As “A-Day” approaches (i.e., the release day for final section 409A regulations), this Legal Alert sets the stage for final regulations with – (1) a list of what to look for in the final regulations, and (2) a brief review of interim guidance issued since the proposed regulations. But read quickly, the wait for finals should not be long. If Treasury and IRS hit their current target, final regulations will be out this month. If not, early April seems a safe bet. Expect them to be long (300+ pages), which is fine; it is more important that the final regulations address problems well than briefly. Key problem areas are noted in the list below.
Scouting Report: What to Look for in the Final 409A Regulations
- The Compliance Deadline: Employers should plan on moving promptly in response to the final 409A regulations. Unless “A-Day” is pushed back significantly, IRS and Treasury appear unwilling to provide any further delay in the current January 1, 2008 compliance deadline.
- Definition of 409A Covered Deferred Compensation – Stock Options: The great many employees covered by stock options make the exemption from 409A for stock options both an executive compensation issue and a rank and file issue. It also means that stock options arise in a wide range of different circumstances, and they are affected by a wide range of different transactions and events. This means that the current exemption needs to be broadened, e.g., with respect to whose stock may be used and the extent to which the exercise period may be extended. Look for relief in both these areas.
- Definition of 409A Covered Deferred Compensation – Severance: Severance is similar to options in the breadth of employees covered. However, anyone who has wrestled with the 2-times-compensation exemption for severance benefits knows that it raises a host of operational issues and is dauntingly data intensive. Expect clearer rules here. Liberalized rules are likely.
- Definition of 409A Covered Deferred Compensation – Reimbursement Arrangements: The proposed regulations exempt certain expense reimbursement arrangements (a category that includes self-insured health plans). However, the narrowness of these rules pushes companies to waste money, i.e., to convert expense reimbursement arrangements into automatic scheduled payments in order to meet 409A’s requirement for fixed payments. Expect relaxed requirements for 409A-exempt reimbursement arrangements to reduce this effect. The final rules should also clarify that tax-excludible benefits are not covered by 409A, unless there is a choice to receive deferred compensation. Discriminatory health benefits, which are taxable, will not merit a general exemption. However, look for the limited exemption in the proposed regulations to be adjusted to make it more workable (e.g., by focusing more on the duration of coverage and less on the time of payment).
- Definition of 409A Covered Deferred Compensation – “Good Reason” Termination: The short-term deferral rule is the general-purpose 409A exemption. However, too often it is not applicable in the employment agreement context because the existence of protections for “good reason” termination arguably prevents benefits under the agreement from being considered subject to a substantial risk of forfeiture. Good reason termination benefits can also be ineligible for the 2-times-compensation exemption for severance. Many commentators requested guidance clarifying when good reason protections are not a problem under the short-term deferral and severance exemptions. Other commentators called for keeping the facts-and-circumstances approach of the proposed regulations. Expect the first group of commentators to prevail, but many employers’ current definitions of “good reason” are unlikely to make the cut.
- Separation from Service: In many deferred compensation programs, not all separations from service are treated the same. For example, a plan may allow participants to elect from a broader range of payout options upon separation from service after attaining the age and service requirements for retirement, than for an earlier separation from service. The proposed regulations allow differentiating between separations before and after a stated age, but not based on a combination of age and service. In addition, many arrangements distinguish between voluntary and involuntary terminations. Under the proposed regulations, the ability to subcategorize separations from service is quite limited, and at first it appeared that this was unlikely to change. Government representatives expressed the concern that the ability to distinguish between different separations from service could result in “designer deferred compensation plans” that allowed participants more control that Congress intended. (As an extreme example, different payouts depending on which day of the week the service provide was deemed to terminate would allow last minute collusion on the form of payment.) It appears, however, that attitudes have partly softened over time, and some relief is expected here. For example, being able to distinguish separations before and after retirement eligibility and separations that are voluntary and involuntary seems likely. One of the big questions under the final 409A regulations, however, is where IRS and Treasury will draw the line between acceptable subcategories and those that seemed too likely to permit designer deferred compensation.
- Recovery from Disability: SERPs and defined benefit restoration plans often pay benefits to disabled participants upon their recovery from disability (benefits are delayed while the participant receives LTD to avoid an offset of the participant’s LTD benefits by the non-qualified plan benefits). Although becoming disabled is a payment event under section 409A, recovery from disability is not. Expect the final regulations to address this helpfully, perhaps through rules focusing on offset situations. Kilpatrick Stockton’s June 2006 comments to Treasury and IRS on this issue are available on our website under the “Article” category.
- Documentary Compliance: 409A compliance requires more than operation that is consistent with section 409A, it also requires documents that provide for such compliance. The deadline for this documentary compliance has been delayed until January 1, 2008, so that plans could be drafted based on final 409A guidelines. Expect the final regulations to address expressly what is necessary for documentary compliance. Key questions here are to what extent the final regulations will apply expectations that are reduced for the period before January 1, 2008 (seems likely), and that are scaled to the specific arrangement (e.g., with more expected in the case of an elective deferral plan for a group of employees, than in the case of an individual employment agreement).
- Transitioning from Good Faith Positions: Under the proposed regulations, the right to rely on good faith positions appears to expire immediately on January 1, 2008. However, it is unlikely that the 8 or 9 months between “A-Day” and January 1, 2008 will be enough time for all employers to move fully away from good faith positions that are inconsistent with the final regulations. The potential for disruption in this regard is very considerable, which is why Kilpatrick Stockton made this issue the centerpiece of its comments at the hearing on the proposed regulations (also available on our website under the “Article” category). Since that time, it is clear that a lot of IRS and Treasury thinking has gone into this “second transition” to 409A compliance. Expect this to be robustly addressed in the final regulations. The key question is how much latitude will be allowed.
- Items That Will Be Addressed Later: Reporting on deferrals and taxable amounts will continue to be dealt with separately through updated guidance on 2007 reporting later in the year. Also coming later will be guidance on income measurement and inclusion, as well as on determining the portion of the penalty that relies on an interest calculation. Guidance on split-dollar life insurance, including the interaction of section 409A and the grandfather of certain split-dollar arrangements under Notice 2002-8, should also follow separately.
Looking Beyond the 409A Regulations
Looking beyond the final 409A regulations and the separate guidance that will be issued (noted above), we see the time when IRS and Treasury will focus significantly on the application of 409A. Section 409A auditing has already begun, e.g., as an adjunct to the executive compensation audits that have focused on option backdating. However, few employer audit cycles are beyond 2005 and its particularly generous transition rules, so more serious 409A auditing will occur in the future. The IRS has begun to think about the feasibility of a program for private letter rulings on section 409A issues, as well as a correction program in the vein of EPCRS. A key issue in both cases is resources. There would need to be a significant increase in staffing to permit such initiatives to go forward. Employer and practitioner support will be a major factor in determining whether to allocate increased resources. The likely scope of a future 409A corrections program is discussed at the end of this Legal Alert.
Section 409A Guidance Issued Since Proposed Regulations
- Notice 2005-94 (December 8, 2005). Notice 2005-94 suspended an employer’s reporting and wage withholding requirements for calendar year 2005 with respect to section 409A deferrals of compensation. For calendar year 2005, an employer was not required to report deferrals for the year under a nonqualified deferred compensation plan and was not required to include in the total amount of the employee’s taxable wages amounts includible in the gross income of an employee under section 409A that the employee had neither actually nor constructively received during 2005. However, the IRS cautioned in Notice 2005-94 that future published guidance may require an employer to file a corrected information return and to furnish a corrected payee statement reporting any previously unreported amounts includible in gross income under section 409A. With respect to employees, Notice 2005-94 did not affect an employee’s filing requirements, individual income tax liability, or interest on underpayments of tax. However, the IRS provided that it will not assert penalties under Code Sections 6651(a)(1) and (2), 6654, and 6662 with respect to amounts includible in gross income under section 409A for calendar year 2005, if the employee reports and pays any taxes due with respect to such amounts in accordance with future published guidance.
- Notice 2006-4 (December 23, 2005). Notice 2006-4 provided interim guidance with respect to the application of section 409A to stock options and stock appreciation rights issued before and after January 1, 2005 (i.e., the section 409A effective date). The concern was that although issuers of stock options and stock appreciation rights may have intended to establish an exercise price not less than the fair market value of the stock at the time of grant, the issuers may not be able to demonstrate that the exercise price was determined using a reasonable valuation method in accordance with the requirements set forth in Notice 2005-1 and the proposed regulations. Notice 2006-4 provided that until further guidance is issued, with respect to a stock option or stock appreciation right issued before January 1, 2005, for purposes of determining whether a stock option results in a deferral of compensation pursuant to Notice 2005-1, or a stock appreciation right results in a deferral of compensation pursuant to the proposed regulations, principles similar to those set forth in Treas. Reg. Section 1.422-2(e)(2) will be applied. Thus, if there was a good-faith attempt to set the exercise price of grants before January 1, 2005, at a price not less than the fair market value of the stock subject to the option or right at the time of the grant, then this exercise price will be treated as being not less than the fair market value of the stock at the time of grant for purposes of determining whether the option or right is excluded from section 409A. Further, the Notice provided that where an employer can demonstrate that the exercise price of a stock option or right, granted on or after January 1, 2005, and before the effective date of final regulations, is intended to be not less than the fair market value of the stock at the date of grant and that the value of this stock was determined using a reasonable valuation method, then that valuation will meet the requirements of Notice 2005-1, Q&A-4(d)(ii) regardless of whether that determination satisfies the valuation requirements in Prop. Treas. Reg. Section 1.409A-1(b)(5)(i)(B).
- Notice 2006-33 (March 21, 2006). Notice 2006-33 provided transition relief with respect to the application of section 409A(b). Section 409A(b) generally applies to the use of offshore trusts in connection with amounts payable under a nonqualified deferred compensation plan, and also the use of restrictions on assets to protect the payment of benefits under a nonqualified deferred compensation plan in connection with a change in the employer’s financial health. The Notice provided that until further guidance is issued, employers may rely upon a reasonable, good faith interpretation of section 409A(b) to determine whether the use of a trust or other arrangement causes an amount to be included in income under section 409A(b). In addition, with respect to assets that are set aside, transferred or restricted (on or before March 21, 2006) so as to be subject ordinarily to inclusion under Sections 409A(b)(1) or 409A(b)(2) (“grace period assets”), employers shall be treated as not having triggered the inclusion or additional tax provisions if the nonqualified deferred compensation plan comes into conformity on or before December 31, 2007 with the requirements of section 409A(b). If grace period assets are used to pay deferred compensation and included in income not later than December 31, 2007 (including payments on termination of the plan), the plan will be treated as complying with section 409A(b) for the period before the payment. Further, if grace period assets are no longer associated with the payment of nonqualified deferred compensation, either under the terms of the plan or through the dissolution of a trust on or before December 31, 2007, the plan will be treated as having complied with section 409A(b) with respect to those assets through the date the action is taken. In general, “grace period assets” include earnings on these assets after March 21, 2006. However, if a new post-March 21, 2006 restriction, set aside or transfer is applied to grace period assets, it will cause them to cease to be grace period assets.
- Notice 2006-64 (June 30, 2006). In certain situations, a divesture of deferred compensation is necessary to meet a Federal conflict of interest statute, regulation, or order, or is requested by Congressional committee as a condition to confirmation. Notice 2005-1 and the section 409A proposed regulations provided that a “certificate of divestiture” that is issued by the Office of Government Ethics would be needed to permit an accelerated payment of section 409A nonqualified deferred compensation. However, the Office of Government Ethics only issues certificates of divestiture so that an employee may defer recognition of capital gains when property is divested. Because payment under a nonqualified deferred compensation plan is treated as ordinary income, rather than as capital gain, the Office of Government Ethics could not issue a certificate of divestiture in connection with an accelerated payment under section 409A. Therefore, Notice 2006-64 provided that until further guidance is issued, a section 409A nonqualified deferred compensation plan may permit the acceleration of the time or schedule of payment as is necessary to satisfy requirements established pursuant to a “written determination” by the Office of Government Ethics. The written determination must specify (1) that the divestiture is reasonably necessary to comply with any Federal conflict of interest statute, regulation, rule or executive order, or is requested by a Congressional committee as a condition of confirmation and (2) the financial interest to be divested.
- Notice 2006-79 (October 4, 2006). Notice 2005-1 set forth initial guidance with respect to the application of section 409A, and provided transition guidance. When the section 409A proposed regulations were issued, the IRS and Treasury anticipated that the final regulations would be effective January 1, 2007, and therefore the preamble to the proposed regulations clarified and extended certain provisions of the Notice 2005-1 transition guidance generally through December 31, 2006. However, by October 2006, it became apparent that the final regulations would not be released in time to allow employers sufficient time to come into compliance with section 409A. Therefore, Notice 2006-79 provided additional transition relief applicable through December 31, 2007, and stated that the final regulations would not become effective until January 1, 2008. The Notice also generally extended through 2007 the transition relief provided for 2006 in the preamble to the proposed regulations except with respect to certain discounted stock rights. Accordingly, a plan may provide, or be amended to provide, for new payment elections on or before December 31, 2007, with respect to both the time and form of payment of such amounts and the election or amendment will not be treated as a change in the time or form of payment or an acceleration of a payment under section 409A, provided that the plan is amended and elections are made on or before December 31, 2007. Further, with respect to an election or amendment to change a time and form of payment made in 2007, the election or amendment may apply only to amounts that would not otherwise be payable in 2007 and may not cause an amount to be paid in 2007 that would not otherwise be payable in 2007 (e.g., where an amount would otherwise be payable upon an event, such as a separation from service, an election in 2007 cannot change the amount that would be payable in 2007 if the service provider separated from service in 2007). In addition, the Notice extended the period during which a stock option or stock appreciation right providing for a section 409A deferral of compensation can be cancelled and reissued as not providing for a section 409A deferral of compensation from December 31, 2006 to December 31, 2007. However, this transition relief does not apply to certain discounted stock options or stock appreciation rights. Lastly, the Notice provided additional transition relief for certain payment elections in linked plans and certain collective bargaining arrangements.
- Notice 2006-100 (December 1, 2006). Notice 2006-100 superseded Notice 2005-94 and provided guidance on reporting and wage withholding requirements for calendar years 2005 and 2006 with respect to deferrals of compensation and amounts includible in gross income under section 409A. The Notice provided that for calendar years 2005 and 2006 an employer is not required to report amounts deferred during the year under a section 409A nonqualified deferred compensation plan. However, in a change from 2005, for calendar year 2006 an employer must treat amounts includible in gross income under section 409A as wages for income tax withholding purposes, and an employer is required to report such amounts as taxable wages paid on its quarterly employment tax return and on the employee’s Form W-2. In addition, employers who relied on Notice 2005-94 for calendar year 2005 were required to file an original or a corrected information return and furnish an original or a corrected Form W-2 for calendar year 2005 reporting any previously unreported amounts includible in gross income under section 409A for calendar year 2005, but they were not liable for any income tax withholding or related penalties for 2005 with respect to any previously unreported amounts of section 409A gross income. The Notice provided that an employer who complied with the rules of the Notice for calendar years 2005 and 2006 would not be liable for additional income tax withholding or penalties, or be required to file a subsequent corrected information return or furnish a corrected Form W-2. However, if the IRS subsequently determined that the employer did not follow the rules of this Notice for calendar years 2005 or 2006, any recalculation of the amounts includible in gross income would result in additional liability for income tax withholding plus any applicable penalties.
The Interim Guidance as a Whole
Taken as a whole it is apparent that the IRS and Treasury have slowly been ratcheting up their compliance expectations under section 409A. For example, Notice 2005-94, which suspended the reporting and withholding requirements for 2005, could aptly be described as a “free lunch” for employers in that it required employers to basically do nothing. However, Notice 2006-100 suspended some but not other reporting and withholding requirements for 2006, and also required employers to go back and report section 409A gross income created in 2005. If an employer did not follow this Notice, it was then subject to income tax withholding liability plus penalties. This Notice, issued only a short while ago, might be described as a “discount lunch” for employers, i.e., some but not complete relief.
This same trend seems apparent in the latest guidance from IRS and Treasury, Announcement 2007-18. In Announcement 2007-18, the IRS announced a compliance resolution program that permitted employers to pay the additional taxes arising under section 409A due to the exercise of certain discounted or back-dated stock options and stock appreciation rights. The announcement provided a way for employers to minimize the burdens of compliance on employees who are not corporate insiders, but required the payment of all applicable taxes and compliance with all section 409A reporting obligations. The announcement did not provide employers with a free or even discount lunch. However, some of this may be the context, as there is little natural sympathy for option backdating. There is still reason to think that IRS and Treasury may be willing to apply a more proportional sanction, as part of an eventual correction program, for minor 409A violations that technically trigger enormous consequences because of the operation of the aggregation rules.