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IRS releases interim guidance on certain nonqualified deferred compensation programs

Apr 10, 2009

On January 26, the IRS issued Notice 2009-8, providing interim guidance under new Code section 457A (“Nonqualified Deferred Compensation From Certain Tax Indifferent Parties”). Section 457A was added to the Internal Revenue Code by the Emergency Economic Stabilization Act of 2008, also known as the “Bailout Bill”. As publicized by the media, the Bailout Bill was drafted and enacted rapidly. Unfortunately, this often leads to very complex provisions that both regulators and practitioners find difficult to interpret. In this article, we review the IRS’s initial interpretation effort of section 457A.

Generally, under section 457A, nonqualified deferred compensation (NQDC) that is deferred under a plan of a nonqualified entity becomes taxable at the later of the date when there is no longer substantial risk of forfeiture or the date when the amount is determinable. We will consider the meanings of nonqualified entity and determinable in more detail later in the article. For the time being, assume that a nonqualified entity is a tax-indifferent organization (for example, a company domiciled in a tax haven), and that an amount is not determinable if calculation of the amount requires more information than available at the end of the tax period.

Similarities to section 409A

In many ways, section 457A and Notice 2009-8 parallel section 409A and Notice 2005-1, which provided initial interim guidance on that section. Should this new section prove as difficult to implement as its older sibling, it would not be surprising to witness a similar long-term good faith compliance period.

In general, nonqualified deferred compensation (NQDC) under 457A has the same meaning assigned under 409A. But, there are a few exceptions:

The exemption for stock appreciation rights (SARs) does not apply – except  when the SARs are required to be, and are settled in, the form of service recipient (employer) stock.

The short-term deferral rule is extended from 2 ½ months under 409A to 12 months after the end of the service provider’s (employee’s) taxable year in which the right to payment becomes nonforfeitable.

The service recipient is the entity to whom the service provider directly provides services when the compensation becomes nonforfeitable. For example, if an employee provides services for a subsidiary S of a parent company P, then S is the service recipient for these purposes.

Nonqualified entities

The service recipient is a nonqualified entity if either of the following is true:

It is a foreign corporation where less than substantially all of its net income is effectively connected with the conduct of a US trade or business or is subject to a comprehensive foreign income tax

It is a partnership where less than substantially all of its income is allocated to partners who are not subject to a comprehensive foreign income tax and are exempt from income tax under the Internal Revenue Code.

The determination of whether an entity is a nonqualified entity is made independent of the answers to certain questions:

Whether the service provider is an individual or group of individuals, a corporation or some unincorporated entity

Whether the service provider accounts on a cash basis or an accrual basis

Section 457A introduces many new terms and Notice 2009-8 goes to great lengths to define each one through a fairly intricate web of definitions. Readers who need to understand the minute details of this guidance are directed to the Notice itself. For the sake of brevity, we will not delve deeper into these definitions here.

Determining the taxable amount

Under 457A, nonqualified deferred compensation includes both actual income and notional income that may be attributed to the compensation. So, earnings on compensation generally become taxable when the related compensation becomes taxable. As exceptions, earnings not considered “reasonable” (undefined term) and earnings credited less frequently than annually are considered currently deferred, and therefore potentially subject to taxation. The actual taxable amount is then calculated by analogy to the income inclusion rules under section 409A.

Income inclusion will not cause double taxation under section 457A. Income taxed under 457A before it is paid will not be taxed a second time, though reasonable earnings on that compensation may still be taxed if not taxed already. Further, the service provider (employee) may deduct the loss for income taxed under 457A but forfeited before payment.

Certain vested amounts, calculated as a formula amount within the meaning of the 409A income inclusion regulations, will be considered currently undeterminable under 457A. Generally, this occurs when, at year end, the amount of the payment could still vary prior to the payment date due to unknown factors. For example, consider a company (service recipient) with a March 31 fiscal year that pays bonuses immediately after the end of its fiscal year. As of the immediately preceding December 31, an employee’s bonus may not be determinable based on the information known on that date.

Amounts that become determinable after the date when they would have been taxable under 457A have an additional tax equal to 20% of the taxable amount plus a premium interest tax calculated at the IRS underpayment rate plus 1%.

When 409A and 457A both apply

Both sections 409A and 457A will, in some cases, apply to the same nonqualified deferred compensation. When this occurs with regard to short-term deferrals, taxes under 457A will be considered a payment under both sections. And, in general, until Treasury and the IRS provide us with further guidance, taxes on earnings under 457A will be considered to pay the taxes under 409A as well.

For compensation attributable to services provided prior to 2009, a change in the form or timing of payment to conform to the date that the deferred compensation becomes taxable under 457A is not a prohibited acceleration. Similarly, with respect to services performed before 2009, where the NQDC was earned and vested prior to 2005 and is not otherwise covered under 409A, a change in the form and/or timing of payment solely to conform to the date that it becomes taxable under 457A will not constitute a material modification of the agreement if it is written and effective before 2012.

Effective dates

Even the effective date of 457A is complicated. Generally, it applies to NQDC for services performed after December 31, 2008. However, if an amount escapes 457A because it is for services performed before 2009 and it is not taxable for any year beginning before 2018, then it automatically becomes taxable at the later of the year in which it becomes vested or the last taxable year beginning before 2018. In other words, only limited grandfathering applies to NQDC earned prior to 2009.

Conclusion

As with its sibling 409A, the IRS has begun to address 457A with a Notice that provides interim guidance. Also like its sibling, we expect many more iterations of guidance on this topic. We will keep our readers informed throughout these developments.