BY GEORGE G. JONES AND MARK A. LUSCOMBE
In June 2016, the Internal Revenue Service issued proposed regulations under Code Sec. 409A with respect to the taxation of deferred-compensation arrangements. The IRS also issued proposed regulations under Code Sec. 457(f) with respect to deferred-compensation plans of tax-exempt entities and state and local governments. The 409A guidance provides some modification and clarification to the regulations issued in 2007, as well as some related income inclusion proposed regulations issued in 2008.
These new proposed regulations not only provide needed guidance in a significant number of areas that were confusing, but the guidance issued generally comes down in favor of taxpayers in trying to avoid income inclusion from these situations — and the IRS states that taxpayers may currently rely upon them.
THE 409A PROPOSED REGS
The 409A proposed regulations identify 19 areas in which the regulations try to provide additional clarity or make modifications to existing regulations. Eighteen of the 19 would be overall positive changes for taxpayers:
1. Modify the short-term deferral rule to permit a delay in payments to avoid violating federal securities laws or other applicable laws. The general short-term deferral rule required deferred compensation to be paid on or before the fifteenth day of the third month following the end of the later of the employer’s or employee’s tax year in which the employee’s right to the payment is no longer subject to a substantial risk of forfeiture. This change adds to the list of acceptable delays.
2. Clarify that a buyback of a stock right that does not otherwise provide for a deferral of compensation will not be treated as deferred compensation solely because the amount payable under the stock right upon an involuntary termination for cause or the occurrence of a condition within the employee’s control (such as violation of a covenant not to compete) is based on a measure that is less than fair market value. This change provides additional flexibility to the existing exceptions for limited duration buybacks.
3. A deferred-comp award prior to hire can now be exempt from 409A treatment if the individual is reasonably expected to begin, and actually begins providing services within 12 months after the grant date of a stock right. The right must otherwise be forfeited.
4. Severance payments can be exempt from 409A even if severance is in the year of hire. The payments are exempt if the severance is due to an involuntary separation and does exceed two times the lesser of the employee’s annualized compensation for the year (rather than the usual test that looks to the annual compensation for the preceding year), or the limit on qualified plan compensation — adjusted annually for inflation, but currently at $265,000.
5. Deferred compensation does not include 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 with respect to the service relationship.
6. A stock purchase treated as a deemed asset sale under Code Sec. 338 is not a sale or other disposition of assets for purposes of determining whether a service provider has a separation from service.
7. Clarification that an employee who transitions to independent contractor status has a separation from service if the former employee provides no more than 20 percent of the volume of services being provided as an employee over the past 36 months.
8. Clarification that a payment under 409A is considered made with a taxable benefit that is actually or constructively received. Under Sec. 457(f), an amount included in income is treated as a 409A payment. An election under Sec. 83(b) to include the current value of a transfer of non-vested property in income is a 409A payment. A payment also includes a contribution to a trust or transfer or creation of a beneficial interest in a trust under Sec. 402(b) at the time it is includible in income under that code section.
9. For amounts being paid after a service provider’s death, plans can now accelerate payments, rather than being tied to the schedule applicable at the date of death.
10. Payment on a service provider’s death is timely if made at any time between the date of death and December 31 of the year after the date of death.
11. Clarify that the rules for transaction-based compensation apply to stock rights that do not provide for a deferral of compensation and statutory stock options.
12. Recurring part-year compensation, such as a teacher who works for nine months but has their pay spread over 12 months, is not subject to 409A if the payment of the recurring part-year comp is not deferred beyond the last day of the thirteenth month following the first day of the service period, and the recurring part-year compensation does not exceed the qualified plan compensation limit, again currently at $265,000.
13. Modify the conflict-of-interest exception to the prohibition on the acceleration of payments to permit the payment of all types of deferred comp to comply with bona fide foreign ethics or conflicts of interest laws.
14. Clarify the provision permitting payments upon the termination and liquidation of a plan in connection with a bankruptcy.
15. Clarify rules permitting payments in connection with the termination and liquidation of a plan.
16. Provide that a plan may accelerate the time of payment to comply with federal debt collection laws.
17. Clarify that a service provider can be an entity as well as an individual.
18. Clarify that the 409A rules apply to non-qualified deferred-compensation plans separately and in addition to the rules under Code Sec. 457A.
The nineteenth change clarifies and modifies the 2008 proposed income inclusion regulations with respect to amounts subject to a substantial risk of forfeiture. The proposed regulations strengthen the anti-abuse rule. The anti-abuse rule is modified to clarify that errors in plans will not be permitted as a pretext for establishing or changing the time or form of payment in a manner that fails to comply with 409A. A deferred amount that is otherwise subject to a substantial risk of forfeiture is treated as not subject to a substantial risk of forfeiture for a service provider’s tax year during which there is a change in a plan provision that is not otherwise permitted under 409A and that affects the time or form of payment of the amount if there is no reasonable, good-faith basis for concluding that the original provision failed to meet the 409A requirements and the change was necessary.
The proposed regulations also provide guidance with respect to the correction methods that must be used for a plan failure.
While the proposed regs are not effective until finalized, they provide that, until the regulations are finalized, taxpayers may rely on the proposed regulations and the IRS will not assert positions that are contrary to the positions set forth in the proposed regulations. To the extent that provisions of the proposed regulations are considered clarifications, rather than modifications to the 2007 regulations, the proposed regulations specify certain positions that may not be properly taken by taxpayers under the 2007 final regulations:
1. That the transfer of restricted stock for which no Code Sec. 83(b) election is made or the transfer of a stock option that does not have a readily ascertainable fair market value would result in a payment under a plan;
2. That a contribution to a Code Sec. 402(b) trust includible in income under Code Sec. 402(b) to fund an obligation under a plan would not result in a payment under a plan;
3. That a stock purchase treated as a deemed asset sale under Code Sec. 338 is a sale or other disposition of assets for purposes of determining when a service provider separates from service as a result of an asset purchase transaction; and,
4. That the exception to the prohibition on acceleration of a payment upon termination and liquidation of a plan pursuant to Sec. 1.409A-3(j)(4)(ix)(C) applies if the service recipient terminates and liquidates only the plans of the same category in which a particular service provider participates, rather than all plans of the same category that the service recipient sponsors.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at Wolters Kluwer Tax & Accounting.