Lynn A. Hinrichs, Member

On June 22, 2016, the Internal Revenue Service (IRS) published proposed regulations concerning the application of Internal Revenue Code Section 409A to nonqualified deferred compensation plans. The preamble to these proposed regulations acknowledged that they were "not intended to propose a general revision of, or broad changes to," the final regulations under Code Section 409A. Rather, they were meant to clarify or modify certain provisions of said regulations. This alert briefly explains the particular changes/clarifications and how they affect nonqualified deferred compensation plans.

Clarifying Regulations

The proposed regulations that are meant to provide additional clarity to the final regulations convey the following:

• The rules under Code Section 409A apply to nonqualified deferred compensation plans separately and in addition to the rules under Code Section 457A.
• The separation pay plan exception set forth in Treas. Reg. § 1.409A-1(b)(9)(iii) is available not only to multi-year employees but to employees who have worked for an employer for less than a year.
• A plan does not provide for a deferral of compensation to the extent it provides for the payment or reimbursement of an employer's reasonable attorneys' fees and other expenses incurred to pursue a bona fide legal claim against the employee with respect to the employment relationship.
• A stock purpose transaction that is treated as a deemed asset sale under Code Section 338 is not a sale or other disposition of assets for the purpose of determining whether an employee has a separation from service.
• An employee who ceases providing services as an employee and begins providing services as an independent contractor is treated as having a separation from service if, at the time of the change, the level of services (e.g., number of hours) expected to be provided by the individual post-change would result in a separation from service under the final regulations applicable to employees generally.
• For purposes of Code Section 409A, a payment is made when any taxable benefit is actually or constructively received.
• The payment rules for transaction-based compensation apply to stock rights that do not provide for a deferral of compensation or of statutory stock options.
• Acceleration of a payment pursuant to the plan termination rule is permitted only if the employer terminates and liquidates all plans of the same category that the employer sponsors.
• If a plan was terminated and liquidated pursuant to the plan termination rule, the employer must wait at least three years before adopting a new plan of the same category.
• A stock right that does not otherwise provide for a deferral of compensation will not be treated as such solely because the amount payable under the stock right upon an involuntary separation from service for cause or "the occurrence of a condition that is within the control of the [employer]" is based on a measure less than fair market value. This proposed regulation makes clear that employers can reduce the compensation payable when there is a separation from service for cause or an employee violation of an employer-employee agreement (e.g., a covenant not to complete or a covenant not to disclose certain information).

Modifying Regulations

The proposed regulations that modify or expand the final regulations convey the following substantive changes:

• The short-term deferral rule would allow a payment that would otherwise qualify as a short-term deferral, to qualify as such if the reason for the delay in payment is the avoidance of violating federal securities laws or other applicable law.
• The definition of an "eligible issuer of service recipient stock" has been expanded so that employers may offer stock options or other stock rights during employment negotiations and still adhere to Code Section 409A.
• A plan or arrangement under which an employee receives recurring part-year compensation that is earned over a period of service (for example, salary arrangements for teachers and professors) will not provide for the deferral of compensation if the amount of the employee's recurring part-year compensation does not exceed the annual compensation limit set forth in Code Section 401(a)(17) ($265,000 for 2016). This proposed regulation supplants Notice 2008-62, which commentators noted, could have adversely affected part-year employees with annual compensation as low as $80,000.
• An amount payable following the death of an employee (or following the death of a beneficiary who has become entitled to payment due to the employee's death) that is to be paid "at any time during the period beginning on the date of death and ending on December 31 of the first calendar year following the calendar year during which the death occur[ed]" will be treated as timely paid if it is paid at any time during this period.
• An amount will not be treated as subject to a substantial risk of forfeiture for purposes of calculating the amount of includible income if the facts and circumstances indicate that the employer "has a pattern or practice of permitting impermissible changes in the time or form of payment with respect to nonvested deferred amounts under one or more nonqualified deferred compensation plans and either (i) an impermissible change in the time or form of payment applies to the amount, or (ii) the facts and circumstances indicate that the amount would be affected by the pattern or practice." This proposed regulation is intended to deter employers that have a pattern of permitting such changes, from doing so.

A Note on Acceleration

In general, an early payment of deferred compensation (or any right to receive an early payment) will constitute an impermissible acceleration under Code Section 409A. The final regulations, however, set forth several exceptions to the general rule prohibiting accelerations. Some of these exceptions would be modified or clarified by the proposed regulations to more accurately reflect the purpose of the exception. For example, the final regulations generally except an early payment of deferred compensation when the payment was the result of the death, disability, or unforeseeable emergency of the employee. The proposed regulations would extend this exception so that it applies to payments of deferred amounts upon the death, disability, or unforeseeable emergency of a beneficiary who has become entitled to payment due to an employee's death. The regulations also would allow the acceleration of nonqualified deferred compensation when "reasonably necessary to comply with a bona fide foreign ethics or conflicts of interest law" or when necessary to payment to comply with federal debt collection laws.