Unfunded Deferred Compensation

<div class="Section1">The employer has no obligation to pay FICA or FUTA taxes, or to withhold federal income taxes, when an option is granted. Pending further guidance from the IRS, employers also are not obligated to pay or withhold FICA and FUTA taxes on the exercise of ISOs.<a href="#_ftn1" name="_ftnref1">¹</a> However, the IRS has announced that any sponsor determination to impose FICA or FUTA on the exercise of ISOs will not take effect before January 1 following the second anniversary of the announcement.IRC Section 6039 requires employers to provide a written statement to each employee regarding any exercise of an ISO and, beginning for transfers occurring in 2009 or later, to file a similar information return with the IRS by January 31 of the year following the transfer.<a href="#_ftn2" name="_ftnref2">²</a> Under proposed regulations, the information return must identify the parties and provide the following information:<br /> <ul><br /> <li>The date the option was granted</li><br /> <li>The exercise price per share</li><br /> <li>The date the option was exercised</li><br /> <li>The fair market value of a share on the date of exercise</li><br /> <li>The number of shares transferred pursuant to the exercise</li><br /> </ul><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; Notice 2002-47, 2002-28 IRB 97.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; Prop. Treas. Reg. &sect;&sect; 1.6039-1, 1.6039-2.<br /> <br /> </div></div><br />

<div class="Section1">An ISO generally is not subject to ERISA&rsquo;s reporting requirements since it is usually not a covered ERISA &ldquo;employee benefit plan.&rdquo; Therefore, a summary plan description need not be distributed to participants. An employer must furnish a statement to an employee on or before January 31 of the year following the year in which the employee exercises the ISO, stating details about the options granted.<a href="#_ftn1" name="_ftnref1">¹</a><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 6039(a).<br /> <br /> </div></div><br />

<div class="Section1">Congress imposed additional documentary and operational requirements in IRC Section 409A to avoid a current constructive receipt on a &ldquo;nonqualified deferred compensation plan&rdquo; at inception and during the life of a covered plan. Many of these new requirements actually are those that the IRS formerly required to receive a favorable private letter ruling on income tax deferral under a plan and so are not new.Section 409A imposes requirements on plans in four primary areas:<br /> <ol><br /> <li>Minimum plan documentation</li><br /> <li>Permissible Distributions</li><br /> <li>Elections to defer</li><br /> <li>Prohibited Accelerations</li><br /> </ol><br /> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3544">3544</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3547">3547</a> for a detailed discussion of each of these requirements.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Planners should assume that any compensation plan is covered by Section 409A and plan to comply with the form and operational requirements until and unless they have satisfied themselves that the plan (which may be for only a single person) is either 1.) specifically statutorily exempted &ndash; such as a 457(b) plan &ndash; or 2.) meets (or can be designed to claim) a regulatory exception &ndash; such as the short term deferral exception.<br /> <br /> <hr><br /> <br /> </div><br />

<div class="Section1">Under &ldquo;eligible&rdquo; plans, only individuals may participate, but they may be either employees or independent contractors. Partnerships and corporations cannot be participants.<a href="#_ftn1" name="_ftnref1">¹</a> Where local government employees were hired by a for-profit water company as part of privatization, they could no longer continue to participate in the local government&rsquo;s Section 457 plan.<a href="#_ftn2" name="_ftnref2">²</a>It should be noted that plans for nongovernmental private tax-exempt employers are subject to ERISA (unlike a governmental plan), except for church plans. Therefore, private tax-exempts must structure their 457 plans to take advantage of a top hat ERISA exemption (e.g., by allowing only a select group of management or highly compensated employees to participate). Otherwise, the plan would be subject to the exclusive purpose and funding requirements of Title I of ERISA, and a nongovernmental tax-exempt Section 457 plan cannot, by definition, meet those requirements.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. Sen. Rep. 95-1263 (Revenue Act of 1978), <em>reprinted in</em> 1978-3 CB (vol. 1) 364.)<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. IRS Information Letter 2000-0300.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. See Let. Rul. 8950056.<br /> <br /> </div></div><br />

<div class="Section1">The IRS procedures for the voluntary correction of errors in qualified pension plans (e.g., VCP) do not apply to the correction of errors in nonqualified deferred compensation plans. Moreover, the correction of errors in connection with nonqualified deferred compensation plans was not the subject of much discussion prior to the enactment of Section 409A. However, there were legal theories for the correction of both documentation and operational administrative errors in connection with nonqualified deferred compensation plans that existed prior to Section 409A ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3553">3553</a>).Most documentary errors, in general, were corrected under various legal theories for the reformation of contracts (such as correction of &ldquo;scrivener errors&rdquo;) because nonqualified deferred compensation plans are contracts. Likewise, longstanding tax bookkeeping theories and principles were applied to correct operation plan administration errors, such as the correction of incorrectly calculated participant phantom account balances ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3553">3553</a>).<br /> <br /> Where plans can claim a regulatory exception from Section 409A coverage or are grandfathered from Section 409A coverage, these pre-409A legal theories remain the appropriate methods for correcting both documentary and operational plan administration errors. Some commentators believe these pre-409A legal theories still can be used to correct errors as to 409A-covered plans not covered by Notices 2008-113 and 2010-6 (as modified by Notice 2010-80), and even as to errors specifically covered by these notices. The fact that Section 409A is additive law would seem to support this position. However, the IRS takes a strict view as to the correction of errors in 409A covered plans and is unlikely to agree with corrections made outside the notices at this stage, except as to grandfathered and 409A-excepted plans, and plans that fall under the short term deferral exception ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3548">3548</a>).<br /> <br /> </div><br />

<div class="Section1">The Qualified Domestic Relations Order (QDRO) rules applicable to qualified plans ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3915">3915</a>) also apply to eligible Section 457 plans, so that the IRC Section 457(d) distribution rules are not violated if an eligible Section 457 plan makes a distribution to an alternate payee pursuant to a valid QDRO.<a href="#_ftn1" name="_ftnref1">¹</a>Contrast this with a 457(f) &ldquo;ineligible&rdquo; plan where a DRO outlined by Section 409A regulations applies ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3541">3541</a>). Although there are parallels, the DRO has significant differences from the QDRO that a QDRO is designed to act on escrowed &ldquo;plan assets&rdquo; of a qualified plan that do not and must not exist in the case of a 457(f) &ldquo;ineligible&rdquo; plan that is and must be unfunded and unsecured (even if placed in a Rabbi Trust).<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect;&sect; 414(p)(10), 414(p)(11).<br /> <br /> </div></div><br />

<div class="Section1">Where an employee receives a basic vested right in cash values of a policy, or basic life insurance protection and a vested right in the cash surrender values of a policy, the policy becomes a split dollar life insurance arrangement. A split dollar arrangement is also subject to Section 409A, unless it is structured as one of the two excepted variations under IRS Notice 2007-34.<a href="#_ftn1" name="_ftnref1">¹</a>Premiums for a split dollar policy should be taxable to the employee under both split dollar and Section 409A rules (making it subject to the Section 409A penalty taxes and interest if the arrangement does not comply with Section 409A requirements in both form and operation). The Tax Court has held that employer-paid life insurance premiums on an employee&rsquo;s life, where the annual increase in the cash surrender value benefits the employee and the employee also receives annual insurance protection for both the employee and family, will be includable in the employee&rsquo;s gross income.<a href="#_ftn2" name="_ftnref2">²</a> Only an endorsement split dollar (where the participant receives only an interest in a portion of the policy death benefits and pays only an economic benefit tax cost) seems to escape additional taxation under both split dollar and Section 409A tax rules.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRS Notice 2007-34 was issued as the same time as the final Section 409A regulations in April of 2007 and were intended to specifically discuss the application of Section 409A to split dollar life insurance plans in more detail.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. <em>Frost v. Comm.</em>, 52 TC 89 (1969).<br /> <br /> </div></div><br />

<div class="Section1">Since the enactment of IRC Section 409A, the IRS has refused to issue advance rulings on the tax consequences of nonqualified deferred compensation plans of for-profit companies as it once did prior to Section 409A ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3541">3541</a>). The availability and requirements for favorable letter rulings for plans under Section 457(b) were not clear even before the enactment of Section 409A (and even before the IRS&rsquo; release of guidance refusing to issue letter rulings on all plans in for-profit entities).It was clear though, prior to the enactment of Section 409A, that the IRS would not issue an advance ruling on the tax consequences of a Section 457(b) plan covering independent contractors, unless all such independent contractors were identified.<a href="#_ftn1" name="_ftnref1">¹</a> Now that 457(b) &ldquo;eligible&rdquo; plans are specifically exempted from, and 457(f) &ldquo;ineligible&rdquo; plans are specifically covered by, Section 409A statutorily, perhaps the IRS will begin to provide letter rulings on 457(b) &ldquo;eligible&rdquo; plans. However, the IRS has indicated its direction will be to issue fewer letter rulings on qualified plans, so it is currently not likely that 457(b) plan can obtain a letter ruling either. As noted, the IRS specifically will not issue letter rulings on the income tax consequences of plans that are covered by Section 409A, which would include 457(f) &ldquo;ineligible&rdquo; plans (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3541">3541</a>).<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. Rev. Proc. 2003-3, &sect; 3.01(36), 2003-1 CB 113, as modified by Rev. Proc. 2011-56.<br /> <br /> </div></div><br />

<div class="Section1">For a stock option to qualify as an ISO (and thus receive special tax treatment under IRC Section 421(a)), it must meet the requirements of IRC Section 422 when granted and at all times from the grant until its exercise. The key requirements are that an ISO have an exercise price not less than the fair market value of the stock at the time of the grant, expire within no more than 10 years, and be generally nontransferable and exercisable only by the grantee.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> Although technically ISOs are exempt from Section 409A, they are required to be issued at fair market value at the date of grant in order to qualify as an ISO. If they are not issued at fair market value at the date of grant, they become an NQSO that has not been issued at fair market value and thereby subject to Section 409A, because they fail to meet the requirements for the Section 409A exemption. Therefore, the planner must make certain that the ISO, like an NQSO, is issued at fair market value at the date of grant in order to avoid the application of Section 409A to the stock, which is not desirable, since it will loss the exemption and fail 409A with the imposition of 409A tax and penalties.<br /> <br /> <hr><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC &sect; 422; Treas. Reg. &sect; 1.422.<br /> <br /> </div></div><br />

<div class="Section1">The following plans and benefits are not considered deferred compensation &ldquo;wages&rdquo; for FICA and FUTA purposes (but may well be a &ldquo;nonqualified deferred compensation plan&rdquo; for 409A purposes and includible for income tax purposes for noncompliance):<br /> <p style="padding-left: 40px">(1) Stock options, stock appreciation rights, and other stock value rights, but not phantom stock plans or other arrangements under which an employee is awarded the right to receive a fixed payment equal to the value of a specified number of shares of employer stock</p><br /> <p style="padding-left: 40px">(2) Some restricted property received in connection with the performance of services</p><br /> <p style="padding-left: 40px">(3) Compensatory time, disability pay, severance pay, and death benefits</p><br /> <p style="padding-left: 40px">(4) Certain benefits provided in connection with impending termination, including window benefits</p><br /> <p style="padding-left: 40px">(5) Excess (golden) parachute payments</p><br /> <p style="padding-left: 40px">(6) Benefits established 12 months before an employee&rsquo;s termination, if there was an indication that benefits were provided in contemplation of termination</p><br /> <p style="padding-left: 40px">(7) Benefits established after termination of employment</p><br /> <p style="padding-left: 40px">(8) Compensation paid for current services<a href="#_ftn1" name="_ftnref1">¹</a></p><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. &sect;&sect; 31.3121(v)(2)-1(b)(4), 31.3306(r)(2)-1(a).<br /> <br /> </div></div><br />