Recently-issued proposed regulations under Section 409A of the Internal Revenue Code provide guidance relating to the operational and documentary compliance requirements for nonqualified deferred compensation plans. This Alert summarizes the rules in the proposed regulations applicable to nonqualified deferred compensation plans, which are typically provided for the benefit of a select group of key employees as "top hat" plans. Although these are "proposed regulations," they can be relied on currently, and we expect that most companies and tax advisors will treat them as applicable immediately.1 Click on the following links for Cooley Alerts describing the background and enactment of Section 409A, initial guidance from the IRS and Treasury, and other aspects of the new proposed regulations.
- Enactment of Section 409A
- Initial guidance under Section 409A  and 
Written plan requirement
Although the proposed regulations do not explicitly require that a nonqualified deferred compensation plan be in writing, various provisions regarding deferral elections and distributions must be contained within the plan in order to comply with Section 409A. Thus, a written plan document is a virtual necessity.
Initial deferral elections
In general, Section 409A requires a plan that allows elective participant deferrals to provide that a participant’s election to defer compensation must be made not later than the close of his or her taxable year that precedes the service year. The proposed regulations include certain exceptions to this general rule regarding the timing of participant deferral elections, and clarify that participant elections are treated as made as of the date the election becomes irrevocable.
For performance-based compensation for services performed over a period of at least 12 months, if the performance goals are preestablished in writing no later than 90 days after the commencement of the performance period and the outcome is substantially uncertain at the time the criteria are established, the participant’s initial deferral election may be made at any time before the 6 month period prior to the end of the performance period. For example, participants in a bonus plan that has a calendar year performance period could make deferral elections with respect to such bonuses anytime on or prior to June 30th of the calendar year in which the bonus is earned. To qualify for this exception, the service provider must have performed services continuously from a date no later than the date upon which the performance goals were established through the date the initial deferral election is made.
To defer compensation earned during the first year that a service provider becomes eligible to participate in a plan, the participant’s deferral election must be made within the first 30 days that he or she becomes eligible and may only apply to compensation earned for services performed after the election is made. For compensation earned based upon a specified performance period (e.g., an annual bonus) the election may apply to the pro rata portion of the compensation earned after the election is made, based upon the number of days remaining in the performance period over the total number of days in the performance period.
The proposed regulations also include special timing rules for deferral elections related to commission compensation, compensation specifically based upon the service recipient’s fiscal year, compensation subject to forfeiture conditions requiring the continued performance of services for a period of at least 12 months, and short-term deferrals.
Changes to deferral elections
A subsequent participant election to delay a payment or change the form of payment must not take effect for at least 12 months (and may not be made less than 12 months prior to the date the payment is scheduled to be paid) and, except for payments triggered by the death or disability of the participant, must defer the payment for at least 5 years. For such purposes, a series of installment payments that is not a life annuity is generally treated as the entitlement to a single payment on the date the first installment is scheduled to be paid unless the plan provides otherwise.
For example, assume a participant makes an initial deferral election to receive a series of installment payments over a 5 year period commencing on July 1, 2010. If the participant wants to change the election, the election change must be made before July 1, 2009, and could provide for a lump sum payment on July 1, 2015 or a series of installment payments on the same or on a different schedule so long as the first payment is no earlier than July 1, 2015. However, if the plan provided that the installment payments would be treated as a series of separate payments to be made from July 1, 2010 through 2014, then the election could not be changed to a lump sum payment on July 1, 2015 because the payments scheduled for 2011 through 2014 would not have been deferred at least 5 years; however, the form of payment could be changed to a lump sum payment on July 1, 2019, 5 years after the last of the originally scheduled installment payments.
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.
The proposed regulations clarify that payments may be made upon the earlier of, or the later of, two or more specified permissible payment events or times, and a different form of payment may be elected for each potential payment event. For example, the plan may provide that the service provider will receive installment payments upon a termination from service, or a lump sum payment upon his or her earlier death. For purposes of making payments upon a specified time, an objectively determinable date may include the time of lapsing of a substantial risk of forfeiture. For example, a plan that requires that an employee is entitled to a payment if the employee remains employed until an initial public offering occurs, and which provides that payments will be made on the December 31st following the initial public offering, would satisfy the requirement that the plan provide for payments at a specified time.
The proposed regulations require that the plan designate an objectively determinable date or year following the payment event upon which the payment will be made. For example, the plan may designate the payment date as 30 days following a separation from service, or the first calendar year following the service provider’s death. If a plan does not designate a specific date, but only a year in which the payment will be made, the first scheduled payment is deemed to be paid as of January 1st of such year for purposes of determining when changes to deferral elections must be made. For purposes of administrative feasibility, the proposed regulations relax the timing rules relating to distributions by providing that a payment will be treated as made upon the designated date if it is made by the later of: (1) the first date it is administratively feasible to make the payment on or after the designated date, or (2) the last day of the calendar year in which the payment was to be made. Additional flexibility with respect to the timing of payments is permitted in limited circumstances where calculation of the payment amount is not administratively feasible or the payments would jeopardize the solvency of the service recipient.
The proposed regulations specify the circumstances under which employees and independent contractors will be treated as actually separating from service for purposes of eligibility to receive termination of service triggered distributions, and address various issues including the impact of leaves of absence and continued provision of services following a termination of employment.
Six-month delay of distributions to specified employees of public companies upon separation from service
Like Section 409A, the proposed regulations provide that payments to a specified employee of a public company triggered by a separation from service payment event must be delayed at least 6 months following the termination, except in the event of terminations caused by the disability or death of the specified employee. For purposes of this provision, "specified employees" generally include officers having annual compensation greater than $135,000 (adjusted for inflation)2 5% owners, and 1% owners having annual compensation from the employer greater than $150,000.
The proposed regulations provide that if an individual is a specified employee at any time during the 12-month period ending on an identification date, the 6-month delay rule will apply to any distributions made during the 12-month period beginning on the first day of the fourth month following the identification date. For example, if the identification date is December 31, 2005 then with respect to any individual who qualified as a specified employee at any time during the 2005, calendar year, termination of service distributions that were otherwise scheduled to be made to such person during the period from April 1, 2006 through March 30, 2007 must be delayed at least 6 months.
Any date during a calendar year may be designated by the service recipient as the specified employee identification date; however, the service recipient must use the same identification date for all nonqualified deferred compensation plans, and any change to the identification date may not be effective for a period of at least 12 months. If no identification date is designated by the plan, the identification date is deemed to be December 31st.
The plan must provide the manner in which the 6 month delay in payments will be implemented. For example, the plan could provide that any payment scheduled to be made within the 6-month period will be delayed and paid out during the seventh month, or could alternatively provide that each scheduled payment is delayed 6 months, or a combination of the two. The plan may also allow the service provider to make an election as to how the 6-month delay will be implemented, provided the election complies with the deferral election timing rules described above.
Permitted delay and acceleration of payments
The proposed regulations allow service recipients to incorporate provisions in plans that allow payments to be delayed in order to avoid violating securities laws, loan covenants, or other contractual terms, and to avoid application of the Section 162(m) limitation on deductibility of executive compensation. Additionally, the proposed regulations provide a limited exception whereby service recipients may delay payments if there is a bona fide dispute as to the service recipient’s obligation to make the payment or the amount of payment.
Like Section 409A, the proposed regulations provide that payments of deferred compensation generally may not be accelerated, except under certain specified conditions. The proposed regulations contain the same permitted acceleration conditions as included in Notice 2005-1, namely, payments necessary to comply with domestic relations orders or with conflict of interest rules, payment necessary to satisfy employment tax withholding obligations, and $10,000 or less de minimis distributions of a participant’s entire plan interest. The proposed regulations also provide that a plan may permit the acceleration of payment in the amount that the service provider must include in income as a result of the plan failing to satisfy the requirements of Section 409A.
Nothing in Section 409A or the proposed regulations prohibits a plan from being amended at any time to prohibit future deferral elections to be made under the plan. However, the proposed regulations provide that there are only three circumstances under which a plan may be terminated and payments accelerated at the discretion of the service recipient in accordance with the terms of the plan.
First, within the 30 days preceding or the 12-month period following a change in control, the service recipient may elect to terminate a deferred compensation plan along with all other aggregated plans and make accelerated payments to participants. It is unclear under the proposed regulations whether during the 12-month period following the effective date of the change in control the deferred compensation plans of an acquiror would be required to be aggregated with the target’s plans for such purposes. (See discussion of the aggregation rules below). Therefore, an acquiror might not be permitted to terminate the target’s deferred compensation plans following the effective date of an acquisition, or alternatively might be required to terminate all of the acquiror’s deferred compensation plans in order to terminate of the target’s plans, depending upon whether the acquiror also underwent a change in control as a result of the transaction.
Second, a plan may also be terminated and plan payments accelerated if the service recipient desires to cease providing a certain category of nonqualified deferred compensation plans entirely. To qualify for this exception: (1) all plans of the same type that would be aggregated with such plan must also be terminated with respect to all participants, (2) all plan termination related payments must be made no earlier than 12 months before, and no later than 24 months following, the termination, and (3) the service recipient must not adopt a new plan that would be aggregated with any terminated plan under the plan aggregation rules for a period of 5 years following the termination of the plan.
Third, a plan may permit the service recipient the discretion to terminate the plan and accelerate payments within 12 months following a corporate dissolution, or with the approval of a bankruptcy court, provided that the payments are included in the participants’ income by the latest of the calendar year (1) in which the plan termination occurs, (2) the amounts are no longer subject to a substantial risk of forfeiture, or (3) in which the payment is administratively practicable.
Unforeseeable emergency cancellation of deferrals
Although Section 409A permitted distribution of payments upon an unforeseeable emergency of the service recipient, it did not explicitly permit cancellation of deferral elections upon an unforeseeable emergency. The proposed regulations clarify that a plan may provide that a deferral election is cancelled automatically if the service recipient obtains an unforeseeable emergency distribution under the nonqualified plan, or if such cancellation is necessary for the service recipient to receive a hardship distribution under a Section 401(k) plan. The cancellation must be effective for the remainder of the year.
Impact on plans linked to qualified plans
Linked nonqualified deferred compensation plans usually are designed to replace the benefits that would have been provided under a tax qualified plan (e.g., 401(k), profit sharing, or defined benefit pension plan) in the absence of certain limitations of the Internal Revenue Code applicable to the amounts that may be deferred or accrued under the tax qualified plan. Such linked nonqualified deferred compensation plans are commonly referred to as "wrap" or "excess benefit" plans or "SERPs" (supplemental executive retirement plans), and often provide an offset formula under which the amounts deferred or accrued under the nonqualified plan are offset by any benefits credited under the qualified plan. The proposed regulations generally permit tax qualified plans linked to nonqualified deferred compensation plans to continue to be established, amended and operated under the rules governing tax qualified plans without causing the linked nonqualified deferred compensation plans to violate the rules of Section 409A.
In general, neither the amendment of a tax qualified plan to increase or decrease the benefits under the tax qualified plan, a participant’s election as to whether to accept or decline a subsidized benefit or ancillary benefit under the tax qualified plan, nor the cessation of future accruals under the tax qualified plan, will be treated as a deferral election or acceleration of payment under the linked nonqualified deferred compensation plan. For nonqualified plans linked to 401(k) plans, a participant’s action or inaction, including an adjustment to the deferral election under the 401(k) plan, will not be treated as a deferral election or acceleration of payment under the nonqualified deferred compensation plan if it does not result in an increase or decrease in the amounts deferred under the nonqualified plan in excess of the Internal Revenue Code Section 402(g) limit in effect for such year. Similar relief is also provided with respect to plans allowing matching contributions.
The proposed regulations also extend through December 31, 2006 the transition relief provided in Notice 2005-1 for linked nonqualified deferred compensation plans where the time and form of payment under the nonqualified plan is controlled by the time and form of payment elected by the participant under the qualified plan.
Plan aggregation rules
The proposed regulations clarify application of the Section 409A plan aggregation rules. All amounts deferred by a participant under all similar plans (e.g., account balance, non-account balance, and separation pay plans) sponsored by the same service recipient are treated as deferred under a single plan. For example, if a service recipient sponsors a plan that allows elective deferral of bonuses and a separate plan that allows elective deferral of salary, the salary and bonus amounts deferred by a participant under the two separate plans would be treated as deferred under a single plan for purposes of compliance with Section 409A. Therefore, the administration of aggregated plans must be closely coordinated to comply with Section 409A timing requirements for first year of eligibility deferral elections, limits applicable to de minimis distributions and plan termination provisions.
Practical considerations in amending plan documents
As long as a plan is operated in good faith compliance with the provisions of Section 409A and Notice 2005-1 during 2005 and 2006, and the plan is amended on or before December 31, 2006 to comply with the guidance in the proposed regulations, the plan will be in compliance with Section 409A. However, the proposed regulations do not extend the transitional relief of the one time exception under Notice 2005-1 that allows plan participants to elect during 2005 to cancel their deferral elections with respect to 2005 deferrals if a plan amendment permitting such elective participant cancellation of 2005 deferrals is adopted on or before December 31, 2005. Similarly, the proposed regulations do not extend the transitional relief of the Notice 2005-1 exception that permits a plan sponsor to amend a plan on or before December 31, 2005 to terminate the plan and distribute all amounts deferred under the plan. Any payout of previously deferred amounts will be subject to income tax at the time of payout. Note that a plan may be "terminated" with respect to one participant, but not another. Although the proposed regulations extend to December 31, 2006 the transitional relief under Notice 2005-1 that allows a plan to be amended to permit participants to make new payment elections with respect to amounts subject to Section 409A, if such election changes would affect payments that the participant would otherwise receive in 2006 or would cause payments to be made in 2006, such election changes apparently must still be made by December 31, 2005.
Nothing in Section 409A or the proposed regulations requires that the grandfathered portion of a plan not subject to Section 409A be placed into a separate plan. However, as a practical matter it may be desirable to remove the grandfathered portion of a plan into a separate plan in order to avoid making inadvertent material modifications to the grandfathered portion of the plan so that it becomes subject to Section 409A. If a plan that is funded through a trust is divided into two plans, there is no requirement to create a separate trust. Regardless of whether a plan is divided into two plans or funded through one or more trusts, care should be taken to ensure that grandfathered amounts can be administered separately from amounts that are subject to Section 409A.
Circular 230 disclosure
The following disclosure is provided in accordance with the Internal Revenue Service’s Circular 230 (21 CFR Part 10). 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.
1. Although the proposed regulations are not yet technically effective, IRS Notice 2005-1 (guidance under Section 409A that is currently effective) requires taxpayers to comply with Section 409A in "good faith" during this transition period before the proposed regulations become effective on January 1, 2007. Compliance with the proposed regulations will be considered good faith for this purpose. Because the proposed regulations contain the only rules on numerous issues under Section 409A, the IRS is likely to apply the principles described in the proposed regulations even before they become effective, and many companies likely will wish to utilize those principles to ensure good faith compliance during this transition period.
2. The number of officers that the employer must treat as specified employees is limited to 50 employees (or if lesser, the greater of 3 employees or 10 percent of the employees). However, for administrative purposes, an employer may want to treat an additional number of officers as specified employees. Whether an individual is an officer is determined based upon the total facts and circumstances, including for example, the source of the individual’s authority, the term for which elected or appointed, and the nature and extent of the individual’s duties. Generally, the term officer means an administrative executive who is in regular and continued service. An employee who merely has the title of an officer but not the authority of an officer is not considered an officer for purposes of the specified employee test. On the other hand, an employee who does not have the title of an officer but has the authority of an officer is an officer for purposes of the specified employee test.
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.