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IRS issues proposed reliance regs on Sec. 409A nonqualified deferred compensation plans

Preamble to Prop Reg 06/21/2016, Prop Reg § 1.409A-1, Prop Reg § 1.409A-2, Prop Reg § 1.409A-3, Prop Reg § 1.409A-4, Prop Reg § 1.409A-6

IRS has issued proposed reliance regs on nonqualified deferred compensation (NQDC) plans under Code Sec. 409A that clarify or modify specific provisions of the final regs. The proposed regs also withdraw a provision in the previous proposed regs on the calculation of amounts includible in income under Code Sec. 409A(a)(1) and replaces it with a revised proposed reg. Taxpayers may rely on the proposed regs until final regs are issued.

Background. All amounts deferred under a NQDC plan for all tax years are currently includible in income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income, unless the plan: (a) meets the distribution, acceleration of benefit, and election requirements under Code Sec. 409A; and (b) is operated in accordance with them. (Code Sec. 409A(a)(1)(A)) Noncompliance results in inclusion in income for all amounts deferred under the plan by a participant, an interest charge (at the underpayment rate plus one percentage point), and an additional 20% tax. (Code Sec. 409A(a)(1)(B))

In April of 2007, IRS issued final regs under Code Sec. 409A (the final regs). In December of 2008, IRS issued additional proposed regs, which included proposed Reg. § 1.409A-4 (the proposed income inclusion regs) on the calculation of amounts includible in income under Code Sec. 409A(a)(1) and the additional taxes imposed by Code Sec. 409A.

Proposed reliance regs. The proposed regs address certain specific provisions of the final regs and the proposed income inclusion regs, but aren’t intended to provide a general revision of, or make broad changes to, the final regs or the proposed income inclusion regs. The proposed regs:

…Clarify that the Code Sec. 409A rules apply to NQDC plans separately and in addition to the Code Sec. 457A rules dealing with deferred compensation from tax-indifferent corporations and partnerships.

…Modify the short-term deferral rule under Reg. § 1.409A-1(b)(4) to allow a delay in payments to avoid violating Federal securities laws or other applicable law. The proposed regs provide that a payment that otherwise qualifies as a short-term deferral, but is made after the end of the applicable 2 1/2 month period, may still qualify as a short-term deferral if the service recipient reasonably anticipates that making the payment during the applicable 2 1/2 month period will violate Federal securities laws or other applicable law and the payment is made as soon as reasonably practicable following the first date on which the service recipient anticipates or reasonably should anticipate that making the payment would not cause a violation.

…Clarify that a stock right that doesn’t otherwise provide for a deferral of compensation will not be treated as providing for a deferral of compensation solely because the amount payable under the stock right upon an involuntary separation from service for cause, or the occurrence of a condition within the service provider’s control, is based on a measure that is less than fair market value.

…Modify the definition of the term “eligible issuer of service recipient stock” to provide that it includes a corporation (or other entity) for which a person is reasonably expected to begin, and actually begins, providing services within 12 months after the grant date of a stock right. Thus, service recipients can grant stock rights to service providers as part of employment negotiations before they are employed by the service recipient.

…Clarify that certain separation pay plans that do not provide for a deferral of compensation may apply to a service provider who had no compensation from the service recipient during the year preceding the year in which a separation from service occurs. Under the proposed regs, the service provider’s annualized compensation for the tax year in which the service provider separates from service may be used for purposes of the separation pay plan exception if the service provider had no compensation from the service recipient in the tax year preceding the year in which the service provider separates from service.

…Provide that a plan under which a service provider has a right to payment or reimbursement of reasonable attorneys’ fees and other expenses incurred to pursue a bona fide legal claim against the service recipient with respect to the service relationship doesn’t provide for a deferral of compensation.

…Modify the rules regarding recurring part-year compensation, i.e., compensation paid for services rendered in a position that the service recipient and service provider reasonably anticipate will continue on similar terms and conditions in subsequent years, and will require services to be provided during successive service periods each of which comprises less than 12 months and each of which begins in one tax year of the service provider and ends in the next tax year (for example, a teacher with a 10-month school year). The proposed regs provide that a plan or arrangement under which a service provider receives recurring part-year compensation that is earned over a period of service doesn’t provide for the deferral of compensation if the plan doesn’t defer payment of any of the recurring part-year compensation to a date beyond the last day of the 13th month following the first day of the service period for which the recurring part-year compensation is paid, and the amount of the service provider s recurring part-year compensation (not merely the amount deferred) doesn’t exceed the annual compensation limit under Code Sec. 401(a)(17) ($265,000 for 2016) for the calendar year in which the service period begins.

…Explicitly state that a stock purchase treated as a deemed asset sale under Code Sec. 338 is not a sale or other disposition of assets for purposes of determining whether a service provider has a separation from service.

…Clarify that a service provider 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 in employment status, the level of services reasonably anticipated to be provided after the change would result in a separation from service under the rules applicable to employees.

…Provide a rule that is generally applicable to determine when a “payment” has been made for all purposes under the Code Sec. 409A regs. Under the proposed regs, a payment is made, or the payment of an amount occurs, when any taxable benefit is actually or constructively received. A payment includes a transfer of cash, any event that results in the inclusion of an amount in income under the economic benefit doctrine, a transfer of property includible in income under Code Sec. 83, a contribution to a trust described in Code Sec. 402(b) at the time includible in income under that section, and the transfer or creation of a beneficial interest in a Code Sec. 402(b) trust at the time includible in income under that section. A payment is also made upon the transfer, cancellation, or reduction of an amount of deferred compensation in exchange for benefits under a welfare plan, a non-taxable fringe benefit, or any other nontaxable benefit.

…Modify the rules applicable to amounts payable following death. An amount deferred under a NQDC plan may be paid only at a specified time or upon an event set out under the regs. One of the permissible events is the service provider’s death. Under the proposed regs, an amount payable following the death of a service provider, or following the death of a beneficiary who has become entitled to payment due to the service provider’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 occurs is treated as timely paid if it is paid at any time during this period.

…Clarify that the rules for transaction-based compensation apply to stock rights that do not provide for a deferral of compensation and statutory stock options. Thus, the purchase (or agreement to purchase) such a statutory stock option or stock right in a manner consistent with these rules does not result in the statutory stock option or stock right being treated as having provided for the deferral of compensation from the original grant date.

…Provide that the addition of the death, disability, or unforeseeable emergency of a beneficiary who has become entitled to a payment due to a service provider’s death as a potentially earlier or intervening payment event will not violate the prohibition on the acceleration of payments. The proposed regs also clarify that a schedule of payments (including payments treated as a single payment) that has already begun before a service provider’s or a beneficiary’s death, disability, or unforeseeable emergency may be accelerated upon the death, disability, or unforeseeable emergency.

…Modify the conflict of interest exception to the prohibition on the acceleration of payments to allow the payment of all types of deferred compensation (rather than only foreign earned income from sources within the foreign country that promulgated the law) to comply with bona fide foreign ethics or conflicts of interest laws.

…Clarify the provision permitting payments upon the termination and liquidation of a plan in connection with bankruptcy. The proposed regs clarify that the acceleration of a payment pursuant to this rule is allowed only if the service recipient terminates and liquidates all plans of the same category that the service recipient sponsors, and not merely all plans of the same category in which a particular service provider actually participates. The proposed regs also clarify that, for a period of three years following the termination and liquidation of a plan, the service recipient cannot adopt a new plan of the same category as the terminated and liquidated plan, regardless of which service providers participate in the plan.

…Provide that a plan may accelerate the time of payment to comply with Federal debt collection laws. The proposed regs expand the current exception to the prohibition on accelerated payments for certain offsets to allow a plan to provide for the acceleration of the time or schedule of a payment, or to make a payment, to the extent reasonably necessary to comply with Federal laws regarding debt collection.

…Clarify various provisions of the final regs to recognize that a service provider can be an entity as well as an individual.

…Clarify and modify the anti-abuse rule in Prop Reg § 1.409A-4(a)(1)(ii)(B) of the income inclusion regs on the treatment of deferred amounts subject to a substantial risk of forfeiture for purposes of calculating the amount includible in income under Code Sec. 409A(a)(1) . The proposed regs amend this rule to preclude service recipients from intentionally creating errors in NQDC plans with respect to nonvested amounts for the purpose of using these errors as a pretext for establishing or changing a time or form of payment in a manner that fails to comply with Code Sec. 409A(a). The proposed regs: (a) clarify that a deferred amount that is otherwise subject to a substantial risk of forfeiture is treated as not subject to a substantial risk of forfeiture for a service provider’s tax year during which there is a change in a plan provision (including an initial deferral election provision) that is not otherwise permitted under Code Sec. 409A(a) and the final regs and that affects the time or form of payment of the amount if there is no reasonable, good faith basis for concluding that the original provision failed to meet the requirements of Code Sec. 409A(a) and that the change is necessary to bring the plan into compliance with the requirements of Code Sec. 409A(a); (b) provide examples of the types of facts and circumstances that indicate whether a service recipient 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 plans; and (c) provide that, to the extent generally applicable guidance regarding the correction of Code Sec. 409A(a) failures prescribes a particular correction method (or methods) for a type of plan failure, that correction method (or one of the permissible correction methods) must be used if a service recipient chooses to correct that type of a failure with respect to a nonvested deferred amount.

Effective date. The proposed regs are effective when finalized, but taxpayers may rely on the proposed regs until final regs are published, and IRS will not assert positions that are contrary to those in the proposed regs. Until IRS issues further guidance, taxpayers may rely on the proposed income inclusion regs, as modified by the amendment to Prop Reg § 1.409A-4(a)(1)(ii)(B) in the proposed regs, for purposes of calculating the amount includible in income and the calculation of the additional taxes under Code Sec. 409A(a)(1). Taxpayers may rely on either the rules in the proposed regs on recurring part-year compensation or the rules in Notice 2010-6, 2010-3 IRB 275, for the tax year in which these proposed regs are published as final and all prior tax years.

References: For the Code Sec. 409A NQDC plan rules, see FTC 2d/FIN ¶  H-3200.1  et seq.; United States Tax Reporter ¶  409A4  et seq.; TaxDesk ¶  135,501  et seq.; TG ¶  7141  et seq.