- IRS extends transition relief for Section 409A nonqualified deferred compensation rules
- October 16, 2006
- Law Firm: Nixon Peabody LLP - New York Office
In a welcome bit of grace, the IRS has extended into 2007 its transition relief for the nonqualified deferred compensation rules of Section 409A of the Internal Revenue Code. In particular, IRS Notice 2006-79:
- Announces that the final regulations will not become effective until January 1, 2008.
- Generally extends through 2007 the transition relief that would otherwise have closed as of the end of 2006, except with respect to certain discounted stock rights of public companies subject to backdating issues.
- Extends through 2007 the ability to link a nonqualified plan distribution payment election to qualified retirement plans.
- Extends the amendment date for certain plans that took advantage of transition relief provided for 2005 and for certain collectively bargained plans.
Work to do
While this extension relieves the pressure for year-end plan amendments, sponsors of nonqualified deferred compensation plans still will have work to do. In particular:
- Plan sponsors should become fully familiar with the proposed Section 409A tax rules to ensure that their plans are operated in compliance with a good-faith interpretation.
- Employers should identify all deferral arrangements subject to Section 409A, including, potentially, bonus plans, employment agreements, and severance arrangements.
- Plan sponsors should consider what design changes are appropriate in light of the Section 409A rules.
- Nonpublic companies that grant stock options or stock appreciation rights should have reasonable valuation methodologies in place to set the fair market value of the exercise price of the stock grants.
- Finally, plan sponsors should be prepared to make necessary plan amendments following the issuance of final regulations later this year.
Section 409A in general
Section 409A sets forth comprehensive tax rules for nonqualified deferred compensation plans. In brief, Section 409A limits the flexibility in the timing of elections to defer compensation; restricts distributions while employed to fixed dates, certain changes of control, or extreme financial hardship; prohibits accelerated distributions of deferred compensation; prevents key employees of public companies from receiving deferred compensation until at least six months after termination of employment; and prevents deferrals of distribution dates or changes in the form of payment unless made at least one year in advance of the scheduled distribution date and the new distribution date is at least five years after the prior distribution date.
If these rules are not followed, a participant is immediately taxed on the value of his/her deferred compensation once it is no longer subject to a substantial risk of forfeiture. Additionally, the participant will have to pay a 20-percent excise tax on the amount that is included in his/her income, as well as an interest penalty. Section 409A treats as nonqualified deferred compensation not only traditional supplemental retirement plans, but also many other arrangements, such as certain discounted stock grants and executive severance arrangements. For a more detailed description of the scope of Section 409A, please refer to our October 20, 2005, and January 10, 2006, Benefits Alerts.
Plan amendment deadline and good-faith operational compliance
The IRS previously provided guidance on Section 409A transition relief in a notice issued in late 2004 and in proposed regulations issued in October 2005. Under the proposed regulations, the final regulations were proposed to become effective January 1, 2007. The Treasury Department and the IRS anticipate that the final regulations will be published in 2006. To allow sufficient time for taxpayers and their representatives to analyze the final regulations and come into compliance, the IRS now expects the effective date for the final regulations to be January 1, 2008. Accordingly, the date by which plans must be amended to comply with Section 409A has been extended to December 31, 2007.
However, the 409A statute is effective with respect to all nonqualified deferred compensation that has been accrued or vested on or after January 1, 2005. Therefore, the IRS continues to require that nonqualified deferred compensation plans be operated in good-faith compliance with Section 409A even before January 1, 2008. For example, if an employer retains the discretion under the terms of a plan to delay or extend payments under the plan in a manner that violates Section 409A, and does exercise that discretion, the plan will not be considered to be operated in good-faith compliance with Section 409A with regard to any plan participant.
Distribution payment election changes
With respect to amounts subject to Section 409A, a plan may be amended to provide for new elections on or before December 31, 2007, with respect to both the time and form of distribution payment of such amounts. The election or amendment will not be treated as a change in the time or form of payment or a prohibited acceleration of a prohibited payment under Section 409A, provided that the plan is so amended and elections are made on or before December 31, 2007.
With respect to an election or amendment to change a time and form of payment made during 2006, the election or amendment may apply only to amounts that would not otherwise be payable in 2006 and may not cause an amount to be paid in 2006 that would not otherwise be payable in 2006. With respect to an election or amendment to change a time and form of payment made during 2007, the election or amendment may apply only to amounts that would not otherwise be payable in 2007 and may not cause an amount to be paid in 2007 that would not otherwise be payable in 2007. So, for example, where an amount would otherwise be payable upon an event, such as a separation from service, an election in 2006 cannot change the amount that would be payable in 2006 if the participant separated from service in 2006.
A plan or participant may make more than one distribution election change under this relief, provided that each such change is made in accordance with the deadlines and conditions set forth in the applicable transition relief. For example, a participant who, in 2005, elected to change the time and form of payment of deferred compensation to a lump sum payment in 2010 may elect again, in 2006 or 2007, to change the time and form of payment in accordance with the proposed regulations. However, a participant who, in 2005, elected to be paid an amount in 2006 may not, in 2006, change the time and form of payment to be paid in a later year.
Plan amendments for 2005 deferral elections
Section 409A generally requires that elections to defer compensation for a calendar year be made before that year begins. IRS guidance issued in late 2004 provided a one-time grace period for making elections for deferrals of compensation that were to be earned in 2005, generally providing that certain requirements would not be applicable to 2005 elections made on or before March 15, 2005. The 2004 guidance generally required that plans be amended by December 31, 2005. That March 15, 2005, deadline for initial deferral elections was not explicitly extended in the preamble to the proposed regulations; however, the plan amendment requirement generally was extended to December 31, 2006. To avoid unintentional noncompliance in this area, the deadline for a plan to be amended to reflect use of the one-time 2005 deferral election relief has been extended to December 31, 2007. However, taxpayers retain the burden of demonstrating satisfaction of the requirement by showing that the deferral election was actually made by March 15, 2005.
Distribution elections linked to a qualified plan distribution election
The ability to link distributions under a nonqualified deferred compensation plan to an election under a qualified plan has also been extended through 2007. In addition, this relief is extended to payment elections under nonqualified deferred compensation plans that are linked to certain additional employer plans, including Section 403(b) annuities, Section 457(b) eligible plans, and certain foreign broad-based plans.
Stock options and stock appreciation rights
Discounted stock options and stock appreciation rights, where the exercise price is below the fair market value of stock at the time of grant, are generally treated as nonqualified deferred compensation subject to Section 409A. Prior IRS guidance allows substitutions of non-discounted stock options and stock appreciation rights for discounted stock options and stock appreciation rights. Except with respect to certain discounted stock rights described below, the period during which the cancellation and reissuance may occur is extended until December 31, 2007, but only to the extent such cancellation and reissuance in 2007 does not result in the cancellation of a deferral in exchange for cash or vested property in 2007. For example, a discounted option generally may be replaced through December 31, 2007 with an option that would not have provided for a deferral of compensation, although the exercise of such a discounted option in 2007 before the cancellation and replacement generally would result in a violation of Section 409A.
The transition relief is not extended with respect to certain discounted stock rights of public companies subject to backdating concerns. The transition relief provided in the preamble to the proposed regulations and described in Notice 2006-79 is not extended for any stock option or stock appreciation right (“stock right”) that (A) was granted with respect to stock of a corporation required to be registered under federal securities laws; (B) was granted to a person who was an executive subject to the disclosure requirements of section 16(a) of the Securities Exchange Act of 1934; and (C) with respect to the grant of such stock right, such corporation either has reported or reasonably expects to report a financial expense due to the issuance of a stock right with an exercise price lower than the fair market value of the underlying stock at the date of grant that was not timely reported on financial statements or reports for the period in which the related expense should have been reported under generally accepted accounting principles.
Extension for collectively bargained plans
Notice 2006-79 also creates a new extension for certain nonqualified deferred compensation arrangements for union employees. A nonqualified deferred compensation arrangement maintained pursuant to one or more collective bargaining agreements in effect on October 3, 2004 is not required to comply with the provisions of Section 409A on or before the earlier of the date on which the last of such collective bargaining agreements terminates (determined without regard to any extension thereof after October 3, 2004) or December 31, 2009.