Employers and benefit professionals who had been eagerly awaiting the IRS’s recently released final regulations for its Code Section 409A, the section of the tax code that deals with non-qualified deferred compensation, now know one thing for certain: If they want to comply with the law, they have their work cut out for them.
The regulations, released on April 10, define in great detail the 2004 law on the treatment of non-qualified deferred compensation plans, and in essence, call for these plans to be in full operational and documentary compliance with Code Section 409A. It is not just traditional deferred compensation arrangements that need to be reported: Employers also need to identify any and every employment agreement that they might have with employees and former employees, including, among others, consulting agreements, severance agreements, and equity compensation plans. All these need to be in documentary and operational compliance with Code Section 409A; if employers don’t comply, employees– not the employer–will face immediate taxation on the full
amount of deferral plus a 20% penalty.
With the fire thus lit under them, employers are rushing to get things in order before the December 31 deadline. But professionals like Lynn Dudley, VP of retirement policy at the Washington, DC-based American Benefits Council (ABC), do not think that there will be any major problem of non-compliance, since even without specification, most companies have already been doing what’s needed to comply in the non-qualified deferred compensation area.
“Employers have been complying in good faith all along; now, they just need to make sure that all documentation complies, too, and this is going to mean a lot of work for a lot of people,” Dudley says.
In essence, the goal of both the 2004 law and the final regulations that were recently released are noble. They seek to redress any potential abuses in the non-qualified plan area, Dudley says, so as to ultimately protect workers. Since failure to comply with regulation will mean that employees will have to suffer the consequences by immediate taxation, companies need to be all the more vigilant, and this is a good thing, she says.
Both the IRS and Congress are trying to bring about a cohesive, homogenous regulatory environment for all areas of employee benefits, including the non-qualified deferred compensation arena, agrees Bruce Ashton, a partner in the Los Angeles-based law firm Reish Luftman Reicher & Cohen. The final regulations to Code 409A are significant in that they exemplify the kind of coherence that is necessary in the employee benefits world today, he says.
“We have pretty detailed laws for both the 401(k) and 403(b) areas, so it is time for something similar to be done for non-qualified compensation plans as well, to make them look more like qualified plans,” Ashton says.
However, both Dudley and Ashton believe that the final regulations to Code 409A are far more harsh and stringent than they need to be, and are bound to create undue complication.
“We’ve gone from having no documentation at all to being in an extremely strict regime,” Dudley says. “Things that have never been regulated before are being regulated and yes, there are parts of this regulation that are very good, but there are also other parts that are just overkill and make things very complicated for a great number of people.”
For both large and small companies with lots of different non-qualified compensation arrangements in place, the regulations mean a lot of work, and the fact that anything slipping through the cracks will result in immediate penalty to an employee is a very drastic measure, Ashton says.
The American Benefits Council had commented on the proposed regulation and was successful in getting some of its recommendations taken into account, Dudley says. For example, the final regulations were also going to include company stock option plans, where employees can buy stock at market rate, and penalize people with these plans for non-compliance to the rules. But the Council’s proposal that people who do buy stock at market rate should only have to pay tax on it when they sell it since they cannot afford otherwise, was taken into account, Dudley says.
As the regulation gets digested, it’s possible that further changes could come out, Dudley says.
“We anticipate that some companies are going to make mistakes as this process gets underway, and so we are working with Treasury to make sure that people don’t get penalized,” Dudley says. “Congress realizes that it is unfair to penalize employees for something that is not their fault, so while this is all very hard, they are listening to us.”
The IRS also released final regulation to Section Code 415, which contains limitations on benefits and contributions under qualified retirement plans. Comprehensive Code 415 regulations were last issued in 1981 and the final regulations incorporate much of the interim guidance, usually provided in the form of IRS Notices, issued since 1981, Dudley says. The final regulations closely follow the proposed regulations released in May 2005, albeit with some modifications, but they came as no surprise to anyone, and should not have any major impact.