United States: Section 409A Meets 162(m) And Some Deferred Compensation Plans And Agreements May Need To Be Amended By December 31

As readers know all too well, Code Sec. 162(m) limits the amount that a publicly-traded company can deduct for payments to a "covered employee" in any year to $1,000,000, with no exception for performance-based compensation. Additionally, after the Tax Cuts and Jobs Act of 2017 ("TCJA"), a covered employee in any year remains a covered employee for all subsequent taxable years (including beyond employment termination and even death).

The Problem: Code Section 409A requires that an arrangement providing for deferred compensation must clearly specify, and must not further defer, the timing of payment of such deferred compensation. However, Treas. Reg. §§1.409A-1(b)(4)(ii) and 1.409A-2(b)(7)(i) provide that a plan or agreement may delay a payment to the extent that the company reasonably anticipates that if the payment were made as scheduled, the company's deduction with respect to such payment would not be permitted due to the application of Code Section 162(m). Some plans and agreements took advantage of this exception to Section 409A by explicitly providing that any payment with respect to which the company's deduction would not be permitted due to Code Section 162(m) would be delayed automatically until the first taxable year in which the company would be entitled to the deduction.

That was fine until the TCJA. However, since a covered employee in any year remains a covered employee for all subsequent taxable years, this language could result in the payments being delayed forever. Further, eliminating the included delay language could itself be a violation of Section 409A rules. This delay in payment trap would not affect plans that allow a delay in payment due to the Section 162(m) deductibility cap, but do not require it.

IRS To the Rescue: Recognizing this problem, the proposed regulation under Section 162(m) issued by IRS and the Treasury Department in December 2019, allow a company to amend its plans and agreement by December 31, 2020, to eliminate any such automatic delay. Even though Treas. Reg. §§1.409A-1(b)(4)(ii) and 1.409A-2(b)(7)(i) provide that the company has discretion to delay a payment, and that the discretion is not required to be set forth in the written plan or agreement, the IRS and Treasury understand that compensation arrangements in effect on November 2, 2017, may explicitly require the company to delay a payment if the company believes the deduction of the payment will not be permitted under Section 162(m).

The proposed regulations provide that if a plan or agreement is amended to remove the provision requiring the company to delay a payment if the company reasonably anticipates at the time of the scheduled payment that the deduction would not be permitted under Section 162(m), then the amendment will not (i) result in an impermissible acceleration of payment under Section 409A, or (ii) be considered a material modification for purposes of the grandfather rule under the amended Section 162(m). The proposed regulations indicate that the IRS and Treasury intend to incorporate these modifications into the regulations under section 409A, and taxpayers may rely on the guidance in this paragraph of the preamble for any taxable year beginning after December 31, 2017, until the issuance of proposed regulations under section 409A incorporating these modifications and permitting taxpayers to rely on such proposed regulations under section 409A.

Grandfather Amounts: Additionally, since the deduction for amounts grandfathered under amended Section 162(m) is not subject to Section 162(m) when paid to a former covered employee who separated from service, the proposed regulations clarify that the payment of these grandfathered amounts may still be delayed consistent with Section 409A. In circumstances in which the company has discretion to delay the payment, a company may delay the scheduled payment of grandfathered amounts without delaying the payment of non-grandfathered amounts, and the delay of the grandfathered amounts will not be treated as a subsequent deferral election.

The IRS and Treasury intend to incorporate these modifications into the regulations under section 409A, and taxpayers may rely on the guidance in this paragraph of the preamble for any taxable year beginning after December 31, 2017, until the issuance of proposed regulations under section 409A incorporating these modifications and permitting taxpayers to rely on such proposed regulations under section 409A.

Action Item: The plan amendment must be made no later than December 31, 2020. Executives earning over $1,000,000 annually may permanently lose deferred compensation benefits if their employer does not take action by December 31, 2020. If, pursuant to the amended plan, the company would have been required to make a payment (or payments) prior to December 31, 2020, then the payment (or payments) must be made no later than December 31, 2020.

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.