• Additional Guidance on Code Section 409A: What must be done before January 1, 2006?
  • October 28, 2005
  • Law Firm: Orrick, Herrington & Sutcliffe LLP - San Francisco Office
  • On September 29, 2005, the Treasury Department and IRS released long-awaited additional guidance on the new Section 409A of the Internal Revenue Code ("409A"). Although the guidance, which is in the form of proposed regulations, spans nearly 240 pages, it does not address some important issues.1 We intend to publish a series of Client Alerts, of which this is the first, that will briefly summarize the most important areas covered by the proposed regulations. This Client Alert specifically addresses the very important question: "What must be done before January 1, 2006?"


    409A imposes new restrictive Federal tax rules governing "nonqualified deferred compensation plans" and provides significant taxes on individuals who violate them. IRS Notice 2005-1, which was issued on December 20, 2004, provided initial 409A guidance, including generous transition relief, in the form of 38 questions and answers. (See Client Alert: Initial Guidance on 409A) Much of that initial guidance and transition relief is incorporated into the proposed regulations.

    Proposed Regulations

    In general, the proposed regulations extend most (but not all) of the transition relief until December 31, 2006. As a result, while compliance with 409A was required in operation as of January 1, 2005 (for those plans not "grandfathered" under 409A), the proposed regulations extend a plan sponsor's ability to rely on the "good faith" compliance standard in Notice 2005-1 until December 31, 2006. Furthermore, a plan sponsor's reliance on the proposed regulations will be deemed "good faith" compliance.

    "What Must Be Done Before January 1, 2006?"

    Terminate Grandfathered Plan.
    If a plan sponsor wants to amend a grandfathered plan to allow its termination, followed by the distribution of amounts previously deferred, the plan must be amended before December 31, 2005. Under the proposed regulations (like Notice 2005-1), if a grandfathered plan is amended after December 31, 2005 to provide the plan sponsor with new authority to terminate the plan and distribute benefits, the plan will lose its grandfathered status and become subject to 409A.

    Terminate Participation or Cancel Deferral Election under Non-Grandfathered Plan.
    A plan must be amended before December 31, 2005 to give participants the right either

    • to terminate their participation in a non-grandfathered plan and receive a total distribution; or to cancel an outstanding deferral election covering amounts subject to 409A.

    • The proposed regulations (like Notice 2005-1) provide that the anti-acceleration and deferral provisions of 409A will be violated if a non-grandfathered plan is amended after December 31, 2005 to allow participants to either terminate participation or cancel a deferral election.

    Rescind Material Modifications Made in 2005.
    If a grandfathered plan has been materially modified (i.e., enhancing a benefit or adding a new benefit) after October 3, 2004, then, in general, the plan would lose its grandfathered status and be subject to 409A. However, under the proposed regulations, a plan sponsor has until December 31, 2005 to rescind a material modification that was made in 2005, unless the benefit had been previously exercised. If the material modification is rescinded timely, then the plan will regain its grandfathered status.

    Distribute Amounts from Terminated Grandfathered Plan and from Terminated Participation or Cancelled Election under Non-Grandfathered Plan.
    As discussed above, if a grandfathered plan is terminated, then all amounts deferred under the terminated plan must be distributed and taken into income in 2005. Furthermore, if a participant terminates his/her participation or cancels a deferral election (both under a non-grandfathered plan), then the amounts covered by the termination or cancellation must be distributed and taken into income in 2005 (or the tax year in which the amounts are earned and vested, if later).

    Make Payment for "Lost Discount" Following Adjustment of Discounted Stock Right.
    Although the proposed regulations extend until December 31, 2006 the ability to cure discounted stock rights (i.e., cancel and re-grant) in order to avoid being treated as a nonqualified deferred compensation arrangement, if the employer (or other service recipient) wishes to compensate the participant for the "lost discount," then the "make-whole" payment must be taken into income in 2005, unless it is subject to vesting.

    Make Deferral Elections for 2006 Compensation.
    In general, participants must make deferral elections with respect to compensation to be earned for services performed in 2006 on or before December 31, 2005. Participants also must specify the time and form of distribution at the time the deferral election is made.

    Make Deferral Elections for Bonus Earned in 2006.
    Similarly, participants must make deferral elections with respect to a bonus earned for services performed in 2006 (but payable in 2007 or later) on or before December 31, 2005, unless the bonus qualifies as "performance-based compensation."2 The deferral election for the bonus must specify the time and form of distribution. If the bonus will constitute "performance-based compensation," performance criteria for the bonus must be established in writing within 90 days from start of the performance period.

    "What Can Wait Until after December 31, 2005?"

    Other than the exceptions described above, nonqualified deferred compensation plans do not need to be amended to comply with 409A until December 31, 2006. In particular, the deadline of December 31, 2005 has been extended one year:,/p>

    • to amend documents to comply with 409A;
    • to permit new distribution elections that will not be treated as a change in the form and timing or an acceleration of a distribution; and
    • to unlink distribution elections with respect to nonqualified deferred compensation that are tied to the timing and form of distribution under a tax-qualified retirement plan (provided that this conforms to the terms of the nonqualified plan in effect on October 3, 2004).

    However, plans must be (and, since January 1, 2005, must have been) operated in accordance with a "good faith, reasonable interpretation" of 409A.

Coming Attractions

Be on the lookout for our continuing series of 409A Client Alerts that will cover, among other things, the application of the proposed regulations to severance pay arrangements and "specified employees," stock rights and private company valuations, deferral and distribution elections, and the coordination ("linkage") between nonqualified deferred compensation plans and qualified plans.

IRS Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication, unless expressly stated otherwise, was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matter(s) addressed herein.

1 The proposed regulations fail to address the following:(i) the methodology for calculating deferral amounts or income inclusion amounts as a result of violating 409A; (ii) the timing of income inclusion (and related withholding obligations); and (iii) the types of arrangements, such as offshore trusts, that will be prohibited under 409A for funding nonqualified deferred compensation plans and the tax consequences for such prohibited arrangements.

These issues will be addressed in future guidance from the IRS and Treasury Department.

2 The proposed regulations define "performance-based compensation" to mean "compensation where the amount of, or entitlement to, the compensation is contingent on the satisfaction of preestablished organizational or individual performance criteria relating to a performance period of at least 12 consecutive months in which the service provider performs services."See Prop. Reg. ยง1.409A-1(e)(1).