Article by Ben Delancy and Vicki Nielsen
Section 409A of the Internal Revenue Code imposes detailed requirements on "nonqualified deferred compensation plans," which are broadly defined to include such things as separation pay and certain stock rights in addition to traditional deferral arrangements. Violating those rules causes immediate taxation plus a 20% penalty. Final §409A regulations were released on April 10, 2007, and are scheduled for publication in the Federal Register on April 17, 2007. The regulations are generally effective January 1, 2008. Prior to that date, taxpayers may generally continue to rely on the existing transition guidance. This report identifies many of the significant changes from the September 2005 proposed regulations, some transitional issues addressed in the final regulations, and some of the documentation requirements contained in the final regulations.
Significant Changes from the Proposed Regulations
- Stock Rights: The final regulations significantly expand the definition of service recipient stock and provide much greater flexibility for structuring stock options and stock appreciation rights to avoid §409A, for valuing stock that is not publicly traded, and for extending options without triggering §409A.
- Separation Pay: The final regulations provide greater flexibility for separation pay arrangements, including amounts paid upon separation from service for good reason and the ability to rely on one or more of the exceptions from §409A while also paying amounts that are subject to and comply with §409A. There are also new rules addressing post-termination reimbursements and other fringe benefits.
- Separation from Service: The final regulations liberalize the definition of separation from service, more clearly address the consequences of various leaves of absence, and provide significant flexibility for determining whether a separation from service occurs in the context of corporate transactions.
- Six-month delay for specified employees: The final regulations provide more flexibility for identifying employees subject to the six-month delay. The new rules also significantly alter the identification of the specified employees following a corporate transaction.
- Subsequent elections: The final regulations clarify when companies may add or delete payment events without satisfying the subsequent election rules.
- Plan terminations: The final regulations change the rules applicable to plan terminations, both adding new restrictions and relaxing previously proposed restrictions.
- Plan requirements: The final regulations clarify which provisions must be included in written plan documents, and also clarify that terms of a plan may be provided in more than one document.
Transition From Good Faith Positions
The final regulations describe how plan sponsors can move from the "reasonable good faith" transition period to full compliance. These transition rules address issues such as:
- The treatment of stock rights granted prior to April 10, 2007 (the publication date of the final regulations) that comply with earlier transition guidance but not the final regulations (e.g., fair market value exercise price, extensions, service recipient stock).
- The continued effectiveness of initial deferral elections in effect prior to January 1, 2008, and deferral elections relating to performance-based compensation programs established prior to April 10, 2007.
- The need for elections relating to the time and form of payment to comply fully by January 1, 2008.
- The treatment of participants who are either in pay status prior to January 1, 2008, or who, according to the final regulations, should be in pay status prior to that date.
- The extent to which companies may rely on a good faith application of the 6-month delay for specified employees if a separation from service occurs prior to January 1, 2008.
Documentation Requirements
The final regulations provide that plan documents must fully comply with §409A, effective January 1, 2008. To comply with §409A, plan documents must, generally on or before December 31, 2007, contain:
- The material terms, including the amount (or method or formula) of deferred compensation and the payment schedule or payment triggering events,
- The 6-month delay requirement (for public companies), and
- The conditions for electing deferrals.
The final regulations do not require plan sponsors to amend plan documents to comply for periods prior to 2008; however, the taxpayer must be able to demonstrate that the plan was operated in compliance with the transition guidance, and this will be easier to do if the plan documents are amended to reflect actual operation. In addition, if a plan does not comply with §409A on or after January 1, 2008, that violation will not affect any amounts for any taxable year before January 1, 2008 if the taxpayer can demonstrate operational compliance with the transition guidance.
Click here to view the final regulations and their preamble.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
