Focus On Employee Benefits
Exec Comp: Qualification of Bonuses as “Performance-Based Compensation” for Purposes of Section 409A Should be Reviewed Before Year-End
Anne Batter and Garrett Fenton
Employers who have allowed deferral elections to be made with respect to bonus compensation in reliance on the six-month rule in Internal Revenue Code (Code) section 409A(a)(4)(B)(iii) should review their decisions in light of the changes made to the definition of performance-based compensation in the final regulations, the upcoming end of “transition” under section 409A, and the January 1, 2009, effective date of the final regulations. If bonus deferral elections are currently expected to be made in 2009 using the six-month rule, but it is determined that the change in the definition of performance-based compensation in the final section 409A regulations makes the bonus ineligible for deferral under the six-month rule, the last opportunity for making the deferral election likely will be at the end of 2008.
The performance-based compensation rule in section 409A(a)(4)(B)(iii), and the associated regulations, provides an exception to the general requirement that a deferral election for compensation earned in a taxable year be made no later than the close of the preceding taxable year. If compensation qualifies as performance-based, the deferral election can be made at any time until six months before the end of the current performance period. The legislative history to section 409A (H. Rept. 108-755 at 732 (Conf. Rept. 2004)) and the preamble to the proposed regulations (70 Fed. Reg. 57930, 57943 (Oct. 4, 2005)) both indicate that performance-based compensation for purposes of this election rule is intended to cover bonuses that meet certain requirements similar to those for a section 162(m) performance bonus, but not all requirements for a section 162(m) bonus. This history suggested that, at a minimum, bonuses that qualified as performance-based compensation under section 162(m) would qualify for the six-month election rule. Although this is still generally true, the final regulations added an important wrinkle to the definition of performance-based compensation for purposes of section 409A, which on the one hand incorporates more elements of the section 162(m) performance plan requirements, while on the other hand makes it less clear that even section 162(m) plans will necessarily qualify for the six-month election rule. The critical language in the final regulations provides that compensation may be deemed performance-based, even if it will be paid regardless of the satisfaction of specified performance criteria “due to the service provider’s death, disability, or a change in control event (as defined in [Treas. Reg.] § 1.409A-3(i)(5)(i)).” For this purpose, not only is a “change in control” defined as a section 409A change in control, but “disability” is defined as an impairment that results in the employee’s inability to perform the duties of his or her position or any substantially similar position, where such impairment can be expected to result in death or can be expected to last for a continuous period of not less than six months.
Notwithstanding the similarity of the “death, disability or change in control” language in the final section 409A regulations to that in the section 162(m) regulations, it is not clear that even section 162(m) bonus plans that have already been amended to comply with Revenue Ruling 2008-13 will qualify as performance-based compensation for purposes of section 409A. (Recall that Revenue Ruling 2008-13 announced the IRS’s more conservative position on the meaning of the section 162(m) regulations, holding that bonus plans that pay at target in the case of involuntary termination or retirement do not result in deductible performance-based compensation even when bonuses are actually paid based on achievement of performance goals to employees who do not involuntary terminate or retire.) For example, even if a section 162(m) bonus plan (as well as any employment or change-in-control agreements that impact the plan) has been amended to comply with Revenue Ruling 2008-13, so that provisions allowing a target bonus to be paid on involuntary termination or retirement have been removed, the plan may not necessarily define “disability” or “change in control” as specified in the section 409A final regulations, making it unclear whether the section 409A definition of performance-based compensation is met. Thus, even section 162(m) compliant plans need to be reviewed to determine whether, in the case of target amounts payable upon disability and/or change-in-control, those terms are defined in compliance with the relevant section 409A definitions. If not, deferral elections made with respect to those bonuses using the six-month rule run the risk of violating section 409A as late elections.
In addition, section 162(m) bonus plans that have not been amended to comply with Revenue Ruling 2008-13 (note that the ruling is not by its terms effective with respect to 2009 annual bonuses if the performance period begins no later than January 1, 2009, so many bonus plans will not yet be amended), as well as bonus plans that were never intended to be performance-based compensation for section 162(m) purposes, often do provide for (or provide the employer with discretion to pay) a target payout in the event of certain kinds of termination, such as involuntary terminations, terminations in connection with a potential change in control, layoffs and reductions-in-force, and in the event of retirement. Even if the bonus plan does not so provide, an employment agreement or severance arrangement may do so. Given that the applicable rule added to the final section 409A regulations essentially parallels the requirement in the section 162(m) regulations, concerns have arisen that that the standard of Revenue Ruling 2008-13 has been incorporated for section 409A deferral election purposes as well. It is not clear that this is what the IRS and Treasury intended when they added the language to the final regulations, considering that at the time the language was added, Revenue Ruling 2008-13 had not been published, and the prevailing Private Letter Ruling guidance indicated that allowing target payments on involuntary termination would not take away from a plan’s qualification as a performance-based plan under section 162(m). It is also curious to suggest that the Revenue Ruling 2008-13 standard should apply to 2009 annual bonuses for purposes of section 409A when it is not yet applicable by its term for purposes of section 162(m).
Ultimately, companies wishing to be assured that their bonus programs are within the performance-based compensation deferral rules of section 409A will need to revisit whether the final regulations effectively incorporate the Revenue Ruling 2008-13 standards, if so, when those standards begin to apply, and whether the bonus programs at issue would thus be treated as performance-based compensation for deferral election purposes.
Payroll Tax & Fringe Benefits: IRS Issues Guidance on Interest Free Adjustments and Cross-Border Payments
Thomas Cryan and Michael Lloyd
Two recent developments in the withholding area that should be of interest to employers are the recently issued interest free adjustment regulations and new guidance in the Internal Revenue Manual (IRM) regarding U.S. withholding agent examinations. On July 1, 2008, the Treasury issued final regulations in Treasury Decision 9405 regarding employment tax adjustments and employment tax refund claims. These regulations, which are effective on January 1, 2009, are issued under sections 6205, 6402, 6413, and 6414 of the Internal Revenue Code (Code) and address changes to existing procedures under which employers make payroll tax adjustments. Most notably, the regulations restrict the availability of interest-free adjustments for employer-identified underpayments of Federal Income Tax Withholding (FITW) taxes made after the calendar year in which the wages were paid to three situations: (1) where the error is attributable to an administrative error (an error involving an inaccurate reporting of the amount actually withheld), (2) section 3509 applies to determine the amount of the underpayment (i.e., worker classification disputes), or (3) when the IRS identifies the underpayment of FITW taxes on audit and includes the adjustment on a Form 2504 (Agreement to Assessment and Collection of Additional Tax and Acceptance of Overassessment). Accordingly, under the final regulations, employers may not be able to obtain an interest-free adjustment for underpayment of FITW in the case of a closing agreement following a voluntary disclosure of an error to the IRS unless the IRS formally prepares a Form 2504. Employers should be cognizant of this additional administrative hurdle when attempting to settle FITW underpayments for prior years. The preamble to the regulations also references the development of new forms for use in making employment tax adjustments, including refunds. A draft Form 941X (Adjusted Employer’s Quarterly Federal Tax Return or Claim for Refund) can now be found on the IRS website.
Since the close of the IRS’s voluntary compliance initiative described in Rev. Proc. 2004-59, it has been rumored that the IRS is planning to more aggressively enforce the requirements for withholding and reporting cross-border payments, including payments to nonresident alien individuals. These rumors were fueled by public statements by IRS personnel encouraging employers to review the state of their compliance efforts with respect to payments to nonresident alien individuals. On July 29, 2008, the IRS issued guidance to field examiners regarding U.S. Withholding Agent Examinations. See IRM § 4.10.21. The examination guidance focuses on cross-border payments by all industries and suggests Initial Data Requests be issued to inquire into the taxpayer’s internal procedures to identify payments subject to withholding and reporting. The absence of business procedures to identify payments to nonresident aliens may be interpreted by examiners as an indicator of noncompliance, which may prompt a more in-depth examination. The manual also instructs examiners to “consider all applicable penalties,” including failure to file penalties, failure to pay penalties, deposit penalties, accuracy-related penalties, fraud penalties, and information reporting penalties. As a consequence of these new examination guidelines, employers should consider taking steps to ensure that they are complying with the cross-border payment withholding and reporting rules. Failure to do so may prove costly if the examination guidelines are administered as contemplated and the enumerated penalties are applied.
ERISA Litigation: Posting SPD on Company Intranet does not Satisfy ERISA’s Disclosure Requirements
Susan Relland and Garrett Fenton
As illustrated by a recent unpublished Ninth Circuit Court of Appeals decision (Gertjejansen v. Kemper Insurance Companies, Inc., No. 06-563929 (9th Cir. 2008)), employers should use caution in determining how to distribute required disclosure documents - such as Summary Plan Descriptions (SPDs) - to plan participants, particularly when considering the use of electronic means. As a general rule, an SPD must be distributed in a manner that is reasonably calculated to ensure actual receipt by the participants. This would include, for example, hand-delivering the document to the employee at the workplace; mailing it to the participant via first class mail, or a lower class if return and forwarding postage is guaranteed and address correction is requested; or delivering the SPD via electronic communication, provided that certain specific requirements are satisfied.
The Gertjejansen case apparently provides one bright-line rule regarding electronic delivery of SPDs: posting the document on the employer’s intranet site, alone, is not a sufficient means of distribution under ERISA and the relevant Department of Labor (DOL) regulations. In the Ninth Circuit’s view, such distribution will warrant a court’s use of a de novo standard of review (as opposed to the more deferential abuse of discretion standard) as to a denial of benefits. The DOL has provided guidance on this issue, propounding safe harbor regulations to help employers use electronic media when distributing documents and notices. See DOL Reg. § 2520.104b-1(c). While the safe harbor does not provide the exclusive means by which disclosure requirements may be satisfied, electronic distributions that satisfy the regulations will be deemed to have met the distribution requirements for necessary disclosures. For example, electronic SPD delivery would generally be sufficient with respect to an employee who uses a work-related computer, and has one at his or her desk, but would be insufficient if the computer was merely made available for use by an employee who did not otherwise have work-related access. Given the specific rules and safe harbor, employers should review their distribution methods with respect to required disclosures, such as SPDs, to ensure compliance with the relevant requirements.
Qualified Plans: IRS Refines its Fix-It Program -- The Employee Plan Compliance Resolution System (EPCRS) -- in Revenue Procedure 2008-50
Fred Oliphant and Barbara Graham
In Revenue Procedure 2008-50, the IRS has issued its latest enhancement to its correction programs for qualified plans that allow plan sponsors to correct plan failures without the plan losing its qualification status. The three components of EPCRS have not changed: (1) the Self-Correction Program (SCP); (2) the Voluntary Correction Program (VCP), and (3) the Audit Closing Agreement Program (Audit CAP), but the Revenue Procedure makes a number of modifications to those programs, which are briefly highlighted below.
The new Revenue Procedure will allow streamlined VCP submissions for certain common plan failures, provided the submissions follow the formats provided in the Revenue Procedure without modifications. The failures covered by the new streamlined submission procedure include the failure to administer plan loans in accordance with Internal Revenue Code (Code) section 72(p)(2) and also the failure to adopt timely discretionary amendments to implement optional law changes specified in the Revenue Procedure, for example, the optional good faith EGTRRA amendment to allow catch-up contributions.
In addition to streamlining the application and reducing the fee in some instances for plan loan failures, the new Revenue Procedure will allow corrections for such failures even if the plan document does not provide that the loans must comply with Code section 72(p)(2). One advantage of submitting plan loan failures under VCP is that if the correction requires the reporting of a deemed distribution to the participant on a Form 1099-R, the plan sponsor may request that the deemed distribution to the participant be reported on the 1099-R for the year of correction rather than the year of failure. Note, however, the plan sponsor must now specifically request this relief in the VCP submission. (This relief is not available under SCP or Audit CAP). It bears keeping in mind that for plan loan failures to be eligible for VCP, the failure must not simply be due to an individual employee’s failure, such as failure to repay on time, but must represent a systematic failure of some kind on the part of the plan sponsor.
Often a correction method involves making an earnings adjustment to a corrective distribution or contribution. In the new Revenue Procedure the IRS is now allowing the use of the Department of Labor’s Voluntary Fiduciary Correction Program (VFCP) Online Calculator to determine this earnings adjustment. The plan sponsor must show, however, it is not feasible to make a reasonable estimate of what the actual investment results would have been.
This Revenue Procedure provides some clarification on when a determination letter should or should not be submitted in the context of a VCP submission or correction under Audit CAP where a plan amendment is part of the correction. The rules are complex but in general whether such an application is required will depend upon the type of plan amendment and whether the VCP submission or correction under Audit CAP occurs in an on-cycle or off-cycle year. An on-cycle year refers to the last 12 months of the plan’s remedial amendment cycle. For example, if a plan sponsor files a VCP submission during an off-cycle year for failure to adopt timely an amendment to allow catch-up contributions, then the VCP submission should not include a determination letter application. The compliance statement issued by the IRS in the VCP process will treat the amendment as timely made but the plan sponsor will still need to submit the amendment along with the compliance statement with a determination letter application in the plan’s on-cycle year. Certain other nonamender failures require a determination letter application even during an off-cycle year.
Health & Welfare: Prohibitions on Health Plan Opt-Out Incentive Options
Both Medicare and TRICARE prohibit employers from offering any financial or other incentives to Medicare or TRICARE-eligible employees to not enroll, or to terminate enrollment, in an employer-sponsored group health plan that is or would be primary to Medicare or TRICARE. Medicare principally covers individuals age 65 and older. TRICARE covers active duty and military retirees and their families. For the most part, both Medicare and TRICARE are intended to pay secondary to employer-sponsored coverage. (One common exception is that Medicare pays primary to retiree coverage.)
The TRICARE provision was adopted in October 2006 as part of the John Warner National Defense Authorization Act for Fiscal Year 2007 and the incentive prohibition took effect January 1, 2008. In March 2008, the Department of Defense (DOD) published proposed regulations on the coordination of TRICARE with employer-sponsored health plans. 73 Fed. Reg. 16612 (March 28, 2008). The proposed rules closely follow the Medicare Secondary Payer rules issued by the Centers for Medicare and Medicaid Services.
Under the DOD regulations, an employer may not offer TRICARE beneficiaries an alternative to the employer’s plan unless either the beneficiary has primary coverage other than TRICARE or the benefit is a cafeteria plan offered to all employees, including those who are not TRICARE-eligible. As with the Medicare rules, if the employee elected to receive cash under the cafeteria plan instead of health coverage, the employee could use the cash to individually purchase a TRICARE Supplement plan. However, an employer may not directly sponsor a TRICARE Supplement plan or offer such coverage as an option under the cafeteria plan because it would not be available to all employees and would improperly target TRICARE beneficiaries.
An employer’s health plan may be affected by these rules if, for example, employees or their spouses are over age 65 or in the military reserves and called to active duty but remain on the employer’s health plan. These employers should ensure that their group health plans pay primary to Medicare and TRICARE and that no plan provisions or company policies prohibit Medicare or TRICARE-eligible employees from participating. In addition, plans may not offer these employees an incentive to opt out of the employer’s coverage. A feature becoming more common with employers is to offer employees a cash incentive not to enroll in the employer’s plan. Such a provision would violate the Medicare or TRICARE rules for individuals who are eligible for those programs.
For further information, please contact any of the following lawyers:
Michael Lloyd, firstname.lastname@example.org, 202-626-1589
Fred Oliphant, email@example.com, 202-626-5834
Garrett Fenton, firstname.lastname@example.org, 202-626-5562