Frequently Asked Questions About 409A

 

What is 409A?

In 2004, Congress passed the American Jobs Creation Act of 2004. As part of this Act, Congress completely rewrote the rules governing nonqualified deferred compensation by adding Section 409A to the tax code. The rules are effective starting January 1, 2005, and all deferred compensation plans must operate in compliance with the rules as of that date. Documentary compliance must be completed by December 31, 2005.


What is covered by 409A?

409A generally applies to any plan that provides for the deferral of compensation, which is broadly defined as a legally binding right to be paid compensation in the future. This includes supplemental executive retirement plans (commonly called “SERPs”), and could include employment agreements and severance arrangements. There are some notable exceptions, however. For example, 409A does not apply to tax qualified retirement or pension plans, such as a 401(k) plan or a 457(b) plan – or certain welfare benefit plans, such as bona fide vacation leave, sick leave, and death benefit plans.


Why is 409A important?

409A is important because failure to comply with it imposes significant tax penalties on the individual – not on the sponsoring company. In short, if a plan fails to comply with 409A, the IRS will impose an additional 20% income tax, plus interest on the underpaid amounts. This is all in addition to ordinary income taxes due on these amounts. The net result could be that an individual pays more than 50% tax on the amounts deferred.


When does 409A go into effect?

As a general rule, 409A applies to all compensation deferred starting January 1, 2005, although it could also apply to pre-2005 deferrals that are “materially modified.” To ensure compliance, any plan documentation must be updated for 409A compliance by December 31, 2005. Operationally, all plans must be in compliance going back to January 1, 2005.


What about deferrals made before January 1, 2005?

Deferrals that are earned and vested prior to January 1, 2005, are considered “grandfathered,” and not subject to 409A. For a defined benefit, or “non-account balance” plan, the amount a participant could get upon an early termination of employment would be the grandfathered amount. For a defined contribution, or “account balance” plan, the vested deferrals would be grandfathered.


What are an employer’s responsibilities?

Starting with deferrals made in 2006, employers will now be required to report the amount of a participant’s deferrals on an annual basis. Please note that until amounts are actually received by a participant, no taxation of deferrals takes place. The IRS and Treasury Department are still developing the rules for 1099 and W-2 reporting.


Are there other rules still pending?

Yes. The IRS is still developing rules under 409A. For example, one of the issues outstanding is how to treat split dollar arrangements. Some split dollar arrangements may fit the definition of deferred compensation if the arrangement grants the participant a legally binding right to a future transfer of interests in a policy owned by a financial institution.


Can changes be made in current plans?

Yes. Remember, though, that grandfathered deferrals may lose grandfathering if a plan amendment adds an additional right or enhanced benefit. Also, during 2006, the IRS is permitting certain changes that will not be allowed after 2006. For example, plans may be amended to change benefit distribution elections, as long as such changes do not delay benefit distributions already scheduled to be made in 2006, or to schedule new distributions in 2006.


In general, what types of benefit distributions are allowed?

Six types of distributions are allowed. distributions may be made to a participant upon a separation from service, as defined; disability, as defined; death; specified time or schedule; changes in ownership or control, as defined; and unforeseeable emergencies (only to the extent of severe financial hardships for the participant). Changes that would accelerate distributions are prohibited, with very few exceptions. One such exception is to satisfy a domestic relations order, such as a divorce settlement. The form of distribution and timing of its payment must generally be specified at the time of the deferral.


What do the regulations have to say about elections?

Generally, deferral elections must be made during the year that precedes the taxable year in which the compensation will be deferred. For example, elections for 2007 deferrals must be made by December 31, 2006.

Changes in elections that impact a distribution’s form or timing are also restricted, and must be made at least one year in advance.


How can I learn more?

For a printed version of these Frequently Asked Questions or for more information, please call us toll-free at 877.332.2265x208 or by e-mail at gadams@bfbbenefit.com

In addition, for a nominal fee, we will review your current plans and evaluate them in terms of compliance with 409A. Then, if you choose, we will help you find an attorney who can help bring your plan into compliance.


Who is Burns-Fazzi, Brock & Associates?

We are a experienced compensation consultant to independent banks and credit unions. Since 1995, we have provided an increasingly wide range of retirement benefits and other compensation-related services to bank and credit union executives, directors and employees. We have broad experience in many different areas, including tax, accounting, legal, regulatory, funding and administrative issues that govern financial institutions’ use of benefits and other compensation programs. This allows us to offer our clients a uniquely large array of solutions. For more details, visit us online at www.bfbbenefit.com.


Disclaimer:

To ensure compliance with requirements imposed by the IRS and other taxing authorities, we inform you that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose if (1) avoiding penalties that may be imposed on any taxpayer or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Additionally, any information contained herein is not to be construed as legal advice. Consequently, any legal and tax consequences should be reviewed and approved by qualified legal and tax counsel before it is utilized for any purpose.