On April 10, 2007, the Internal Revenue Service ("IRS") and the Department of the Treasury issued final regulations under Internal Revenue Code Section 409A. Section 409A was added to the Code by the American Jobs Creation Act of 2004 and is generally effective for compensation deferred on or after January 1, 2005, under certain nonqualified deferred compensation plans and arrangements ("nonqualified plans").
Amounts subject to Section 409A that are deferred under a nonqualified plan are subject to current income taxation unless the nonqualified plan complies in form and in operation with the election, distribution, and acceleration requirements of Section 409A. If a nonqualified plan fails to comply with these requirements at any time during a taxable year, all amounts deferred under the plan for that year and all preceding taxable years, by each participant to whom the failure relates, are included in the participant's gross income in the taxable year in which the failure occurred, to the extent such amounts are vested and were not previously included in income. Further, such amounts are subject to an additional 20 percent penalty tax plus interest at an enhanced rate on any resulting tax underpayments.
The IRS issued initial guidance under Section 409A in Notice 2005-1 (Dec. 20, 2004), and published notice of proposed regulations under Section 409A for public comment on October 4, 2005. These notices and other interim guidance issued by the IRS also included transition relief and transition guidance on which taxpayers could rely to show good faith compliance with Section 409A prior to the effective date of final regulations under Section 409A.
Documentary Compliance. The provisions of the final regulations that may have the greatest significance to the broadest number of employers are the provisions relating to documentary compliance. The final regulations make it clear that the document establishing a nonqualified plan subject to Section 409A must include terms that embody the limitations on deferral elections and distributions that are imposed by Section 409A. Furthermore, the IRS has not extended the December 31, 2007, deadline for documentary compliance. Thus, any nonqualified plan under which compensation has been deferred but not paid as of January 1, 2008, will be out of compliance on that date with respect to such compensation unless the plan is amended as necessary to conform to the requirements of the final regulations on or before December 31, 2007.
A Few Substantial Changes. For the most part, the final regulations appear to follow the proposed regulations, but they also differ from the proposed regulations in a few significant respects. One example is a change in the way nonqualified plans are categorized for purposes of treating a compliance failure with respect to one plan as a compliance failure with respect to all other plans of a similar type. Earlier guidance, including the proposed regulations, divided nonqualified deferred compensation plans into four categories for this purpose: account balance plans; non-account balance plans; separation pay arrangements; and all other plans. The final regulations divide nonqualified plans into additional categories: elective account balance plans; non-elective account balance plans; non-account balance plans; separation pay plans; split dollar life insurance arrangements; plans providing for in-kind benefits or reimbursement of expenses; foreign plans; stock rights; and a catch-all category.
Limited Exceptions to Certain Rules in Prior Guidance. The final regulations provide a handful of new exceptions to rules established by prior guidance - either explicitly or by liberalizing a general rule - but many of these exceptions appear to be narrow. For example, under prior guidance, the anti-acceleration prohibition arguably would have been violated by adding a provision to an existing nonqualified plan for a distribution on death, disability, or an unforeseen emergency. The final regulations specify certain limited circumstances in which the addition of these alternative payment events will not be treated as violating the anti-acceleration rule. Similarly, the final regulations include several provisions dealing with stock options and stock appreciation rights that broaden the scope of certain exemptions from coverage under Section 409A.
New Topics Covered by the Final Regulations. The final regulations address several topics that were not explicitly addressed in the proposed regulations. For example, the final regulations establish a general rule and a safe harbor for treating a voluntary termination for good reason as an involuntary termination in the context of applying Section 409A to separation pay arrangements. The final regulations also adopt specific rules for determining whether a right to a tax gross up payment satisfies the fixed time and form of payment requirements under Section 409A.
Some Questions Remain Unanswered. The final regulations do not address every topic arising under Section 409A. For example, the final regulations do not address: the calculation or timing of amounts required to be included in income under Section 409A(a); the application of Section 409A to arrangements between partnerships and partners; or certain topics on which questions were posed during the comment period which followed publication of the proposed regulations, such as when a leave program will be treated as a bona fide sick leave or vacation leave plan for purposes of Section 409A.
The final regulations are generally applicable for taxable years beginning on or after January 1, 2008, but may be relied on with respect to taxable years beginning prior to that date.