The gist of the section makes sense. Essentially, Congress (I hope I'm not attributing more logic to them than they deserve) wanted to ensure that participants in nonqualified deferred compensation plans (NQDC) couldn't get treatment preferable to that of the rank and file in qualified retirement plans. For example, there are generally restrictions on when an individual can receive on an unpenalized basis a distribution from a qualified plan. Section 409A seeks to ensure that the deal is no better in the NQDC world.
The tax penalties for failure to comply with 409A are severe. I've discussed them many times. Essentially, a failure is subject to 20% additional income tax (a marginal tax rate of 39.6% becomes 59.6% on that money) plus interest on underpaid taxes at the federal underpayment rate plus 1%. That's pretty severe.
Despite the IRS having announced that they had started an executive compensation audit program, more than a few companies have been cavalier in their efforts to comply with 409A.
They should perhaps reconsider.
I say this in response to a Federal Court ruling in Sutardja v US. Often, I provide my readers with a link to these cases so that they can experience all the excitement in reading the decision that I have, but this time I am refraining. There just wasn't enough excitement. However, here is a synopsis.
- Dr. Sutardja is the CEO of Marvell Technology Group Limited
- On 12/10/2003 (note that 409A became law in late 2004), the Board of Marvell approved a grant of not more than 2 million stock options to Dr. Sutardja. The closing stock price that day was $36.19.
- On 12/16/2003, the Compensation Committee of the Board approved a grant of 1.5 million shares to Dr. Sutardja at an exercise price of $36.50, the stock price on that day.
- Said grant was ratified on 1/16/04 when the stock price was $43.64 (Alert: alarm bells go off ... discounted stock option alert).
- In January 2006, Dr. Sutardja exercised some of his options. He paid an additional amount to make up for the perhaps incorrect grant price.
- The IRS hit Dr. Sutardja and his wife with a tax bill for a 409A penalty for more than $5 million.
- After the Court went through a whole lot of technical mumbo jumbo, it ruled in favor of the IRS.
So, what's the point?
Marvell could have handled this more cleanly. 409A wasn't a glimmer in anyone's eyes when they authorized or granted the options. While they didn't use an approved method, Dr. Sutardja and Marvell tried to use what they viewed as good faith to fix the issue. Dr. Sutardja and his wife lost.
The real point is that Congress intended that 409A be a revenue raiser for the United States. The IRS is trying to live up to that intent. Now, there are procedures in place to fix 409A problems. Most companies don't have the expertise to do that internally. Depending on the NQDC plan in question, review of the plan including its administration may appropriately be done by some combination of attorneys, tax experts, compensation experts and retirement plan experts. Often, it should include people from more than one of these categories.
If you engage such people to conduct a review, one of three things can happen and two may be better than the alternative:
- They will find no problems because there are no problems.
- They will find problems and you can use approved correction procedures before the IRS finds the problems.
- They will not find any problems, but the IRS will (this is the one bad one, but I think it's unlikely if your experts are really experts).
Consider conducting such a review.