09.12.2007

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Updates

On September 10, 2007, the IRS issued Notice 2007-78 providing limited relief and guidance for the deferred compensation tax rules of Internal Revenue Code Section 409A, including a limited extension until December 31, 2008 of the deadline to adopt documents that comply with Section 409A.

This update summarizes the key aspects of the notice and offers practical tips for employers and other service recipients.

Background on Section 409A

What Is Section 409A? Section 409A generally provides that amounts deferred under a "nonqualified deferred compensation plan" (including individual agreements) are currently includable in taxable income if not subject to a substantial risk of forfeiture, unless the plan or agreement 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 (referred to under Section 409A as a "service provider").

Section 409A Final Regulations. In April of this year, the IRS issued final regulations that supplement the requirements for deferral elections, payment timing and form, and other aspects of Section 409A. The final regulations also require that the material terms of "nonqualified deferred compensation" be set forth in a document that complies with Section 409A, which in most cases translates to an amendment of an existing plan or agreement. The final regulations are effective January 1, 2008 and set a documentation deadline of December 31, 2007. In addition to documentation compliance, Section 409A also requires operational compliance with its requirements effective January 1, 2005, except to the extent provided in transition relief for 2005, 2006 and 2007. For more information on the final regulations and transition relief, see our April 16, 2007 Update and our December 28, 2004 Update.

Full Operational Compliance Deadline Remains January 1, 2008

Other than the limited extension of the documentation deadline (discussed below), Notice 2007-78 does not extend after 2007 any transition relief based on Notice 2005-1, the proposed regulations or a reasonable good faith interpretation of the statute. Accordingly, effective January 1, 2008, a covered plan or agreement must be in full operational compliance with the requirements of Section 409A and the final regulations. For example, starting next year, a service provider may not change the time and form of payment for covered deferred compensation arrangements unless the change complies with the one-year advance notice and five-year payment delay requirements.

Deadline to Adopt Section 409A-Compliant Documents—Limited Extension to December 31, 2008

The IRS 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 (discussed below). An employer or other service recipient must amend the documentation no later than December 31, 2008 to comply with the applicable requirements of Section 409A, the final regulations and all guidance, and these amendments must be effective January 1, 2008.

Must Designate Compliant Payment Timing and Form Provisions Before January 1, 2008

Employers and other service recipients must designate in writing compliant payment timing and form provisions for each covered plan and agreement before January 1, 2008. In some cases, this may require obtaining approval from service providers who are participants in plans or parties to agreements. The notice defines the level of detail required in the designation. The notice also includes IRS comments on related governance considerations. For example, the designation may appear in a separate written document, instead of in a formal amendment to a plan or agreement, that describes the applicable payment timing and form provisions by reference to specific plans and agreements, to arrangements generically (such as "all nonqualified deferred compensation plans maintained by the company and providing deferred compensation to service providers under Section 409A") or a combination of both.

Other Limited Relief and Guidance

The notice provides other limited relief and guidance addressing the following situations.

  • Modifying Good Reason Conditions. The notice provides 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) and permits certain changes by December 31, 2007.
  •  Extending, Renewing or Renegotiating an Employment Agreement. The notice provides guidance on whether extending, renewing or renegotiating an employment agreement violates the "no substitution" rule set forth in the final regulations that is designed to prevent substituting compensation at the time of separation for deferred compensation rights in a prior agreement which will be forfeited at that time.
  • Cashout of Remaining Installment or Annuity Payments. The notice provides guidance on whether a provision that allows for the cashout of all remaining installment or annuity payments when the present value of remaining payments falls below a predetermined threshold may be set to apply only at the original payment commencement date (not any future date as contemplated by the final regulations) and still comply with the final regulations.
  • Offshore Funding Arrangement and Financial Health Triggers. The notice provides a limited extension of the relief found in Notice 2006-33 regarding the use of offshore funding arrangements and financial health triggers, but subjects "grace period" assets to good faith compliance after December 31, 2007.

Announcement of Limited Voluntary Compliance Program

The notice announces that the IRS anticipates issuing guidance in the "near future" to establish a limited voluntary compliance program that will apply to the correction of certain unintentional operational failures. This is good news and hopefully will take into account the IRS's positive experiences with the plan sponsor community under similar voluntary compliance programs for tax-qualified pension plans.

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 the requirements include the following:

  • traditional deferred compensation plans
  • offer letters
  • employment agreements
  • reimbursement agreements
  • retention agreements
  • discounted stock options
  • discounted stock appreciation rights
  • phantom stock
  • restricted stock units
  • some other equity compensation arrangements
  • annual and multi-year bonus plans
  • separation pay plans and agreements
  • salary continuation arrangements
  • change in control agreements

 

Strategize Appropriate Timing for Amendments. Despite the extended deadline to adopt documents that comply with Section 409A, we believe that many employers and other service recipients will continue to wrestle with whether to adopt compliant amendments at the next convenient opportunity in 2007 or await such action until closer to the new deadline of December 31, 2008. There are potential advantages to both approaches depending on the type of entity, type of deferred compensation arrangement and other potential factors. Management should complete this evaluation as soon as possible to facilitate addressing these matters at the fourth quarter meeting of boards of directors and other governing bodies.

Finalize Action Items for Documentation Compliance. Employers and other service recipients should finalize action items and timing for meeting the deadline to adopt documents that comply with Section 409A, including:

  • identifying all plans and agreements covered by Section 409A as soon as possible;
  • properly designating compliant payment timing and form provisions before the January 1, 2008 deadline;
  • adopting all necessary amendments to comply with the requirements of Section 409A, the final regulations, the notice and other guidance no later than the December 31, 2008 deadline;
  • if needed, consider changes to "good reason" conditions by December 31, 2007; and

for public companies, evaluating and 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 following the adoption of any compliant designations or amendments.

Implement Compliance Controls for Future Documents. There are many document requirements and potential traps raised by the final regulations and Notice 2007-78. Employers and other service recipients should institutionalize controls that promote future document compliance. For example, employers and other service recipients should implement procedures to review drafts of all new benefit plans and agreements to verify Section 409A compliance. 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 in order to spot issues and then properly address them.

Implement Operational Requirements. The notice makes clear that the IRS does not intend to extend the effective date of January 1, 2008 for operational compliance with the Section 409A final regulations. In response, employers and other service recipients must properly implement these 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 initiatives.

Additional Information

This update is intended to provide only a general summary of Notice 2007-78. 

You can find discussions of other recent cases, laws, regulations and rule proposals of interest to public companies on our website.


 

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