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Nonqualified deferred compensation plans are subject to the complexities of § 409A of the Internal Revenue Code ("IRC"). Failure to comply with the requirements of IRC § 409A can result in significant adverse federal income tax consequences for the participants. A recent decision in one of the first cases considering IRC § 409A shows just how tough the IRS can be on these plans.

Q-1: Does your company have any deferred compensation plans subject to IRC § 409A?

The application of § 409A can be surprisingly extensive. It can affect many types of employee plans and arrangements and has implications for most forms of equity and cash compensation. Treasury Regulations broadly define the term "deferred compensation" as including bonus arrangements, long-term incentives, supplemental retirement plans, deferred payments provided under both employment agreements as well as severance agreements, and equity compensation plans – including plans under which employees are granted non-qualified stock options with a strike price below the stock's fair market value at the date the option is granted.

Q-2: What must your deferred compensation plans provide in order to meet the requirements of IRC § 409A?

The express requirements of IRC § 409A are very complex. In general, non-qualified deferred compensation plans must:

  • Be in writing;
  • Specify the amount(s) being deferred;
  • Identify a specific time when the deferred compensation becomes payable; and
  • State the form and manner of the payment.

If the deferral is elected, the employee must request the deferral in writing prior to the year in which the compensation is earned.

Q-3: What are the federal income tax consequences if your deferred compensation plans fail to comply with the requirements of IRC § 409A?

If a deferred compensation plan fails to comply with the complex requirements of IRC § 409A, then those employees who are affected by the non-compliance must include the deferred compensation in their gross income in the later of (i) the tax year that the non-compliance occurs, or (ii) the tax year when the deferred compensation becomes vested and is no longer subject to a substantial risk of forfeiture.

The affected employee must also pay to the IRS an additional tax penalty of 20% of the amount of deferred compensation included in gross income and penalty interest at the federal income tax underpayment rate plus 1%.

Q-4: Are there any cases which have dealt with the tax consequences of a deferred compensation plan that does not comply with the requirements of IRC § 409A?

As of today, there are only two such reported cases. The first of these cases was Slater, et ux. v. Commissioner, TC Summary Opinion 2010-1 (2010), which, as a Summary Opinion, cannot be treated as precedent for any other case. The second case, Sutardja v. U.S., 111 AFTR 2d 2013-997 (Ct. Cl. 2013), was recently decided on February 27, 2013. The Sutardja case is of much more significance and is described in greater detail below.

Q-5: What is the significance of the Sutardja decision?

A precedent-setting case in which the IRS imposes significant penalties and interest for § 409A violations should catch everyone's attention. In this decision, Dr. Sutardja received deferred compensation in the form of a grant of 1.5 million stock options. The plan was covered by § 409A because the options were initially granted at an exercise price of $36.50 which was below the stock's fair market value of $43.64. The Plan was in violation of IRC § 409A because Dr. Sutardja could exercise the options at his discretion rather than only upon the occurrence of one of the specified events, such as, a change of control of the employer or the employee's separation due to disability. The Company believed its plan was exempt from IRC § 409A because it discovered the discount problem and issued a "Reformation of Stock Option Agreement" to adjust the option price up to the fair market value. Dr. Sutardja paid an additional $7.14 per share on options he previously exercised to cover this difference. However, the IRS rejected this correction, asserting that the $43.64 exercise price had to be in place at the time the option vested. The Court upheld the IRS position and the penalties and interest were enforced.

This case demonstrates that the IRS is not looking for "good faith" compliance with § 409A. The IRS will seek maximum penalties and interest wherever it uncovers a technical violation to IRC § 409A.

Q-6: What can we learn from the Sutardja case?

Some of the more important lessons related to this case include:

  • The Sutardja decision is a wake-up call that the IRS is ready to enforce IRC § 409A. In an earlier edition of this Newsletter (November 2009), we reported that the IRS announced it was developing an executive compensation audit program. Companies should now take this announcement seriously and review all of their deferred compensation arrangements to make sure that they comply with IRC § 409A or are otherwise exempt from the provisions.
  • The IRS appears ready to aggressively assert violations of IRC § 409A whether or not stock options are involved.
  • The Sutardja case was interesting in that the stock options were granted prior to the legislation which introduced IRC § 409A. Further, Dr. Sutardja exercised his options prior to adoption of the Treasury Regulations thereunder.
  • If an employer wants to provide stock options to its employees but wants to avoid IRC § 409A, the employer needs to be prepared to adequately document that the exercise price is at least equal to the fair market value on the date the option is granted.
  • If the employer nevertheless wants to issue "discounted" stock options to its employees, then the employer must provide among other requirements that the option can only be exercised upon the occurrence of one of the types of events specifically listed in the IRC § 409A Regulations (e.g., the employee's disability or separation from service, change in control of the employer, or according to a time or fixed schedule specified in the option plan). Simply allowing the discounted option to be exercised at the discretion of the employee at any time will not comply with the requirements.

Q-7: If, in reviewing your non-qualified stock option plan, you discover that the plan is subject to IRC § 409A because either the option is "discounted" or the distribution requirements of the IRC § 409A Regulations are violated, can the problem be fixed?

Yes, provided the applicable remedial steps outlined in IRS Notice 2008-113 and IRS Notice 2010-6 are timely taken.

In the case where the exercise price is less than the fair market value of the stock determined as of the date the option is granted, IRS Notice 2008-113, Section IV. D. provides that the exercise price can be reset to an amount not less than the fair market value of the stock on the date of the grant. In addition, the reset must occur before the option is exercised and before the last day of the year in which the option is granted.

If the option is a "discounted" option, but the distribution requirements as set forth in the stock option plan do not comply with the requirements of IRC § 409A, the plan can be brought into compliance with IRC § 409A by amending the plan as specified in IRS Notice 2010-6, Section VII. B. to remove any impermissible distribution events before they occur. In addition, the impermissible distribution provisions must be replaced with a distribution provision occurring only upon the later of the employee's separation from service and the sixth (6th) anniversary of the date of the correction.

For additional information regarding this topic, please contact your local UHY LLP professional.