On September 10, 2007 the IRS issued Notice 2007-78, extending to December 31, 2008 the written document compliance deadline for Section 409A of the Internal Revenue Code of 1986, as amended. This move gives taxpayers additional time to amend or otherwise update the written documents covering nonqualified deferred compensation plans to comply with Section 409A. However, all of the decisions regarding how to comply with Section 409A must be made by December 31, 2007 and implemented by January 1, 2008. That is, the notice did not extend the January 1, 2008 effective date of the final Section 409A regulations. Neither does the notice extend the good faith interpretation period under Section 409A. Starting January 1, 2008, good faith interpretation will be insufficient and plans will have to comply with the final regulations. As a consequence, all deferred compensation plans, employment agreements, severance pay arrangements, and other compensation plans and arrangements will need to be reviewed by December 31, 2007 for compliance with Section 409A, and many documentary changes will need to be implemented by December 31, 2007.
Section 409A sets forth certain requirements for nonqualified deferred compensation plans, specifically deferred amounts that were not earned and vested before January 1, 2005. If a plan does not comply with Section 409A, participants must immediately include deferred amounts under the plan in income and pay interest and a 20% excise tax. One of the requirements of the final regulations is that the material terms of a nonqualified deferred compensation plan be in writing.
Some Actions Required by Year-End
Payment Provisions. Deferred compensation payment provisions must be in place by year-end. Employers have until December 31, 2007 to allow deferred compensation plan participants to make new elections regarding the time and form of payments without violating Section 409A and to document those payment elections that comply with Section 409A. As a result, employers must act now to make any such changes required or desirable in light of any redesign implemented to comply with Section 409A.
For example, action would be required by the end of this year if, for reasons of administrative simplicity, a public company employer wanted to apply the six month delay for payments after the date of separation from service (except in the event of death) to all employees under a plan, rather than just to “specified employees.” Another example is that employers must by year-end put in place separate elections as to the time and form of payment for nonqualified deferred compensation plans under which payments otherwise would be “linked” to qualified plan elections.
Good Reason Provisions of Employment Agreements. The final regulations provide significant relief from the deferred compensation rules for both lump sum and installment payments of severance in connection on an “involuntary separation” of services, including a separation for “good reason” as long as the good reason definition complies with the final regulations. The notice provides that an amendment to a current definition of good reason in a severance agreement, plan, or an employment agreement that does not comply with the final regulations in order to bring the definition into compliance with the final regulations may only be made by December 31, 2007 in many circumstances.
Discount Options. Options that were granted with an exercise price of less than 100% of fair market value that were not vested prior to January 1, 2005 are subject to adverse tax consequences unless corrected. No additional transition relief has been provided for these options, and these options must be amended to have a specified payment date or otherwise to be corrected by December 31, 2007. As a consequence, taxable income will be recognized for all such discount options that are still outstanding and not corrected by December 31, 2007.
Application of Substitution Rule to Employment Agreements. Under the final regulations, there is a limited ability to amend or replace plans and agreements if the new plans or agreements provide for payments of amounts as a substitute for payments of deferred compensation under the prior plan or agreement. This rule applies to employment agreements that provide for deferred compensation, for example by providing for severance payments pursuant to a “good reason” termination that does not comply with the final regulations. Assuming this agreement is not corrected by year-end, it can be corrected in an employment agreement that does not provide for severance on termination of the employment agreement. Consequently, employment agreements that treat non-renewal of the employment agreement as a termination of employment for severance purposes, will not be able to be replaced at the end of the term of the agreement with an employment agreement that has a compliant definition of good reason.
Anticipated Limited Voluntary Compliance Program. The Treasury Department and the IRS anticipate issuing guidance in the near future establishing a limited voluntary compliance program that will apply to certain unintentional operational failures to comply with Section 409A. It is expected that such guidance will provide methods to correct unintentional operational failures in the same taxable year in which such failure occurred to avoid application of Section 409A, as well as other methods by which certain unintentional operational failures may result in only limited amounts becoming includible in income and subject to additional taxes under Section 409A.