service were subject to the six-month delay. In accordance with Sec. 409A, the RSU awards were payable six months after the date Humphrey retired. The issue was whether the cash portion of the RSU awards should be valued as of the date of his retirement or the date the awards became payable. The company imposed the six-month delay but failed to take that delay into account when determining the value of the payment. As a result, the company paid Humphrey approximately $1.2 million based on the value of the awards as of the date of retirement rather than the value of the awards as of the date the RSUs became payable, after the expiration of the six-month delay. The stock plan did not specify a valuation date. Humphrey’s retirement was the first time the company had imposed the six-month delay. As a result, the company did not have a past practice to use to determine how the award should be valued. The company notified Humphrey of the error, but he refused to repay the amounts that were allegedly overpaid.
The court determined that the company was required to produce evidence that demonstrated why valuing the award as of the date it became payable was correct and valuing the award as of the date of retirement was incorrect. The court held that the company did not meet its burden to prove that it made a mistake in valuing the RSU awards as of the date of retirement. The court agreed with the district court’s conclusion that “valuing Humphrey’s RSUs as of the date of his retirement was a reasonable interpretation of the relevant agreements that was confirmed repeatedly through numerous letters and, ultimately, by paying Humphrey accordingly.” The court noted that the governing documents did not provide for the Sec. 409A six-month delay to change the value of the RSU award and that “nothing in §409A suggests that the proper valuation date should be at the end of the six-month holding period.” Since there was no past practice to show that the company erred when it valued the award as of the date of retirement, there was no indication in the record that valuing the award as of the date of retirement was incorrect. The court thus held in favor of Humphrey.
This case does not address the interpretation of Sec. 409A, but it does demonstrate the importance of drafting documents that clearly address all relevant terms of the arrangement. Although Sec. 409A sets forth certain plan document requirements, plan documents should include additional terms that address other aspects of the compensation arrangement. As the court indicated in Graphic Packaging, Sec. 409A does not specify how amounts should be valued upon the expiration of the six-month delay. This provision simply governs the timing of payments to certain individuals. Parties to arrangements that are subject to Sec. 409A should be aware of the situations in which Sec. 409A is silent and consider how the parties would like these situations to be managed under the terms of the agreement. If an agreement is clear, the parties will not have to resort to determining subjective intent or look to past practices. Employers should review their NQDC arrangements to determine whether there are any ambiguities with respect to the terms of the governing documents, such as the date on which payments are to be valued when the six-month delay applies or does not apply.
Conclusion
In general, the guidance and case law issued in 2010 provide insight and lessons about operating NQDC plans in light of Sec. 409A. Notice 2010-80 provides welcome relief with respect to correcting payment provisions that are conditioned upon an employment-related action and certain notice requirements under the correction programs. The guidance provided under Rev. Rul. 2010-27 clarifies how plans may interpret their unforeseeable emergency payment provisions and provides an expanded interpretation of the events that constitute an unforeseeable emergency. While Graphic Packaging did not address specific Sec. 409A compliance issues, it highlights the importance of ensuring that the governing documents of NQDC arrangements address more than the provisions that are required to comply with Sec. 409A.
EditorNotes
Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, DC.
For additional information about these items, contact Mr. Almeras at (202) 758-1437 or jalmeras@deloitte.com.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.
