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All eyes on Sec. 409A

Many people expect to see significant tax reform in the near future now that Republicans are in
control of Congress and President Trump is in office. Among the changes being discussed are
reduced marginal tax rates for individuals, lower corporate tax rates and the elimination of the
surtax on net investment income. It’s uncertain, however, when (and if) such changes will be
implemented and how long reduced tax rates will last.

Assuming that tax rates are reduced, and that favorable rates won’t last forever, what does this
mean for compensation programs? Many executives and business owners will want to take
advantage of this window of opportunity by deferring or accelerating compensation so that it’s
received while rates are low. As you consider strategies for timing compensation payments,
however, it’s critical to be mindful of Internal Revenue Code Section 409A.

Sec. 409A in a nutshell

Sec. 409A is designed to prevent executives, other employees and certain independent
contractors from using nonqualified deferred compensation arrangements — including bonus
plans, supplemental executive retirement plans and discounted stock options — to defer
income taxes while retaining control over the timing of benefits. Violations result in immediate
taxation of vested benefits and a 20% excise tax, plus interest.

Certain arrangements are exempt from Sec. 409A, including qualified retirement plans and
“bona fide” vacation, sick leave, compensatory time, disability and death benefit plans.

Sec. 409A is complex, but in a nutshell, it restricts an employee’s ability to manipulate the timing
of income as follows:

  1. An election to defer income must be made before the year in which the compensation is
    earned. For example, if you wish to defer a portion of your 2018 compensation to 2019, you
    must make the election by the end of 2017. There are exceptions for new employees, certain
    qualifying performance-based compensation and certain bonus plans. (See “Limited exception
    allows deferral of bonus payments.”)
  2. Deferred compensation must be paid (a) on a specified date or according to a fixed payment
    schedule, or (b) after the occurrence of a specified event, such as death, disability, separation
    from service, change in ownership or control of the employer, or an unforeseeable emergency.
  3. Once scheduled, payments may be deferred further, provided an election is made at least
    12 months in advance and the new payment date is at least five years after the originally
    scheduled date.

Generally, once an election is made to defer compensation, payments can’t be accelerated
except, as discussed below, in limited circumstances.

Accelerating compensation

Sec. 409A generally prohibits companies from paying deferred compensation earlier than
scheduled. This prohibition makes it difficult to accelerate payments to take advantage of tax
cuts. There are, however, 13 limited exceptions to the antiacceleration rule. Most of the
exceptions involve extraordinary circumstances, such as payments needed to comply with a
domestic relations order, pay employment taxes or meet certain other obligations. However,
one exception — for plan termination — may create tax-planning opportunities for some
businesses.

Under this exception, an employer may accelerate deferred compensation payments without
violating Sec. 409A, provided the payments are made in connection with termination and
liquidation of the plan and:

The plan isn’t terminated because of a downturn in the employer’s financial condition,

  • All similar nonqualified deferred compensation plans are also terminated,
  • No payments are made within 12 months after termination,
  • All payments are completed within 24 months after termination, and
  • The employer doesn’t adopt any similar plans within 36 months after the termination was
    initiated.

Terminating a plan is one option for taking advantage of lower tax rates. But before choosing
this strategy, it’s important to consider its impact on your company’s compensation programs.

Plan carefully

Accelerating and deferring income is a tried-and-true strategy for making the most of fluctuating
tax rates. But when nonqualified deferred compensation plans are involved, it’s important to
plan carefully to avoid running afoul of Sec. 409A.

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