Immediate Action Required: Plans, contracts, programs and other compensation arrangements have only until December 31, 2008, to comply with the nonqualified deferred compensation rules of Section 409A of the Internal Revenue Code. These requirements have been in effect since 2005.

Nonqualified deferred compensation that fails to comply with the requirements of Section 409A will subject employees and other service providers to acceleration of tax liability, a 20 percent excise tax and punitive interest penalties. 


Deferred Compensation is EVERYWHERE: In general, compensation is "deferred" if there is a legally binding right to it and, by its terms, it is or may be payable in a subsequent tax year.

The Section 409A rules are not limited to executives or even to employees. They apply to all "service providers," including directors, independent contractors and consultants (including partnerships, corporations, LLCs and other organizations that provide services).*

Examples of Compensation Arrangements Subject to Section 409A: The following is a non-exhaustive list of compensation that may be subject to Section 409A:

    • Severance benefits, including severance benefits provided under individual employment agreements or broad-based plans
    • Change of control benefits
    • Section 457(f) arrangements (deferred compensation for tax-exempt entities)
    • Discounted stock options and stock appreciation rights (i.e., options and SARs with an exercise price below fair market value of the stock on the date of grant)
    • Restricted stock units and deferred stock or deferred stock units
    • Performance stock and performance stock units
    • Expense reimbursement arrangements
    • Tax gross-up provisions (including excess parachute tax gross-ups)
    • Annual and long-term bonuses, deferred bonus arrangements
    • Post-employment fringe and welfare benefit continuation arrangements
    • Split-dollar life insurance arrangements
    • Deferred director fees
    • Excess benefit plans, supplemental retirement plans (SERPs), 401(k) excess plans, and traditional deferred compensation arrangements
    • Make-whole plans or restoration plans

Exempt Arrangements: The Section 409A rules do not apply to certain types of compensation, including:

    • Short-term deferrals: Compensation that, by its terms, is payable no later than two and a half months after the end of the year in which the right to such compensation vests and becomes nonforfeitable
    • Stock options and stock appreciation rights that have an exercise price not less than the fair market value on the date of grant
    • Restricted stock
    • Tax-favored retirement benefits, including qualified plans, 403(b) annuities, 457(b) plans, SEPs and SIMPLE IRAs
    • Nontaxable benefits such as insured medical benefits
    • Indemnification payments
    • Foreign plans that meet certain specific requirements

Key Requirements of Section 409A. The key requirements of Section 409A are:

Permissible Payment Events or Specified Payment Date. The deferred compensation must be payable only upon death, disability, separation from service, change of control or unforeseeable emergency, or pursuant to a fixed schedule.

Six-Month Delay for Separation from Service Payment to Specified Key Employees. Payments to a "specified" key employee of a public company triggered by separation from service must be delayed for a minimum of six months after separation.

Initial Deferral Elections. The initial decision to defer compensation for a year must be made before the beginning of the year in which the services for which the compensation is earned are performed. Thus, for instance, a bonus deferral election must be made before the beginning of the start of the year in which the bonus performance period begins. The amount of compensation being deferred and the time and form of payment of the deferred compensation must be irrevocably specified at the time the deferral election becomes effective. The following limited exceptions to the timing of initial deferral elections apply:

    • First year of eligibility. A person may make an initial deferral election during his or her first 30 days of eligibility under the deferred compensation plan. This election may not apply to compensation for services rendered before the election is made.
    • Performance-Based Compensation. The initial election with respect to "performance-based compensation" may be made as late as six months before the end of the performance period if the employee renders services continuously from the beginning of the performance period (or, if later, the date the performance criteria are determined) until the date the election is made. Any performance-based compensation that is both calculable and substantially certain to be paid cannot be electively deferred. Compensation will qualify as "performance-based compensation" only if the payment is contingent on meeting pre-established organizational or individual goals during a performance period of at least 12 months.
    • Subsequent Changes to Time and Form of Payment. Subsequent changes to the time and form of payment initially elected are severely restricted. Acceleration of payment is generally prohibited, even if the plan is terminated. The time and form of payment may be changed only if (i) the election to change the time and form of payment is made at least 12 months before the payment is due to be paid; (ii) the election does not become effective for a period of at least 12 months after the election is made; and (iii) the election extends the deferral period by at least five years (except for payments made on account of death, disability or unforeseeable financial hardship).

Common Issues to Consider

Annual and Long-Term Bonus Arrangements

    • Short-Term Deferral Exception. Annual and long-term bonus arrangements will be exempt from Section 409A only if the bonus is required to be paid no later than two and a half months after the end of the year in which the employee's right to the bonus vests and becomes nonforfeitable.

Bonus arrangements should be written and should identify a specific payment date. Terms such as "as soon as practical" or "within 90 days" will not comply.

Certain Severance Pay May be Exempted 

    • Separation Pay Exclusion. Section 409A does not apply to severance pay provided solely on involuntary separation from service to the extent that the severance payments are completed within two years after the involuntary separation in an amount not exceeding two times the employee's annual rate of pay at the end of the prior year or, if less, two times the compensation limit in effect for qualified retirement plans ($230,000 for 2008). To the extent that severance pay conditioned on involuntary separation exceeds these limits, only the amount in excess of the limits will be subject to Section 409A.
    • Short-Term Deferral. Severance pay may qualify as a short-term deferral if it is only payable on an involuntary separation and if the payments must be completed no later than two and a half months after the end of the year in which the involuntary separation occurs.
    • Collectively Bargained Employee Exclusions. Section 409A does not apply to severance pay provided on involuntary separation from service to employees covered by a bona fide collective bargaining agreement. Involuntary Separation and "Good Reason." Under Section 409A a "good reason" termination may be treated as an involuntary separation if good-reason is limited to material adverse acts or omissions. The regulations include a safe-harbor good-reason standard. In order for a separation to be treated as involuntary, the employee must be willing and able to work. Thus, it appears that a separation from service on account of death or disability will generally not qualify as an involuntary separation for purposes of the short-term deferral exemption or the separation pay exclusion.
    • Common Pitfalls.
      • Severance Conditioned on Execution of a Release. Standard provisions in employment agreements and severance plans conditioning severance pay on execution of a release may not comply with Section 409A. Where the severance pay is treated as deferred compensation, the plan or employment agreement must limit the period during which the employee may execute the release to ensure that the severance is payable within the appropriate time frame. In the case of year-end terminations, the plan or agreement must prevent the employee from being able to control the year in which the severance will be paid by deciding when to sign the release.
      • Coordination with Change of Control Agreements. Employment agreements and severance plans must be closely coordinated with change of control agreements to ensure that changes in time and form of payment of severance following a change of control does not result in a loss of exempt status or impermissibly change the time and form of payment of severance.
      • Payment of Pro-rata Bonus at Target. Severance plans and employment agreements often provide for the payment of a pro-rata annual bonus based on target performance upon involuntary separation or retirement. This type of provision will prevent the bonus from qualifying as a performance-based bonus for all years and will prevent the employee from being allowed to make a deferral election with respect to any bonus deferral election after the performance period begins.
      • Entitlement to Severance Upon Expiration of Employment Agreement. Many employment agreements provide that the employee will be entitled to resign and receive severance pay if the employment agreement expires due to the employer's refusal to extend the term of the agreement. Severance pay due upon expiration of the initial term of the agreement will be subject to Section 409A.
      • Changes in Form of Severance Pay. Changes in the form of severance pay (from lump sum to salary continuation or from salary continuation to lump sum) may violate Section 409A. Circumstances that may result in a change in the form of severance pay include, in addition to renegotiation, entering into a new employment agreement or changes in severance plan eligibility due to promotions or job transfers within the same controlled group.

Stock Options and Stock Appreciation Rights ("Stock Rights"). For Stock Rights to qualify for exemption from Section 409A:

    • Valuation. Stock Rights must have an exercise price not more than fair market value of the underlying stock on the grant date. A valuation of stock that is not publicly traded may be made under one of the following safe-harbor standards: (i) valuation performed by a qualified independent appraiser; (ii) valuation of an illiquid start-up company performed by a person with valuation experience; or (iii) formulaic valuation, which is used for substantially all transactions involving the company's stock (other than an arm's length transaction involving the sale of substantially all of the company's stock). Safe-harbor valuations are rebuttably presumed to be reasonable.
    • "Service Recipient Stock." The stock underlying a Stock Right must be "service recipient stock." Service recipient stock means common stock issued by any corporation in the parent-subsidiary chain of corporations between the ultimate parent corporation and the entity that employs the person receiving the Stock Right. Options to purchase stock of a subsidiary of the direct employer will be treated as deferred compensation subject to Section 409A. This would require significant changes to the structure of typical options.
    • Stock Right Extensions. An extension of the exercise period may not go beyond the original term of the Stock Right or 10 years from the date of grant.
    • Modifications. A modification to the terms of a Stock Right that results in a direct or indirect decrease in the exercise price will cause the Stock Right to be treated as deferred compensation from the date the Stock Right was initially granted.
    • Exception for Underwater Stock Rights. If a Stock Right is "underwater," the term may be extended, or it may be cancelled and replaced with a new Stock Right that meets the requirements for exemption from Section 409A.

Tax Gross-Ups. A tax gross-up payment (e.g., for parachute taxes) will comply with Section 409A if it is required to be paid by the end of the calendar year after the year in which the taxes are paid to the government, or in the event of an audit or other tax dispute, by the end of the calendar year after the year in which the disputed taxes are paid (or the audit or dispute is concluded, if no taxes are paid). "Standard" tax gross-up provisions may not comply.

Reimbursement and In-Kind Benefit Arrangements. Reimbursement arrangements and in-kind benefits will meet the "fixed schedule" requirement under Section 409A if they provide objectively determinable benefits payable over an objectively prescribed period and the amount of reimbursement or benefits provided in one calendar year cannot affect the amount of reimbursement or benefits provided in another calendar year (with limited exceptions for lifetime caps on medical benefits) and if the right to reimbursement cannot be commuted to cash.

Separation from Service. Separation from service is one of the permissible payment events for deferred compensation. There are detailed rules on when a "separation from service" occurs.

    • Substantial Reduction in Level of Services. An employee will not be treated as having had a separation from service unless there is a substantial reduction in the level of services provided in all capacities (other than as a non-employee director). Accordingly, a termination of employment will not be treated as a separation from service if the individual continues to perform substantial services as an independent contractor or consultant. Conversely, an employee who experiences a sharp reduction in his or her level of services may be treated as having had a separation from service triggering deferred compensation payments, even if the employment relationship continues. The regulations provide certain presumptions for determining whether a separation from service has or has not occurred based on a reduction in the level of services.
    • Transfers to Affiliates/Joint Ventures. All members of the employer's controlled group are aggregated to determine whether there is a separation from service. A transfer of employment to a joint venture or other affiliate that is not a member of the employer's controlled group is a separation from service, triggering payment of all deferred compensation payable on separation from service. In general, controlled group status for this purpose is based on an ownership interest of "more than 50 percent" (for example, a parent company and a more than 50 percent owned subsidiary would be members of the same controlled group). However, a deferred compensation plan may specify a different ownership percentage interest to determine control (between 20 percent and 80 percent). Any ownership percentage interest (other than "more than 50 percent") must be written into the plan documents and cannot be changed with respect to amounts previously deferred.

Determining Specified Employees. "Specified employee" of public companies entitled to deferred compensation payable on separation from service must wait for payment until at least six months after separation from service. Generally, the specified employees include certain highly paid officers and shareholders of the company who are "key" employees for purposes of the "top heavy" rules applicable to qualified retirement plans. The same definition of specified employee must be used for all deferred compensation arrangements maintained within the public company's controlled group.

Excess Plans. Excess benefits plans that provide contributions or benefits in excess of the limitations imposed under a tax qualified plan, or which offset benefits provided under qualified plan, are subject to Section 409A.

    • 401(k) Excess Plans. Deferral elections under 401(k) excess plans must comply with the Section 409A timing rules and may not be changed once the year commences. If an election applies to both annual bonus and salary, the election may apply to payments made in different years. For instance, if deferral elections for 2009 are allowed to be made at any time up to December 31, 2008, the elections would apply to salary otherwise payable in 2009 and the 2009 bonus otherwise payable in 2010. The 2008 bonus payable in 2009 would be subject to the deferral election, if any, made in 2007. The performance-based compensation exception may allow separate elections for salary and bonus deferrals.
    • Time and Form of Payment Must Not be Linked to Qualified Plan Distributions. Any excess plan that provides for distributions at the same time and in the same form of payment as distributions from the underlying qualified plan will be in violation of Section 409A after December 31, 2008. To comply, the excess plan must have independent (de-linked) distribution provisions.

Change of Control Payments. Change of control is a permissible payment event under Section 409A. The regulations contain very detailed rules regarding what constitutes a change of control so as to trigger a payment and or determining the persons to whom the change of control event applies. A change of control standard that is written into a plan may not be modified after December 31, 2008, with respect to amounts previously deferred. Although Section 409A severely restricts payments on plan termination within a limited period before or after a change of control, an employer may terminate all (but not less than all) of its deferred compensation arrangements with respect to all plan participants who are affected by the change of control.

Transition Relief Ends December 31, 2008. Special broad transition relief allows existing arrangements to be modified before January 1, 2009, to comply with Section 409A. In addition, this broad transition relief permits changes to the time and form of payment of deferred compensation under existing arrangements that will be prohibited after the end of this year. Certain limitations apply to this transition relief. The changes may not accelerate payments into 2008 that would otherwise be made in later years, and may not defer payments beyond 2008 that would otherwise be made in 2008. Note that this transition relief ends on December 31, 2008.

* Section 409A does not apply to any person or organization that is an accrual basis taxpayer or receives significant compensation for services (other than as a director) from two or more unrelated service recipients.