While businesspeople are making their rounds at holiday gatherings this winter, some tax attorneys, accountants and other tax professionals are likely to be at their desks, completing last-minute inspections of clients' deferred-compensation arrangements in anticipation of an end-of-the-year compliance deadline under the federal tax laws.

Section 409A of the Internal Revenue Code was enacted into law by Congress as part of the American Jobs Creation Act of 2004 and has, in many ways, transformed tax analysis with respect to deferred-compensation arrangements.

This section was enacted by Congress in the wake of the corporate scandal involving Enron Corp. and, in part, based on determinations by a joint congressional committee investigation that Enron executives were able to defer millions of dollars in federal income taxes through nonqualified deferred-compensation arrangements, while the value of retirement plan accounts of other Enron employees declined precipitously due to the high level of investment in Enron stock in those accounts.

Section 409A has been characterized by some practitioners and commentators as being "deceptively simple." This observation is primarily attributable to the fact that the focal point of 409A - the term "nonqualified deferred compensation plan" - is simply defined, but the term is interpreted to encompass a broad spectrum of deferred-compensation arrangements, including deferred amounts under executive employment agreements, bonus arrangements, excess benefit or "top hat" plans, plans that mirror qualified retirement plans, change in control arrangements, certain bonus programs and certain severance arrangements.

Under 409A, distributions of deferred compensation to employees, independent contractors, officers and directors under these arrangements are only permitted in specific situations, such as where the service provider: (1) has a separation of service, (2) experiences an unforeseen emergency, (3) suffers a disability or (4) dies. Additionally, distributions are permitted in a case where the company experiences a "change of control" or where the payments are made to the service provider pursuant to a fixed schedule of payment dates and amounts in place at the time of the deferral.

Detailed rules associated with each of these permitted scenarios have been furnished in the final regulations issued by the Treasury Department in 2007. Arrangements that permit distributions for any other reason generally will not comply with the requirements of Section 409A.

Significant penalties are imposed to the extent a deferred compensation plan that is subject to Section 409A violates its requirements. If such a deferred-compensation arrangement fails to comply with 409A, all compensation deferred in the current year and prior years will be includible in taxable income. Further, the tax imposed on that income will be increased by the underpayment interest rate plus 1 percent, retroactive to the date that the original deferral was made. Additionally, a penalty tax of 20 percent of the amount included in income will also be due. These significant tax consequences apply to service providers, regardless of the fact that the affected participant may have had no control over the action that triggered noncompliance with Section 409A. From an employer perspective, failure to comply with the 409A requirements will result in employer tax penalties for any deficiencies regarding reporting and withholding.

Given the sweeping impact of 409A and the related Treasury regulations, practitioners have requested additional time from the Internal Revenue Service to ensure compliance with the new deferred-compensation requirements. In response to these requests, the Internal Revenue Service has indicated that full compliance with the 409A requirements will not be mandatory until Jan. 1, 2009.

As this deadline approaches, practitioners are currently in the process of reviewing existing deferred-compensation arrangements to determine whether amendments to those arrangements are necessary in light of the mandates of Section 409A and the related regulations.

In the course of reviewing existing deferred-compensation arrangements, there are a variety of considerations that practitioners must keep in mind for Section 409A purposes.

For example, deferred compensation that has been "earned and vested" by a service provider as of Dec. 31, 2004, would not ordinarily be subject to the 409A requirements, but a subsequent material modification to the underlying arrangement could cause the deferred compensation to fall within the purview of 409A.

Additionally, the examination of deferred-compensation plans must involve the review of each of the arrangements individually as well as on a collective basis, in view of specific aggregation requirements under 409A.

Finally, though existing arrangements may contemplate the payment of deferred compensation in the event of a change of control, practitioners must nonetheless inspect these arrangements, as definitions of "change of control" that have typically been used in the past by practitioners vary somewhat from the definition reflected in the 409A regulations.

Faced with the task of reviewing existing deferred-compensation arrangements against the complex and detailed requirements of the 409A Treasury regulations, the significant penalties for 409A noncompliance and the looming deadline at year's end, tax practitioners in this area are likely to have their hands full for the remainder of 2008.

Benjamin Farber is an associate at Phillips Lytle LLP. He can be reached at bfarber@phillipslytle.com.