Employee Benefits Law Alert: IRS Extends Transition Relief Under Section 409A Through 2007
10/10/2006

Section 409A, which was added to the Internal Revenue Code in October 2004, imposes onerous penalties on nonqualified deferred compensation that fails to meet strict new rules. The Internal Revenue Service (IRS) has provided preliminary guidance regarding Section 409A in several notices and in proposed regulations issued in September 2005. On October 4, 2006, the IRS issued Notice 2006-79 (the "Notice"), which extends through 2007 the good faith compliance period and most of the transition relief previously extended through 2006 under the proposed regulations.

Extension of Good Faith Compliance Period and Plan Amendment Deadline

The Notice provides that a plan adopted on or before December 31, 2007 will be treated as complying with Section 409A if the plan is operated through December 31, 2007 in reasonable, good faith compliance with the provisions of Section 409A and other IRS guidance published with an effective date prior to January 1, 2008, and the plan is amended prior to January 1, 2008 to conform to the provisions of Section 409A and the final regulations. The IRS intends to issue final regulations before the end of 2006, but has stated that the final regulations will not be effective prior to January 1, 2008.

Extension of Transition Relief

Distribution Elections. Under the proposed regulations, a plan can be amended to provide for new payment elections, and participants can revise the time and form of their distribution elections, on or before December 31, 2006, without violating the subsequent deferral and anti-acceleration rules. The Notice further extends this relief through 2007, with certain limits.

Discounted Stock Options and Stock Appreciation Rights. The proposed regulations permit employers to substitute non-discounted stock options or stock appreciation rights ("SARs") for discounted stock options or SARs, without such substitution being treated as a material modification, provided the substitution is made on or before December 31, 2006. Additionally, discounted stock options and SARs can be amended to provide for fixed payment terms (or to permit holders of such options or rights to elect fixed payment terms) consistent with Section 409A, without violating the Section 409A rules regarding changes in the time and form of payments, provided the amendment (or election) is made on or before December 31, 2006. The Notice further extends this relief through 2007, except with respect to discounted stock options and SARs granted to Section 16 officers and directors of publicly-traded companies, which were not properly expensed. For these grants, this relief is not extended beyond 2006.

Distributions Tied to Qualified and Other Employer Plans. Distributions under nonqualified deferred compensation plans may continue to be controlled by distributions under tax-qualified retirement plans for another year, until December 31, 2007. In addition, the Notice extends this relief to distributions under nonqualified deferred compensation plans linked to certain other employer plans, such as Section 403(b) and 457(b) plans. To take advantage of this transition rule, the time and form of payment must be made under the terms of the nonqualified plan in effect as of October 3, 2004.

Plan Amendments for Certain Initial Deferrals. Notice 2005-1 gave participants until March 15, 2005 to elect to defer amounts attributable to services performed in 2005 that, as of the time of the election, had not been paid or become payable. Employers whose employees took advantage of this special election rule were required to amend their plans to provide for the special election no later than December 31, 2005. The proposed regulations extended the plan amendment deadline until December 31, 2006. The Notice further extends the plan amendment deadline until December 31, 2007.

New Transition Rule for Certain Collectively-Bargained Plans

The Notice provides new transition relief for nonqualified deferred compensation plans maintained pursuant to one or more collective bargaining agreements in effect on October 3, 2004. Such plans are not required to comply with Section 409A until the date on which the collective bargaining agreements terminate (determined without regard to extensions past October 3, 2004), or December 31, 2009, if earlier.