The IRS provided welcome relief in IRS Notice 2007-86, which delayed certain compliance deadlines for Section 409A to December 31, 2008. This advisory focuses on the additional planning opportunities available under the delay, as well as a new timeline for compliance with the final regulations. Despite the delay, one thing is clear: no matter how tempting it may be, the notice is not a signal to stop work. The delay was granted in recognition of the fact that it can take a lot of planning and time to bring plans into compliance with the final rules. It requires numerous decisions, the consent of many parties (including, often, the compensation committee of the board of directors), and in many cases, negotiations. Companies that wait until this time next year to begin their compliance efforts will find themselves short of time and with no sympathy from the IRS.
What Still Needs To Be Done in 2007?
Make changes in time and form of payment for amounts to be paid in 2008: Elections or plan amendments that change the time and form of payment of an amount that otherwise would be payable in 2008 must be made by December 31, 2007. Likewise, elections or plan amendments that accelerate the time and form of payment into 2008 of an amount that would otherwise be payable in 2009 or later must be made by December 31, 2007. This is the last opportunity to make such changes with respect to 2008 without complying with the anti-acceleration and subsequent deferral rules of Section 409A. Examples include:
- President and CEO Brown is planning to retire on July 1, 2008. Payment of her deferred compensation is currently scheduled to begin following separation from service. Ms. Brown does not want her payments to be deferred six months after her separation. She can elect a fixed payment date of July 1, 2008, and avoid the six-month delay, but only if the election is made by December 31, 2007.
- VP Jones is scheduled to be paid deferred compensation in 2011 and wishes, for tax purposes, to have a portion of the amount paid in 2008. Mr. Jones may change the payment time and form, provided the election is made by December 31, 2007.
- CFO Taylor is scheduled to receive an in-service distribution of deferred compensation in a lump sum on July 1, 2008. Due to a change in his financial circumstances, he would now prefer to begin payment in 2009 and have payments made over a period of three years. He may do so, but only if the election is made by December 31, 2007.
Note, any elections or plan amendments made in 2007 cannot change the time and form of a payment that would otherwise be made in 2007, or cause an amount scheduled to be paid in a later year to be paid in 2007.
Bring offshore and certain other trusts into compliance: Section 409A(b) prohibits the use of offshore trust arrangements to secure nonqualified deferred compensation. It also prohibits the restriction of assets for the use of nonqualified deferred compensation in the event of a change in the financial health of the employer. In the case of assets set aside or restricted on or before March 31, 2006, (grace period assets) that are subject to these rules, the arrangement must be brought into conformity with Section 409A by December 31, 2007. This compliance deadline has not been delayed.
Review good faith operational compliance: Since January 1, 2005, plans have been required to operate in good faith compliance with Section 409A. If you have not completed a review of your deferred compensation arrangements, there may be operational compliance issues that need to be addressed now. Until 2008, IRS guidance that is relevant in determining good faith compliance includes Notice 2005-1, the proposed regulations and the final regulations.
Fix plans that have been amended to comply with the proposed regulations. If you were ahead of the game and amended your plans to comply with the proposed regulations, you need to take another look at those plans now. Starting January 1, 2008, you can no longer rely on the proposed regulations, therefore, you should look at those plans to determine if operational changes are needed by January 1, 2008.
What Prior Relief Is Extended Through 2008?
Linked plans: The ability to link payment elections under a nonqualified deferred compensation plan to an election under a qualified plan continues to be available through 2008. The relief is also extended to payments under Section 403(b) annuities, eligible Section 457(b) plans and certain broad-based foreign plans.
Change time and form of payment for amounts to be paid in 2009: The existing transition relief that allowed changes to the time and form of payment of previously deferred amounts was pushed out one year. This means that elections or plan amendments that change the time and form of payment of an amount that would otherwise be payable in 2009 may be made through December 31, 2008. Elections or plan amendments that accelerate the time and form of payment into 2009 of an amount that would otherwise be payable in 2010 or later may be made through December 31, 2008. This is the last opportunity to make changes with respect to such payments without the need to comply with the anti-acceleration and subsequent deferral rules of Section 409A and the final regulations. Note, any elections or plan amendments made in 2008 cannot change the time and form of a payment that would otherwise be made in 2008, or cause an amount scheduled to be paid in a later year to be paid in 2008.
Modification of “good reason” definition: The ability to modify a good reason definition to comply with the final regulations or to comply with the safe harbor in the final regulations, as provided in Notice 2007-78, is extended through 2008. As under that notice, in order to qualify for a short-term deferral exemption, any change in a “good reason” definition must be made at a time when the employee’s right to payment is subject to a substantial risk of forfeiture. However, even if the payment is not currently subject to a substantial risk of forfeiture, it may be possible to qualify for the “two-times, two-year” separation pay exemption by adopting the safe-harbor good reason definition and amending the agreement to condition the payment on an involuntary termination. There are special issues to consider here, particularly for “specified employees” who wish to avoid the six-month payment delay under Section 409A.
Substitution of non-discounted stock options and stock appreciation rights for discounted stock options and stock appreciation rights: The ability to substitute non-discounted options and SARs for non-Section 16 officers is extended through 2008. This is the last opportunity to make such substitutions.
Initial deferral elections: Earlier guidance (Notice 2005-1) provided relief with respect to certain deferral elections made on or before March 15, 2005, provided the plan was amended by December 31, 2005, to allow such “late” deferrals. In recognition of the fact that some taxpayers interpreted earlier delays to apply to this amendment deadline, the deadline for making amendments under this relief is extended to December 31, 2008. However, taxpayers should be prepared to demonstrate that the election was made by the March 15, 2005, deadline.
What Needs To Be Done in 2008?
Elections to change time and form of payments; stock rights: As described above, 2008 is the last opportunity to take advantage of this transition relief.
Good faith operational compliance: Plans must continue to be operated in good faith compliance through 2008. For 2008, taxpayers may still rely on Notice 2005-1, but reliance on the proposed regulations is not considered good faith compliance. During 2008, compliance with the final regulations is deemed to be good faith compliance.
Final amendments: Amendments needed to comply with the final regulations need to be adopted by December 31, 2008.
What Prior Guidance Is NOT Affected by the Delay?
Guidance with respect to the following issues is not affected by Notice 2007-86:
- Application of “substitution rule” to employment agreements: The “document delay notice” issued in September 2007 (Notice 2007-78) indicated that if an employment agreement provides a payment that is triggered by the expiration of or failure to renew the agreement, then any renewal of that agreement could be deemed to be a substitution of one form of deferred compensation for another, in violation of Section 409A. The new transition relief in Notice 2007-86 does not modify the earlier guidance of Notice 2007-78 in this regard. Thus, if the employment agreement is renewed, deferred compensation under the renewal may be treated as a substitute for deferred compensation under the old agreement. This presents a conundrum for “evergreen” agreements that provide a payment upon non-renewal.
- Cash-outs of small amounts: Until further notice, a plan may continue to have a provision requiring cash-out of a benefit at a specified time if the value at that time is less than some specified amount.
- Application of Section 409A to arrangements between a partner and a partnership: Earlier guidance, provided in Notice 2005-1, is not affected. Thus, for example, as provided in that notice, the issuance of a profits interest in a partnership that is properly treated as not includible in gross income when issued does not result in the deferral of compensation under Section 409A. Similarly, the issuance of a capital interest continues to be treated under the guidance applicable to the issuance of stock.
How Are Reporting and Withholding Requirements for 2007 and 2008 Affected by the Latest Guidance?
The prior guidance with respect to withholding and reporting has essentially been extended for 2007 and 2008. Thus, for those years, in general:
- Reporting of amounts deferred is not required.
- Amounts includible in income that involve a violation of Section 409A are reportable as wages on the employee’s W-2 in box 1 and in box 12, using code Z. This coding serves to inform the IRS that a violation of Section 409A has occurred. Such amounts are subject to withholding, generally as supplemental wages. The employer is not required to withhold the additional 20 percent or interest imposed by Section 409A. Therefore, employees who incur these additional taxes may need to make estimated tax payments.
- Deferred compensation that is includible in income that does not involve a violation of Section 409A is subject to the generally applicable reporting and withholding rules.
What Do I Do if I Have Already Amended All My Plans To Comply with the Final Regulations?
These plans should already be in compliance. However, you may wish to consider whether to take advantage of certain aspects of the new transition relief, as described above. For example, you may wish to consider whether to further change the time and form of payment of already deferred amounts. As noted above, for payments otherwise payable in 2008 or if payments are to be accelerated into 2008, this needs to be done before the end of this year. For payments otherwise payable in 2009 or to accelerate payments into 2009, this needs to be done before the end of 2008.
In addition, it is possible that, before the end of 2008, Treasury will provide additional planning opportunities. We will continue to monitor developments in the event there are such changes.
What Do I Do if I Am in the Process of Making Plan Amendments, but the Amendments Have Not Yet Been Finally Adopted?
The delay provides additional time, as needed, to obtain final approval for plan amendments. For example, if amendments were final, subject to board approval, the board approval can be delayed until next year. This may be helpful if there are other urgent matters that need board attention before the end of the year.
In general, however, the efforts to amend plans to conform to the final regulations should continue with due speed, as plans need to be in good faith operational compliance now. Employers in this position may also wish to determine whether to take advantage of certain aspects of the delay as discussed under the previous question.
What Do I Do if Not All Plans Have Been Amended for Compliance with the Final Regulations?
Especially for these plans, the delay provides needed relief. However, even with the delay, plans must be in good faith operational compliance with Section 409A now. Compliance with Section 409A involves not only technical compliance with the law, but also often involves choices about plan design. The amendment process also may take some time, as communication with employees and board action is typically required. Where individual agreements are involved, they typically require all parties to consent to any amendment. This may require reviews by several sets of advisors, which adds to the timeline for completion.
With limited exceptions, once a plan design decision is implemented the plan amendment ultimately must conform to the actual operation of the plan. This requires careful consideration of all operational decisions made prior to making formal amendments. If you have plans that are still in the initial stages of the amendment process, we recommend that you act as soon as possible.
Will There Be Any Relief if There Are Mistakes in Complying with these Complex Rules?
The IRS and Treasury continue to state that they will soon announce a limited voluntary correction program for violations of Section 409A. The guidance is expected to allow, without penalty, the correction of certain unintentional operational failures in the same taxable year in which the failure occurred. In other cases, the program may limit the amount included in income and subject to additional taxes under Section 409A.
While any such relief will be helpful, IRS officials have also cautioned that the relief is expected to apply in very limited circumstances. This underscores the need to continue efforts to ensure good faith compliance through 2008 and to have plan documents reflecting the final regulations as soon as possible.