On June 21, 2016, the IRS issued proposed regulations intended to amend and clarify the current regulations under Section 409A of the Internal Revenue Code of 1986, as amended ("409A"). 409A contains strict rules that govern most forms of deferred compensation. Prior to the new proposed regulations, the IRS had not issued formal 409A guidance since the correction procedures issued in 2010 (click here for more information), and had not issued proposed regulations under 409A since 2008.

The proposed regulations primarily provide clarifications to the existing 409A regulations that are consistent with how most practitioners interpret 409A. However, the proposed regulations also make certain critical, substantive modifications to the 409A regulations.

Changes to Unvested Deferred Compensation

The 2008 proposed regulations provide that an amount deferred under a plan that otherwise fails to comply with 409A is not required to be included in income under 409A to the extent the amount is subject to a substantial risk of forfeiture (i.e., is nonvested). Many practitioners have interpreted this provision broadly to allow for changes to nonvested deferred compensation that would not otherwise be permissible under 409A. The proposed regulations limit the changes that can be made to nonvested deferred compensation to modifications made in good faith to bring a plan into compliance with 409A, and also restrict the manner in which such corrections can be made.

Separation from Service Definition

A "separation from service" (for employees, generally a termination of employment) is a permissible payment event (that is, an event that can trigger payment of deferred compensation under 409A). Under the current 409A regulations, if an employee terminates employment but continues to perform services as a consultant or otherwise as an independent contractor, they are not considered to have a separation from service until the consulting relationship is also terminated. The proposed regulations modify this rule and provide that an employee will be considered to have a separation from service if the number of hours they will provide as a consultant are sufficiently lower than the employee previously provided.

Other Clarifications and Changes

The proposed regulations make numerous other clarifications and modifications to the existing regulations, including:

  • Expanding the short-term deferral exception;
  • Adding flexibility for payments following a service provider's (or their beneficiary's) death;
  • Adding a payment timing rule applicable to all 409A provisions;
  • Clarifying the rules governing termination and liquidation of a deferred compensation plan; and
  • Provide that the 409A stock right exception (e.g., for stock options) applies with respect to an award even if the recipient is not currently providing services for the granting company, so long as it is reasonably expected the individual will begin providing services for the company.

Effective Date

The proposed regulations generally will be effective once they are finalized. However, taxpayers may rely on the proposed regulations immediately. Additionally, the IRS has provided that certain provisions in the proposed regulations are not intended to be substantive changes and are therefore immediately effective.

A copy of the proposed 409A regulations can be obtained here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.