1. Chicago Tax Club February 23, 2009 Michael H. Woolever
NOW THAT YOUR 409A AMENDMENTS ARE DONE – KEY DEFERRED COMPENSATION ISSUES FOR 2009 AND BEYOND
Chicago Tax Club
February 23, 2009
Michael H. Woolever

2. Topics For Discussion 409A – A Primer
Avoiding 409A Operational Violations
Correcting 409A Violations
The Forgotten Plan – What Do We Do Now?
409A Withholding and Reporting Requirements

3. Topics For Discussion 409A Income and Penalty Computation Issues
Don’t Forget the Accounting Treatment!
457A – It’s Broader Than You Think!
The 457(f) Regulations – How Bad Will It Be?
EES and its Progeny – The Camel’s Nose?

4. 409A – A PRIMER
Welcome to the brave new world of non-qualified deferred compensation.
New law effective January 1, 2005;
“Good faith” compliance with statute and interim guidance required through December 31, 2008;
Operational and document compliance with final regulations required as of January 1, 2009.

5. 409A – A PRIMER 409A – A little history?
The “constructive receipt” and “cash equivalence” cases;
IRS proposed regulations in the 70s;
1978 Tax Act;
IRS Comprehensive Executive Compensation Audits;
2004 American Jobs Creation Act.

6. 409A – A PRIMER 409A – A seismic shift.
409A changes are similar in scope to 1974 ERISA changes to qualified retirement plan rules;
Designed to address perceived wide scale abuses;
Broad application seen as necessary to make new enforcement system work.

7. 409A – A PRIMER 409A – What it does.
Adds objective regulatory scheme to prior subjective rules (e.g. constructive receipt).
Creates a strict liability regime tied to compliance with objective rules.
Deferral ineffective, unless rules complied with.
Like qualified plans, violations may arise from both operational and document failures.

8. 409A – A PRIMER 409A –What it does.
Adopts a very broad concept of deferred compensation;
Imposes significant penalties on violations;
20% additional tax, plus premium interest tax from date of deferral or vesting.
Aggregation and strict liability can result in significant penalties for minor violations.

9. 409A – A PRIMER
Before 409A – “deferred compensation” was generally used only to describe elective deferral arrangements.
After 409A – “deferred compensation’ includes any legally binding right to compensation that is or may be payable in a later taxable year.
Note – a legally binding right includes a contingent or conditional right (e.g., the right to severance following an involuntary termination or the right to a bonus upon the occurrence of a specified event).

10. 409A – A PRIMER “Qualified” versus “Non-Qualified” plans.
409A does not cover:
Qualified retirement plans;
Bona fide vacation, sick leave, compensatory time, disability pay, or death benefit plans;
ISOs, 423 plans, and some stock options and SARs;
Plans covering only non-US taxpayers;
Severance following involuntary termination of limited amount and term.

11. 409A – A PRIMER 409A can apply to:
Employment, CIC and other agreements providing post-employment payments or benefits;
Supplemental retirement benefits, including 401(k) wraps and defined benefit SERPs;
Short and long-term incentive compensation (both cash and equity components);
Elective deferrals;
Golden parachute and other gross-up payments;
Any other arrangement resulting in a deferral of compensation;
Directors and other independent contractors.

12. 409A – A PRIMER 409A – Key Requirements:
Arrangement must be in writing;
The time and form of payment must generally be elected before services are performed or when legally binding right is created;
Payment may only be accelerated due to death, disability, separation from service or a change in control;
Deferrals may be extended only within a limited window and for a minimum additional period.

13. 409A – A PRIMER 409A – Common Provisions Now Prohibited
Most forms of employer or employee discretion as to time or form of payment;
“hair cut” provisions;
“financial triggers”;
Off-shore rabbi trusts

14. AVOIDING 409A OPERATIONAL VIOLATIONS
Existing arrangements had to be amended to come into documentary compliance with 409A and final regulations by 12/31/09.
New arrangements will need to be carefully drafted to avoid documentary issues under 409A.
Care will be required to avoid inadvertent operational violations.

15. AVOIDING 409A OPERATIONAL VIOLATIONS
Situations with significant violation risks.
Use of stock options/SARs in non-public companies or subsidiaries of public companies.
Combining other rights with stock options/SARs.
Specified employee rules for public company employees

16. AVOIDING 409A OPERATIONAL VIOLATIONS
Situations with significant violation risks.
Revising severance benefits or other post-employment rights at time of termination;
Continuing, substantial post-employment services;
Adding (substituting) new benefits for existing 409A rights;
Participation in multiple plans of the same type.

17. CORRECTING 409A VIOLATIONS
Notice – It’s not EPCRS!
Provides limited relief for certain specified operational failures;
Recognizes administrative errors will occur;
Rewards early discovery and correction of errors with reduced penalties.

18. CORRECTING 409A VIOLATIONS
Notice – It’s Not EPCRS.
Available correction methods depend on:
when error corrected;
whether or not the service provider is an insider;
Section 16 director, officer, 10% owner
Amount involved.
Notice to IRS always required

19. CORRECTING 409A VIOLATIONS
Notice – General Requirements.
Commercially reasonable steps taken to avoid recurrence of failure (like EPCRS);
After 2009, second failure covered only if it occurred “despite service recipient’s diligent efforts”;
Service provider not under exam;
Service recipient not subject to financial downturn;
Only inadvertent and unintentional failures;
Does not involve listed transaction;
Full correction and no substitute benefit to service provider.

20. CORRECTING 409A VIOLATIONS
Notice – Same Year Correction.
Failure to defer;
Improper acceleration;
Early payment in the right tax year;
Payment to “specified employee” within six month window;
Excess deferrals;
“In the money” options.
Generally no 409A penalty if properly and timely corrected and reported to IRS.

21. CORRECTING 409A VIOLATIONS
Same year correction examples:
Employee timely elects to defer $50,000 from bonus payable in 2009, but employer only defers $10,000 of bonus.
If employee repays $40,000 by 12/31/09, it may be excluded from 2009 income and no 409A penalty will be imposed.
Employer may adjust account for earnings as if deferred originally
If employee is an insider, repayment must include interest.
Transactions must be disclosed on statement filed with employer’s tax return and given to employee.

22. CORRECTING 409A VIOLATIONS
Same year correction examples:
Employer pays “specified employee” within six month window;
No 409A penalty will be imposed if:
If Employee repays full amount before year end; and
Employee has legally binding right to payment, but payment deferred for period Employee had the funds.

23. CORRECTING 409A VIOLATIONS
Same year correction examples:
Employer defers payment of $20,000, rather than $10,000 elected by employee;
No 409A penalty will be imposed if:
Employer pays additional $10,000 before end of year;
Deferral account balance is adjusted to remove earnings on improper deferral;
Adjustment for losses or paying employee interest on excess deferral is optional

24. CORRECTING 409A VIOLATIONS
Same year correction examples:
Employer unintentionally grants option with below market exercise price;
Option will be considered as no subject to 409A if:
Employer retroactively corrects exercise price before end of year;
But correction is not effective to extent option was exercised prior to correction and 409A penalties will apply to gain recognized on exercise.

25. CORRECTING 409A VIOLATIONS
Notice –Following Year Correction
Not available to insiders (Section 16 officers, directors and 10% owners);
Covers same six failures as same year correction;
Extended repayment period available if “immediate and substantial financial need” under 401(k) rules;
Time value of money adjustment is part of correction;
Earnings adjustment allowed;
Correction must be reported on tax return;
No 409A additional tax or interest penalty tax if timely correction.

26. CORRECTING 409A VIOLATIONS
Following year correction example:
Employee elects $20,000 deferral in 2009, but employer only defers $10,000.
No 409A penalties imposed if:
Employee repays $10,000, plus interest in 2010;.
Employee taxed on $10,000 for 2009, but entitled to $10,000 deduction in 2010;
Interest paid by employee not deductible;
Employer may adjust employee’s account for earnings back to 2009 before 12/31/10.

27. CORRECTING 409A VIOLATIONS
Following year correction example:
Employer reduces current compensation and credits $20,000 to deferred compensation account in 2009, rather than $10,000 elected by employee.
No 409A penalties will be imposed if:
$10,000 is paid to employee before end of 2010.
Employee reports the payment;
Account balance is corrected;
Employee is NOT paid interest or otherwise compensated for time value of money.

28. CORRECTING 409A VIOLATIONS
Following year correction example:
In 2009, employer discovers that it deferred an incorrect amount for a non-insider during 2006.
Under special rule, 2009 is considered the year next following the violation year and the employer has until the end of 2009 to correct under Notice

29. CORRECTING 409A VIOLATIONS
Notice Failures Involving Limited Amounts.
Amount involved can not exceed 402(g)(1)(B) elective deferral amount;
Violation limited to:
Failure to defer;
Improper acceleration;
Excess deferral.
Pay normal tax and 20% additional tax on amount involved, but not interest penalty tax, before end of second taxable year after violation.
No acceleration of other deferred amounts.

30. CORRECTING 409A VIOLATIONS
Limited Amount Violation Example:
In 2009, Employer erroneously pays former employee $5,000 within six months of separation in violation of specified employee rule.
If employee files original or amended 2009 return reflecting the 20% additional tax on $5,000 before the end of 2011, additional tax on other amounts and interest penalty tax on both is waived.

31. CORRECTING 409A VIOLATIONS
Limited Amount Violation example:
Employer defers $10,000, rather than $8,000 elected by employee in 2008.
Before end of 2010, employer pays employee the additional $2000.
Employee reports payment as 2010 income and pays additional 20% tax.
Earnings on $2000 may be paid as additional taxable 409A income or forfeited.
Employee not responsible for penalty interest tax or 409A penalties on other deferrals.

32. CORRECTING 409A VIOLATIONS
Limited Amount Violation example:
Employer defers $10,000, rather than $8,000 elected by employee in 2008.
Employer pays employee the additional $2000 in 2011.
Limited amount correction not available as correction not timely.
Employee reports second payment as 2010 income
Employee is taxable on all 2008 and prior deferrals and subject to full 409A penalties on all such deferrals.

33. CORRECTING 409A VIOLATIONS
Notice Other Failures Corrected Before End of Second Year
All covers all failures correctible in the same year, but option pricing failures;
Covers insiders;
409A income inclusion is limited to amount of failure, not all deferrals;
20% additional tax, but not interest penalty tax, must be paid on 409A income.

34. CORRECTING 409A VIOLATIONS
Other Operational Failure Examples
Employer defers $50,000 in 2008, rather than $100,000 elected by employee
Employee repays $50,000 before end of 2010 (plus interest, if insider)
Employee must amend 2008 return and pay additional 20% tax on $50,000
Employee not allowed to deduct 2010 payment
If future violation, $50,000 considered previously taxed

35. CORRECTING 409A VIOLATIONS
Other Operational Failure Examples
Employer makes $1000 payment to specified employee in 2009; payment made 31 days earlier than 180 day payment date.
Employee repays the payment in 2010 and has legally binding right to repayment 31 days later.
Employee pays additional 20% tax on the 2009 payment on an original or amended 2009 return;
Deficiency interest payable on late payments;
Employer issues corrected 2009 W-2 showing $1,000 of 409A income.

36. CORRECTING 409A VIOLATIONS
Where Notice correction is not available then full 409A penalties apply:
All like deferrals accelerated;
20% additional tax applies to all accelerated deferrals;
Penalty interest tax applies back to date of violation;
Normal deficiency interest may also apply.

37. THE FORGOTTEN PLAN – WHAT DO WE DO NOW?
Notice does not cover document violations.
Thousands of qualified plans were not timely amended for ERISA even though employers knew they had qualified plans.
Many employers have not even identified all of the 409A plans.

38. THE FORGOTTEN PLAN – WHAT DO WE DO NOW?
IRS approach to 409A has been very responsible – consistent with nature of change wrought by 409A.
Notice asks for comments on what types of correction programs would make sense to deal with document failures;
ERISA late amender program could be model, but may not cover HCEs;
Consistent with actions during transition, some relief prior to year end likely.
Best approach is to wait until guidance comes out
Arguable that income recognized and withholding required only at year end.

39. THE FORGOTTEN PLAN – WHAT DO WE DO NOW?
Treasury issues under study:
Types of failures to be covered;
Limit to minor, non-material failures;
Limit to non-compliant provision with no effect on benefits;
Limit to non-insiders or non-NHCEs;
Proper correction methods and need to avoid otherwise impermissible late elections or acceleration of payments;

40. 409A REPORTING AND WITHHOLDING REQUIREMENTS
Statute requires:
Reporting annual deferrals under 409A plans on W-2 or 1099-MISC;
Reporting income includible under 409A on W-2 or 1099-MISC;
Income tax withholding with respect to employees on income includible under 409A.

41. 409A REPORTING AND WITHHOLDING REQUIREMENTS
Reporting of annual deferrals waived until December 2008 proposed regulations on calculation of amounts includible in income and additional taxes are finalized.
Reporting of 409A income and withholding has been required since 2005 under interim guidance.

42. 409A REPORTING AND WITHHOLDING REQUIREMENTS
Notice
Applies for 2008 and later years until regulations finalized;
No reporting of deferrals;
Income must be reported on W-2 or 1099-MISC;
Withholding on wages required;
No withholding with respect to additional taxes.

43. 409A REPORTING AND WITHHOLDING REQUIREMENTS
Notice
409A income not actually or constructively received earlier treated as a payment of wages on December 31.
Two options if no withholding by December 31:
Withhold by February 1 and report on 4th quarter 941 and W-2; or
Employer pays withholding and includes grossed up wages on 4th quarter 941 and W-2.

44. 409A REPORTING AND WITHHOLDING REQUIREMENTS
Notice
If 409A violated, amount includible in income includes all amounts deferred under a plan for the year of violation and all prior years, except:
Previously taxed amounts;
Grandfathered amounts;
Amounts subject to substantial risk of forfeiture.

45. 409A REPORTING AND WITHHOLDING REQUIREMENTS
Notice
All plans of same type must be aggregated;
Account balance plan – include full account balance at year end, including earnings;
Non-Account balance –
include present value of future payments if reasonably ascertainable for 3121(v) purposes;
Otherwise a good faith estimate.
Stock Rights – include spread.
Annual deemed exercise.

46. SECTION 409A CALCULATION ISSUES
Notice and proposed and final regulations reserved discussion of how to calculate.
Interim guidance provided for some basic situations in 2006, 2007 and 2008.
Extensive proposed regulations issued in December 2008
not covering 409A(b) violations (offshore trusts).

47. SECTION 409A CALCULATION ISSUES
Some key issues addressed in proposed regulations:
Unlike qualified plan rules, operational violations do not taint subsequent deferrals;
Assessments against closed years are time barred;
But duty of consistency rules do apply;
Violations only accelerate vested deferrals.

48. SECTION 409A CALCULATION ISSUES
Some key issues addressed in proposed regulations
Calculation done on last day of the tax year:
Includes amounts paid during the year;
Includes earnings (losses) credited during the year;
Excludes possible short-term deferrals;
Included in following year if not paid within STD window

49. DON’T FORGET THE ACCOUNTING TREATMENT
When dealing with options and SARs, 409A and accounting rules on what constitutes a new grant differ.
Extending post-employment period allowed under 409A, but a new grant for accounting purposes.
Need to verify tax and compensation costs before amending 409A benefits.

50. 457A – IT’S BROADER THAN YOU THINK!
457A – Added to Code by EES legislation
Expands 457 deferred compensation treatment beyond tax exempt area to tax indifferent entities.
Focused on offshore hedge funds, but scope of 457A is much broader.
Any deferred compensation payable to a US taxpayer by an entity in a tax haven.

51. 457A – IT IS BROADER THAN YOU THINK
Like 457(f), substantial risk of forfeiture limited to situations where right to payment is subject to performance of substantial future services.
20% additional tax and penalty interest tax (like 409A) imposed where amount of deferral can not be measured when first taxable.

52. 457A – IT’S BROADER THAN YOU THINK
Investment manager sets up Caymans hedge fund. On the fifth anniversary of the fund, the manager is entitled to be paid compensation equal to 2% of AOM per year, adjusted as if such payment had been made quarterly and invested in the fund.
The fund is a tax indifferent party;
The agreement with the manager provides for a deferral of compensation;
The deferral is not subject to a substantial risk of forfeiture;
The amount due in year five is not readily determinable as it is tied to the fund’s future investment performance.
In year 5, the manager pays the normal tax, an additional 20%, plus five years of the penalty interest tax.

53. 457A – IT’S BROADER THAN YOU THINK
Executive works in the US for a Bermuda insurance company.
Insurance Company’s bonus plan provides that 1/3rd of the executive’s annual bonus is paid in each of the first 3 years after the end of the bonus period.
Deferred payments include an “interest factor” based on the company’s ROI.
Same result as the hedge fund example.

54. THE 457(f) REGULATIONS – HOW BAD WILL IT BE?
Tax exempt employers are subject not only to 409A, but also 457(f).
Under 457(f), with limited exceptions, compensation income may be deferred for tax purposes only if the executive’s rights to the income is conditioned on the performance of substantial future services.
For years, TE employer have entered into arrangements based on a non-competition covenant as the substantial risk of forfeiture.

55. 457(f) REGULATIONS – HOW BAD WILL IT BE?
409A regulations state that a non-competition covenant is not a substantial risk of forfeiture for 409A purposes.
IRS has announced that new 457(f) regulations will take the same position.
Regulations were promised by end of 2008, but have not been issued.
Big question is whether prior deferrals will be grandfathered or will have to be paid out in 2009.
Many employers cashed out benefits in 2009 taking advantage of 409A transition rule.

56. EES AND ITS PROGENY – THE CAMEL’S NOSE?
EES,TARP, CPP,CAP, PSSFI, EFRAP, ARRA – when and where will it end?
Tremendous focus on and criticism of executive compensation, particularly with respect to companies getting financial assistance from the government.
New concepts have been included in recent legislation and Treasury guidelines that may well be adopted for general application in subsequent legislation or rule making.

57. EES AND ITS PROGENY – THE CAMEL’S NOSE?
Two areas to watch:
162(m) deduction limitations:
162(m)(5) added by EES;
Not limited to public companies;
Cap measured by when legally binding right arises, not when paid;
Includes earnings on deferred amounts;
No performance based exception...

58. EES AND ITS PROGENY – THE CAMEL’S NOSE?
Two areas to watch:
Restrictions on post-employment payments.
EES expands 280G to:
cover all severance, not only following a CIC;
Eliminate small business and shareholder approval exceptions;
eliminate reasonable compensation exception;
ARRA prohibits any severance to senior executive officers.

59. Contact Information
Michael H. Woolever
Partner
Foley & Lardner, LLP
Chicago, Illinois
(312)