Employee Benefits Law Alert: Overview of Key Provisions of the Section 409A Final Regulations

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• Section 409A Overview
• Nonqualified Deferred Compensation Subject to Section 409A
• Equity Compensation
• Severance Pay
• Foreign Deferred Compensation Arrangements
• Initial Deferral Election Rules
• Payment Rules
• Tax Withholding and Reporting Rules
• Effective Date

Section 409A, which was added to the Internal Revenue Code (the Code) in October 2004, imposes onerous penalties on nonqualified deferred compensation that fails to meet strict new rules. The Department of the Treasury issued final regulations for section 409A on April 10, 2007. This Client Alert highlights certain key provisions of the final regulations.

Section 409A Overview Section 409A operates by specifying the nonqualified deferred compensation arrangements that are subject to its rules and by setting out detailed rules that must be satisfied with respect to (1) the timing of elections to defer compensation and (2) the timing of payment of amounts treated as deferred. To the extent these rules are not met, section 409A accelerates the taxation of deferred amounts and imposes an additional 20 percent penalty tax on the amount included in income and an additional interest charge on amounts deferred at the IRS's interest rate for underpayments, plus 1 percent. As a result, section 409A requires companies to determine whether a particular compensation arrangement is nonqualified deferred compensation covered by section 409A, and if so, what deferral elections and payment procedures must be followed to avoid the acceleration of tax and penalty taxes imposed on arrangements that do not comply with section 409A.

Nonqualified Deferred Compensation Subject to Section 409
Section 409A applies to amounts deferred under a nonqualified deferred compensation plan, which is defined as any plan that provides for the deferral of compensation, unless a specific exception applies. Such a plan can involve compensation payable to employees, to partners, or to independent contractors, including certain corporations or partnerships. Section 409A and the final regulations refer to these collectively as "service providers," and to the persons or entities for whom the services are provided as "service recipients." Because most cases will involve employees and employers, this Client Alert uses those terms instead of "service providers" and "service recipients." Plan Aggregation Rules. The proposed regulations set out rules that treat all plans of the same type as a single plan. Thus, if an employee's benefits under one deferred compensation plan violate section 409A, the employee is taxable under section 409A on all benefits in other plans of the same type. Similarly, an employee may not take advantage of a rule permitting initial elections to defer compensation to be made within 30 days after the employee becomes eligible to participate in the plan if the employee is already covered under another plan of the same type. In addition, a rule that permits an employer to accelerate payments by terminating a nonqualified deferred compensation plan applies only if all plans of the same type are also terminated. The final regulations expand the types of plan that are aggregated under section 409A. In addition to the plan types listed in the proposed regulations (account balance plans, nonaccount balance plans, separation pay plans, and "other plans"), the final regulations add split-dollar life insurance, in-kind benefits or expense reimbursement arrangements, stock rights constituting deferred compensation, and foreign plans, and the regulations split account balance plans between account balance plans that defer compensation at the employee's election and account balance plans for nonelective deferrals, including matching contributions. Short-Term Deferrals. Plans that fit within the "short-term deferral" exception are not subject to section 409A. Under this exception, no deferral of compensation generally occurs if payment is made to the employee by the later of (1) 2½ months after the end of the employee's taxable year in which the amount becomes vested or (2) 2½ months after the end of the employer's taxable year in which the amount becomes vested. The final regulations retain protection against inadvertent violations that result from failing to make a payment by the end of the 2½-month period when payment was administratively impracticable and the delay was unforeseeable, or when payment would jeopardize the employer's ability to continue as a going concern. On the other hand, the short-term deferral exception will not apply if the plan specifies that payment will be made upon an event that does not necessarily coincide with the lapsing of the substantial risk of forfeiture, and could occur at a time beyond the short-term deferral period.

Planning Tip: There is no requirement that a plan specify in writing that payments must be made by the short-term deferral deadline to avoid application of section 409A. However, if a date is specified and the payment is made after the specified date and after the 2½-month period, the plan can still comply with the section 409A rules if payment is made by the end of the year in which the specified date occurs. Employers should consider specifying a date or year of payment in the plan, even if payment will be made within the short-term deferral period. However, a plan provision requiring only that a payment be made "before the end of the short-term deferral period" may not qualify as a permissible specified date for this purpose, if under the facts and circumstances the payment could have been made in more than one taxable year.

Equity Compensation
The final regulations provide that nonqualified stock options and stock appreciation rights (SAR) will not be treated as deferred compensation subject to section 409A unless they are granted at a discount or have other deferral features. Incentive stock options and options granted pursuant to an employee stock purchase plan generally do not constitute a deferral of compensation. Common Stock of Eligible Issuer Required. A stock option or SAR will be subject to section 409A if the underlying stock is not common stock of an eligible issuer. The stock cannot be subject to a mandatory repurchase right (other than a right of first refusal) or a put or call right (other than a "lapse" restriction that is conditioned on the performance of substantial services by the employee) if the repurchase price is not based on fair market value. An eligible issuer is the corporation for which the employee provides services or a direct or indirect parent of the employer. A corporation is the parent of another if it owns at least 50 percent of the shares of the second corporation. This level is reduced to 20 percent if the grant of stock options or SARs is based on "legitimate business criteria." Valuation Methods. Stock options and SARs are exempt from section 409A only if the exercise price is at least equal to the fair market value of the underlying common stock on the date of grant. The following standards apply in determining fair market value: Publicly Traded Stock. Fair market value of publicly traded securities may be determined on the basis of the last sale before or the first sale after the grant, the closing price on the trading day before or the trading day of the grant, the arithmetic mean of the high and low prices on the trading day before or the trading day of the grant, or any other reasonable method using actual transactions in such stock as reported by such market. The determination also may be made using an average selling price during a specified period that is no more than 30 days before or 30 days after the applicable valuation date if the recipient and the number of shares subject to the grant are irrevocably determined before the beginning of the specified period. Stock That Is Not Publicly Traded. The regulations list factors that are to be taken into account when determining fair market value of stock that is not publicly traded. These include the value of tangible and intangible assets, the present value of future cash flows, the market value of stock or equity interests in similar corporations, and applicable control premiums and minority discounts. Three valuation methods generally will be presumed reasonable:

• Independent appraisals as of a date no more than 12 months before the grant date;
• Formula-based valuations used as part of a nonlapse restriction on the sale of the underlying stock (such as a right of first refusal) under section 83 of the Code if the stock is valued in the same manner for all nonlapse restrictions with respect to the stock; and
• In the case of illiquid stock of a "start-up" corporation (i.e., a nonpublicly traded corporation with less than 10 years in business), a good-faith written valuation that takes into account the valuation factors described above. This approach is not available if it is reasonably anticipated that the corporation will undergo a change in control within 90 days or will make a public offering of securities within 180 days (the proposed regulations used a 12-month rule for both tests). In addition, the valuation must be performed by persons that the corporation reasonably determines to be qualified based on their significant knowledge, experience, education, or training.

Repurchase Obligations and Put/Call Rights.
A stock right subject to a mandatory repurchase obligation or a nonlapse put or call right that is based on a value other than fair market value of the stock will be deemed to provide for the deferral of compensation, and therefore will not be exempt from section 409A. Modifications and Extensions. A modification of a stock option or SAR is considered to be the grant of a new stock right that must comply with the section 409A rules as of the date of the new grant to avoid treatment as deferred compensation. A modification generally is any change in the terms of a stock option or SAR that may provide the holder with a direct or indirect reduction of the exercise price. In addition, an extension of a stock right will result in the stock right being treated as having had an additional deferral feature as of the original date of grant. The final regulations provide two helpful new exceptions to this rule:

• Second, the exercise period of an option or a SAR may be extended to a date no later than the earlier of (1) the latest date on which the exercise period could have expired by its original terms under any circumstances or (2) the 10th anniversary of the original grant date without subjecting the option or SAR to section 409A. As under the proposed regulations, a change to the terms of a stock right will not be considered a modification or an extension to the extent that the change is rescinded by the earlier of the date the stock right is rescinded or the last day of the employee's taxable year.

Restricted Stock and Restricted Stock Units.
Restricted stock grants generally are not subject to section 409A, whether or not the employee makes a section 83(b) election. Restricted stock units that entitle the employee to receive stock following satisfaction of a vesting condition generally will not be subject to section 409A if the stock is issued in compliance with the short-term deferral exception (i.e., issued either at the time of vesting or within 2½ months following the close of the year in which vesting occurs). If issuance of the stock is to be deferred beyond the short-term deferral period, the arrangement will need to be structured to comply with section 409A.

Severance Pay
The final regulations confirm that severance plans and severance pay provisions in employment agreements are generally subject to section 409A. However, plans or agreements that (1) pay severance benefits only on an involuntary separation (including a voluntary separation for good reason in some circumstances) or pursuant to a voluntary window program, and (2) meet either of the following conditions, are not subject to section 409A:

• The plan is collectively bargained; or
• The plan provides that all payments must be made by the end of the second calendar year following the year in which separation occurs. If this exception applies, then the separation pay is exempt from section 409A to the extent it does not exceed two times the lesser of (i) the employee's annualized compensation for the prior calendar year or (ii) the limit on compensation that can be counted in a qualified retirement plan for the year in which employment terminates ($225,000 for 2007). Only separation pay in excess of this limit is then subject to section 409A.

Exemption for Certain Reimbursements.
The final regulations expand the types of reimbursements that are excluded from section 409A. Excluded reimbursements now include reimbursement of reasonable outplacement expenses, reasonable moving expenses (including a loss incurred on the sale of a primary residence), and expenses relating to deductible employee business expenses, if the expenses are incurred before the end of the second calendar year and reimbursed before the end of the third calendar year following the calendar year in which the separation occurs. In addition, reimbursements of deductible medical expenses (without regard to the 7.5 percent deduction threshold) will also be excluded from section 409A so long as the reimbursements apply to expenses incurred during the period that the employee would be entitled under COBRA to continue health coverage under the employer's health plan. Furthermore, the employer can provide reimbursements up to the limit on elective deferrals under 401(k) plans for the year ($15,500 for 2007). Applying the Short-Term Deferral Exception. Severance arrangements that do not meet the separation pay exception may still be exempt from section 409A if the plan provides that benefits are fully paid to the departing employee by March 15 of the calendar year following the calendar year during which the benefits first become vested (i.e., are no longer subject to a substantial risk of forfeiture), or, if later, 2½ months after the close of the employer's taxable year in which the benefits become vested. There is no requirement that a plan specify in writing that payments must be made by the short-term deferral deadline to avoid application of section 409A. However, if a date is specified and the payment is made after both the specified date and the 2½-month period, the payment will be subject to section 409A. The payment may comply with the section 409A rules if it is made by the end of the year in which the specified date occurs and the six-month rule, if applicable, is satisfied. Severance Benefits Payable on Involuntary Termination "Without Cause" or Voluntary Termination "With Good Reason." The final regulations retain the rule in the proposed regulations that payments made only on account of an involuntary separation are not vested. This allows employers to structure involuntary severance arrangements to meet the requirements of the short-term deferral exception. In addition, the final regulations state that voluntary terminations for good reason may qualify as "involuntary terminations." Termination for good reason will qualify as involuntary termination if the plan or agreement defines what constitutes good reason, using factors that refer to material negative changes to the employee's employment, such as material changes in duties or compensation. The regulations include a safe harbor definition of what constitutes termination for good reason. Use of Severance Pay as Replacement of Amounts Deferred by the Employee Under a Separate Nonqualified Deferred Compensation Plan. Although the final regulations give employers and employees additional flexibility in several areas relating to severance pay, an employer may not make payments to the employee that are intended to be a substitute or replacement for amounts deferred by the employee under a separate nonqualified deferred compensation plan, unless the substitute payments will comply with section 409A. For example, if an employee with a legally binding right to deferred compensation that would be forfeited upon termination of employment receives additional separation pay, the additional pay may, depending on whether it acts as a replacement of the forfeited deferred compensation, be treated as an acceleration of payments in violation of section 409A and may also violate the six-month rule for specified employees of publicly traded companies.

Foreign Deferred Compensation Arrangements
The final regulations retain the exclusion from section 409A for certain foreign nonqualified deferred compensation plans covered by an applicable income tax treaty and clarify that the exclusion applies to any bilateral income tax convention to which the United States is a party, and not just an income tax treaty. Arrangements excluded by the final regulations include the following:

• Arrangements Covered by U.S. Bilateral Income Tax Conventions. Plan contributions and benefit accruals are exempt from section 409A to the extent they are exempt under a bilateral income tax convention to which the United States is a party.
• Non-U.S. Source Income. Deferred compensation of a nonresident alien is exempt to the extent the compensation would have been exempt from U.S. income tax when first vested.
• De Minimis Amounts. Deferred compensation of a nonresident alien is exempt if the compensation is derived from the performance of services within the United States, for amounts up to the limit that applies to 401(k) elective deferrals for the year ($15,500 in 2007), and the compensation is deferred under a plan maintained by a non-U.S. employer. The exclusion applies to deferred compensation amounts up to the limit for the year (plus earnings on the deferred amount if those earnings can be identified), even if more than $15,500 is deferred during the year.
• Foreign Earned Income. Deferred compensation of U.S. citizens and U.S. residents is exempt from section 409A to the extent the compensation, when added to all other foreign earned income of the individual during the year in which the individual's right to the deferred compensation first vests, does not exceed the exclusion for foreign earned income under section 911 ($82,400 for 2006). The final regulations also exclude any earnings on these deferred amounts from section 409A.
• Broad Based Foreign Retirement Plans Maintained by Non-U.S. Employers. Amounts deferred under a "broad based foreign retirement plan" maintained by a non-U.S. employer are exempt from section 409A coverage to the extent the plan covers nonresident aliens and U.S. resident aliens without a green card. If the plan covers U.S. citizens and U.S. resident aliens with a green card, the exclusion applies to such individuals only if they are ineligible to participate in a U.S. tax-qualified plan, and is limited to nonelective deferrals of foreign earned income that do not exceed the dollar limit under section 415 for a similar U.S. tax-qualified plan (i.e., defined contribution or defined benefit).

Initial Deferral Election Rules
General Rules. Section 409A regulates when elections to defer compensation may be made. The final regulations generally adopt the initial deferral election provisions contained in the proposed regulations. The final regulations generally require a deferral election to be made in the taxable year before the taxable year in which the services giving rise to the compensation are performed. Because a deferral election includes an election as to the time and form of payment, an election of the form of payment must also comply with the timing rule, even under a plan that does not permit the employee to elect the amount of the deferral (a nonelective plan). Evergreen elections (i.e., elections that remain in place for subsequent years until changed or revoked) will satisfy the general rule. First Year of Eligibility. An initial deferral election may be made up to 30 days after an employee first becomes eligible to participate in the plan, but only with respect to compensation earned after the date of the election. For purposes of this rule, however, the term "plan" is defined to include all plans of the same type (e.g., elective account balance, nonaccount balance, etc.). Thus, for example, employees who participate in an elective account balance plan and who become eligible to participate in another elective account balance plan will not be eligible to use this rule to make a midyear election under the second plan. The final regulations provide additional relief by permitting employees who have not been active participants in a plan for at least 24 months (e.g., a rehired employee) to use the 30-day rule even though they participated in the plan before. Employees in nonelective excess benefit plans (i.e., plans that provide benefits in excess of those permitted under qualified retirement plans) may make an initial deferral election during the 30-day period that starts on the first day of the plan year after the plan year in which the employee first earns a benefit under the excess plan. Performance-Based Compensation. If deferred compensation is based on a performance period of at least 12 months, the initial deferral election must be made no later than six months before the end of the applicable performance period and before the amount of the compensation is readily ascertainable. In addition, the employee must have performed services continuously from the later of the beginning of the performance period or the date the performance criteria are established, until the date of the election. For this purpose, compensation that is specified or calculable is readily ascertainable when the amount is first substantially certain to be paid. On the other hand, compensation that is neither specified nor calculable (e.g., because the amount may vary based on performance) becomes readily ascertainable only when the amount first becomes calculable and substantially certain to be paid. As with the rules under section 162(m) (dealing with the $1 million limit on deducting pay to certain public company executives), the final regulations also permit the performance criteria to be established within 90 days after the beginning of the performance period, so long as the outcome is not substantially certain at the time the criteria are established. In addition, the final regulations clarify that a plan provision for automatic payment of performance-based compensation upon death, disability, or a change-in-control event will not disqualify the award from being considered performance-based compensation, if the deferral election is made before the event occurs.

Payment Rules
Section 409A generally requires that payments be made no earlier than a fixed date or under a fixed schedule, or upon any of the five following events: (1) separation from service, (2) death, (3) disability, (4) change in control, or (5) unforeseeable emergency. The final regulations require a designation of an objectively determinable payment date that coincides with or follows the event (e.g., 30 days following separation from service). In addition, as long as the employee is not permitted to designate the taxable year of payment, payments will be treated as being made upon a designated date if they are made by the later of (i) the end of the calendar year containing the designated date or (ii) the 15th day of the third month following the designated date. Payments may also be delayed in certain other cases without violating section 409A (e.g., when required to comply with the $1 million deduction limit for executive pay under section 162(m) or securities laws). A plan may provide for payments to be made upon the earlier of, or the later of, two or more specified permissible payment events or times, and may permit a different form of payment to be elected for each of the five potential payment events. Although only one time and form of payment may be elected for each type of payment event, the final regulations permit a plan to allow elections of different time and form of payment for a separation from service (i) during the two-year period following a change in control or (ii) before or after a specified date (e.g., age 55) or combination of a specified date and specified period of service (e.g., age 55 and 10 years of service), as well as for any other type of separation from service. Six-Month Delay for Specified Employees. Section 409A requires that nonqualified deferred compensation payable upon separation from service to "specified employees" of public companies be delayed at least six months following the date of separation. Specified employees are generally defined as officers, 5 percent owners, or certain 1 percent owners of the employer who are treated as key employees under the top-heavy rules that apply to tax-qualified retirement plans. A plan may meet this requirement by providing that all payments otherwise due within the six-month period be delayed until the end of the six-month period (with the first six months of payments paid in a lump sum), or that each scheduled payment that becomes payable pursuant to a separation from service is delayed six months after the date it was otherwise payable. The final regulations provide additional rules and options for determining who is a specified employee, including after mergers or initial public offerings, and permit designation of all employees as subject to the rule where the employer elects. Plan Terminations. The final regulations permit an employer to terminate a plan and make distributions to participants without violating the prohibition under section 409A against accelerating payment of benefits. This is permitted (1) when the employer ceases providing a certain category of nonqualified deferred compensation plans altogether (e.g., elective account balance plans) and terminates all such plans with respect to all participants, (2) during the 30 days before or 12 months following a change in control of a corporation (but only if all substantially similar arrangements of the employer are terminated), or (3) in the case of certain corporate dissolutions or with the approval of a bankruptcy court.

Tax Withholding and Reporting Rules
Additional guidance will be issued by the Treasury and the IRS to address tax withholding and reporting of amounts subject to section 409A. Until such guidance is issued, the tax withholding and reporting rules presented in Notice 2005-1 will continue to be applicable. Employers must treat amounts that are taxable under section 409A as wages subject to wage withholding, and report them in box 1 of Form W-2 as taxable wages, and also in box 12 of Form W-2 using the code "Z." Service recipients must similarly report deferrals of nonemployees in box 15a of Form 1099-MISC, and must report section 409A income as nonemployee compensation in box 7 of Form 1099-MISC.

Effective Date
The final regulations for section 409A are effective for taxable years beginning on or after January 1, 2008. All plans and arrangements that provide for deferral of compensation must be reviewed and, where required, amended before January 1, 2008. This includes deferred compensation plans, supplemental executive retirement plans, annual and long-term incentive plans, stock option and equity award plans, employment agreements, severance agreements, and post-employment reimbursement arrangements.

This Client Alert is a summary of certain of the provisions of the final regulations. In the interest of brevity, many details and issues have been omitted.