04.16.2007
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Updates
Last week the IRS issued the long-awaited final regulations under Section 409A of the Internal Revenue Code, which generally provides that amounts deferred under a "nonqualified deferred compensation plan" are currently includible in taxable income if not subject to a substantial risk of forfeiture, unless the plan meets specified design and operational requirements. Failure to comply with the applicable requirements of Section 409A can result in significant income tax consequences, including a 20% additional tax imposed on the employee or independent contractor.
This Update summarizes the key highlights from the final regulations and offers practical advice.
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Many Typical Compensation Arrangements May Be Nonqualified Deferred Compensation Plans Subject to Section 409A. Section 409A defines "nonqualified deferred compensation plan" so broadly that any compensation arrangement, formal or informal, that results in the deferral of taxation on compensation may be covered, even agreements that cover only one person. Common types of arrangements that may be subject to the requirements include the following:
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Key Highlights From Section 409A Final Regulations
Retained December 31, 2007 Section 409A Compliance Deadline. The Section 409A final regulations did not extend the Section 409A compliance deadline. All companies have until December 31, 2007 to take a series of required steps to get their covered plans, programs and agreements into compliance with the final regulations. In the meantime, companies must continue to administer covered arrangements in good faith compliance with Section 409A and Notice 2005-1 or, alternatively, in compliance with the proposed regulations or the final regulations. In some cases, an exemption or grandfathering relief may apply.
Practical Tips Only Eight Months Left to Complete Section 409A Compliance – Start Now! All employers should immediately identify and begin reviewing all their formal and informal compensation arrangements to identify those that may be treated as covered nonqualified deferred compensation plans and that may require them to take steps to get these compensation arrangements into compliance with the final regulations by December 31, 2007. As the next step, we recommend that each company create a time and responsibilities schedule for the steps identified to get covered compensation arrangements into compliance with the final regulations to facilitate timely completion of this process. Companies May Not Have to Amend Plans Retroactively. While companies must generally amend a covered plan, program or agreement by December 31, 2007 to reflect compliance with Section 409A as of January 1, 2008, the final regulations do not require companies to bring a covered plan, program or agreement into compliance retroactively if the company can otherwise substantiate compliance during the transition period (calendar years 2005 through 2007), such as through election forms or internal memoranda. |
Relief on Extending a Stock Option's Post-Termination Exercise Period. Companies can now generally extend the post-termination exercise period for a stock option exercise to the earlier of
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the original maximum term of the option and
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10 years from the original date of grant.
In addition, the exercise period for an underwater option can generally be extended beyond the option's original maximum term.
"Good Reason" Safe Harbor. Employees terminating employment for "good reason" within the meaning of the final regulations, after proper notice and opportunity to cure, may qualify for a new safe harbor that would allow payments upon this type of termination to be treated for purposes of Section 409A as payments upon an involuntary separation from service. "Good reason" terminations that do not satisfy the safe harbor may nevertheless be treated as an involuntary separation from service based on the facts and circumstances.
Adding Deferral Feature Eliminates Exclusion. Adding any deferral feature to otherwise excluded stock compensation creates a covered nonqualified deferred compensation plan that must comply with Section 409A's requirements regardless of whether such deferral feature is used.
Start-Up Company Written Report Safe Harbor Liberalized. The "written report" valuation presumption for illiquid start-up companies is liberalized to reduce from 12 months to 90 days for a change-in-control event, and to 180 days for an initial public offering, the time period companies must look to in reasonably anticipating one of these events that would make the presumption unavailable.
Relief From Deferral Election Timing Requirements for Separation Pay Negotiated at Employment Termination. Employees may make a deferral election made on separation pay negotiated shortly prior to a termination of employment if there is then no preexisting or binding right to such pay and the deferral results from bona fide, arm's-length negotiations.
Flexibility for Determining Separation From Service. The final regulations provide companies with some added flexibility in determining when a separation from service occurs, either based on reduced services or conversions to independent contractor status.
Flexibility for Determining Which Employees Require Delayed Distributions. The final regulations provide public companies with flexibility in how they determine the identity of their "specified employees" for whom 409A distributions must be delayed by six months. This flexibility includes an alternative method that allows public companies to designate all or up to 200 employees as specified employees and detailed rules for dealing with this aspect of Section 409A following mergers and acquisitions, spinoffs and IPOs. The final regulations also clarify that specified employees may generally receive involuntary severance payments up to the lesser of $450,000 or twice their compensation and avoid the six-month delay period.
Retained Definition of Change in Control. The "change in control" definition provided in the final regulations reduces the effective control threshold to 30% (from 35% in the proposed regulations), but otherwise remains mostly unchanged. An IPO will still not constitute a change-in-control event for purposes of Section 409A.
Consistent Valuation Method No Longer Required. Companies may now use different valuation methods for establishing the exercise price of stock and determining the fair market value of stock at the time of exercise.
Limited Relief From Short-Term Deferral Exception Requirements. Companies may now delay a payment and continue to comply with the short-term deferral exception if the payment would jeopardize the ability of a company to continue as a going concern.
Liberalized Definition of Service Recipient Stock. "Service recipient stock" can now generally be any class of common stock of any corporation or parent in the upward vertical chain of control, subject to the restrictions governing certain distribution preferences and other potential limitations (instead of being limited to the class of common stock with the highest value as provided in the proposed regulations), and can even be preferred stock with a liquidation preference, but not with a dividend preference.
Clarified Treatment of Reimbursements and Indemnification Payments. Reimbursements, in-kind benefits and tax gross-ups can generally be structured to meet the fixed time and form of payment requirements of Section 409A. The final regulations clarified that indemnification provisions generally are not treated as a right to defer compensation for purposes of Section 409A.
More Plan Categories Reduce Consequences of 409A Failure. The final regulations expanded the categories for different types of nonqualified deferred compensation plans from three to nine, which will reduce, but not eliminate, the tax fallout for an employee or independent contractor in the event of Section 409A violations where he or she participates in multiple covered arrangements.
Additional Information
Read the full text of the 397-page final regulations at the U.S. Treasury Web site.
You may also find the following Perkins Coie Updates helpful:
- December 2004 Update on Notice 2005-1.
- October 2005 Update on the Section 409A Proposed Regulations.
- December 2005 Update on Valuing Private Company Stock for Compensation Purposes.
- October 2004 Update on the Deferred Compensation Provisions of the American Jobs Creation Act of 2004.
