Last week the IRS issued Notice 2007-86, which delays until January 1, 2009 the deferred compensation final regulations of Internal Revenue Code Section 409A and generally provides expanded relief and guidance. Notice 2007-86 retains the deadline of December 31, 2008 to adopt documents that comply with Section 409A, but no longer requires employers and other service recipients to designate compliant payment timing and form provisions in 2007. It also extends until December 31, 2008 some, but not all, transition relief. Last week the IRS separately issued Notice 2007-89, which generally extends for the 2007 tax year prior IRS guidance to employers and other service providers regarding reporting and withholding obligations for annual deferrals of compensation and amounts includible in gross income due to Section 409A violations.
This update summarizes key aspects of both notices and provides practical guidance.
Background on Section 409A
Section 409A generally provides that amounts deferred under a nonqualified deferred compensation plan or arrangement are currently includible in taxable income if not subject to a substantial risk of forfeiture, unless the plan meets specified documentation 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 service provider. In April of this year, the IRS issued Section 409A final regulations. For more information on the final regulations, see our April 16, 2007 Update, Deferred No Longer! IRS Issues Section 409A Final Regulations Adding Generally Modest – but Helpful – Relief.
Several weeks ago the IRS issued Notice 2007-78, which granted a limited extension of the deadline to adopt documents that comply with Section 409A until December 31, 2008 but with a requirement to adopt by December 31, 2007 a designation of compliant payment timing and form provisions for all covered plans (it also required certain modifications by December 31, 2007 to good reason conditions in employment-related agreements). Notice 2007-78 did not extend the effective date of the final regulations and thereby left intact the need for full operational compliance with the final regulations on and after January 1, 2008. For more information on this and other guidance in Notice 2007-78, see our September 12, 2007 Update, Limited Deferred Compensation Relief: IRS Partially Extends Section 409A Documentation Deadline and Provides Guidance — but Employers Must Still Take Some Actions by December 31, 2007.
The IRS issued Notice 2007-86 in response to commentators who basically stated that Notice 2007-78, while helpful, did not adequately address the need for additional time for service recipients and service providers to analyze all of their plans and make informed and reasoned decisions regarding the changes necessary to bring existing arrangements into compliance with the final regulations.
Effect of Notice 2007-86
Notice 2007-86 provides the relief that taxpayers sought to allow sufficient time to facilitate full and informed compliance with Section 409A.
Final Regulations Effective January 1, 2009. The effective date of the final regulations is extended to January 1, 2009.
Transition Operational Compliance in 2008. In 2008 plans must be operated in compliance with the provisions of Section 409A and with applicable provisions of Notice 2005-1 and other generally applicable guidance. To the extent an issue is not addressed in such guidance, plans must be operated consistent with a reasonable, good faith interpretation of Section 409A and applicable plan terms not inconsistent with the statute. During this time, the IRS will treat compliance with the final regulations as a reasonable, good faith interpretation of Section 409A.
Generally May Not Rely on Proposed Regulations After December 31, 2007. For periods prior to 2008, reliance on the proposed regulations is treated as a reasonable, good faith interpretation of Section 409A. But in most cases taxpayers cannot rely on the provisions of the proposed regulations after December 31, 2007.
Eliminates Requirement to Designate Compliant Payment Timing and Form Provisions in 2007. Notice 2007-86 eliminates the Notice 2007-78 requirement that companies must designate compliant payment timing and form provisions in all covered plans by December 31, 2007. Accordingly, employers and other service recipients must merely include compliant payment timing and form provisions as part of overall documentation compliance.
Retains December 31, 2008 Deadline for Documentation Compliance. The final regulations require that the material terms of "nonqualified deferred compensation" be set forth in a document that complies with Section 409A, which in most cases means amending of an existing plan or agreement. Notice 2007-78 extended the deadline for complying with Section 409A's documentation requirements until December 31, 2008, subject to the proper designation of compliant payment timing and form provisions. An employer or other service recipient must amend the documents no later than December 31, 2008 to comply with the applicable requirements of Section 409A, the final regulations and all applicable guidance. However, Notice 2007-86 provides that these amendments must also be effective no later than January 1, 2009 (instead of the earlier January 1, 2008 deadline provided in Notice 2007-78).
Changes in Payment Elections – Most Transition Relief Extended to December 31, 2008
Special Payment Elections Now Required by December 31, 2008, but Limitations Continue. Notice 2007-86 extends through December 31, 2008 prior relief allowing deferral elections for special payments without imposing Section 409A's one-year advance election, no acceleration and five-year delays rules, provided that the plan is amended and special elections are made on or before December 31, 2008. The same limitations on special payment elections continue to apply in 2007 and 2008, which means that a special payment election cannot cause an amount
that would have otherwise been payable in a future year to be paid in the year the election is made or
that is otherwise payable in the year the election is made to be payable in a future year.
More than one special payment election may be made under this relief, provided that each payment election satisfies the deadlines and conditions set forth in this transition relief.
Payment Elections Under Nonqualified Deferred Compensation Plans May Now Be Linked with Qualified Plans Elections Through December 31, 2008
Under Notice 2007-86, companies may continue to link a payment election under a nonqualified deferred compensation plan with an election under a qualified plan through December 31, 2008, provided that the determination of the time and form of payment is made in accordance with the terms of the nonqualified deferred compensation plan that were in effect on October 3, 2004. This relief also covers payment elections under nonqualified deferred compensation plans linked with other types of employer plans, including Section 403(b) plans, Section 457(b) eligible plans and certain foreign broad-based plans.
Transition Relief for Stock Options and Stock Appreciation Rights Extended to December 31, 2008
Change to Fixed Payment Terms. Companies may amend most outstanding stock options and stock appreciation rights subject to Section 409A to provide fixed payment terms or to permit holders of stock rights to elect such fixed payment terms consistent with Section 409A, provided that the awards are amended, and any elections are made, on or before December 31, 2008. The limitations discussed above for changes in payment elections also apply.
Exchange for Non-Discounted Awards. With certain exceptions, Notice 2007-86 extends through December 31, 2008 the relief provided by Notice 2005-1 with respect to the substitution of a non-discounted stock option or stock appreciation right for a discounted stock option or stock appreciation right, but only to the extent that a cancellation and re-issuance does not result in the cancellation of a deferral in exchange for cash or vested property in the same year. Notice 2007-86 also confirms that the guidance included in the preamble to the proposed regulations continues to apply. However, neither this extension nor the previous extension in Notice 2006‑79 applies to discounted stock options that are covered by Section 409A and held by individuals who were subject to Section 16(a) of the Securities Exchange Act of 1934 at the time the discounted options were granted – these awards must have been corrected by December 31, 2006.
Other Transition Guidance
Deadline to Modify Good Reason Conditions Extended to December 31, 2008. Notice 2007-86 affirms the guidance provided in Notice 2007-78 on whether modifying good reason conditions in an employment agreement will allow such conditions to continue to result in an involuntary separation from service for purposes of specific regulatory exceptions to Section 409A (often referred to as the "short-term deferral" and the "two-year, two-times" rules), but extends until December 31, 2008 the deadline to modify these conditions.
Other Guidance in Notice 2007-78 Affirmed. Notice 2007-86 also affirms the guidance provided in Notice 2007-78 regarding extending, renewing or renegotiating employment agreements and cashing out remaining installment or annuity payments.
Partners and Partnerships May Continue to Rely on Preamble to Proposed Regulations. Notice 2007-86 highlights that taxpayers may continue to rely on the preamble comments in the proposed regulations regarding the application of Section 409A to partners and partnerships.
No Extended Relief for Offshore Funding Arrangements and Financial Health Triggers. Notice 2007-86 does not further extend the relief found in Notice 2006-33 regarding the use of offshore funding arrangements and financial health triggers.
Correction Program Guidance Coming Soon. The IRS also states in Notice 2007-86 that it anticipates the release of guidance "as soon as possible" with respect to the correction program described in Notice 2007-78.
Effect of Notice 2007-89
Notice 2007-89 generally extends prior guidance regarding reporting and withholding obligations with respect to deferrals of compensation and amounts includible in gross income under Section 409A for 2007.
Code "Y" Amounts. For 2007, amounts of annual deferrals under plans subject to Section 409A are not required to be reported in box 12 of Form W-2 or box 15a of Form 1099-MISC (Code "Y" amounts).
Code "Z" Amounts. For 2007, amounts includible in gross income under Section 409A due to a violation of the requirements of Section 409A (Code "Z" amounts) must be reported on line 2 of Form 941, in box 1 of Form W-2 and in box 12 of Form W-2 (for employees), or reported in box 7 and in box 15b of Form 1099-MISC (for non-employees).
Notice 2007-89 also contains details regarding the calculation of amounts includible in income under Section 409A; the wage payment date for such amounts; the reporting obligations with respect to offshore trusts; and a service provider's obligations with respect to amounts includible in gross income under Section 409A.
Identify Compensation Arrangements That 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. Employers and other service recipients should have previously completed reviewing their plans to ensure that each covered plan complies with the operational requirements of Section 409A. Any questions about covered status should therefore be promptly resolved. Common types of arrangements that may be subject to the requirements of Section 409A include the following:
Strategize Appropriate Timing for Amendments. With the extended deadline to adopt documents that comply with Section 409A, employers and other service recipients should consider how to adjust their governance planning in response. We anticipate that most but not all companies will delay adoption until 2008. Management should complete this evaluation regarding the timing for amendments as soon as possible to facilitate addressing these matters, if needed, at upcoming meetings of boards of directors and other governing bodies.
Finalize Action Items for Documentation Compliance. Even with the extended deadline to adopt documents that comply with Section 409A, employers and other service recipients should finalize action items and timing for meeting the new deadline, including adopting all necessary amendments no later than the December 31, 2008 deadline. Public companies should remain vigilant about complying with all applicable shareholder approval and reporting and disclosure obligations in current and periodic reports (Form 8-K, Form 10-Q and Form 10-K) and in proxy statements.
Implement Compliance Controls for Future Documents. The final regulations and IRS guidance raise many document requirements and potential traps, including Notices 2007-86 and 2007-89. Employers and other service recipients should institutionalize controls that promote future document compliance. For example, employers should implement procedures to review drafts of all new benefit plans and agreements, or amendments to existing plans or agreements, to verify Section 409A compliance before adopting, or amending, them. Employers and other service recipients should also consider offering special training and other education for those personnel responsible for negotiating compensatory arrangements to ensure a basic understanding of all applicable documentation and operational requirements. Their focus should be to spot issues and then properly address them before entering into new compensatory arrangements or amending existing compensatory arrangements.
Implement Operational Requirements. Notice 2007-86 extends until January 1, 2009 the effective date for operational compliance with the Section 409A final regulations. In response, employers and other service recipients must properly implement these additional operational requirements within all applicable systems, administrative forms, communications and other sources. This may include contacting service providers, such as third party administrators, recordkeepers and trustees, to verify their compliance and to finalize any necessary coordination. In the meantime, for the remainder of 2007 and throughout 2008 (including upcoming open enrollment periods this year for 2008 deferred compensation elections), employers and service recipients should be sure that all applicable documents and other communications comply with the current transition relief as supplemented and confirmed by Notice 2007-86.
This Update provides only a general summary of IRS Notice 2007-86 and Notice 2007-89. You can find a copy of Notice 2007-89 at http://www.irs.gov/pub/irs-drop/n-07-89.pdf. You can find discussions of other recent cases, laws, regulations and rule proposals of interest on our website.
In this update we have used the style and format for "Practical Tips" from The Public Company Handbook: A Corporate Governance and Disclosure Guide for Directors and Executives (Bowne SecuritiesConnect(TM) Library). The third edition of The Public Company Handbook may be ordered by email to SecuritiesConnect@bowne.com and can be downloaded at http://www.bowne.com/securitiesconnect/pubs_public.asp.