On October 22, 2007, the Internal Revenue Service (the "IRS") issued Notice 2007-86, which extends the applicable period of much of the transition relief regarding Section 409A of the Internal Revenue Code ("Section 409A") through 2008. One day later, the IRS issued Notice 2007-89, relating to relief from certain reporting and withholding requirements. The recent guidance comes in part in response to concerted requests for relief from the business and benefits communities. These efforts culminated in a meeting last month in Washington, DC between high-level US Treasury Department ("Treasury") and IRS personnel and a select group of representatives from the private sector, including White & Case personnel.
The terms of the extended transition relief are summarized below.
Section 409A Generally. Enacted as part of the American Jobs Creation Act of 2004, Section 409A is applicable to amounts deferred in taxable years beginning after December 31, 2004 (and amounts deferred in taxable years beginning before January 1, 2005, if the plan under which the deferral is made was materially modified after October 3, 2004). Section 409A provides that all amounts deferred under a nonqualified deferred compensation plan are included in income when deferred (or, if later when the amounts are no longer subject to a substantial risk of forfeiture), unless certain requirements established by Section 409A are satisfied. If an amount of deferred compensation is required to be included in income under Section 409A, that amount is subject to ordinary income taxation plus an additional 20% income tax, and interest may be assessed on tax underpayments in certain circumstances. For more on Section 409A and the requirements prior to the relief in Notice 2007-86, click here.
After the enactment of Section 409A, the Treasury and the IRS issued a number of significant pieces of broad substantive guidance, including (i) Notice 2005-1 on December 20, 2004, (ii) comprehensive proposed regulations on September 29, 2005, and (iii) comprehensive final regulations on April 10, 2007. Under the final regulations, the regulatory regime was scheduled to go fully into effect on January 1, 2008. Shortly thereafter, it became apparent that the market was growing increasingly uncomfortable with the January 1, 2008 compliance deadline.
Initial Regulatory Response. As an initial response to relief requests from the business and benefits communities, on September 10, 2007 the IRS released Notice 2007-78, which provided only limited relief from certain documentary compliance deadlines set forth in the final regulations. For a detailed discussion of Notice 2007-78, please see the September 2007 White & Case LLP Executive Compensation, Benefits and Employment Law Focus.
Following the release of Notice 2007-78, the market continued actively to seek additional extensions of the key transition relief periods under Section 409A. These efforts culminated in a meeting in Washington last month between high-level Treasury and IRS officials and select representatives of the private sector, including White & Case personnel.
Provisions of Notice 2007-86
In response to the concerns expressed, Notice 2007-86 explicitly revokes certain provisions of Notice 2007-78 and generally extends the key transition relief periods currently scheduled to expire on December 31, 2007, through December 31, 2008.
Amendment and Operation of Plans Before 2009. Notice 2007-86 provides that compliance with the final regulations before January 1, 2009 is not required. Rather, a nonqualified deferred compensation plan subject to Section 409A will not be treated as violating Section 409A on or before December 31, 2008, if the plan is operated in compliance with Section 409A and any generally applicable guidance published with a pre-2008 effective date (other than the final regulations), so long as the plan is amended before 2009 to conform to the provisions of Section 409A (including the final regulations). Prior to 2009, to the extent an issue is not addressed in generally applicable guidance published with a pre-2008 effective date, the plan must be operated consistent with a good faith, reasonable interpretation of Section 409A, and, to the extent not inconsistent therewith, the plan's terms.
For periods before January 1, 2008:
- compliance with the proposed regulations or the final regulations will constitute reasonable, good faith compliance with Section 409A; and
- to the extent that any of the proposed regulations, the final regulations or Notice 2005-1 is inconsistent with each other, the plan may comply with any of them.
For periods after December 31, 2007 and before January 1, 2009:
- compliance with the final regulations (but not the proposed regulations) will constitute reasonable, good faith compliance with Section 409A; and
- to the extent the final regulations are inconsistent with Notice 2005-1, the plan may comply with the final regulations or Notice 2005-1 (but not the proposed regulations).
As before, a plan will generally not be considered to be operating in compliance with Section 409A if discretion provided under the terms of the plan is exercised in a manner that causes the plan to fail to meet the requirements of Section 409A.
Changes in Time and Form of Payment — In General. Substantial extended relief has been provided for changes in the time and form of payment. On or prior to December 31, 2008, plans may permit changes to the time and form of payment of deferred amounts, including elections or amendments that accelerate payments, without violating Section 409A. However, changes may not be made in 2007 that would accelerate the payment of any amount into 2007 or defer the payment of any amount that would otherwise be paid in 2007 to a later year. Likewise, changes may not be made in 2008 that would accelerate the payment of any amount into 2008 or defer the payment of any amount that would otherwise be paid in 2008 to a later year. Notice 2007-86 also clarifies that a deferral election may be made with respect to an amount that is a so-called "short-term deferral," provided that the election is made before January 1, 2009 and before the year in which the amount would otherwise have been paid. Except with respect to certain discounted stock rights,1 an outstanding stock right (i.e., a stock option or stock appreciation right) that is subject to Section 409A (e.g., a stock right with an exercise price below the fair market value of the underlying stock on the date of grant) may be amended to provide for fixed payment terms consistent with Section 409A, and such amendment will not be treated as a violation of Section 409A, provided that such amendment is made on or before December 31, 2008. Stock rights are discussed further immediately below.
Substitutions of Stock Rights Subject to Section 409A. If an outstanding stock right would be subject to Section 409A, such stock right may be cancelled and replaced with a stock right that would not have constituted a deferral of compensation under Section 409A (e.g., the exercise price of the replacement stock right may be increased to the fair market value of the underlying stock on the grant date of the stock right). Generally, such a cancellation and reissuance of a stock right may occur at any time on or prior to December 31, 2008. However, the exercise of a discounted stock right in 2007 or 2008, before it is replaced, will result in a violation of Section 409A. Where a discounted stock right is replaced with a stock right not subject to Section 409A, the employer or other service recipient may compensate the holder by paying or providing the holder with new awards in an amount based on the aggregate increase in the exercise or strike price of the old stock rights, provided that such awards comply with (or are not subject to) Section 409A. However, payments of cash or vested property made in the year of cancellation to compensate for a lost discount will not comply with Section 409A.
Payments Linked to Qualified Plans. For periods ending on or before December 31, 2008, an election as to the time or form of a payment under a nonqualified deferred compensation plan that is linked to a payment election made by a participant under a tax-qualified retirement plan will not violate Section 409A, provided that the determination of the time and form of the payment is made in accordance with the terms of the nonqualified deferred compensation plan as of October 3, 2004. For example, where a nonqualified deferred compensation plan provided as of October 3, 2004 that the time and form of payment to a participant will be the same time and form of payment elected by the participant under a related tax-qualified retirement plan, it will not be a violation of Section 409A for the nonqualified deferred compensation plan to make or commence payments during the period between January 1, 2005 and December 31, 2008 pursuant to the payment election under the related tax-qualified retirement plan.
Reporting and Withholding for 2007. One day following the release of Notice 2007-86, the IRS released Notice 2007-89, which provides transition relief from certain Section 409A reporting and withholding requirements for 2007. Similar to the relief provided with respect to calendar year 2006, employers and other service recipients are not required to report amounts deferred during calendar year 2007 under a nonqualified deferred compensation plan subject to Section 409A. However, service recipients are required to report all vested amounts that are includible in income under Section 409A during 2007 and employers must withhold federal income taxes on such includible amounts (i.e., reporting and withholding is required for non-qualified deferred compensation that does not comply with Section 409A, but reporting is not required for nonqualified deferred compensation that complies with Section 409A). However, no additional withholding is required with respect to the additional 20% income tax and interest on includible amounts.
Correction Program. Notice 2007-86 also confirms the IRS's intention to issue further guidance regarding a Section 409A correction program as soon as possible. White & Case personnel participated actively in the professional activities and meetings with the Treasury and the IRS during which ideas relating to a voluntary correction program have been developed, and would be happy to discuss with you their insights into the evolving program.
Notice 2007-86 provides significant relief, which was appropriate due to the burdens and complexities of Section 409A compliance. Employers and other service recipients maintaining nonqualified deferred compensation plans that are subject to Section 409A should operate the plans in compliance with Section 409A at all times and bring the plans into full administrative compliance with Section 409A, as soon as possible, but in no event later than December 31, 2008. White & Case would be pleased to answer any questions you may have or assist you in your Section 409A compliance efforts.