The IRS has issued proposed regulations that expand the guidance available for complying with the deferred compensation tax rules of Section 409A of the Internal Revenue Code. Section 409A generally provides that amounts deferred under a nonqualified deferred compensation plan are currently includible in income if not subject to a substantial risk of forfeiture, unless the plan meets specified design and operational requirements. Failure to comply can result in significant federal income tax consequences, including a 20% additional tax.

The IRS had issued initial guidance and transition relief in Notice 2005-1 in December 2004. The new proposed regulations generally incorporate and expand this initial guidance.

One-Year Extension for Many Deferred Compensation Compliance Requirements

The proposed regulations extend for one year (until December 31, 2006) most, but not all, of the Notice 2005-1 transition relief periods, including:

• The deadline for adopting conforming amendments to plans and arrangements;
• The period for operating plans and arrangements in good faith compliance with the provisions of Section 409A and Notice 2005-1 (compliance with the proposed regulations, or any final regulations issued prior to January 1, 2007, will also be treated as good faith compliance with Section 409A);
• The period for changing payment elections, except that payments otherwise payable in 2006 cannot be changed in 2006, and in 2006 payments payable later cannot be accelerated to 2006;
• The period for allowing an election as to the timing and form of payment under a nonqualified deferred compensation plan to be controlled by a payment election made under a qualified pension plan; and
• The period for substituting nondiscounted stock options/stock appreciation rights (SARs) for discounted stock options/SARs (although there can be adverse consequences to participants if the substitution of vested rights does not occur until 2006).

No Extension for Certain Compensation Deferrals, Elections and Amendments

The proposed regulations do not extend the following transition relief:

• Notice 2005-1 provided limited relief for initial deferrals relating to services performed during 2005, but the proposed regulations do not contain similar relief for 2006; and
• The period for participants to cancel deferral elections or terminate participation in a plan ends December 31, 2005, as provided in Notice 2005-1 (and plans may need to be amended by this date if either of these rights is in fact provided).

Proposed Regulations Clarify Definitions and Provide Details on Section 409A's Rules

Among many other highlights, the proposed regulations clarify and supplement the definition of covered "nonqualified deferred compensation plans" and the exceptions to treatment as deferred compensation. In particular, the proposed regulations clarify how Section 409A treats:

• short-term deferrals (commonly referred to as the "2-1/2 month rule"), including permitting involuntary separation pay within this category;
• separation pay, including a general exemption for involuntary separation pay not exceeding the lesser of two times annual compensation or $420,000 (although the preamble suggests that the limit may be $410,000), indexed, paid by the end of the second calendar year following termination of employment;
• split dollar insurance; and
• foreign arrangements.

Some Basic Rules Expanded and Added. The proposed regulations add details to Section 409A's basic rules regarding initial deferral elections, anti-acceleration and the time and form of payment, including permissible payment events and subsequent changes. The proposed regulations also contain guidance for when plan terminations do not violate the anti-acceleration rule. New rules included in the proposed regulations address nonqualified deferred compensation plans linked with qualified pension plans, including 401(k) wrap around plans.

Proposed Regulations Clarify Which Types of Equity Compensation Are Not Considered Deferred Compensation

The proposed regulations contain new exceptions, valuation rules and guidance for nondiscounted stock options and SARs, which are together referred to as "stock rights," including some welcome relief for private companies.

Expanded Exception for Nondiscounted SARs. The proposed regulations contain a new exception for private as well as public company nondiscounted SARs that have no other deferral features, whether settled in cash or stock (which expands the prior exception that was limited to public company stock-settled SARs).

New Valuation Rules for Stock Rights. The proposed regulations contain new valuation rules for public and private company stock rights.

• Public Companies. Public companies may generally use a consistently applied valuation method based on one of the following:
  • the last sale before or the first sale after grant;
  • the closing price on the trading day before or the trading day of the date of grant;
  • an average of the price of the stock over a specified period occurring within the 30 days before and 30 days after the date of grant; or
  • any other reasonable basis using actual transactions in the stock as reported by the securities market.
• Private Companies. For private companies generally, a valuation will be presumed to be equal to the fair market value where it is determined through the reasonable application of a reasonable valuation method that is applied consistently. Consistent use of certain valuation methods set forth in the proposed regulations provides a presumption of fair market value, rebuttable only by a showing that the valuation is grossly unreasonable. In addition, the proposed regulations provide more generous valuation methods for certain start-up corporations.

New Guidance for Put and Call Repurchase Rights. The proposed regulations contain new guidance for put and call repurchase rights, which generally provides that the purchase price must be at fair market value, the determination of which must comply with the consistency requirements for the methods used in determining fair market value.

New Guidance on Modifications, Extensions and Renewals of Outstanding Stock Rights. The proposed regulations contain new guidance on when modifications, extensions or renewals of outstanding stock rights will be considered new grants (which must be newly evaluated as potential discounted stock rights that would be considered deferred compensation subject to Section 409A).

• Modifications That Do Not Result in a New Grant. Modifications of a stock right to achieve the following results generally will not be considered modifications that result in treatment as a new grant:
  • accelerate vesting;
  • extend the exercise period of a stock right to a date no later than the later of the fifteenth day of the third month following the date, or December 31 of the calendar year in which the stock right would otherwise expire;
  • permit the holder to exchange the stock right for a cash amount that would be available if the stock right were exercised;
  • permit payment of the exercise price with pre-owned stock;
  • facilitate the payment of employment taxes or required withholding taxes associated with the exercise of the right; or
  • provide a limited tolling of the expiration of the stock right if the exercise would violate securities laws.
• Modifications That Result in a New Grant. Other changes in the terms of a stock right that may provide the holder with a direct or indirect reduction in the exercise price or an additional deferral feature or an extension or renewal of the stock right will generally be deemed a modification resulting in treatment as a new grant.

Proposed Regulations Decline to Address Some Issues

Notably, the proposed regulations postpone for future consideration and comment the treatment of separation pay for good reason terminations, and invite continued reliance on Notice 2005-1 for arrangements between partnerships and partners until further guidance is issued.

IRS Requests Comments on Proposed Regulations

The IRS requests public comments. The proposed regulations provide further information on submitting such comments, with a public hearing scheduled for January 25, 2006.

Additional Information

You can find a copy of the full text of the proposed regulations at http://www.ustreas.gov/press/releases/reports/reg15808004.pdf.  You can find discussion of other recent cases and other topics of interest on our website.