Risk & Economy » Tax » US tax hits deferred payments

UK companies that have operations in the US or which employ US citizens in
the UK have been slow to get to grips with a US tax rule change which could
seriously affect employee benefits schemes.

The rule change means that deferred payments made to employee benefit schemes
could leave employees with a huge tax bill just when they wanted to make good
use of the money they have been hoarding away for years.

According to Kristian Wiggert, partner at law firm Morrison & Foerster,
“employees could find that they will be landed with a sizeable tax bill ­ plus
an interest payment ­ to the US Internal Revenue Service (IRS) because their
employers have not taken into account how their deferred payments, which can
include pension entitlements and retirement schemes, will be affected by the tax
rule changes that are coming into force.”

Section 409A

Section 409A is a new section of the Internal Revenue Code that deals
specifically with non-qualified deferred compensation plans. It was created as
part of the American Jobs Creation Act of 2004, which became law in October 2004
as a response to perceived abuses stemming from the corporate finance scandals
of recent years. Section 409A generally applies to amounts deferred after 31
December 2004. However, the rules in 409A would also apply to any amounts
deferred prior to that time if a “material modification” is made to the plan
after 3 October 2004.

“The legislation impacts virtually all companies that have non-qualified
deferred compensation plans,” says Wiggert. “Furthermore, the statute itself is
very broad and may affect certain types of arrangements that are not typically
considered to be deferred compensation, such as provisions in employment
contracts, all kinds of share or stock-related compensation benefits, as well as
some pension entitlements, severance benefits, deferred bonuses, and some
retirement plans,” he adds.

Wiggert says that section 409A has been described as a “sea change” for
non-qualified deferred compensation. “There is little doubt regarding the
significance these new rules will have on the design and operation of
non-qualified deferred compensation plans and on those who sponsor them. Plan
sponsors need to be familiar with the new rules and have the information and
resources necessary to implement the changes required.”

In general terms, section 409A is intended:

  • To impose significant restrictions on deferred compensation arrangements of
    all sorts by limiting the timing of elections to defer compensation by “service
    providers” (meaning employees, directors, or contractors);
  • To impose significant restrictions on the timing and form of subsequent
    payments of deferred compensation; and
  • To impose restrictions on the timing of subsequent changes to either.
    Violating any of these broad requirements (or any of the more specific
    requirements included in the proposed regulations and other guidance) not only
    triggers income tax on the deferred amounts but also triggers an additional 20%
    income tax and interest at a prescribed rate.

Transition rule

To ease the transition process from the “pre-409A” world to compliance with the
foregoing limitations, the IRS created a transition rule that allows changes to
the form and timing of deferred compensation payments that would not otherwise
be permissible. In addition to allowing a variety of “409A first aid” for
traditional deferred compensation plans, the transition rule has proven
invaluable in addressing stock options and stock appreciation rights that have
inadvertently become subject to section 409A.

Under the recently-issued Notice 2007-86, operational compliance with the
final regulations is now not required until 1 January 2009. In the interim,
employers and other “service recipients” are required to operate their
non-qualified deferred compensation arrangements in good faith compliance with
currently effective guidance and with the terms of those arrangements to the
extent they are consistent with section 409A.

As the IRS has noted in prior guidance, a deferred compensation arrangement
will not be considered to be operating in “good faith compliance” during the
transition period if:

  • Discretion provided by the terms of the arrangement is exercised in a manner
    inconsistent with section 409A. For example, if an employer exercises discretion
    under a deferred compensation plan to delay payments in a manner that is not
    consistent with section 409A, the entire plan will be considered not to have
    been operated in good faith compliance.

However, a single employee’s use of an impermissible “haircut” provision, for
example, will result in a section 409A violation for that employee but not for
other participants in the arrangement.

Wiggert says that companies need to act quickly to ensure that full
compliance is observed and that employees’ benefit and compensation schemes are
protected and in accordance with the new legislation. “Now is the time to review
your arrangements that may be subject to section 409 and to determine the
necessary steps to bring those arrangements into compliance with the statute,”
he warns.