On October 23, 2007, the Treasury Department and the Internal Revenue Service announced in Notice 2007-86 that the transition relief for compliance with the final regulations under Section 409A of the Internal Revenue Code has been extended. Notice 2007-86 generally extends the transition period for compliance with the final regulations until December 31, 2008. The notice also confirms that the Treasury Department and the IRS expect to issue guidance regarding a correction program shortly.

THE EXTENSION: Section 409A was added to the Internal Revenue Code in 2004 and made significant changes to the rules relating to nonqualified deferred compensation. Section 409A has been in effect since January 1, 2005 and “good faith” operational compliance has been required since then. Compliance with the written plan requirements, however, has been deferred pending issuance of the final regulations. In April 2007, the IRS issued final Section 409A regulations which were scheduled to take effect on January 1, 2008. On September 10, 2007, due to the complexity of the final regulations and the significant burden associated with identifying and restating affected plans, in Notice 2007-78, the IRS extended the deadline for compliance with the written plan requirements until December 31, 2008. However, the extension provided under Notice 2007-78 was subject to several conditions. Practitioners advised the IRS that although Notice 2007-78 was helpful, the transition relief did not adequately address the need for additional time to analyze all of the affected plans and make decisions regarding the changes that would be necessary to bring the arrangements into compliance. Based upon this response, the Treasury Department and the IRS issued Notice 2007-86 further extending the transitional relief currently scheduled to expire on December 31, 2007 until December 31, 2008. This is welcomed news from the IRS and will greatly assist those attempting to comply with the complex requirements of Section 409A.

WHAT YOU SHOULD DO: Despite this relief, you should continue working to bring affected plans into compliance not only because compliance eventually will be required, but also to ensure operational compliance during the transition period. The cost of noncompliance with Section 409A is significant. If a plan does not meet the requirements of Section 409A, the participants will be required to include the amounts deferred in income and pay additional taxes on the income at the rate of 20%, along with interest. While these sanctions fall on the participant/service provider who receives the deferred compensation, the impact may well be felt by the service recipient, either by reason of a formal indemnification agreement, claim or participant dissatisfaction.

Accordingly, if you have not already done so, you should:

1. Identify any and all plans and arrangements that are potentially subject to Section 409A. In this regard, you should error on the side of over-inclusion and identify and review all compensation policies and agreements providing for the payment of compensation. The objective is to identify all potentially covered arrangements and then eliminate those which are not covered.

2. If it is determined that Section 409A applies to a plan or arrangement, begin the process of bringing the plan or arrangement into compliance with the requirements of Section 409A. This may be an interactive process with the service recipient because during the extended transition period, various payment elections are still available.

Many arrangements that may not be perceived as providing for deferred compensation are potentially subject to the rules. A nonqualified deferred compensation “plan” refers to any plan or arrangement that provides for the payment of deferred compensation. A deferred compensation plan under Section 409A is not limited to a formal plan within the common meaning of the term. It also includes individual employment agreements, patterns, practices or simply policies which provide for the payment of “deferred compensation”. “Deferred compensation” refers to compensation to which a service provider obtains a legally binding right but, which is payable in a later tax year. A plan or arrangement may provide for nonqualified deferred compensation even if payment of the compensation is subject to a later condition or risk of forfeiture, such as the requirement that the service provider continue to perform services until a future date.

Potentially covered arrangements include performance and incentive bonus arrangements, individual employment contracts which provide for the payment of compensation or benefits in future years, as well as agreements or plans which provide for severance pay upon termination, change of control agreements, commission arrangements, etc. Section 409A applies to both equity and cash arrangements. It also applies to elective as well as non-elective plans. Finally, Section 409A is not limited to arrangements between employers and employees; it also applies to arrangements with independent contractors.

lans and arrangements that are exempt from the Section 409A requirements include qualified retirement plans, tax-deferred annuities, simplified employee pensions (SEPs), SIMPLE retirement accounts, and certain welfare benefit plans, such as bona fide vacation leave, sick leave, compensatory time, disability pay, and death benefit plans. Also, the final regulations exempt from coverage severance pay arrangements which meet certain specific requirements set forth in the regulations as well as amounts paid within a “short-term deferral period”.