Section 409A of the Internal Revenue Code (IRC§409A) refers to the treatment of compensation that is not taken in the current tax year, or deferred compensation. Guidance provided by the IRS through Final Regulations published in April 2007 in correspondence to the rule provide a straightforward framework for what items are defined under the rules and how they are treated for the purposes of taxation. The regulations also establish rules for the valuation of those items classified as deferred compensation as well as circumstances under which an exception to section 409A applies.

The issue of valuation has come into focus as the IRS seeks to crack down on those employers and employees who, often through no fault of their own, fail to properly appraise or value their deferred compensation arrangements in accordance with the provisions of 409A. It is vital to understand the importance of valuing your deferred compensation plans in accordance with the law and to seek professional assistance in appraising and valuating certain types of arrangements in order to avoid unwanted scrutiny and possible penalties from the IRS.

The Importance of Properly Valuating Deferred Compensation Arrangements
Equity-based arrangements in particular, such as certain Short- and Long-Term Incentive Plans (STIP and LTIP), phantom stock, SERPs and deferred bonuses, are being examined to determine the applicability of 409A and whether plan organizers have applied the proper valuation measure as required under law. Drafting agreements for these and other types of deferred compensation arrangements are scrutinized to determine the applicability of 409A and the method used for valuing the future compensation.

As an example, most nonqualified stock option (NSO) grants used in connection with an executive compensation incentive program fall outside of 409A treatment for tax purposes. This is provided that such grants are valued at an exercise price, at the time of issuance to an executive, that is at or higher than the fair market value (FMV) of the stock at the time when the options are granted to the employee. Should the exercise price be lower than the FMV of the underlying stock, this creates a taxable benefit to the employee, which is not only reportable as income but also subject to a 20% penalty excise tax.

Seeking Assistance to Properly Value Your Arrangements and Maintain Compliance
As the IRS seeks to determine the applicability of section 409A to existing deferred compensation arrangements, it is important to enlist the services of a professional appraiser who is well versed in the rules. The role of the appraiser is to advise you and your company as to the applicability of section 409A to the deferred compensation plans that you have already established, as well as to work alongside your accountants and other financial professionals to ensure that drafting agreements not only fall within the letter of the law but also adhere to it in spirit. Achieving compliance ensures that your intentions of incentivizing those employees whose contributions are vital to the success of your company are met, and that you are not penalized for errors that may have been avoidable.