United States: IRS Issues Additional (But Limited) Transition Relief Under 409A

On September 10, 2007, the IRS issued Notice 2007-78, which permits taxpayers to bring nonqualified deferred compensation plans into documentary compliance with Section 409A of the Internal Revenue Code and the final regulations issued thereunder.

Background

Section 409A covers a wide range of nonqualified deferred compensation plans and arrangements (including stock option grants and separation arrangements) and imposes a number of strict requirements on such plans and arrangements for participants to avoid premature taxation, an additional 20% federal income tax, and interest on underpayments of tax. Section 409A and its impact on various forms of non-qualified deferred compensation plans and arrangements are discussed in our prior Cooley Alerts.

On April 10, 2007, the Department of Treasury and the IRS issued final regulations under Code Section 409A, which provided guidance regarding the requirements for deferral elections and payment timing under Section 409A. Under the final 409A regulations, non-qualified deferred compensation plans and arrangements are required to comply with the final regulations beginning January 1, 2008.

What does Notice 2007-78 do? Notice 2007-78 extends the documentary compliance deadline for one year and provides additional limited transition relief, but it does not extend the January 1, 2008 effective date of the final regulations. Notice 2007-78 also announces that Treasury and the IRS anticipate issuing guidance, in the near future, that will establish a limited voluntary compliance program that will permit corrections of certain unintentional operational violations of Section 409A.

Does Notice 2007-78 delay the effective date of the final regulations under Section 409A until January 1, 2009? No, it does not. Notice 2007-78 has no impact on the effective date of the final 409A regulations. Non-qualified deferred compensation plans must be operated in compliance with the final regulations under Section 409A on and after January 1, 2008.

Under Notice 2007-78, may we delay providing a designated time and form of payment under our non-qualified deferred compensation plan until December 31, 2008? No, you may not. To comply with Section 409A, payments of deferred compensation may only be made at a specified time or under a fixed schedule that is objectively determinable, or upon the following events: separation from service, death, disability, change in the ownership or effective control of the service recipient, or unforeseeable emergency, in each case as specifically defined under the rules.

In order to comply with Section 409A, the employer or the participant in the non-qualified deferred compensation plan must designate a compliant time and form of payment in writing, before January 1, 2008. For example, a non-qualified deferred compensation plan that provides that a -participant’s deferred compensation will be paid or commenced to be paid "not later than 60 days after the end of the Plan Year in which the Participant terminates employment in a lump sum or installments over a period not exceeding ten years, as determined by the Employer" contains a non-compliant time and form of payment and must be amended on or before December 31, 2007.

If our non-qualified deferred compensation plan contains a distribution event that is not permitted under Section 409A (e.g., a "haircut" provision), must we amend the plan to remove that provision on or before December 31, 2007? No, as long as the employer or the participant in the non-qualified deferred compensation plan designates a compliant time and form of payment by December 31, 2007 and the plan is operated in compliance with 409A (e.g., disregarding the "haircut" provision), you may remove an impermissible distribution event (like the "haircut" provision) after December 31, 2007 as long as it is done before January 1, 2009.

If our non-qualified deferred compensation plan provides a 409A-compliant time and form of payment of deferred compensation, may we amend the plan to add or remove a time or form of payment after December 31, 2007? No, you may not. For example, if your non-qualified deferred compensation plan provides that deferred compensation will be distributed on the earlier of separation from service or 2011, it may not be amended to add a distribution upon a change in ownership or control, even though that is a permitted distribution event. Similarly, it may not be amended to remove "separation from service" as a distribution event.

In a prior Cooley Alert, you said that we have until December 31, 2007 to permit plan participants to make changes to payment elections and fix eligible outstanding discounted stock rights. Does Notice 2007-78 extend the period during which we may take such actions? No, it does not. You have only until December 31, 2007 to:

• permit plan participants to make changes to payment elections (e.g., to change the time and/or form of payments under the plan), provided that if the change in the payment election is made in 2007, the change may apply only to amounts that would not otherwise be payable in 2007 and may not cause an amount to be paid in 2007 that would not otherwise be payable in 2007;
• fix eligible outstanding discounted stock rights (i.e., discounted stock options and stock appreciation rights); and
• change an existing payment provision in the plan or payment election by a participant that provides that the time and form of payment under the nonqualified plan is the same as the payment election made by the participant under a qualified plan.

However, you have until December 31, 2008 to amend your deferred compensation plan to come into documentary compliance with Section 409A, including documenting the required six-month delay in distributions of deferred compensation to specified employees, as long as the amendments to the plan are effective January 1, 2008 and reflect the plan’s operation during 2008.

We want to amend our executive’s employment contract to revise the "good reason" definition giving rise to separation pay in order to take advantage of the short-term deferral exception and the double pay exception to Section 409A mentioned in the May 3, 2007 Cooley Alert. May we do so? Yes, you may amend the definition of "good reason" to conform to the requirements in the final 409A regulations (including the safe harbor definition of "good reason," if desired), provided that:

• the current definition of good reason either creates a "substantial risk of forfeiture" or is not applicable until another event that constitutes a "substantial risk of forfeiture" (e.g., a change in control) has occurred; and
• the amendment is made no later than December 31, 2007.

An existing good reason definition may not be a substantial risk of forfeiture if the employee has the right to resign employment upon an occurrence of events that do not result in a material adverse change in the terms and conditions of that person’s employment.

If we want to amend our non-qualified deferred compensation plan to designate each payment in a series of installment payments as a "separate payment," may we do so by December 31, 2008? No, if you are going to designate each payment in a series of installment payments as a "separate payment," you must do so no later than December 31, 2007. As explained in our May 3, 2007 Cooley Alert, if each payment in an installment stream is designated as a separate "payment"—as permitted by the final regulations—then any such payment in the installment stream that is paid within the short-term deferral period will not be subject to Section 409A, even if the remainder of the stream of installment payments extends beyond the short-term deferral period.

What actions should we take before the end of 2007? Employers should review all of their deferred compensation plans and arrangements for compliance with Section 409A. For a list of arrangements that are covered by Section 409A, please see our July 1, 2007 Cooley Alert.

Although Notice 2007-78 provides employers with additional time to come into documentary compliance with Section 409A, employers must determine whether their deferred compensation plans and arrangements contain a compliant time and form of payment. If any plan or arrangement does not contain a compliant time and form of payment, then the plan or arrangement must be amended before January 1, 2008. Similarly, defective "good reason" definitions may only be amended prior to the end of this year, provided the substantial risk of forfeiture requirement is satisfied.

Employers should examine their past stock option grant practices to determine whether any stock options were granted with an exercise price at less than the fair market value of the underlying stock on the date of grant. If any options were granted with an exercise price less than the fair market value of the stock on the date of grant, then the employer has until December 31, 2007 to fix those discounted options.

Finally, if employers wish to permit deferred compensation plan participants to modify their elections for distributions scheduled to occur after 2007, then the employer must provide the participants with that right, and participants must make their elections, before January 1, 2008.

The Compensation & Benefits Group at Cooley is prepared to work with you to identify and, where necessary, amend deferred compensation plans and arrangements.

The following disclosure is provided in accordance with the Internal Revenue Service’s Circular 230 (21 CFR Part 10). This Alert is not intended to constitute tax advice to any specific taxpayer or for any specific situation. Any tax advice contained in this Alert is intended to be preliminary, for discussion purposes only, and not final. Any such advice is not intended to be used for marketing, promoting or recommending any transaction or for the use of any person in connection with the preparation of any tax return. Accordingly, this advice is not intended or written to be used, and it cannot be used, by any person for the purpose of avoiding tax penalties that may be imposed on such person.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.