TRANSITION RELIEF

On October 22, 2007, the Internal Revenue Service issued Notice 2007-86 (the Notice), which provides significant additional transition relief for deferred compensation arrangements subject to Section 409A. The Notice generally extends the deadline for required amendments to deferred compensation arrangements to December 31, 2008, and provides additional relief for good faith operational compliance. In summary, the Notice provides the following: 

  • Good Faith Operational Compliance. Compliance with the final regulations under Section 409A is not required until January 1, 2009. Prior to 2009, taxpayers must apply a reasonable, good faith interpretation of Section 409A that is consistent with applicable guidance. After 2007, reliance on the proposed regulations is no longer permitted (subject to limited exceptions). Reliance upon the final regulations is treated as a reasonable, good faith interpretation of Section 409A. Where the terms of a plan permit the exercise of discretion (by the employer or the employee), proceed with caution. Any exercise of discretion permitted under a plan may cause the plan to fail to satisfy the requirements of Section 409A.

For Example: The Notice provides that where an employer retains discretion under the plan to delay or extend payments in a manner that does not comply with Section 409A and the employer exercises such discretion, the plan will not be considered to be operated in good faith compliance with Section 409A with regard to any plan participant. 

  • Timing of Amendments. Plans must be operated in compliance with Section 409A throughout the transition period and must be amended on or before December 31, 2008, to conform to the technical requirements of Section 409A and the final regulations under Section 409A.
  • Changes to Payment Elections. On or before December 31, 2008, a plan may be amended to provide for new payment elections or to change to the time and form of payment for amounts subject to Section 409A. Any elections or changes to the time and form of payment may not (i) accelerate payments into the year of the election or (ii) defer payments to a later year that are otherwise payable in the year of the election (the “no acceleration – no deferral rule”).

For Example: Assume that an employment agreement provides for installment payments of deferred compensation over five years upon separation from service. A change in the time and form of payment during 2007 cannot change the amount that would be payable in 2007 if the employee in fact separated from service during 2007.

  • Compliance for Linked Plans. The transition relief for payment elections under a nonqualified deferred compensation plan that is linked to an election under a qualified plan is extended through December 31, 2008. 
  • Stock Options and Stock Appreciation Rights (SARs). Section 409A applies to discounted stock options and SARs (stock rights). Many companies are not aware that Section 409A applies to discounted stock rights even if the grant was made prior to 2005 (unless the grant was fully earned and vested prior to 2005). Solely during the transition period, stock rights subject to Section 409A may generally be “fixed” as follows:
  1.  An outstanding stock right may be amended on or before December 31, 2008, to permit the holder to elect a fixed payment period or to provide for fixed payment terms consistent with Section 409A. Any such change must be consistent with the “no acceleration – no deferral rule,” and cannot be made during the year in which the stock right is reasonably expected to be exercisable. Consider the limitations of this relief in planning with respect to anticipated corporate transactions.
  2.  A discounted outstanding stock right may be replaced with a stock right that on the original grant date would not have been discounted, provided that the cancellation and reissuance occurs on or before December 31, 2008. Any cash payment or vested property received in exchange for the cancellation and reissuance must comply with the “no acceleration – no deferral rule,” and cannot be received during the year of the cancellation and reissuance. For purposes of Section 409A, any replacement stock right will be treated as if granted on the grant date of the original stock option or SAR.

The transition relief for stock rights does not apply to stock rights of a publicly-traded corporation issued to certain officers and managers where the corporation has reported or reasonably expects to report financial expense associated with a discounted stock right that was not timely reported. 

  • Correction Program. The IRS anticipates issuing guidance soon with respect to a limited voluntary compliance correction program designed to apply to certain unintentional operational failures to comply with Section 409A. The program is anticipated to permit correction of failures during the same taxable year and other limited methods of correction. Based upon the limited scope of the anticipated correction program, it will be critical that companies timely identify any operational failures to permit correction under the voluntary correction program during the same year that the failure occurs.

WHERE WE HAVE BEEN

Section 409A was enacted in 2004 to limit favorable income tax treatment of nonqualified deferred compensation to arrangements that meet specified design and operational requirements. Many companies have been surprised to learn that the reach of Section 409A is very broad and requires changes to many common compensation arrangements (e.g., offer letters, employment and consulting agreements, bonus awards, stock options and restricted stock units) in addition to traditional deferred compensation plans.

If an arrangement fails to comply with Section 409A, the employee or other service provider (e.g., director, independent contractor or consultant) will be subject to immediate taxation on the compensation (even if no payment is received), an additional 20% income tax, plus interest. Since 2004, the IRS has issued several notices and other guidance providing transition relief to assist companies and their advisors in complying with the many technical requirements of Section 409A. On September 10, 2007 (Notice 2007-78), the IRS issued limited transition relief for operational compliance and plan amendments. On October 22, 2007, in response to many comments from companies and their advisors that transition relief was insufficient, the IRS issued Notice 2007-86, which provides much more extensive transition relief for compliance with Section 409A.

WHAT NEEDS TO BE DONE NOW

Although the Notice provides welcome relief for companies and their advisors to thoughtfully consider the required changes to compensation arrangements to comply with, or to be excepted from, Section 409A, there is much work to be done.

During the transition period (generally from now until December 31, 2008), companies need to be diligent in identifying all “deferred compensation” arrangements. Remember almost any type of compensation arrangement (written or unwritten) can constitute deferred compensation subject to Section 409A. The rules apply to all types of companies and service recipients (e.g., private companies, publicly-traded companies, tax-exempt organizations, churches, and governmental entities). The rules are not limited to executives; Section 409A applies to all types of service providers (employees, consultants, directors, and independent contractors).

Many of the transition relief provisions include incentives for early action, in particular: (i) the ability to change payment elections, subject to the “no acceleration – no deferral rule” and (ii) the ability to “fix” outstanding stock rights to comply with Section 409A or to replace the stock right with a stock right not subject to Section 409A, both subject to the “no acceleration – no deferral rule.”

PRIOR TO DECEMBER 31, 2007 

  • Identify all deferred compensation arrangements and ensure that all arrangements are operated in good faith compliance with Section 409A. 
  • Remember that relief under any correction program will necessitate prompt identification of any failures and prompt action to correct the failure. 
  • Remember that the exercise of discretion (by a company or a service provider) may result in a violation of Section 409A. Identify discretionary provisions in current arrangements and determine to what extent discretion may be permitted without violating Section 409A. 
  • Consider changes to payment elections during 2007 for amounts that may be payable in 2008 or beyond. The application of the “no acceleration – no deferral rule” limits some planning opportunities. 
  • Review all stock options and SARs that have been granted or vested after December 31, 2004, and identify outstanding awards that are subject to Section 409A. Consider fixing stock rights during 2007 consistent with the “no acceleration – no deferral rule.” Consider the timing of any potential corporate transactions in determining when to make changes to stock rights.

PRIOR TO DECEMBER 31, 2008

  • Continue to identify all deferred compensation arrangements (both new arrangements and arrangements that may have been previously overlooked) and ensure that all arrangements are operated in good faith compliance with Section 409A. 
  • Remember that relief under any correction program will necessitate prompt identification of any failures and prompt action to correct the failure.
  • Consider changes to payment elections during 2008 for amounts that may be payable in 2009 or beyond. The application of the “no acceleration – no deferral rule” limits some planning opportunities. 
  • Fix any remaining stock rights that are subject to Section 409A. 
  • Establish systems to comply with the reporting and withholding requirements of Section 409A.

AMENDMENTS 

  • Arrange to obtain board of director or compensation committee approvals for new plans and agreements or amendments to existing arrangements.
  • Determine whether shareholder approval is required for any new plans and agreements or amendments. 
  • Determine whether SEC reporting requirements apply to new or modified plans or agreements:

— Form 8-K (four-day reporting)    — Form 10-K or 10-Q (material contracts)

— Proxy Statement (disclosures)    — Form S-8 (update prospectus) 

  • Complete all action required and adopt amendments to comply with Section 409A by December 31, 2008. 
  • Continue to watch for additional IRS guidance.

We encourage you to continue your efforts to comply with Section 409A. If you have not already done so, prepare an action plan in coordination with your advisors.