Publications: Deferred Compensation Arrangements Must Comply with Code Section 409A by December 31, 2008

Failure to comply with new Code Section 409A may result in severe adverse tax consequences for employees entitled to deferred compensation or benefits. Employers may have tax withholding and reporting obligations under Section 409A, and could be exposed to indemnification claims from employees for accelerated taxation, penalties and interest.

Arrangements Subject to Section 409A

Section 409A covers a wide variety of arrangements. Subject to several important exceptions, Section 409A governs any plan or arrangement that provides deferred compensation or benefits. Generally, a deferral of compensation occurs when an employee obtains a legally binding right (today) to receive compensation or benefits payable in the future. Thus, Section 409A extends well beyond traditional nonqualified deferred compensation plans and could include arrangements such as:

• Employment (and Consulting) Agreements
• Bonus Programs and Long-Term Incentive Plans
• Severance Arrangements
• Change in Control Plans and Agreements
• Contractual Rights to Receive Benefits or Reimbursement of Expenses in the Future
• Tax Gross-Up Arrangements
• Stock Options,¹ Stock Appreciation Rights,² Other Equity Plans and Grants
• Phantom Equity Plans and Grants
• Transaction-Related Bonus Arrangements
• Supplemental Executive Retirement Plans (SERPs) and Arrangements
• Split Dollar Life Insurance Arrangements
• Earnouts in Connection with a Merger or Acquisition

Section 409A has been in effect since January 1, 2005, and covered arrangements should have been operated in accordance with these rules since that date. Beginning on January 1, 2009, however, all covered arrangements must be properly documented as well.

Who is Subject to Section 409A

Section 409A is not limited in application to publicly-traded companies. In fact, private companies, nonprofit organizations, and unions may be parties to arrangements that are subject to Section 409A. Additionally, Section 409A compliance is not limited to arrangements covering employees. All service providers, such as independent contractors and independent members of corporate boards of directors, may have arrangements that are subject to Section 409A.

Section 409A Non-Compliance May Be Costly

For arrangements subject to Section 409A, the failure to (a) amend the governing documents to bring them into written compliance with Section 409A requirements, or (b) document verbal deferred compensation arrangements by December 31, 2008 may result in severe adverse tax consequences for the employees (service providers) who participate in deferred compensation arrangements, including:

1. Current taxation of amounts that are not payable until later;
2. Retroactive interest on the tax due, calculated back to the date of the original deferral; and
3. A 20% additional penalty tax.

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It is important that employers identify all covered arrangements (or potentially covered arrangements) as soon as possible. Employers should develop and execute an action plan immediately to assure operational compliance and meet the December 31, 2008 documentation deadline.

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