On April 10, 2007, the US Treasury Department and the IRS finally issued the long-promised final regulations under Section 409A of the Internal Revenue Code. These generally follow the proposed regulations and guidance previously issued by the IRS, but do contain certain clarifications and differences, the most significant of which are highlighted below.

All nonqualified deferred compensation plans must be amended to comply with Section 409A by December 31, 2007

Because of this requirement and the breadth of coverage of Section 409A, it is critical to review all nonqualified deferred compensation plans and arrangements, including individual severance agreements, employment agreements, change in control agreements, discounted stock options and stock appreciation rights (SARs), severance pay plans, certain reimbursement and fringe benefit arrangements as well as standard deferred compensation plans in order to assess the impact of the regulations.

Written Document Requirement. All nonqualified deferred compensation plans must be in writing, and plans of publicly traded companies must specifically provide for a six-month delay of benefits to key employees who separate from service. In addition, the preamble to the regulations provides that a general savings provision will not work – full documentary compliance is required by December 31, 2007.

Stock Right

Fair Market Value. In order to be exempt from Section 409A, a stock option or SAR must specify an exercise price that is at least equal to the fair market value of the underlying stock on the date of grant. For private companies, fair market value is presumed if one of the safe harbor alternatives is utilized – (i) a valuation based upon an independent appraisal; (ii) a generally utilized repurchase formula; or (iii) for illiquid stock of a start-up company, a valuation by a qualified individual at a time that the company does not reasonably anticipate a public offering within 180 days or a change in control within 90 days. For publicly traded companies, fair market value is based on the trading price on the applicable securities market. If an averaging methodology is used, an irrevocable commitment to the averaging period must be made before the commencement of such period. In addition, for both private and publicly traded companies, the same valuation method used for purposes of the exercise price does not have to be used for purposes of determining fair market value at the time of exercise.

Service Recipient Stock. In order to be exempt from Section 409A, a stock option or SAR must be issued with respect to "service recipient stock." The final regulations expand the definition of "service recipient stock" to include any class of common stock that does not have any preferential payment right and the stock of any corporation in a chain of organizations all of which have a controlling interest in another organization, beginning with the parent organization and ending with the organization for which the service provider was providing services at the date of grant.

Extension of Exercise Periods. An extension of an exercise period for a stock option or SAR will not be viewed as an additional deferral feature that would subject the option or SAR to Section 409A if the extended exercise period does not exceed the earlier of 10 years from the date of grant or the original maximum term of the option.

Definition of Specified Employee. The final regulations allow publicly traded companies flexibility with respect to the method used to identify the employees for whom distributions will be delayed upon a separation from service, provided the method is designed to include all specified employees, does not allow any direct or indirect election to any service provider regarding its application, and will not identify more than 200 service providers as of any date. The regulations also provide guidance about the determination of specified employees in various types of corporate transactions and make it clear that publicly traded foreign corporations are subject to the six-month delay rule for specified employees.

Separation Pay – Involuntary Separation. The final regulations expand the severance pay exclusion from Section 409A to payments made upon involuntary separation from service that are paid by the end of the second taxable year of the employee following the year in which the separation from service occurs, up to the lesser of: (i) two times the employee's prior year's compensation, or (ii) two times the Section 401(a)(17) compensation limit ($225,000 for 2007). This means that the portion of separation pay up to the limit is excluded from Section 409A and any portion above the limit is subject to Section 409A. In addition, the regulations provide for safe-harbor criteria and a facts and circumstance test for when a "Good Reason Termination" will be deemed an involuntary separation from service.

Plan Aggregation. The final regulations expand the number of aggregation categories for plans, which will have the effect of limiting the Section 409A tax when a plan defect occurs.

January 1, 2008 Effective Date. The final regulations become effective January 1, 2008. Until the effective date, taxpayers must rely on good faith compliance with the statute, Notice 2005-1 and the proposed or final regulations.