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Guest Article

(From the December 8, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Section 409A Proposed Regulations Addressing Income Inclusion

On December 5, 2008, the Department of Treasury ("Treasury") and the Internal Revenue Service (the "IRS") issued proposed regulations addressing the calculation of amounts includible in income and additional taxes imposed under §409A(a). The regulations are proposed to be generally applicable for taxable years beginning on or after the issuance of the final regulations. Taxpayers may rely on these proposed regulations only to the extent provided in future anticipated guidance (described below).

In addition, the proposed regulations provide that Code Y reporting will not be required until final regulations are issued. Code Z, reporting with respect to failures to comply with §409A, continues to apply.

These proposed regulations do not address the calculation of income inclusion for violations of requirements of §409A(b). Treasury and the IRS anticipate issuing interim guidance for taxable years beginning after January 1, 2007 to address the calculation of income inclusion under §409A(b) and the application of federal income tax withholding requirements to such amounts.

Year by Year Approach

Section 409A generally provides that amounts deferred under a nonqualified deferred compensation plan are includible in income unless certain requirements are satisfied. The proposed regulations interpret this rule to provide that failures to comply with §409A(a) apply to amounts deferred under a plan in the year in which the failure occurs and all previous taxable years, to the extent such amounts are not subject to a substantial risk of forfeiture and have not previously been included in income.

As a result, each taxable year is analyzed independently with respect to whether there is a failure. Amounts associated with a failure are required to be included in income for that year, with applicable tax paid. A failure in one year does not, however, continue to taint amounts deferred under the plan in a subsequent year in which there is no failure. A further consequence is that amounts are includible in income in the year of failure. The proposed regulations do not provide taxpayers with a mechanism for current inclusion of income related to a failure from a prior year.

In addition, to the extent that amounts that are unvested in the year of a failure, there is no income inclusion, unless the facts and circumstances indicate that the service recipient has a pattern or practice of permitting failures to avoid the requirements of §409A. In such event, Treasury and the IRS have the authority to disregard the substantial risk of forfeiture if necessary to carry out the purposes of §409A.

Determination of Amount Deferred

Under the proposed regulations the amount of income includible for failure to satisfy §409A(a) is the "total amount deferred" under the plan for the service provider's taxable year and all preceding taxable years, less the portion of the total amount deferred for the taxable year that is either unvested or has been previously included in income. In calculating these amounts, the plan aggregation rules apply.

Calculation of the Total Amount Deferred as of the Last Day of the Taxable Year
The total amount deferred is determined as of the last day of the service provider's taxable year, and is equal to the present value of future payments to which the service provider has a legally binding right under the plan as of such date. In addition, any payments of deferred amounts to, or on behalf of, the service provider during such taxable year are added back to the total amount deferred.
Notional earnings or losses and additional amounts deferred during the year are simply netted against one another in determining the value as of the last day of the taxable year. Thus, in an example provided, if a service provider's account balance were $10,000 at the beginning of the year, defers an additional $5,000 during the year, and has notional losses of $2,000, with no distributions during the year, the total amount deferred at the end of the year is $13,000 ($10,000 plus $5,000 minus $2,000).
In addition, because the determination is as of the last day of the year, the proposed regulations do not distinguish based on the timing of actions inside the year. For example, it is not relevant whether a distribution is made prior to the occurrence of the operational failure, because it occurred during the taxable year of the failure, it is added into the total amount deferred as of the end of the year. Similarly, it is not relevant that an amount was deferred under the plan after the occurrence of an operational failure; it is also taken into account as part of the total amount deferred as of the end of the year.
A similar approach is taken with respect to amounts that, under the terms of the plan and facts and circumstances as of the last day of the taxable year, may satisfy the short-term deferral rule. These amounts are not included in the calculation of the total amount deferred. If a payment is not paid within the short-term deferral period, the amounts will be included in the total amount deferred with respect to the year in which the short-term deferral period ended. The change in status does not require an adjustment to the total amount deferred as of the end of the first year, however.
Calculation of the Total Amount Deferred: General Principles
Generally, the total amount deferred is the present value as of the last day of the taxable year, determined using reasonable actuarial assumptions and methods. If the assumption or method used is not reasonable, as determined by the Commissioner, the total amount deferred is determined using the applicable federal rate (based on annual compounding for the last month of the taxable year for which the income inclusion amount is being determined) and, if applicable, the applicable §417(e) mortality table.
The regulations provide general rules for determining the present value of payments, which include the following:
- Payment Triggers Based on Events: If the payment trigger is based on an event rather than a specific date, the proposed regulations provide assumptions for determining time until payment. Generally, a payment trigger would not be taken into account if the payment would be considered unvested if such trigger were the only applicable payment event. For instance, if an amount is payable upon the earlier of attainment of a specified age or an involuntary separation from service and the involuntary separation provision would be a substantial risk of forfeiture, then the involuntary separation provision is disregarded. If assumptions are required as to when a payment trigger would occur, taxpayers are generally required to assume that the trigger would occur at the earliest possible time that the conditions reasonably could occur, based on the facts and circumstances as of the last day of the taxable year. There is a special rule for determining the present value for distributions upon a separation from service. In such event, the distribution event is treated as occurring as of the last day of the taxable year. Given the difficulty creating assumptions regarding the time of separation from service, the IRS is requesting comments on alternative standards that may be utilized for valuing distributions upon separation from service.
- Alternative Times and Forms of Payment: Generally, amounts that are payable pursuant to alternative times and forms of payment are treated as payable at the time and in the form of payment for which the present value is highest. A time and form of payment is available to the extent a deferred amount may be payable in such time and form of payment under the plan's terms. If there is a bona fide requirement for the service provider to continue performing services after the end of the taxable year to be eligible for the time and form of payment, the payment alternative would not be treated as available.
- Formula Amounts: Generally, if as of the last day of the taxable year, an amount to be paid in a future year is based on a formula, the amount payable in the future year must be determined using reasonable assumptions. This rule does not apply to amounts that are based on information that is not readily available, if such information exists as of the end of such taxable year.
- Payment Restrictions: Restrictions on deferred amounts that are not substantial risks of forfeiture or are risks of forfeitures that may be disregarded due to a pattern or practice of that violates §409A(a) will be disregarded for purposes of determining the total amount deferred under the plan.
Calculation of the Total Amount Deferred: Specific Rules
The regulations also provide rules for determining the amount deferred under specific arrangements. The general rules described above apply in conjunction with the following rules for specific arrangements.
- Account Balance Plans: The present value of amounts deferred under an account balance plan is equal to the amount credited to the service provider's account as of the last day of the taxable year, including earnings or losses credited through the last day of the taxable year.
- Nonaccount Balance Plans: The total amount deferred for a taxable year under a nonaccount balance plan is the present value of deferred amounts as of the last day of the taxable year, discounted to reflect the time value of money, using reasonable actuarial assumptions and methods as provided under the general rules.
- Stock Rights: If an option or stock appreciation right is outstanding as of the last day of the taxable year for which the total amount deferred is being calculated, the total amount deferred under the stock right is equal to the spread between the fair market value of the underlying stock on the last day of the taxable year over the exercise price, less any amount paid for the stock. If an option or stock appreciation right has been exercised during the taxable year, the total amount deferred is the spread between the fair market value on the date of exercise and the exercise price, less any amount paid for the stock.
- Separation Pay Arrangements: Amounts payable only on an involuntary separation from service are generally considered subject to a substantial risk of forfeiture. As a result, the total amount deferred under these arrangements is not required to be calculated until the service provider has involuntarily separated from service.
- Reimbursement and In-Kind Benefit Arrangements: Amounts deferred under these arrangements are treated as providing for a formula amount to the extent the maximum amount that may be reimbursed is not set forth in the arrangement. In this case, the total amount deferred would be based on the maximum amount that reasonably could be expended and reimbursed. If a limit is provided under the arrangement, it is presumed that the limit reflects the reasonable amount of eligible expenses that the service provider will incur at the earliest possible date while the limit applies and that the service provider will request the reimbursement at the earliest possible date. This presumption is rebuttable by clear and convincing evidence that it is unreasonable to assume that the service provider would incur such an amount of expenses during such time period.
- Split-Dollar Life Insurance Arrangements: With respect to split-dollar life insurance arrangements that are subject to Treas. Reg. § 1.61-22 or 1.7872-15, the total amount deferred is determined under the income inclusion rules of such regulations. For arrangements that were entered into before September 17, 2003 and not subject to Treas. Reg. § 1.61-22 or 1.7872-15, the total amount deferred is determined under Notice 2002-8 and any other applicable guidance.
- Foreign Arrangements: The total amount deferred under foreign plans is determined using the same rules that would apply if the plan was not a foreign arrangement.
- Other Plans: If an arrangement is not considered one of the arrangements referenced above, the present value of payment would be determined using the general rules.
The Commissioner may disregard the present value rules for specific arrangements if it is determined that plan has been designed to eliminate or minimize the total amount deferred under the plan.
Calculation of Unvested Amounts and Amounts Previously Included in Income
The unvested portion of total amount deferred for a taxable year is determined as of the last day of the taxable year, and such amounts are not taken into account in the calculation of the total amount deferred. Amounts that vest during the year in which the failure occurred are treated as vested for purposes of §409A(a), regardless if vesting occurs before or after the failure, and thus are taken into account in the calculation.
Additionally, amounts that have previously been included in income are not taken into account for purposes of calculating the total amount deferred. Consistent with the overall approach of analyzing each year independently, the proposed regulations provide that amounts are considered previously included in income only if the service provider included the amount in income under an applicable provision of the Internal Revenue Code for a previous taxable year, including on an original or amended return, as a result of IRS examination or a final decision of a court of competent jurisdiction. The amount previously included in income is reduced to reflect any payments made during the taxable year, as these amounts also reduce the total amount deferred after the year of distribution. Other adjustments are also provided.
For failures that occur in multiple years, each year is analyzed independently to determine if amounts were includible in income. As a result, amounts must be includible in income for each year in which a failure occurs. A failure that occurs in multiple years is not corrected if amounts are only included in income for the last year in which the failure occurred. Income inclusion is required for each year in which the failure occurred.

Determination of the Additional 20% and Premium Interest Taxes

The amount includible in income is the difference between the total amount deferred less the sum of the unvested amounts and amounts previously included in income. This amount is subject to the additional 20% and premium interest taxes. The additional 20% and premium interest taxes are additional income taxes, subject to the rules governing assessment, collection, and payment of income tax, are not excise taxes, and with respect to the premium interest tax, is not interest on an underpayment.

The proposed regulations provide guidance regarding how to calculate the premium interest tax. The premium interest tax is applied to the amounts required to be included in income under §409A(a) for the taxable year, but which were first not subject to a substantial risk of forfeiture in a previous year. The premium interest tax is determined as the amount of interest at the underpayment rate (established under §6621) plus 1% on the underpayment that would have occurred had the deferred compensation been includible in gross income for the taxable year in which the amounts were first deferred or vested (hypothetical underpayment).

In determining the amount deferred and vested in prior years, the proposed regulations provide assumptions that will tend to reduce the amount subject to the premium interest tax. For example, payments are assumed to be made out of the oldest amounts deferred under the plan (rather than on a pro rata or other allocable basis). Deemed losses and other amounts included in income would similarly be treated on a "first in first out" basis.

The hypothetical underpayment is calculated taking into account the taxpayer's taxable income, credits, filing status, and other tax information of the year, based on the original return filed for such year, as adjusted as a result of any examination of such year or any amended return accepted by the IRS. This means that changes cannot be made based on assumptions that were not taken into account in the return. For instance, the taxpayer may not assume that some of the additional compensation would have been deferred under a qualified plan. As a result, the hypothetical underpayment would reflect the effect the additional compensation would have on the amount of federal income tax owed by the taxpayer for such year, including the continued availability of deductions taken, and the use of carryover items.

Treasury and the IRS have indicated that they understand that the premium interest tax calculation provided in the regulations may be cumbersome. As a result, they are considering safe harbor calculation methods for the premium interest tax. Specifically, they are requesting comments on methods that would more easily identify the taxable year or years during which an amount includible in income was first deferred and vested, and that would more easily determine the hypothetical underpayments applicable to such years.

Treatment of Payments and Forfeitures After Amounts Are Included in Income under §409A(a)

The proposed regulations provide that if a service provider includes an amount in income under §409A, the service provider will have a deemed basis in such amounts, so that amounts are not subject to tax a second time. As a result, if an amount under a plan would be includible in income under an Internal Revenue Code section other than §409A, the amount previously included in income would be immediately applied to the amount paid under the plan. The allocation of amounts previously included in income is on a first in first out basis, much like the rules outlined above, so that distributions are excluded from income until all amounts previously included are accounted for. The service provider cannot elect the extent to which amounts previously included in income will be applied. Earnings on amounts included in income and previously included amounts may continue to be subject to §409A. The §409A plan aggregation rules apply.

Additionally, if a service provider has included deferred amounts in income under §409A, but actually receives less than the amount included in income, the service provider may take a deduction equal to the amount included in income, less amounts allocated to a previously included amounts. For these purposes, a deferred amount is treated as permanently lost if the service provider's right to payment becomes wholly worthless during the taxable year. A mere diminution in the deferred amount due to deemed investment loss, actuarial reduction or other decreases in the deferred amount is not treated as a permanent forfeiture or loss if the service provider retains the right to the amount deferred under the plan. The plan aggregation rules apply, which means that whether a right to payment is permanently forfeited or lost is determined by looking at all amounts that remain under the plan. If a service provider is entitled to a deduction, to the extent the service recipient has benefited from a deduction or the inclusion in the service provider's income, the service recipient may be required to recognize income under the tax benefit rule and §111, or make other appropriate adjustments.

Anticipated Guidance

Treasury and the IRS anticipate issuing interim guidance during 2008 addressing the extent to which taxpayers may rely on these proposed regulations. Interim guidance is also expected to address the calculation of amounts includible in income and additional taxes under §409A(b) and service recipient reporting and withholding obligations with respect to amounts includible in income under §409A(a) or (b) for taxable years beginning before the final regulations become applicable. It is anticipated that such interim guidance will provide that taxpayers may rely on these proposed regulations in their entirety, but that taxpayers may not rely on part, but not all, of the proposed regulations.

Notice 2007-89 permanently waives the reporting requirement for annual deferral for 2007 Forms W-2 and Forms 1099. Notice 2006-100 permanently waives the annual deferral reporting requirements for 2005 and 2006 Forms W-2 and Forms 1099. Treasury and the IRS anticipate that annual deferral reporting will be implemented beginning with the first taxable year for which these proposed regulations are finalized and effective. As a result, Code Y reporting is not required for 2008. It is anticipated that annual deferral reporting rules will be based on principals set forth in the proposed regulations as finalized, except that taxpayer will not be required to report amounts that are not reasonably ascertainable (as described in the §31.3121(v)(2) regulations) until such amounts become reasonably ascertainable. In addition, it is anticipated that amounts reported would include earnings on amounts deferred in previous years, if such amount is reasonably ascertainable.

With respect to income inclusion reporting and income tax withholding, Notice 2007-89 provided guidance for 2007 Forms W-2 and Forms 1099, and Notice 2006-100 provided guidance for 2005 and 2006 Forms W-2 and Forms 1099. Treasury and the IRS anticipate issuing interim guidance during 2008 on income inclusion reporting for 2008 Forms W-2 and Forms 1099 for taxable years beginning before the final regulations are effective. They also anticipate issuing interim guidance in 2008 on a service recipient's income tax withholding obligations for calendar years beginning before the final regulations are effective. It is anticipated that such interim guidance will provide that taxpayers may rely on these proposed regulations in their entirety, but that taxpayers may not rely on part, but not all, of the proposed regulations.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

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