Section 409A of the Internal Revenue Code, which was added by the American Jobs Creation Act of 2004 (the “Act”) imposed sweeping new restrictions on a broad variety of “deferred compensation arrangements.” Though effective January 1, 2005, taxpayers have been permitted to operate their deferred compensation arrangements in good faith compliance with Section 409A and various guidance issued by the IRS since that date. Following the IRS’s issuance of final regulations last April, the good faith compliance standard was scheduled to expire on December 31, 2007.

On October 22, 2007, the IRS issued Notice 2007-86 extending the good faith compliance standard until December 31, 2008. The extension also affords taxpayers an additional year to amend their deferred compensation arrangements to comply with the requirements of Section 409A and final IRS regulations.

What The Extension Means

While extension of the 409A full compliance deadline allows taxpayers more time to amend their deferred compensation arrangements, employers and other taxpayers should not wait to review and modify such arrangements. It is important that employers and other taxpayers continue to take inventory of their deferred compensation arrangements and determine what changes need to be made. Our experience shows that virtually all deferred compensation arrangements need to be amended in some manner to comply with Section 409A, and that compliance is a time-consuming effort that often requires challenging decisions involving many parties.

Also, Section 409A covers a variety of arrangements that many would not think of as deferred compensation, including severance arrangements (including the severance terms of employment agreements), change in control agreements, supplemental retirement plans, phantom stock plans, restricted stock units, discounted stock options and multi-year bonus plans. Even arrangements that are not designed to defer payments from one year to the next, such as annual bonus plans, should be reviewed to make sure that they either comply with Section 409A or are designed to fall outside the scope of Section 409A. Importantly, all compensation arrangements should be in writing, and in many cases must be in writing, in order to either comply with Section 409A or be excluded from the requirements of Section 409A.

Consequences of Non-Compliance

Penalties for non-compliance with 409A are extremely harsh. They include the immediate taxation of all deferred compensation to the affected taxpayer, plus a 20% penalty tax and interest penalties. Accordingly, it is critical that employers and other parties to deferred compensation arrangements take measures to maintain compliance with Section 409A. In addition to making sure that all documentation is in order, operational or administrative procedures should be reviewed to make sure that they are consistent with the terms of the arrangements and compliant with Section 409A.

The Good Faith Compliance Standard

Good faith compliance under IRS Notice 2007-86 generally means that deferred compensation arrangements be operated consistent with a good faith, reasonable interpretation of Section 409A, and to the extent not inconsistent with 409A, the terms of the arrangement.

For periods prior to January 1, 2008, compliance with either proposed regulations issued in 2005 or final regulations issued earlier this year will be considered good faith compliance. For 2008, compliance with the final (but not the proposed) regulations will constitute reasonable good faith compliance.

Section 409A generally prohibits either the service recipient (e.g., an employer) or a service provider (e.g., an employee) from exercising discretion over the time and form of payment of deferrals. An arrangement will not be considered to have been operated in good faith compliance if discretion allowed under the arrangement is exercised in a manner that would violate 409A.

Opportunity to Make Election Changes Also Extended

Section 409A also places significant restrictions on the ability of an individual to change the time or form of payment of deferred compensation. In general, any such change requires that the time for payment be deferred for an additional five years from the scheduled payment date. The new relief generally affords taxpayers an additional year to modify elections as to the time and form of payment of deferred compensation without regard to this five-year rule. Under existing transition relief and the new extension, a taxpayer is allowed to make changes to the time and form of deferral payments as follows without regard to the five-year rule:

Up until December 31, 2007:

An election may be made to change the time or form of payment of deferrals due to be paid in 2008 or later. However, amounts due to be paid after 2007 cannot be accelerated into 2007. Amounts due to be paid in 2007 must still be paid in 2007.

During 2008 :

An election may be made to change the time or form of payment of deferrals due to be paid in 2009 or later. However, amounts due to be paid after 2008 cannot be accelerated into 2008. Amounts due to be paid in 2008 must still be paid in 2008 (unless an election to defer the time of payment is made on or before December 31, 2007).

Many employers will soon be in the process of holding “open enrollment” under deferred compensation plans and should consider affording participants opportunities to change existing deferred payment elections consistent with the transition relief.