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Understanding & Clarifying IRS 409A Proposed Regulations

The importance of following the requirements of Internal Revenue Code §409A (409A) was discussed in the Fall 2015 SilverLink magazine article, “Planning by the Rules.” Since that article was published, the Internal Revenue Service (IRS) issued Internal Revenue Code §409A Proposed Regulations, clarifying and modifying the existing and final 409A regulations with regard to deferred compensation. These proposed regulations include 19 technical clarifications, most of which will not affect the core 409A regulations.

In order to avoid adverse taxation and penalties, it is important to be aware of 409A, the previously issued regulations and the proposed changes. 409A states that if certain requirements are not met, employees may need to immediately include the amounts deferred under a nonqualified deferred compensation plan, plus a 20% additional tax, in their taxable income. The U.S. Department of the Treasury and the IRS issued final regulations in 2007 and proposed regulations in 2008. However, in the years that followed, employees and employers encountered many issues while trying to understand the regulations. The following information outlines and clarifies some of the projected changes to 409A included in the proposed regulations issued by the IRS on June 21, 2016.

409A Distribution Timing Following Death

The 2007 final regulations state that the timing rules regarding distributions upon death are relatively the same as the timing rules for distributions upon other triggering events such as a separation from service. The newly proposed regulations give more leeway with the amount of time allowed to make the payments to a beneficiary or estate without violating 409A. Payments may be made any time after the death, up until December 31 of the year following the year of death without violating 409A. The beneficiary has the discretion to select which taxable year to receive payment.

Payment for Section 409A Purposes

Final regulations for 409A have many different rules regarding when a payment is made depending on the type of taxable event. The proposed regulations offer clarity by stating that, for purposes of 409A, a payment is considered to be made when any taxable benefit is actually or constructively received.

Employee to Independent Contractor / Separation from Service

According to the final regulations, separation from service occurs when an employee or employer reasonably expects that the employee’s services will decrease to 20% or less than the average services provided before the change. This is called the “20% test.” The newly proposed regulations clarify this for a person who changes status from an employee to an independent contractor or vice versa. Therefore, a person must separate from service both as an employee and an independent contractor to be treated as separated from service under 409A.

Plans to be Terminated Under the Plan Termination Rule

The proposed regulations clarify the plan termination rule that allows the acceleration of benefits if the sponsor terminates and liquidates a plan. The final regulations currently say:

The service recipient terminates and liquidates all agreements, methods, programs, and other arrangements sponsored by the service recipient that would be aggregated with any terminated and liquidated agreements, methods, programs, and other arrangements under §1.409A-1(c) if the same service provider had deferrals of compensation under all of the agreements, methods, programs and other arrangements that are terminated or liquidated.

The present confusion pertains to whether all plans of the same type sponsored by the employer need to be terminated or if only the same type of plans where the employee is a participant need to be terminated. Taxpayers have pointed out that if the goal was to include all similar plans, whether the employee was a participant or not, the language in the above provision would have said “as if” the same service provider had deferrals under all of the agreements, methods, programs and other arrangements.

The proposed regulations declare that the language in the plan termination provision is not ambiguous. The reference to the same service provider having deferrals refers to participation of a hypothetical employee. Therefore, for the acceleration of benefits to apply, the service recipient must terminate and liquidate all plans of the same type that they sponsor.

Separation Pay Plan Exception Clarification

The 409A final regulations exempt certain separation pay plans from the provisions of 409A if the amount paid under the plan does not exceed two times the employee’s compensation received in the preceding taxable year. This implies that if an employee was hired and then terminated in the same taxable year, they would not have any compensation related to the prior taxable year and would therefore not fit the exemption requirements. The proposed regulations add clarity and explain that the separation pay plan exemption is available for employees who begin and terminate employment in the same taxable year. If this happens, the employee’s annualized compensation from the taxable year in which employment was terminated is used to determine the exemption.

Short-Term Deferral Expansion

The 409A final regulations provide that short-term deferral payments are exempt from 409A. To qualify for the exemption, the compensation must be paid within two and a half months after the end of the employer or employee’s taxable year in which the amounts vest, whichever is later. Under 409A final regulations, payments that are made after that time frame are subject to 409A unless the payment is administratively impractical or would jeopardize the employer’s ability to continue as a going concern, or if the payment would not be deductible under Code Section 162(m). The 409A proposed regulations further extend the short-term deferral exemption to payments made after two and a half months to avoid violating federal securities laws or other applicable laws given that the payment is made as soon as reasonably possible.

Stay Tuned

The 409A proposed regulations and clarifications will not become effective until they are finalized. However, taxpayers may rely on them and treat them as if they are already in effect. SilverStone Group will continue to provide updates on the proposed regulations as these changes unfold.

This article originally appeared in the 2016 | ISSUE THREE of the SilverLink magazine under the title “409A Proposed Regulations & Clarifications.” To receive a complimentary subscription to the SilverLink magazine, sign up here.

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