The deferred compensation reprieve ends

Private equity firms and their portfolio companies have no further time to postpone reviewing their deferred compensation arrangements.
That applies to both those arrangements that they and their employees recognize as deferring compensation and those that the IRS might interpret to do so, notwithstanding how counterintuitive the IRS’s conclusion may be to the rest of us.
In 2004, Congress enacted Section 409A of the Internal Revenue Code, imposing an entirely new regulatory regime on “deferred compensation.” “Deferred compensation” is generally defined under the statute to cover any promise made in one year to pay compensation in a future year. Because of the breadth and complexity of the statute, and because the IRS’s own views on the statute have evolved since its enactment, the IRS initially established, and then extended, a period of transition relief during which deferred compensation plans were not required to be in documentary compliance with the statute. The transition relief is set to expire on December 31, 2008. IRS officials have stated that the period of transition relief is not likely to be extended, notwithstanding many basic and complicated questions about the statute and related Treasury Regulations that remain unanswered. The good news is that there is still time to avoid the effects of this draconian statute, but the window is closing.
If you have not already done so, you need to take action to bring your plans into documentary compliance now.
Here’s why:

Punitive effect onemployees (and employers)
Section 409A has a punitive effect on employees who are subject to a noncompliant deferred compensation arrangement. The statute imposes a 20% additional tax on noncompliant deferred compensation, and, potentially, interest and penalties. In addition, because of plan aggregation rules, a single non-compliant arrangement could have a domino effect and cause otherwise compliant arrangements to fail. This effect is largely the employee’s problem because the employee bears the tax (absent a contractual agreement to the contrary).
However, an employer with noncompliant arrangements will likely have disgruntled employees on its hands, in particular because the task of maintaining compliant arrangements would normally rest with the employer. Section 409A also disregards contractual payment terms and causes noncompliant deferred compensation to be includible in income as soon as it vests. As a result, it may be the case that the employer would have a withholding obligation earlier than the scheduled payout date (although the employer withholding rules are yet another unclear area). For now, the employer has no obligation to withhold the additional tax, but the IRS is considering imposing a withholding obligation with respect to the additional tax.

Limited creative planning
Under the current transition relief, employers and employees can modify deferred compensation arrangements — even compliant deferred compensation arrangements — in ways that will not be available after the end of the year. For example, deferred compensation plans must now designate in writing an objectively determinable distribution amount upon one or more of the permissible payment events — separation from service, change in control, unforeseeable emergency, specified fixed date or fixed schedule of payments and death or disability (all of which — except, not surprisingly, death — have a specific and detailed regulatory gloss). Between now and the end of the year, employers and employees may be able to modify the time and form of payment of deferred compensation (for example, by electing to have deferred compensation payable on a fixed date rather than on termination of employment). Under certain conditions, arrangements may be able to be modified to comply with one of the many available exemptions and remove them from the statute’s reach. There are relatively few limitations on the restructuring opportunities available. One of the few limitations is that payments scheduled to be made in or after 2009 may not be paid in 2008, and payments scheduled to be made in 2008 may not be deferred to 2009 or after. But effective January 1, 2009, these planning opportunities will disappear.

It’s going to take some time
Section 409A covers a wide variety of arrangements such as employment agreements, severance and change-in-control plans and agreements, single- and multi-year bonus arrangements, exit bonuses, non-qualified pension plans, equity compensation plans, phantom carried interest arrangements, expat arrangements and reimbursement policies, as well as traditional deferred compensation plans. As with other significant changes to an employer’s compensatory programs, the Section 409A compliance review will require employers to develop roadmaps, draft new plans and/or plan amendments, educate boards of directors and their compensation committees and obtain appropriate approvals and/or new elections. For employment and severance agreements, employee consent and individual negotiation may be required. Because of the breadth of the statute’s application, it will also take some time to identify all affected compensation arrangements, particularly for companies with far-flung or decentralized operations. In this regard, the statute applies to all arrangements subject to US taxation, including compensation earned under non-US arrangements by US taxpayers. Unlike other challenging US tax regimes (such as the deduction limitations for compensation paid to officers of public companies and the excise tax on golden parachutes), Section 409A covers all employees subject to US tax, not merely those over specified compensation thresholds. Both high- and low-visibility arrangements are affected, from senior management employment agreements and equity compensation programs all the way down to everyday reimbursement arrangements. Employers, even small employers, should not underestimate the amount of time and effort that a compliance review under Section 409A will entail.

Coming soon: reporting of deferred compensation
Noncompliant deferred compensation is required to be reported on an employee’s Form W-2 for the year of vesting. However, Section 409A also requires that compliant deferred compensation be reported in the year of deferral. For now, no one — not even the IRS — knows how to perform these calculations (for example, it’s anyone’s guess how a severance entitlement, which may or may not be paid years in the future, should be reported). Accordingly, these rules will remain suspended for now. As part of its compliance project, employers will need to identify the types of deferred compensation under their arrangements so as ultimately to be able to implement IRS reporting guidance when it is issued.

Additional burden on private equity firms
Private equity firms will shoulder a heightened burden in this compliance review, as they will need to look at both their own arrangements and the arrangements in place at their portfolio companies.
Many customary arrangements of private equity firms with respect to their own employees may require review under Section 409A.
These could include guarantees, single- and multi-year bonus arrangements, and “phantom” carry arrangements with respect to single or multiple investments. (For now, actual carry arrangements structured as partnership interests are not covered by Section 409A.)
With respect to the compensation arrangements of their portfolio companies, private equity firms should expect close scrutiny when the portfolio company is sold, and any noncompliance that rises to a material threshold could affect price, deal terms (such as indemnifications), and negotiations with management.

Think you’re done? take a second look
The IRS issued final regulations under Section 409A in early 2007.
Although the final regulations in large measure track earlier IRS guidance, there were some changes, a few of them significant. In addition, a body of “lore” is slowly building up as practitioners and their clients work through the statute’s complexities. Employers who conducted their Section 409A review prior to the issuance of the final regulations should take a second look at their arrangements to identify any further necessary changes. Another reason for a second look arises because the final regulations contain fairly strict anti-substitution rules that will make it difficult for an employer, in the normal course, to restructure deferred compensation once the transition period expires. According, employers should expect that, starting in 2009, they will have to live with their choices, and therefore they ought to review those choices and, if desired as a commercial matter, modify them by the end of the year.
As with all other complicated regulatory changes, employers need to develop a roadmap for the new Section 409A regime. This roadmap will vary from employer to employer but will likely follow the same general four steps: first, identify of all compensatory arrangements that are or could be subject to Section 409A (which, for many employers, may be all or nearly all their compensatory arrangements), including affected non-US arrangements; second, identify any fixes that are required to comply with the statute and any other modifications that may be desirable as a commercial matter; third, obtain approval of the changes, including any necessary consents from employees and others (and the negotiation that obtaining consents often entails); and fourth, roll out the changes (including establishing any required internal controls, such as accounting, monitoring or other procedural changes) and communications with employees.

Elizabeth Pagel Serebransky also contributed to this article

A version of this article first appeared in the Spring 2008 Debevoise & Plimpton Private Equity Report.