Public company nonqualified plans and incentive plans may need to be amended to avoid a potential violation of Internal Revenue Code (IRC) Section 409A as a result of changes to IRC Section 162(m) under the Tax Cuts and Jobs Act. This amendment most likely is required for employers that mandated deferrals of amounts that exceeded the limit under IRC Section 162(m) but not those whose plans permitted but did not require deferrals of such amounts. Nevertheless, an employer that actually exercised such discretion with respect to non-grandfathered amounts may need to amend such arrangements as well. That is because the act eliminated the performance-based exception to the $1 million deduction limit under IRC Section 162(m) for “covered employees” of publicly traded companies, along with other related changes. Proposed regulations under IRC Section 162(m) indicate that companies may need to amend their nonqualified plans or incentive compensation plans (or potentially both) to avoid an inadvertent violation of IRC Section 409A’s anti-acceleration rules. Otherwise, payment of non-grandfathered incentive awards could subject participants to additional taxes and penalties of 20% or more. We explain further in this blog.
Background on IRC Section 162(m)
As background, IRC Section 162(m) has always contained a general $1 million deduction limitation for payments to “covered employees” of public companies. Before the act amended IRC Section 162(m), qualified performance-based compensation was not counted towards the $1 million limit. Further, a covered employee in one taxable year would not necessarily be on in another taxable year. As a practical matter, once an employee terminated service, that person would no longer be a covered employee.
Background on IRC Section 409A
IRC Section 409A governs payments of nonqualified deferred compensation (NQDC). Failure to follow strict election and payment timing rules subjects amounts deferred to immediate taxation, plus an additional 20% tax (and potential underpayment interest and penalties). In general, these rules require payments to be made only upon certain limited times, and accelerations or delays in payment can trigger those additional taxes unless an exception applies. The regulations under IRC Section 409A contain such an exception. An employer may delay payments under nonqualified plans if the employer reasonably anticipates that its tax deduction would be limited under IRC Section 162(m). As a practical matter, application of this exception typically resulted in delays of payments of incentive awards from a specified vesting date to termination of employment. Some companies hard-wired a mandatory deferral requirement in their plans under these circumstances, while others retained discretion to delay payment or not.
The Tax Cuts and Jobs Act’s changes to IRC Section 162(m)
The act amended IRC Section 162(m) to (1) eliminate the performance-based exception to the $1 million deduction limit and (2) provide that once an individual was a covered employee, he or she would remain a covered employee through the date of death, among other changes. As a result, if an employer’s NQDC arrangements provide for delay until the limitation no longer applies, the payment may be delayed long past termination of service, and in some cases, may never be paid at all. If an employer decided to work around this issue by paying the covered employee at termination or an earlier date, that technically would be considered an impermissible acceleration of payment under IRC Section 409A.
Impact on nonqualified plans and incentive plans
Proposed treasury regulations issued in December 2019 provides companies with a transition rule. They may amend their plans by Dec. 31, 2020, to eliminate any previously hard-wired delays.
Under the proposed regulations, a public company employer may continue to delay payment of amounts that are grandfathered from the amended IRC Section 162(m) rules without delaying non-grandfathered amounts. The proposed regulations under IRC Section 162(m) allow employers to amend their nonqualified arrangements to remove any requirement to delay payment if it is reasonably anticipated, at the time of the scheduled payment, that the deduction would not be permitted under Section 162(m). Such an amendment will not be considered a material modification that causes grandfathered awards to lose their grandfathered status, and it will not be considered an impermissible acceleration of payment under IRC Section 409A. The proposed regulations state that plans must be amended by Dec. 31, 2020, and any amounts that would be payable on or before Dec. 31, 2020, according to the amended plan, must be paid by Dec. 31, 2020. Further, any payments that otherwise would have been made on or before Dec. 31, 2020, without the delay must be paid by Dec. 31, 2020.
Because the proposed regulations provide this transition relief with respect to arrangements that required a delay in payment, it suggests that plans that retained discretion as to whether to delay or not may not need to be amended. Instead, those plans could continue to retain discretion. Employers who sponsor these plans, however, should be aware that if they exercised such discretion, they could be delaying payment for an indefinite amount of time with no ability to accelerate the payment date. Employers may still want to review such arrangements and determine whether it is prudent to amend them anyway.
The proposed regulations suggested that the IRS would issue further guidance under IRC Section 409A to provide more details. The IRS has not issued such guidance, which has led some commentators to wonder if the IRS will extend the deadline to adopt these amendments. As we approach the end of the year, however, it may be prudent to decide now whether it is necessary to amend plans by Dec. 31, 2020.