United States: New IRS Guidance Requires Prompt Action on Non-Qualified Deferred Compensation Arrangements

By Marian A. Tse, Matthew T. Giuliani, Daniel P. Condon, Scott A. Webster and Kristina Hansen Wardwell

• Specific Action Items for 2005 and 2006
• Brief Overview of Section 409A Requirements
• Stock Options and Other Equity-Based Compensation Arrangements
• Separation Pay and Other Severance Arrangements
• Change in Control
• Initial Elections
• Changes in Elections
• Anti-Acceleration Rule
• Effective Date and Transitional Rules

As described in the October 2004 Client Alert and the December 2004 Client Alert, the American Jobs Creation Act of 2004 added Section 409A to the Internal Revenue Code. Section 409A substantially changes the federal income tax treatment of nonqualified deferred compensation ("NQDC") arrangements maintained by employers and other entities that receive services from employees, partners, directors, and other individuals. Failure to comply with the new requirements will result in early taxation of NQDC, as well as a 20% penalty tax and additional interest payable to the IRS. These new rules generally became effective January 1, 2005, but the statute grants the IRS authority to issue transition rules and to provide guidance regarding a number of significant issues concerning the new rules.

In December 2004, the IRS issued Notice 2005-1 (the "Notice"), which provided important transitional relief that extended the time frames for certain actions necessary to comply with the new rules. In particular, the Notice deferred to December 31, 2005 the deadline for adoption of written plan amendments, but included a requirement that NQDC arrangements be operated in good faith compliance beginning January 1, 2005.

Recently, the IRS published comprehensive proposed regulations (the "Proposed Regulations") that provide significant, detailed guidance on Section 409A requirements. The Proposed Regulations generally extend to December 31, 2006 the good faith compliance period and the deadline for adopting written plan amendments to bring NQDC arrangements into compliance with Section 409A. However, in certain circumstances, there are important Section 409A compliance steps that must be taken before the end of 2005.

The guidance in the Notice and the Proposed Regulations is lengthy and complex. This Alert provides a brief overview of the requirements of Section 409A and summarizes some of the major aspects of the IRS guidance included in the Proposed Regulations. It also identifies action steps that must be taken for Section 409A compliance in 2005 and 2006 by an employer or any other entity that receives services from employees, partners, directors, or other individuals (a "Company") and that maintains an NQDC arrangement. However, this Alert does not cover all facets of Section 409A or the Proposed Regulations, and the impact of these tax law requirements can vary substantially based on the specific facts and circumstances. Consequently, Companies are strongly encouraged to review the administration and documentation of their NQDC arrangements with their advisors to ensure timely compliance with Section 409A.

Action Items for 2005. Items to be completed before the end of 2005 include the following:

• Amend, terminate, and pay out an NQDC arrangement by December 31, 2005 if the Company does not wish to bring the NQDC arrangement into compliance with Section 409A.
• Adopt a plan amendment if the Company took advantage of guidance in the Notice and permitted participants (i) to make new deferral elections after December 31, 2004 and by March 15, 2005 for 2005 compensation, or (ii) to cancel or revoke existing payment elections.
• Provide participants with enrollment materials and election forms for deferral of 2006 salary compensation, such forms to be completed and submitted no later than December 31, 2005.
• Unless the Company intends to rely on the rule that permits a later election for certain performance-based compensation (as described beginning on page 8, below), provide participants with enrollment materials and election forms for bonus compensation to be earned in 2006, such forms to be completed and submitted no later than December 31, 2005.
• Notify holders of discounted stock options that do not have a fixed exercise date of the need to exercise any such discounted stock options by December 31, 2005 in order to avoid adverse tax consequences. (Alternatively, if the Company desires to pay the amount of the discount to the option holder as part of the cancellation and reissuance of the options as non-discounted options, the payment must be made in 2005, even though the cancellation and reissuance may occur in 2006.)

Action Items for 2006. Items to be completed no later than December 31, 2006 include the following:

• Adopt written Section 409A plan amendments and documents for all NQDC arrangements to the extent necessary to bring the arrangement into full compliance with Section 409A.
• Finalize payment election forms, if the Company wishes to permit participants to make new elections for amounts deferred in the past.
• Amend any discounted options that do not have a fixed exercise date and that are not exercised in 2005 to eliminate the discount (determined as of the date of the initial grant) in order to avoid Section 409A taxation of, and additional tax on, the options.

Section 409A imposes the following requirements on NQDC arrangements (which are summarized in greater detail in the October 2004 Client Alert):

• NQDC may be distributed only after separation from service, disability, or death, at a time (or in accordance with a schedule) specified in the plan or agreement, or upon an unforeseeable emergency or (to the extent permitted by the IRS) a change in control.
• In the case of a key employee of a public company, a distribution following separation from service cannot be made until six months after the separation.
• The NQDC arrangement may not permit acceleration of the time or schedule for payment.
• An election to defer compensation earned during a calendar year generally must be made before the beginning of the year, although there are special rules in the case of the first year of eligibility and for "performance-based" compensation.
• Once an amount has been deferred, there are significant restrictions on the ability to change the timing and form of payment.
• Substantial limitations apply to the funding of NQDC through the use of certain offshore trusts or under an arrangement connected to the financial health of the Company.

Notably, Section 409A applies to many plans, agreements, and other arrangements that a Company might not typically think of as "deferred compensation" – e.g., some stock options or other equity-based arrangements, certain bonus arrangements, and certain separation pay plans or agreements. However, Section 409A does not apply to plans that have special status under federal tax law – e.g., tax-qualified plans (Section 401(a) plans), Section 403(b) tax-deferred annuities, and eligible Section 457(b) plans of tax-exempt organizations. Also, welfare benefit arrangements such as vacation, sick leave, and death benefit plans generally are not covered by Section 409A.

The Proposed Regulations provide significant guidance regarding the application of Section 409A requirements to equity-based compensation arrangements.

In certain cases, the Proposed Regulations provide special treatment for equity arrangements involving Company stock. To qualify as Company stock for this purpose, the stock must be common stock of a corporation that receives services from the individual (or a member of the same "controlled group" as the Company receiving services, as defined under IRS rules). In addition, in the case of a public company, the stock must be readily tradable on an established securities market; in the case of a private company, the stock must be the class of common stock of the corporation having the greatest aggregate value, or nonvoting common stock with substantially similar rights as that class. Stock that is preferred as to liquidation or dividends or is subject to a mandatory repurchase right at other than a fair market value does not qualify as Company stock.

Covered Arrangements. Under the Proposed Regulations, the following equity-based arrangements are subject to Section 409A:

• Non-qualified stock options or stock appreciation rights that have an exercise price below fair market value at date of grant or that provide a deferral feature;
• Restricted stock units;
• Deferred stock units; and
• Options to acquire (or stock appreciation rights relating to) stock that does not constitute Company stock under Section 409A.

Importantly, however, the following equity arrangements relating to Company stock are not subject to Section 409A:

• Incentive stock options;
• Section 423 employee stock purchase plans;
• Non-qualified stock options or stock appreciation rights that have an exercise price at least equal to fair market value at date of grant and that do not provide any deferral feature;
• Restricted stock; and
• A promise to deliver stock in the future upon satisfaction of a vesting requirement.

Determination of Fair Market Value. The Proposed Regulations provide flexible rules for determining the fair market value for Company stock that is readily traded on an established securities market (including an over-the-counter market or foreign market). Generally, fair market value may be determined on any reasonable basis that uses actual transactions in stock as reported by the market as long as it is consistently applied. Further, fair market value can be determined based on an average of the stock price over a specified period (within 30 days before and 30 days after the grant date). However, if fair market value is to be based on an average stock price, the terms of the grant must be irrevocably established before the beginning of the measurement period.

In the case of a private company, the fair market value of Company stock is to be determined by the reasonable application of a reasonable valuation method that takes into account all of the relevant facts and circumstances, including the following factors to the extent applicable: (i) the value of tangible and intangible assets; (ii) the present value of future cash flows; (iii) the market value of stock in similar corporations that can be determined by objective means; and (iv) control premiums or discounts for lack of marketability. The valuation must not be more than 12 months old and must take into account all available information material to the determination of value as of the valuation date. Further, the value must be adjusted to reflect events subsequent to the valuation such as the issuance of a patent or resolution of material litigation.

The Proposed Regulations provide a presumption of reasonableness where one of the following methods of valuation (as applicable) of private company stock is used, so long as it is employed consistently:

• Valuation determined by an independent qualified professional appraiser that is not more than 12 months old;
• Valuation based upon a formula used as part of a non-lapse restriction, provided that the stock is not transferable and such formula is used consistently for both compensatory and noncompensatory purposes; or
• Valuation of stock of a start-up corporation that is not subject to any put or call, made reasonably and in good faith by a person with significant knowledge and experience and evidenced by a written report that takes into account all relevant factors. Note, however, that this presumption of reasonableness is not available if it is reasonably anticipated that the start-up corporation will undergo a change-in-control event or an initial public offering in the next 12 months. For this purpose, a start-up corporation is a private company that has been in business for less than 10 years.

Modifications. Under the Proposed Regulations, any modification of the terms of a stock right is considered the granting of a new stock right that could become subject to Section 409A. The following will be considered modifications:

• Reduction in exercise price, other than pursuant to a proportionate adjustment to reflect a stock split or a stock dividend;
• Extension of the exercise period beyond the later of two and one-half months after the original expiration date or December 31 of the year containing the original expiration date;
• Addition of discretion to provide added benefits;
• Changes in the terms of the underlying stock that increase the value of the stock;
• Increases in the number of shares purchasable, other than pursuant to a proportionate adjustment to reflect a stock split or a stock dividend.

The following changes to an existing stock right will not be considered a modification:

• Reduction of the exercise period;
• Addition of an ability to tender previously owned stock towards the exercise price;

• Addition of a provision allowing shares to be withheld for taxes;

• Exercise of discretion previously reserved to permit transferability;

• Extension of the exercise period to not more than the later of two and onehalf months after the original expiration date or December 31 of the year that contains the original expiration date;

• Acceleration of vesting or exercisability; and

• Substitution or assumption of stock right by reason of a corporate transaction.

If there is an inadvertent change to an existing stock right, the change will not be considered a modification if it is rescinded by the earlier of the date the stock right is exercised or the last day of the calendar year during which the change is made.

Plans or other arrangements that provide for the payment of severance upon termination of employment may need to comply with the requirements of Section 409A. Under the Proposed Regulations, however, two types of severance arrangements are specifically exempted from these requirements. First, collectively bargained severance plans need not comply. Second, Section 409A requirements do not apply to an arrangement that provides for severance (i) in connection with a "window program" that permits certain groups of employees to terminate employment voluntarily or (ii) upon involuntary termination of employment. In either case, however, the severance to be paid to an employee may not exceed two times the lesser of (a) the employee’s annual compensation for the preceding calendar year or (b) the maximum amount that may be taken into account as compensation under the qualified plan compensation limit in effect for the preceding calendar year. In addition, all of the severance pay must be paid no later than December 31 of the second calendar year following the calendar year in which the termination occurs.

Also exempted from Section 409A are agreements providing for the reimbursement of expenses of a terminated individual to the extent the reimbursements are excludable from the individual’s income, are for reasonable outplacement or moving expenses, relate to deductible business expenses, or are for certain nondeductible medical expenses – but only if such reimbursements are not paid after December 31 of the second calendar year following the calendar year in which the termination occurs. Further, reimbursements or other payments provided in connection with severance are not subject to Section 409A in any event if they do not exceed $5,000 in the aggregate.

Severance plans or arrangements that must comply with Section 409A include any plan or arrangement that provides for payments in excess of the limits described above or that includes any provision that permits the covered individual to terminate employment voluntarily and receive severance. For example, many employment and change-in-control agreements permit an executive to terminate employment voluntarily and receive severance if his or her working conditions have changed in some materially adverse way. Accordingly, as a general matter most employment, change-in-control, or other severance agreements with executives will need to comply with the requirements of Section 409A. Compliance with Section 409A will mean, among other things, that a Company that is a publicly traded corporation will be required to delay payment of severance to a "key employee" until at least six months after termination of employment.

While Section 409A permits distributions to be made upon a "change in control" the statute delegates authority to the IRS to provide the details of how this rule will be applied. In this regard, in the Notice, the IRS provided some guidance regarding how the change-in-control rule applies in the context of transactions affecting corporations (see the December 2004 Client Alert), and in general that guidance is carried forward and explained in more detail in the Proposed Regulations. For example, the Proposed Regulations make clear that an arrangement in connection with a transaction that meets the requirements of a change in control, which is structured so that a portion of the transaction consideration is paid out over time – i.e., an "earn out" – may constitute a permissible change-in-control distribution under Section 409A if the earn out payments are made under the same terms and conditions as payments to shareholders generally and are paid within five years after the change in control.

In general, the Proposed Regulations do not address the change in control of entities other than corporations. However, in issuing the Proposed Regulations, the IRS indicated that it intends eventually to issue regulations under Section 409A that will permit payments to be made upon a change in control of a partnership (including a limited liability company taxed as a partnership). In addition, the IRS stated that, until further guidance is issued, it is permissible to apply by analogy Section 409A’s change-in-control provisions to situations where there is an acquisition of more than 50% of value or voting power of a partnership, or an acquisition of 40% or more of assets of a partnership.

The Proposed Regulations clarify a number of exceptions to the general rule that initial elections to defer compensation for services performed during a calendar year or to specify a time or form of payment of NQDC earned in that year must be made before the beginning of that calendar year. For example, where the Company’s fiscal year is not the calendar year, an NQDC arrangement may provide that compensation that is earned for services performed during a fiscal year period and that is payable only after the end of the fiscal year (i.e., a bonus but not regular salary) may be deferred under an election that is made before the beginning of such fiscal year (rather than before the calendar year in which the services are performed). Under another exception, an individual who first becomes eligible to participate in an NQDC plan mid-year may make an initial deferral election any time during his first 30 days of participation in the plan, provided that the initial deferral election may apply only to compensation earned for services performed after the date of the election. In applying this rule to compensation earned based upon a specified period (for example, an annual bonus), the initial election may apply only to a pro rata portion of such compensation, based on the number of days remaining in the year after the election is made (unless another exception, such as the exception for performance-based compensation, applies).

Performance-Based Compensation. Under a separate exception included in the Proposed Regulations, an NQDC arrangement may provide that an election to defer "performance-based" compensation earned over a period of at least 12 months may be made at any time up to six months before the end of the period during which services must be performed to qualify for the compensation, provided that the preestablished performance criteria have not been met at the time of the election. For example, for a bonus that qualifies as performance-based compensation and that is based on services performed during the 2006 calendar year, a deferral election must be made no later than June 30, 2006, provided that the election to defer is made before such compensation has become both substantially certain to be paid and readily ascertainable.

In the case of compensation that is not tied to equity, "performance-based" compensation is compensation that is contingent on the individual’s or the Company’s satisfaction of pre-established performance criteria over a service period of at least 12 months, where satisfaction of the criteria is substantially uncertain when established. The performance criteria must be stated in writing within 90 days after the service period begins, and generally must be objective. The performance criteria do not have to be approved by the compensation committee of the Company’s board of directors (or other similar entity for non-incorporated businesses) or by the Company’s stockholders (or members).

Compensation that is tied to equity is performance-based compensation if it either (i) is based solely on an increase in the value of the Company or the Company’s stock after the date of the grant or award; (ii) is coupled with an amount that is performance-based compensation; or (iii) is subject to conditions that otherwise make it performance-based compensation. Thus, a stock appreciation right with an exercise price less than fair market value at date of grant is not, by itself, performance-based compensation. However, adding a vesting condition (over at least 12 months) to the grant may qualify it as performance-based compensation.

The Proposed Regulations explain the general rule that, under Section 409A, changes in the time and form of a distribution may be made after the deferral period begins only if all three of the following conditions are met:

• The new election cannot be effective for at least 12 months after the date it is made.
• Any additional deferral under the change must be for a period of at least five years from the date the payment would otherwise be made.
• An election related to a distribution to be made upon a specified time (or fixed schedule) must be made at least 12 months prior to the date of the first scheduled payment.

The Proposed Regulations also provide some exceptions to this general rule – e.g., permitting an NQDC arrangement to provide for a delay of a distribution where a payment on schedule would violate federal securities laws or result in the breach of a loan agreement.

The Proposed Regulations also provide special rules for applying the conditions for changing elections in the context of installment payments, annuity distributions, and multiple payment events (e.g., where an individual’s election calls for a lump sum payment upon separation from service, or an annuity upon attainment of age 65, if earlier). Under the Proposed Regulations, the addition of a new payment event, or the addition of a fixed time or fixed schedule of payments, is treated as a change in election. Thus, the addition of any fixed time of payment must defer distribution at least five years from the date the fixed time was added. Similarly, any added payment event may not result in payment for at least five years from the date the new payment event was added. For example, an employee who is entitled to a payment only on January 1, 2020 cannot subsequently elect to defer payment until the later of January 1, 2020 or separation from service, but may elect (by January 1, 2019) to defer payment to the later of January 1, 2025 or separation from service.

In general, under Section 409A an NQDC plan may not permit the acceleration of the time or schedule of any payment. For example, if a benefit is otherwise scheduled to be paid in installments, an NQDC plan generally cannot permit either the individual or the Company to choose to have the benefit paid as a lump sum. However, the Proposed Regulations provide that the rule against acceleration does not prohibit any of the following:

• Payment in accordance with plan provisions or an initial election (otherwise consistent with the Section 409A requirements) that call for distributions to be made on a relatively faster schedule on account of one event as opposed to another – e.g., it is permissible to provide that benefits will be paid in installments following separation from service but as a lump sum upon death before termination;
• Waiver of a vesting requirement that results in an earlier payment – e.g., a plan that provides for vesting after 10 years of service and payment upon separation from service may be modified to waive the vesting requirement if the individual separates after five years and receives payment at that time;
• Payments made earlier than otherwise scheduled in order to satisfy a divorce decree or other domestic relations order; or
• Certain early payments made to satisfy tax obligations – e.g., to pay employment taxes related to the NQDC, or where federal income tax is due as a result of the NQDC plan’s non-compliance with Section 409A, or because of the special NQDC rules applicable to tax-exempt employers.

In addition, under the Proposed Regulations the anti-acceleration rule generally does not prevent an NQDC plan from requiring payment of a participant’s benefit in a lump sum distribution if it is less than an amount stated in the plan. However, such a mandatory "cash-out" provision that is added by a plan amendment may apply to amounts deferred before the amendment is adopted only if certain requirements are satisfied – i.e., the mandatory cash-out amount cannot exceed $10,000 and payment must be made within a specified time following separation from service.

The anti-acceleration rule has a significant impact on the ability to pay out benefits on account of termination of an NQDC plan. Under the proposed regulations, such plan termination payments may be made only in limited circumstances, such as a change in control, or a corporate dissolution or bankruptcy, or where the Company terminates all similar NQDC plans it maintains and does not establish any such new plans for five years. In any case where a plan is terminated and none of the available exceptions apply, no new amounts will be deferred under the plan, but payment of amounts previously deferred must be made at the time and in the form otherwise provided by the plan’s terms (consistent with the Section 409A rules).

Effective Date. Section 409A generally applies to amounts deferred after December 31, 2004 as well as any amount deferred before January 1, 2005 if the plan under which the deferral was made is "materially modified" (as described below) after October 3, 2004. For this purpose, an amount is considered deferred before January 1, 2005 if the individual is vested in the amount at that time – i.e., there is no requirement for the performance of future services or any other substantial risk of forfeiture. Earnings on pre-2005 deferrals are also exempt from Section 409A.

Material Modification. A plan is considered "materially modified" for purposes of the Section 409A effective date if a benefit or right existing as of October 3, 2004 is enhanced or a new benefit or right is added – whether by amendment or by the exercise of discretion already provided under the plan (e.g., to accelerate vesting). It is not a material modification for an individual to exercise a right or option existing under a plan as of October 3, 2004 or for a Company to exercise discretion over the time and manner of distribution to the extent such discretion was provided under the plan as of October 3, 2004. The Proposed Regulations include a new fail-safe feature that permits a Company to rescind a modification that would otherwise inadvertently cause a plan to become subject to Section 409A, as long as any additional rights granted have not been exercised and the rescission is effected before the end of the calendar year in which the modification was made.

Transitional Operation Requirements. An NQDC plan in existence before December 31, 2006 will not be treated as violating the requirements of the new law if the plan is operated in good faith compliance with the provisions of the new law and the plan is amended on or before December 31, 2006 to conform to the requirements of the new law.

For this purpose, good faith compliance is considered to be compliance with the Notice and a reasonable interpretation of Section 409A to the extent that an issue is not addressed in the Notice. Plan terms cannot be followed to the extent they are inconsistent with a good faith interpretation of Section 409A. Compliance with the Proposed Regulations is not required; however, compliance with the Proposed Regulations will be considered good faith compliance under Section 409A. Indeed, IRS officials have expressed the view that failure to comply with the Proposed Regulations may be considered evidence of failure to meet the good faith compliance requirement. Accordingly, a Company and its advisors should review the operation of its NQDC arrangements thoroughly for compliance with the detailed requirements of the Proposed Regulations; any deviation from the Proposed Regulations should be carefully analyzed and considered.

Special Pre-2007 Election Changes. Under the Proposed Regulations, NQDC plans may be amended to allow for new payment elections for amounts previously deferred, provided the plan amendment and any related payment election are made before January 1, 2007.

Participation and Election Terminations. Under the Notice, an NQDC plan adopted before December 31, 2005 may be amended to allow a participant to terminate participation in the plan or cancel or reduce a deferral election with respect to amounts deferred after December 31, 2004, provided that the amounts are properly included in income. The ability to terminate participation in a plan may be granted to all participants in a plan or on a participant-by-participant basis. In light of this transition rule, discounted stock options that are not amended to comply with Section 409A should be exercised by December 31, 2005. The Proposed Regulations do not extend these special termination rules beyond December 31, 2005.

Payment Elections Tied to Tax-Qualified Plans. For periods ending before January 1, 2007, an election as to the timing and form of payment under an NQDC plan that is controlled by a payment election to be made under a tax-qualified plan (such as a 401(k) plan or defined benefit pension plan) will not violate the terms of the new law, provided that the terms of the NQDC plan as in effect on October 3, 2004 control. It is expected that further guidance will place restrictions starting in 2007 on the ability to tie the payment of NQDC benefits to distribution elections made under tax-qualified plans.

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