Proposed Regulations Govern Sec. 409A Nonqualified Deferred Compensation Plans

The IRS issued proposed rules that clarify and modify previous regulations regarding Sec. 409A nonqualified deferred compensation plans (REG-123854-12). The proposed regulations address specific provisions of final regulations issued in 2007 (T.D. 9321) and partially withdraw proposed regulations on how to calculate amounts includible in income under Sec. 409A(a)(1) (REG-148326-05).

Sec. 409A provides that, if certain requirements are not met, amounts deferred under a nonqualified deferred compensation plan for that year and all previous tax years are currently includible in gross income to the extent they are not subject to a substantial risk of forfeiture and were not previously included in income by the taxpayer.

First, the proposed rules clarify that Sec. 409A applies to nonqualified deferred compensation plans separately and in addition to the Sec. 457A rules. Sec. 457A was enacted after the issuance of the final regulations. It provides that any compensation deferred under a nonqualified deferred compensation plan of a nonqualified entity (as defined in Sec. 457A) is includible in gross income when there is no substantial risk of forfeiture of the rights to the compensation.

The proposed regulations also modify the short-term deferral rule (which provides that a prohibited deferral of compensation does not occur for certain short-term deferrals) to permit a delay in payments to avoid violating federal securities or other laws.

Next, the rules clarify that a stock right that does not otherwise provide for a deferral of compensation will not be treated as providing for a deferral of compensation solely because the amount payable under the stock right upon an involuntary separation from service for cause, or the occurrence of a condition within the service provider’s control, is based on a measure that is less than fair market value. This provision is intended to permit service recipients to reduce compensation payable when the separation from service is for cause or for violating a covenant not to compete or to disclose information. (Service recipients are the employers that sponsor the deferred compensation plan; service providers are the employees or independent contractors who provide services to the employer.)

The definition of “eligible issuer of service recipient stock” is modified to include a corporation (or other 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 change is intended to enable service recipients to offer stock options or other stock rights while negotiating with potential employees.

Another change clarifies that certain separation pay plans that do not provide for a deferral of compensation may apply to a service provider who had no compensation from the service recipient during the year preceding the year in which a separation from service occurs. This provision permits service providers who work for a service recipient less than a full year to still qualify under these rules.

The rules also clarify that a plan under which a service provider has a right to payment or reimbursement of reasonable attorneys’ fees and other expenses incurred to pursue a bona fide legal claim against the service recipient about the service relationship does not provide for a deferral of compensation.

The proposed regulations modify the rules regarding recurring part-year compensation, which excepts from Sec. 409A amounts paid during the year after the services are performed. These provisions apply most often to teachers and professors who receive compensation during months while school is not in session. The old regulations allowed deferral of payments not exceeding certain statutory amounts ($18,000 in 2016), which commentators objected to, pointing out that a professor making $80,000 would run afoul of this rule. The proposed regulations now incorporate the Sec. 401(a)(17) deferral amount instead ($265,000 for 2016).

The final significant change from the earlier regulations is the clarification and modification of the rule under former Prop. Regs. Sec. 1.409A-4(a)(1)(ii)(B) on the treatment of deferred amounts subject to a substantial risk of forfeiture for purposes of calculating the amount includible in income under Sec. 409A(a)(1). This change is intended to deter service recipients that have a pattern of permitting impermissible changes in plan payment terms in an effort to avoid current inclusion in income for service providers.

Although the regulations were issued in proposed form, taxpayers can rely on them until the final rules are published. In the preamble, the IRS stated that until final regulations are issued, it will not assert positions contrary to those in the proposed regulations.