On October 22, 2007, the IRS issued Notice 2007-86, which extended the transition relief from compliance with the final regulations under Section 409A of the Internal Revenue Code (“Section 409A”) from December 31, 2007 to December 31, 2008. The effective date of the final Section 409A regulations is extended from January 1, 2008 to January 1, 2009. The remedial amendment period for deferred compensation arrangements subject to Section 409A will end on December 31, 2008, but new payment elections with respect to existing deferred compensation may now be made until December 31, 2008, rather than December 31, 2007. This update describes the provisions of prior transition relief provided in Notices 2006-79 and 2007-78 as amended by Notice 2007-86.
New Payment Elections on or Before December 31, 2008
Under the final 409A regulations, payment elections may not be changed unless the change is made at least 12 months in advance of the original payment date and the new payment date (or the commencement of the payment) is at least five years after the original payment date (the “12- Month/5-Year Rule”). Despite the 12-Month/5-Year Rule, prior transition relief allowed new payment elections to be made during a transition period that would establish a new payment date as long as certain requirements were met. The transition period has been further extended by Notice 2007-86 to December 31, 2008. The new payment election may not take a payment otherwise payable in 2007 and defer the payment into a later year, and a payment otherwise payable in a year later than 2007 may not be accelerated into 2007. The new transition relief requires that a payment otherwise payable in 2008 cannot be deferred into a later year and a payment from a later year cannot be accelerated into 2008. Notice 2007-86 continues the rule that the new payment election transition relief is available in connection with a payment that would otherwise be made in 2008 or a later year, subject to the rules in the prior paragraph, and that the decision whether to make a new payment election may be made by the service provider or the employer, or both.
Discounted Stock Options and Stock Appreciation Rights (“SARs”)
Discounted options or SARs granted prior to October 4, 2004, which were not vested as of December 31, 2004, constitute deferred compensation that does not comply with Section 409A.
Discounted options and SARs include backdated options and SARs that have an exercise price less than what should have been the grant date fair market value. As a result, there are significant tax implications under Section 409A upon the discovery of backdated options, in addition to the SEC reporting failures and potential accounting consequences.
Prior transition relief included a provision pursuant to which discounted options/SARs could be amended prior to the end of 2007 to comply with Section 409A by increasing the exercise price to the fair market value of the underlying shares on the original date of grant. (Options/SARs issued at fair market value, where the exercise price can never be less than fair market value on the date of grant and under an instrument that does not provide for any additional deferral opportunity, are not deferred compensation within the meaning of Section 409A and thus are not subject to Section 409A). This exercise price recalibration transition relief has been further extended to December 31, 2008 by Notice 2007-86.
The new payment election transition rule described above is also available to fix a discounted option/SAR. This is accomplished by selecting a fixed payment date for the option/SAR. The service provider and service recipient would thereby have converted a discounted option/SAR from non-compliant deferred compensation into compliant deferred compensation. In connection with such an election, the service recipient could exercise the option/SAR at any time during the year that includes the fixed payment date and the option/SAR nevertheless would be treated as deferred compensation complying with Section 409A. There is one notable exception described in the next section.
Both the exercise price recalibration transition relief and the new payment election transition rule are available to remedy discounted options/SARs even if they become vested and exercisable on or after January 1, 2005, as long as they are not actually exercised, but instead are fixed, prior to the end of 2008.
Backdated Options/SARs to Certain Insiders
Beginning January 1, 2007, the relief relating to discounted options did not apply to backdated options/SARs granted to a public company insider whose grant was subject to disclosure under Section 16(a) of the Securities Exchange Act of 1934, if “with respect to the grant of such stock right” the corporation has reported or reasonably expects to report a financial expense. This prohibition piggybacks on the accounting rules, so that if no expense is required to be reported, the discounted option/SAR transition relief continues to apply. Notice 2007-86 does not affect the treatment of backdated options/SARs granted to public company insiders.
Payments Linked to Qualified Plan Elections
Certain deferred compensation plans link payment under the plan to elections as to form and timing of payments under a qualified plan (which includes 403(b) tax-sheltered annuity arrangements, 457(b) eligible plans, and certain foreign-based plans). The exemption for payments to be made or commenced under such arrangements is extended through the end of 2008 by Notice 2007-86. It is important to note, however, that the exception only applies to linked plans in existence on October 3, 2004, and as to which no material modification has been made to the non-qualified deferred compensation plan.
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 with an “involuntary separation” from service, including a separation for “good reason” as long as the good reason definition complies with the final regulations. An amendment to a definition of good reason in a severance agreement, plan or an employment that does not comply with the final regulations in order to bring the definition into compliance may only be made through December 31, 2008 in many circumstances.
Good Faith Compliance
The good faith compliance period, pursuant to which plans may be maintained in good faith compliance with Section 409A, Notice 2005-1 (the original guidance under Section 409A) or the proposed regulations, is extended to the end of 2008 (although taxpayers can not rely upon the proposed regulations after December 31, 2007, as a general matter). Only those deferred compensation plans or other arrangements operated in good faith compliance with Section 409A are entitled to use the remedial amendment period. Accordingly, 409A subject deferred compensation arrangements must have been brought into operational compliance as of January 1, 2005.