Following the U.S. Congress’ lead, on April 10 the IRS issued final regulations under Section 409A of the Internal Revenue Code. If the rules seemed unclear before, they are crystal clear now: Most of the so-called “419(e)” plans as well as the remaining 419A(f)(6) plans are in violation of the law and subject to hefty penalties.
A 419(e) plan is a benefit plans that generally seeks to make the purchase of life insurance tax-deductible to employers. While the concept is appealing, most of the existing arrangements have permitted the plans to transfer the insurance policies to the participants upon retirement.
The Purpose of 409A
Code Section 409A was enacted into law on Oct.10, 2004, to provide some uniformity and to impose several requirements upon nonqualified deferred compensation plans and similar arrangements. The new rules imposed include a required written plan agreement; a limit of payments to death, disability, or retirement; a substantial risk of forfeiture to avoid immediate taxation to the employee; and timing limitations on benefit distributions.
Congress drafted Section 409A broadly to include any payment to an employee after the year for which it was paid or after termination of employment, unless the payment falls under one of the named exceptions. Exceptions include payments within 75 days, COBRA benefits, de minimis cash-outs paid in the year of termination of employment, etc.
409A Applicability to Welfare Benefits
Section 409A does not apply to welfare benefits. In fact, several forms of welfare benefits are specifically excluded under 409A. However, such excluded arrangements do not permit transfer of property to the participant except for death, disability, and payments made upon retirement in accordance with the 409A rules.
Most of the existing 419(e) and 419A(f)(6) welfare benefit plans do not comply with the 409A rules relative to transfers of insurance policies or cash payments other than upon death.
Compliance and Effective Dates
Significant penalties apply for noncompliance with section 409A. In addition to having compensation included in income, tax penalties equal to the IRS underpayment rate plus 1 percent from the time the compensation should have been included in income, plus 20 percent of the compensation amount, apply. Additional penalties may apply for failure to report the arrangement appropriately.
When Section 409A was added, employers and consultants scrambled to comply because the rules were effective for years beginning after 2004 for all arrangements entered into after Oct. 3, 2004. Existing arrangements were given until the end of 2005 to comply. However, IRS granted an extension for compliance for employers who made a “good-faith” effort to comply with the rules. Under the Final Regulations, plans have until Dec. 31, 2007 to be in full compliance.
Effect on CPAs, Plan Sponsors and Others
Under Circular 230 standards a CPA or attorney who advises his or her client about participating in a non-compliant welfare benefit plan may be liable for fines and other sanctions. The authors expect that opinion letters relative to such welfare benefit plans have either been withdrawn or will be shortly, and we admonish professionals to review carefully all communications with clients relative to such plans. The IRS has recently been successful in imposing huge fines on several law firms for blessing questionable transactions.
Sponsors of 419 plans have two choices: totally eliminate distributions from their plans (except medical reimbursement or death benefits), or comply with Code Section 409A and the regulations there under.
Employers have until Dec. 31 to be in compliance. Employers who have adopted 419 plans must choose immediately whether to remain in their current 419 plan, cancel their participation in such arrangement and have their benefits distributed by Dec. 31, or transfer to a plan that is fully compliant with the new rules.