So Long, 409A? The Tax Cuts and Jobs Act Would Significantly Overhaul Tax Rules Governing Deferred Compensation Arrangements

For the past decade, employers have wrestled with Section 409A of the Internal Revenue Code as they are forced to design their executive compensation arrangements in a way that complies with Section 409A’s rules governing deferred compensation or fits within one of its many complicated exemptions. On November 2, 2017, the U.S. House of Representatives released its proposed Tax Cuts and Jobs Acts bill and took the first shot at significantly overhauling Section 409A. If passed, the Tax Cuts and Jobs Act would remove Section 409A from the tax code (along with its hundreds of pages of regulations) and replace it with a new Section 409B, effectively ending nonqualified deferred compensation as we know it.

Beginning in 2018, Section 409B, in its proposed form, would require any compensation (including equity-based compensation) that is deferred under a nonqualified deferred compensation plan to be included in the service provider’s gross income at the point the service provider vests in his or her rights to the payment (i.e., when there is no longer a “substantial risk of forfeiture” of the service provider’s rights to the payment). Moreover, the service provider’s vesting rights must be based on his or her performance of future services to the company. Vesting rights could not be based on the service provider’s adherence to non-competition obligations or the occurrence of a condition related to a purpose of the compensation other than the future performance of services. This would mean that vesting rights could not be based solely on the achievement of economic or operational performance metrics.

If Section 409B takes effect, it would require the Treasury Department to release new regulations allowing employers to amend existing deferred compensation arrangements to accelerate payments. Any compensation currently being deferred under Section 409A would need to be paid out by 2026 (unless such deferred compensation remains subject to a substantial risk of forfeiture).

Although much needs to happen before Section 409A is officially replaced with Section 409B, or otherwise significantly revised, employers might consider taking steps to prepare for significant changes. For example, employers might consider including provisions in new compensation plans and agreements that would allow the employer to amend the plan or agreement to comply with changes to the deferred compensation rules without the consent of the participant or employee. There may be other aspects employers could begin considering with respect to designing awards, their vesting rights and the times of grant.

Calfee will continue to monitor the tax reform process and its application to deferred compensation and other executive compensation matters. In the meantime, employers and executives may contact us to discuss how these changes may affect their compensation arrangements.