On April 10, 2007, the Treasury Department and the Internal Revenue Service ("IRS") issued the long-awaited final regulations interpreting the deferred compensation rules under Internal Revenue Code (the "Code") Section 409A ("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 (as well as prior deferrals which were not vested as of 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. Failure to comply with the Section 409A requirements at any time during a taxable year will cause all amounts deferred under the nonqualified plan for that year and all preceding taxable years to be 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. Additionally, such amounts are subject to a 20 percent penalty tax plus interest at an enhanced rate on any resulting tax underpayments.
The most significant aspect of the final rules is that they maintain the December 31, 2007, deadline for documentary compliance. Failure to properly amend nonqualified plans prior to January 1, 2008, will subject employees to the potentially massive Section 409A penalties. Employers should review all nonqualified plans, including employment agreements and severance pay arrangements, in light of the guidance discussed below to confirm compliance with the final regulations.
The final regulations generally follow the proposed regulations that were issued in October 2005. However, some of the more significant modifications, clarifications and liberalizations are described below.
Definition of Nonqualified Plan
The final regulations define a "nonqualified deferred compensation plan" as any plan that provides for the deferral of compensation. Whether a plan provides for the deferral of compensation generally is determined at the time the service provider obtains a legally binding right to the compensation under the plan, and is not affected by any retroactive change to the plan to characterize the right as one that does not provide for the deferral of compensation.
The definition of nonqualified plans does not include any qualified employer plan or any bona fide vacation leave, sick leave, compensatory time, disability or death benefit plan. The term also does not include any Archer Medical Savings Accounts, any Health Savings Account, or any other medical reimbursement arrangement that satisfies the requirements of section 105 and 106 of the Code.
Stock Options and Stock Appreciation Rights
The final regulations include some important liberalization of the rules for when stock options and stock appreciation rights ("SARs") are exempt from coverage under Section 409A.
Service Recipient Stock
Under the proposed regulations, stock options and SARs issued with an exercise or base price equal to the fair market value of the underlying stock on the date of grant were deemed to be exempt from Section 409A. However, the options and SARs had to be issued with respect to a class of common stock of the employer with the highest aggregate value of any class or stock outstanding, or a class substantially similar to such stock (called "service recipient stock"). The final regulations make it much easier for stock to qualify as service recipient stock because any class of common stock of the employer may be used, even if that class of stock is not publicly traded or is subject to transferability restrictions. However, the service recipient stock cannot have any preferences, other than a preference in liquidation of the issuer.
The final regulations also provide that the eligible issuer of service recipient stock may be any corporation in a chain of organizations under common control, beginning with the parent organization and ending with the organization for which the grantee was providing services as of the date of grant of the stock right. The final regulations provide that any class of common stock of the employer (or a parent or subsidiary) may be used, even if that class of stock is not publicly traded.
Even if an option or SAR is issued at fair market value, it can become retroactively subject to Section 409A if the exercise period is subsequently extended. Under the proposed regulations, any extension of the option or SAR term (other than de minimis extensions such as separation from service) would retroactively subject the option or SAR to Section 409A. The final regulations expand this exception so that option and SAR exercise periods may be extended provided the exercise period is not extended beyond the earlier of the original exercise period or 10 years from the date of grant. Also, if the option or SAR is underwater, the exercise period may be extended to any date without implicating Section 409A.
The final regulations generally reflect the proposed regulations for determining the fair market value of the stock underlying options and SARs. For stock that is readily tradable on an established securities market, the final regulations indicate that the fair market value of the stock may be determined based upon the last sale before or the first sale after the grant, the closing price on the trading day before or the trading day of the grant, the arithmetic mean of the high and low prices on the trading day before or the trading of the grant, or any other reasonable method using actual transactions in such stock as reported by such market. The determination may also be based on a 30-day average, provided that the commitment to grant the stock right on a particular day is irrevocable before the 30-day period begins.
For stock not readily tradable on an established securities market, the final regulations state that the fair market value of the stock as of a valuation date means a value determined by the reasonable application of a reasonable valuation method. The final regulations reflect the three valuation safe harbors set forth in the proposed regulations — an independent appraisal, a non-lapse repurchase formula and the illiquid start-up method. The final regulations also include a presumption that a specified valuation of stock reflects the fair market value of the stock, rebuttable only by a showing that the valuation is grossly unreasonable. The presumption applies where the valuation is based upon an independent appraisal, a generally applicable repurchase formula, or, in the case of illiquid stock of a start-up corporation, a valuation by a qualified individual applied at a time that the corporation did not otherwise anticipate a change in control event within the next 90 days, and no public offering is anticipated in the next 180 days.
"Good Reason" Provisions
Prior IRS guidance suggested that separation pay was not subject to a "substantial risk of forfeiture" if it could be paid in connection with a good reason termination of employment, regardless of the actual circumstances of the termination. The primary impact of this rule was that severance payable to an officer or other "specified employee" (generally the top 50 officers of a public company) of a publicly traded company generally would be subject to a six-month delay in payment following the employee's termination of employment.
In a much-welcomed move, the final regulations provide that a service provider's voluntary separation from service will be treated as an involuntary separation from service if the separation from service occurs under certain limited bona fide conditions, where the avoidance of the requirements of Section 409A is not a purpose of the inclusion of these conditions in the plan or of the actions by the service recipient in connection with the satisfaction of these conditions, and a voluntary separation from service under such conditions effectively constitutes an involuntary separation from service. If treated as payable upon an involuntary separation from service, the payment can be made without the need for a six-month delay as long as the severance is paid in full by March 15 of the year following termination of employment or the severance is not otherwise subject to Section 409A.
An involuntary separation from service is defined as a separation from service due to the independent exercise of the unilateral authority of the employer to terminate the employee's service, other than due to the employee's implicit or explicit request, where the employee was willing and able to continue performing services.
The final regulations also provide a safe harbor under which a payment upon a good reason termination will be treated as providing a payment upon involuntary separation from service. Payments under an arrangement with a good reason provision will be considered payable in connection with an involuntary termination of employment if a number of criteria are satisfied, including:
(1) the separation from service must occur during a pre-determined limited period of time not to exceed two years following the initial existence of the good reason condition;
(2) good reason must consist of one or more of six enumerated conditions arising without the consent of the employee;
(3) the amount, time and form of payment upon the separation from service must be substantially identical to the amount, time and form of payment payable due to an actual involuntary separation from service, to the extent such a right exists; and
(4) the employee must be required to provide notice of the existence of the "good reason" condition within a period not to exceed 90 days of the initial existence of the condition, upon the notice of which the employer must be provided a period of at least 30 days during which it may remedy the condition and not be required to pay the amount.
General Separation Pay Rules
The final regulations provide that a separation pay plan that provides for separation only upon an involuntary separation from service does not provide for a deferral of compensation under Section 409A to the extent that the separation pay provided under the plan: (1) does not exceed two times the lesser of (i) the employee's annual compensation or (ii) the Code section 401(a)(17) limit for the year ($225,000 in 2007), and (2) is paid no later than December 31 of the second year following the year which the occurs the separation from service. This results in a $450,000 limit for 2007 for employees whose average compensation is equal to or exceeds $225,000.
Under the proposed regulations, if separation pay was $1 over this threshold, the entire amount would have been subject to Section 409A. Under the final regulations, only the amount in excess of this limit will be subject to Section 409A.
Separation from Service
The final regulations adopt a simpler standard for determining whether a separation from service, one of the permitted Section 409A payment trigger events, has occurred. In general, the final regulations provide that an employee has a separation from service with the employer if the employee dies, retires, or otherwise has a termination of employment with the employer. Whether a termination of employment has occurred is determined based on whether it is reasonably anticipated that the employee will not provide future services, or if any services are provided by the employee the level of services the employee would perform after such date would permanently decrease to no more than 20 percent of the average level of services performed over the immediately preceding 36-month period. Further, an employee will be presumed not to have separated from service where the level of bona fide services performed continues at a level that is 50 percent or more of the average level of service performed by the employee during the immediately preceding 36-month period. No presumption applies to a decrease in the level of bona fide services performed to a level that is more than 20 percent and less than 50 percent of the average level of bona fide services performed during the immediately preceding 36-month period.
The final regulations also provide guidance on determining who is the employer for purposes of whether a separation from service has occurred. In general this is determined on a modified "controlled group" basis that treats entities that are 50 percent or more related as if they were a single entity (but the relation can be as low as 20 percent or as high as 80 percent if elected by the employer).
In addition, distributions made in connection with a specified employee's (generally the top 50 officers and certain shareholders) separation from service from a publicly traded company are subject to a six-month delay under Section 409A. This six-month delay must be written in the plan.
The final regulations adopt the proposed regulations' notion of permissible payments. An amount of deferred compensation under the plan may be paid only upon one of the following events:
(1) the employee's separation from service;
(2) the employee becomes disabled;
(3) the employee's death;
(4) a time or fixed schedule specified under the plan;
(5) a change in the ownership of the corporation or in the ownership of a substantial portion of the assets of the corporation; or
(6) the occurrence of an unforeseeable emergency.
A payment is treated as made upon the date specified under the plan if the payment is made at such date or a later date within the same year or, if later, by the 15th day of the third calendar year following the date specified under the plan and employee is not permitted, directly or indirectly, to designate the taxable year of the payment.
Reimbursements or In-Kind Benefit Plans
A plan that provides for reimbursements of expenses incurred by an employee, or in-kind benefits, meets the final regulations' requirements of a specified date or fixed schedule of payments with respect to such reimbursements or benefits if the following conditions are met:
(1) the plan provides an objectively determinable nondiscretionary definition of the expenses eligible for reimbursement or of the in-kind benefits to be provided;
(2) the plan provides for the reimbursement of expenses incurred or for the provision of the in-kind benefits during an objectively and specifically prescribed period (including the lifetime of the employee);
(3) the plan provides that the amount of expenses eligible for reimbursement, or in-kind benefits provided, during a service provider's taxable year may not affect the expenses eligible for reimbursement, or in-kind benefits to be provided, in any other taxable year;
(4) the reimbursement of an eligible expense is made on or before the last day of the employee's taxable year following the taxable year in which the expense was incurred; and
(5) the right to reimbursement or in-kind benefits is not subject to liquidation or exchange for another benefit.
The proposed regulations had not provided any guidance on structuring taxable reimbursements or in-kind benefits to comply with Section 409A.
Acceleration of Payments
A nonqualified plan may not permit the acceleration of the time or schedule of any payment or amount scheduled to be paid pursuant to the terms of the plan, and no such accelerated payments may be made whether or not provided for under the terms of such plan. However, the final regulations provide that an impermissible acceleration does not occur if payment is made in accordance with plan provisions or an election as to the time and form of payment in effect at the time of initial deferral.
The final regulations provide for the following exceptions to the general acceleration of payments rule:
(1) pursuant to a domestic relations order;
(2) as necessary due to conflicts of interest;
(3) Section 457 plans;
(4) for limited cashouts;
(5) payment of employment taxes;
(6) payment upon income inclusion under Section 409A;
(7) cancellation of deferrals following an unforeseeable emergency or hardship distribution;
(8) plan terminations and liquidations;
(9) certain distributions to avoid a nonallocation year under Section 409(p);
(10) payment of state, local or foreign taxes;
(11) cancellation of deferral elections due to disability;
(12) certain offsets; and
(13) bona fide disputes as to a right to a payment.
Nonqualified Plans Linked to Qualified Plans
Nonqualified plans that are linked to qualified plans are subject to the Section 409A requirements. The proposed regulations provided certain limited relief which allowed for changes in deferrals to the nonqualified plan based on developments in the qualified plan. The final regulations essentially adopt the same relief, but clarify that the linked plan relief provided for elective deferrals in the nonqualified plan also applies separately to matching contributions in the nonqualified plan.
Split-Dollar Life Insurance
Issued in conjunction with the final regulations, IRS Notice 2007-34 generally provides that split-dollar life insurance that is subject to Section 409A may be modified to comply with Section 409A, and such modification will not be treated as a "material modification."
Regarding good faith positions taken by employers during the Section 409A transition period, the IRS has indicated that it is incumbent on the taxpayer to demonstrate good faith compliance. Although it is easier to do so in writing, the final regulations do not require such a written demonstration of good faith compliance and the taxpayer does not need to show action during the transition period was in fact a good faith determination.
What should be included in a nonelective plan document are payment conditions that are compliant with Section 409A, and for a public company, the specified employee language for any payment triggered by a separation from service. For an elective plan, election provisions have to be included in a plan document no later than the deadline for making an election. If an election provision is added, that provision has to be included in the document by the deadline that the election would become irrevocable.
Regarding savings clauses, they will not save the taxpayer if there are provisions in the plan document that contradict the statutory requirements, or clearly contravene the statute, or if the document lacks a provision that is statutorily required.
Partnerships and Other Non-Corporate Entities
The final regulations provide no further guidance as to how Section 409A applies to equity interests in non-corporate entities such as partnerships. Existing guidance indicates that such interests should be treated in the same manner as equity interests issued by corporate entities and may be eligible for the Section 409A exclusions for options and SARs.
Guidance on Income Inclusion, Reporting and Withholding
The final regulations do not include any further information as to how to calculate the amount to be included in income in the event of a Section 409A violation, or the corresponding reporting and tax withholding obligations of the employer. Previously issued guidance may continue to be relied upon until further guidance is issued.
Action Items for Employers to Consider
- Section 409A is generally applicable to compensation deferred on or after January 1, 2005. Amounts that were "earned and vested" as of December 31, 2004, are exempt from Section 409A unless there has been a "material modification."
- The provisions of the final regulations that will likely have the greatest significance 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. In short, companies subject to Section 409A should expect that full documentary compliance will be required by year-end 2007.
- The failure to properly amend nonqualified plans prior to January 1, 2008, will subject affected employees to the potentially large Section 409A penalties, including a 20 percent penalty tax and early inclusion of income upon vesting. To avoid these penalties, it will be necessary to start the amendment process soon. Companies should not wait until the end of 2007 to amend their nonqualified plans. Due to constructive receipt concerns arising with respect to elections made close in time to actual payment, clients should not wait until the end of 2007 to amend their plans.
- The final regulations require that all nonqualified plans must be written and reflect the requirements of Section 409A. If the sponsoring employer is a publicly traded company, the plan must expressly provide that benefits owed to key employees upon separation from service must be delayed at least six months.