The IRS recently released its much anticipated final regulations (the "Regulations") under Section 409A of the Code. The Regulations and related supplementary explanation expand on many of the key issues that were previously addressed in IRS Notice 2005-1 and the proposed regulations. Notably, however, the Regulations do not extend the transition period for complying with Section 409A, and therefore employers will need to bring their plans into compliance by year end.
Section 409A and the Final Regulations
In enacting The American Jobs Creation Act of 2004 (the "Act"), Congress made far-reaching changes to the rules governing deferred compensation arrangements. The new rules, contained in Section 409A of the Code, affect virtually all existing nonqualified deferred compensation arrangements and are generally effective for amounts deferred on or after January 1, 2005. Failure to satisfy the requirements of Section 409A will result in the acceleration of taxation to the recipient, substantial interest and an additional 20% tax in the year in which such compensation is no longer subject to a substantial risk of forfeiture.
After extensive review and consideration of the numerous comments received from employers and practitioners on the proposed regulations, the IRS has issued final regulations to guide and assist employers in implementing the requirements of Section 409A to both new and existing arrangements. In view of the extensive scope of the Regulations, the following discussion is limited to a summary of select key provisions that employers must be cognizant of as they move forward in developing their Section 409A compliance programs. Future advisories will provide a more in-depth analysis of discrete aspects of Section 409A and the Regulations. For a general summary of Section 409A, please refer to our Tax Advisory "New Law Makes Dramatic Changes to the Rules Governing Deferred Compensation," dated October 27, 2004.
Effective Date and Transition Rules
Effective Date Provisions — The Regulations are generally effective for tax years beginning on or after January 1, 2008. Until such time, the standards and transition rules in Notice 2006-79 will remain in effect. Accordingly, while a plan is not required to comply with the Regulations prior to the effective date, for periods before January 1, 2008, interim compliance with the Regulations, the proposed regulations or IRS Notice 2005-1 will be considered to be "good faith" compliance with Section 409A.
Transition Relief — Under IRS Notice 2006-79 (the "Notice"), the IRS extended a variety of transition rules that were intended to afford employers sufficient time to comply with Section 409A. The transition period was scheduled to expire December 31, 2006, but in light of the IRS's delay in issuing the final regulations under Section 409A the IRS has extended certain transition rules through December 31, 2007. For a general summary of Notice 2006-79, please refer to our Tax Advisory "IRS Extends Transition Relief for Nonqualified Deferred Compensation Plans," dated October 2006.
Stock Option and SARs
The Regulations have made a number of favorable changes to the rules governing stock options and stock appreciation rights ("SARs"):
Service Recipient Stock — The Regulations retain the concept that a stock option or SAR granted with respect to service recipient stock will generally be exempt from Section 409A, provided that certain specific requirements are satisfied. Under the Regulations, however, the definition of service recipient stock has been broadened to include stock of any corporation in a chain of organizations all of which have a controlling interest in another organization, beginning with the parent organization and ending with the organization for which the service provider was providing services at the date of grant. For this purpose, a controlling interest generally means at least a 50% ownership interest (although this threshold can be lowered to at least 20% if supported by legitimate business reasons).
Although not entirely obvious from the language of the Regulations, the IRS has indicated that stock option awards can go up the chain, but not down the chain. For example, it would be permissible to issue a stock option for parent corporation stock to an employee providing services to a subsidiary corporation, but it would not be permissible to issue a stock option for subsidiary stock to an employee providing services to the parent corporation. Similarly, the stock of a brother/sister corporation also appears to fall outside the definition of service recipient stock.
Modification and Extensions — The Regulations retain the rules that generally treat extensions of the exercise period of a stock option or SAR as an additional deferral feature (thereby retroactively tainting the award back to the date of grant). Notwithstanding, the Regulations expand on the proposed regulations by providing that the extension of an option exercise period generally is not treated as an additional deferral feature or a modification of the stock option if the exercise period is not extended beyond the earlier of: (i) the original maximum term of the option; or (ii) 10 years from the original grant date. The Regulations go even further with respect to underwater options (i.e., options where the FMV of the underlying stock equals or exceeds the exercise price), by providing that an extension of an underwater option does not constitute a deferral feature.
Stock Option Gain Deferral — The Regulations explicitly provide that stock option deferral techniques are not compatible with Section 409A, and that an option that includes a provision permitting the deferral of option gain will not satisfy the time and form of payment rules under Section 409A if the service provider can exercise the option in more than one taxable year.
Separation Pay Arrangements
Involuntary Termination — The Regulations retain an exemption from Section 409A with respect to separation pay made in connection with an involuntary termination (or participation in a window program). The exemption generally applies to payments made no later than the second taxable year following the year of separation, and is limited to amounts that do not exceed the lesser of two (2) times: (i) the service provider's annual compensation (for the preceding year); or (ii) the Section 401(a)(17) limit (for the current year). For 2007, this exemption would permit a maximum benefit of $450,000 for individuals whose compensation exceeds $225,000.
Unlike the proposed regulations, this exemption will continue to apply even in situations where the entire separation payments exceed the applicable limit. Accordingly, if a service provider is entitled to a payment that exceeds the limit, only the excess will be subject to Section 409A. For example, this could potentially permit immediate payment of up to $450,000 for 2007 without violating Section 409A (including the requirement that the payment be delayed for six months in the case of a specified employee of a publicly traded company).
Good Reason Terminations — The Regulations also contain a favorable change indicating the circumstances under which a separation from service for "good reason" can qualify as an involuntary termination. Under the prior regulations, the IRS expressed concern that "good reason" termination provisions lacked materiality thresholds and therefore did not function as a substantial risk of forfeiture. This position was particularly problematic for key employees of publicly traded corporations as it would potentially subject the good reason termination payments to the six-month delayed payment provisions.
Under the Regulations, a service provider's voluntary separation from service will be treated as an involuntary separation if the separation occurs under conditions that effectively constitute an involuntary separation. Accordingly, the Regulations provide that the good reason condition must be defined to require actions taken by the service recipient that result in a material negative change to the employment relationship, such as the duties performed, the conditions under which the duties are to be performed, or the compensation to be received for such services. The Regulations also set forth safe harbor "good reason" termination provisions for purposes of satisfying the "involuntary termination" definition.
Short-Term Deferral Exception
Under the short-term deferral rule, a deferral of compensation does not generally occur if the payment of the compensation is made no later than the fifteenth (15th) day of the third month following the later of the end of: (i) the service provider's first taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture; or (ii) the service recipient's first taxable year in which the right to payment is no longer subject to a substantial risk of forfeiture. The Regulations narrow the short-term deferral exception by essentially providing that it does not apply to any plan that provides for a "deferred payment." A plan will be considered to provide for a deferred payment if the plan provides that any payment will be made or completed on or after any date (or the occurrence of any event) that will or may occur after the end of the applicable 2½ month period (e.g., a specified date, or upon separation from service, death or disability).
The Regulations liberalize the standards under which certain delayed payments can qualify as a short-term deferral where the payment is delayed due to unforeseeable events. Under the proposed regulations, a delayed payment can qualify as a short-term deferral if timely payment would have jeopardized the service recipient's solvency and such insolvency was unforeseeable at the time the right to the payment arose. The Regulations now provide that a payment may be delayed where the payment would jeopardize the ability of the service recipient to continue as a going concern.
The Regulations generally require that plans be amended on or before December 31, 2007, to comply with Section 409A. Amendments are required only to bring the documents into compliance on January 1, 2008, and are not required to reflect any amendments made or actions taken under the transition rules to the extent such amendments or actions do not affect the plan's compliance with Section 409A for periods on or after January 1, 2008. Notwithstanding, a plan must be able to demonstrate that the plan was operated in compliance with transition guidance, including demonstrating that amounts were paid in compliance with transition rules.
What Employers Should Do Now
In light of the extension of the transition rules pursuant to Notice 2006-79 through December 31, 2007, employers continue to have the opportunity to take advantage of the transition relief offered under Notice 2006-79. Accordingly, employers contemplating offering new payment elections and/or modifying distribution options during the transition period will need to effectuate those changes prior to year end. Similarly, to the extent non-discounted stock options need to be substituted for discounted stock options, the cancellation and reissuance will need to occur in 2007.
With respect to compliance with the final regulations, employers will need to chart a course of action, including: inventorying existing deferred compensation plans; selecting among the alternative approaches offered under the final regulations; amending plans and developing employee communications. Section 409A defines the term "nonqualified deferred compensation" very broadly to include any arrangement that provides for the deferral of compensation (other than qualified retirement plans, bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plans). As a result, employers will need to evaluate a broad range of programs, including but not limited to:
- Employment agreements
- Change-of-control agreements
- Sevarance plans/separation agreements/window benefits
- Equity incentive plans (stock options, SARs, RSUs, PSU, dividend equivalents)
- Annual bonus programs, including performance based arrangements
- Long-term incentive programs
- Traditional deferred compenstation arrangement (e.g., salary/bonus deferrals/non-employee director arrangements)
- Tax gross-up provisions (280G, 409A)
- Split-dollar arrangements
- SERPs and other supplemental plans
- Post-retirement benefits and reimbursement arrangements
- Indemnification provisions
- Employee stock purchase plans (Section 423 and non-Section 423 plans)
- Tax equalization payments
- Expatriate benefits and subsidies
- Commission programs
For additional information on this subject, please contact John E. McGrady, III at 412-562-1388 or firstname.lastname@example.org. This newsletter is a publication of Buchanan Ingersoll & Rooney PC and is intended to alert the readers to developments in the tax law. It does not constitute legal advice or a legal opinion on any specific facts or circumstances. The contents are intended as general information only. You are urged to consult your own attorney or tax advisor concerning your situation and specific legal questions you may have on Section 409A.