At nearly 400 pages, the Treasury Department’s guidance for Section 409A of the tax code takes a long time to read. Time to comply with its new requirements, however, is in short supply.
Section 409A imposes complex new rules around how deferred compensation agreements should be structured if companies and executives want to avoid higher taxes. The effective date of the rule, already stalled for two years, is now Dec. 31—and compliance experts are pleading with the Internal Revenue Service yet again for more time.
“Many of our corporate clients have literally hundreds of interrelated deferred compensation arrangements which must be collected, reviewed, and analyzed,” says Regina Olshan of the law firm Skadden, Arps, Slate, Meagher & Flom. She calls the new rules “a way to collect some quick revenue” and warns: “It isn’t the company that loses, it’s the employee.”
Olshan even put her feelings to paper, drafting a letter to the IRS asking for a one-year extension on Section 409A’s changes. Ninety-two other law firms added their own names, telling acting IRS Commissioner Kevin Brown that more time is “urgently” needed.
“We are very concerned that the attempts to accomplish the required analysis, decision making, and amendments in the current compressed time frame are likely to cause mistakes, oversights, and errors even by the most sophisticated advisors and clients,” Olshan and the others wrote in their letter.
So far, the Treasury Department doesn’t seem to be moved.
“We did receive the letter … and we’re reviewing all the issues it raised,” Treasury Department spokesman Andrew DeSouza says. “But at this point we have no plans to grant an extension. Really, the whole regulation has been in the works for more than two years and people have known for a while about the deadline date.”
Others say the issue is not so cut-and-dry. Deborah Lifshey, of the compensation consulting firm Pearl Meyer & Partners, notes that the IRS did not publish final compliance rules for Section 409A until April. “The real reality is that we had eight months to go,” she says. “We were told the final guidance would happen then, and who wants to spend one to two years before that guessing what they have to do to comply?”
Companies now have a difficult choice to make before the end of the year: terminate old deferred compensation plans that might be socked with higher taxes under the new Section 409A, or overhaul them to comply with the new standards. For example, companies might be able to amend the exercise price for a stock option grant, or change the language of a contract to define the deferred compensation in a way that would satisfy the IRS. But even then, those fixes might still be deemed a new grant under Section 409A, especially if the company goes through a merger or some similar complicated transaction.
Below is an excerpt of the letter sent to the IRS asking for an extension in the compliance deadline with Section 409A’s revisions.
The final Section 409A regulations, issued in April 2007, are necessarily lengthy and complex, since the statute left a great deal to be explained in regulations. We greatly appreciate the IRS providing this extensive guidance in a timely manner. However, with the final regulations published less than nine months before the documentary compliance deadline, many of the issues raised are still being debated by the most sophisticated practitioners and, we understand, in a number of cases continue to be the subject of evolving consideration and analysis by the Department of Treasury and IRS personnel. As a result, even expert practitioners differ or are uncertain of how to apply the rules to many common business practices. Moreover, failure to comply will result in significant tax liabilities to individuals, many of whom will have had no significant involvement in the compliance process.
Many of our corporate clients have literally hundreds of interrelated deferred compensation arrangements which must be collected, reviewed, and analyzed. These include employment agreements, the severance provisions of each of which must be individually analyzed for Section 409A compliance. Following review and analysis, many decisions, each with varying cost, tax, accounting, human relations, public relations, and securities law implications, need to be made. These decisions require involvement by the highest levels of the company’s management and, thereafter, by the company’s board of directors (or the compensation committee). These decision makers must all be extensively briefed on the issues raised, will then pose questions and review responses to those questions, evaluate various alternatives, and ultimately approve proposed changes. Upon completion of this lengthy process, Section 409A amendments reflecting the decisions reached must then be drafted, reviewed, approved, communicated, and implemented (many will also require negotiations with affected individuals, who themselves may be represented by counsel).
We are very concerned that the attempts to accomplish the required analysis, decision making, and amendments in the current compressed time frame are likely to cause mistakes, oversights, and errors, even by the most sophisticated advisers and clients who are doing their absolute best to comply. The consequences of any errors will fall on the individual employees, not the employers, and most of those employees have little or no ability to address or correct those errors. These issues are exacerbated for the small business community (including tax exempts) and for foreign companies, many of which are still largely unaware of the complexities and burdens of Section 409A compliance and have limited access to sophisticated advisers … Accordingly, we respectfully request that the period to bring plan documents into compliance with Section 409A be extended until Dec. 31, 2008.
Skadden, Arps (Aug. 21, 2007)
And the price for noncompliance can be steep: Section 409A mandates that any compensation deferred after January 2005—from signing or performance bonuses to stock options and severance packages—that fails to meet the requirements of the regulation will risk a levy of up to 20 percent, plus penalties. And that surcharge is likely to be slapped against the employee, who often had no knowledge or control over compliance matters.
How It Came to This
Derrick Neuhauser, of the auditing firm BDO Seidman, says the more muscular Section 409A sprung from what the Treasury Department believed was a lax environment for compensation, where human resources employees simply asked executives “what part of the salary they wanted to defer and when, with little regard for tax-filing inconsistencies or broken audit trails.”
Neuhauser believes the Treasury Department was annoyed with companies setting deferments and award dates whenever they wanted and cracked down with the new Section 409A.
“What really got them upset were the performance and incentive bonuses, where people were filling out documents near the time that they knew what the awards would be [and] what amount they would be, generally trying to beat the system. To add insult to injury, Treasury has never won one [non-qualified deferred compensation] case, ever.”
An opportunity to revise Section 409A came along when Congress passed the American Jobs Creation Act in October 2004. Since 2005, employers have been required to administer deferred compensation arrangements in accordance with the statute, while the Treasury Department drafted the implementation rules it released last April. Neuhauser and others believe the Treasury Department overcompensated, so to speak, for its past frustrations.
“They went before Congress to change the rules and said, ‘While we’re at it, let’s put everything—including the kitchen sink—under these new rules,’ and that’s the environment we’re in now,” Neuhauser says. “The difficulty is that 2,000 companies have 2,000 or more different plans. You can’t go down a checklist and say, here’s 12 things we can do to comply. There are individual differences in plans, and that can be just within one company.”
While the compliance obligations may seem daunting to meet by this December’s deadline, some observers do predict some sort of amnesty or other corrective program after the deadline passes.
Olshan predicts that the volume of errors and non-compliance the IRS could see by the end of the year may lead to a “comprehensive amnesty plan” or some other corrective action. Such a plan might look like a February 2007 measure where the IRS said it would allow employers to correct under-withholding of certain taxes related to backdated stock options in 2006.
Meanwhile, the clock keeps ticking.
“I think we’re focused more on compliance as this deadline approaches than what makes sense in viable, easy-to-administer plans, and that’s the main issue,” says Carol Silverman of Mercer Human Resource Consulting. “My hope is that 409A does not encourage behavior that isn’t best practice just because people are rushing to be compliant. For that reason alone, I think an extension of some sort—or any sort—is a good idea.”