Guest Article

(From the March 20, 2006 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Common Compensation Arrangement and Section 409A Trap

An arrangement that offers a participant a choice among various forms of compensation must comply with the deferral election requirements of IRC § 409A if one of the forms offered is deferred compensation subject to section 409A, even if the employee chooses a form that is otherwise exempt. In essence, the choice should be timed such that any choice of section 409A deferred compensation would be timely.

Deferral Election Requirements

In general, under section 409A an irrevocable deferral election has to be made before the beginning of the service year. Deferral elections relating to performance-based compensation are permitted as late as six months before the end of the performance period, provided that the performance period is at least 12 months long and the service provider performs services continuously from the time when performance criteria were established through the date of the election. In addition, a deferral election cannot be made after the compensation has become both substantially certain to be paid and readily ascertainable. New plan participants are permitted to make deferral elections within 30 days after initial plan eligibility, but only with respect to compensation earned for service performed subsequent to the election. Additionally, if the arrangement provides for a legally binding right subject to a forfeiture condition, the deferral election can be made during the first 30 days after the grant, provided that the participant is required to perform services for at least 12 months after the date of an election.

Example 1. ABC Corp. sponsors a performance-pay plan that offers participants a choice of restricted stock units ("RSUs") or nonqualified options based on services performed during a calendar year. If a participant elects options, they will receive vested options with an exercise price equal to the fair market value at the date of grant that meet the stock option exception to section 409A. If the participant elects RSUs, they will receive vested RSUs with a specified distribution date (i.e., death, disability, separation from service, specified time, unforeseeable emergency or change in control), which meets the definition of deferred compensation subject to section 409A.

Solution 1. The choice between receiving compensation that is subject to section 409A and compensation that is not must be made in accordance with the section 409A deferral timing rules even if the employee elects the arrangement exempt from section 409A. In this example, the deferral election for compensation earned throughout 2007 must be made by June 30, 2007 because the compensation meets the requirements to be considered "performance-based." If that was not the case, the deferral election would be required by December 31, 2006.

Example 2. Assume the same facts as in Example 1 except now the choice is options or RSUs that pay out immediately upon vesting and meet the short-term deferral exception.

Solution 2. Because this plan offers a choice between two alternatives, neither of which is subject to section 409A, the timing of the deferral election is not required to follow the section 409A rules. In this situation, the general rules of constructive receipt under section 451 would apply.

Minor differences in distribution form or deferral timing elections may have significantly different section 409A effects. Deloitte professionals need to be continually vigilant to ensure plans that offer a choice among distribution alternatives are thoroughly reviewed and considered in light of section 409A.

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 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, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608 , Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2006, Deloitte.