06.04.2008

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Updates

The deadline is fast approaching for amending deferred compensation arrangements that are subject to Section 409A of the Internal Revenue Code. All covered deferred compensation arrangements must be amended on or before December 31, 2008. The process of identifying and adopting any necessary amendments to existing compensation arrangements can be time consuming and complex.

This update provides general background information on Section 409A and offers practical tips and guidance on actions that should be taken immediately in light of the upcoming deadline.

General Background on Section 409A

Section 409A 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 documentation and operational requirements. Failure to comply with the applicable requirements of
Section 409A can result in severe federal and state income tax consequences,
including a 20% additional tax imposed on the employee or other service provider. In April 2007, the IRS issued final regulations under Section 409A. For more information about the Section 409A final regulations, see our April 16, 2007 Update, Deferred No Longer! IRS Issues Section 409A Final Regulations Adding Generally Modest – but Helpful – Relief.

All Arrangements Subject to Section 409A Must Be
Fully Compliant by January 1, 2009

In October 2007, to provide additional time for service recipients and service providers to analyze their compensation arrangements and to make informed decisions regarding the changes necessary to bring those arrangements into compliance with Section 409A,
the IRS issued Notice 2007-86 which extended the effective date of the final
Section 409A regulations to January 1, 2009. This means that any existing deferred compensation arrangement that is subject to Section 409A must be operated in accordance with a legally binding written document that complies with all the rules set forth in the final Section 409A regulations on or before December 31, 2008. In most cases, compliance with Section 409A will require amendments to, or restatements of, existing documents or agreements; in some instances it will require documenting previously unwritten arrangements. Notice 2007-86 also provides transition guidance
that can be relied upon during the 2008 transition period. For more information about Notice 2007-86, please see our October 29, 2007 Update, Expanded Deferred Compensation Relief: IRS Fully Extends Section 409A Documentation Deadline and Certain Transition Relief Through 2008, Delays Effective Date of Final Regulations and Provides W-2 and Other Guidance.

What Companies Should Be Doing Now

Employers and other service recipients should review all of their formal and informal compensatory arrangements to identify those that may be subject to Section 409A and that may require action to bring the arrangements into compliance with Section 409A by this year end. In addition, employers and other service recipients should consider whether, and to what extent, they will take advantage of transition relief expiring on December 31, 2008. We recommend that each company consider creating a time and responsibilities schedule for the steps identified to bring covered compensation arrangements into compliance and to ensure that all necessary amendments (or documentation of previously unwritten arrangements) are adopted prior to the company's last committee, board or other governing body meeting of 2008. After 2008, a nonqualified deferred compensation arrangement that is subject to Section 409A but is unwritten or noncompliant with the final Section 409A regulations may result in immediate income inclusion of the deferred amount and trigger the 20% additional tax and interest and other tax consequences.


Practical Tips

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 Section 409A include the following:
  • traditional deferred compensation plans
  • offer letters
  • employment agreements
  • reimbursement agreements
  • retention agreements
  • discounted stock options
  • discounted stock appreciation rights
  • phantom stock or phantom units
  • restricted stock units
  • certain other equity compensation arrangements
  • annual and multi-year bonus plans
  • separation pay plans and agreements
  • salary continuation arrangements
  • change in control agreements
Exhaust Transition Relief. Employers and other service recipients should implement all steps necessary to take advantage in 2008 of any transition relief relevant to them before this relief expires at year end. Potential relief expiring on December 31, 2008 includes:
  • Change in Payment Elections. With respect to the time and form of payment of amounts subject to Section 409A, a plan may provide, or be amended to provide,
    for new payment elections on or before December 31, 2008 without regard to the one-year advance notice, five-year delay and no acceleration limitations of
    Section 409A. If employers and other service recipients choose to take advantage of this transition relief, they should obtain these payment elections from their service providers before the end of this year. Note, however, that any changes made in 2008 cannot delay payments that would otherwise be made in 2008 or accelerate payments into 2008 that would otherwise not be paid in 2008.
  • Change Stock Options and SARs to Provide Fixed Payment Terms.
    Employers and other service recipients 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 fixed payment terms consistent with Section 409A, provided that the awards are amended, and any elections are made, on or before December 31, 2008, subject to the same timing limitations noted above for change in payment elections.
  • Exchange Discounted Stock Options or SARs for Non-Discounted Awards. With respect to the substitution of a non-discounted stock option or stock appreciation right for a discounted stock option or stock appreciation right, this exchange may occur pursuant to Notice 2005-1 and 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. The guidance included
    in the preamble to the proposed Section 409A regulations continues to apply. However, this transition relief does not apply 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—the deadline to correct these awards was December 31, 2006.
  • Deadline to Modify Good Reason Conditions. Notice 2007-78 contains guidance 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). If so, modifications may be required by December 31, 2008.
Determine Appropriate Timing for Amendments. Employers and other service recipients should determine whether any adjustments are necessary to their 2008 governance planning in response to the December 31, 2008 amendment deadline. Management should make this determination as soon as possible to facilitate addressing Section 409A matters, if needed, at upcoming meetings of boards of directors, committees and other governing bodies. The review and amendment process can be time consuming and complex, including the potential need to obtain consents from service providers. Employers and other services recipients should not wait until the last minute to begin the review and amendment process.

Finalize Action Items for Document Compliance. Employers and other service recipients should finalize action items and timelines for meeting the document compliance deadline as soon as possible, including adopting all necessary amendments no later than December 31, 2008. 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 Arrangements. The final regulations under Section 409A and IRS guidance contain a number of documentation requirements and potential traps. Employers and other service recipients should institutionalize controls that promote future document compliance with Section 409A. For example, employers should implement procedures to review drafts of new compensation plans, agreements and arrangements, or amendments to existing plans, agreements or arrangements, 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 personnel responsible for negotiating compensatory arrangements to ensure that those personnel have a basic understanding of all applicable requirements under Section 409A.

Implement Operational Requirements. Employers and other service recipients must properly implement the operational requirements of the final Section 409A regulations within all applicable systems, administrative forms, communications and other sources on and after January 1, 2009. This may include contacting service providers, such as third party administrators, record keepers and trustees, to verify their compliance and to finalize any necessary coordination. In the meantime, for the remainder of 2008, employers and service recipients should confirm that all operations comply with the current transition relief under Notice 2007-86 and any other applicable transition guidance issued by the IRS.


Additional Information

This Update provides only a general summary of Section 409A and guidance on actions that should be taken immediately in light of the upcoming deadline. You can find additional discussions of Section 409A and of other recent cases, laws, regulations and rule proposals of interest on our website.

 

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