Final Regulations Governing Nonqualified Deferred Compensation Under Code Section 409AMay 03, 2007
The following is based on a summary of legal principles. It is not to be construed as legal advice. Individuals should consult with legal counsel before taking any action based on these principles to ensure their applicability in a given situation. ©2007 Godfrey & Kahn, S.C.
Enacted by Congress in 2004 in response to heightened concerns regarding executive pay packages and compensation strategies used by companies such as Enron and Worldcom, Section 409A of the Internal Revenue Code contains an expansive definition of "nonqualified deferred compensation" and limits the flexibility previously available to employers offering such plans to their employees. Section 409A has significantly changed the tax treatment of deferred compensation, primarily with respect to deferral and distribution elections and events. Generally, Section 409A applies to all amounts of nonqualified deferred compensation deferred after December 31, 2004 and to amounts deferred prior thereto if they were not vested as of December 31, 2004. However, to the extent there are material modifications to any deferred plans or agreements after October 3, 2004, Section 409A will apply to amounts deferred under such plans, even if deferred and vested before December 31, 2004.
On April 10, 2007, the IRS issued final regulations under Section 409A. The final regulations are effective as of January 1, 2008, but can be relied on by taxpayers for taxable years prior to 2008. The final regulations require that all nonqualified deferred compensation plans and arrangements be amended to comply with Section 409A no later than December 31, 2007. Until December 31, 2007, parties to nonqualified deferred compensation arrangements will be treated as complying with Section 409A as long as plans and arrangements are operated in good faith compliance with the rules contained in Section 409A and previous guidance (IRS Notices, the proposed regulations or the final regulations). Given the extensive guidance provided in the final regulations, it is important that all parties to nonqualified deferred compensation plans review these arrangements now in order to evaluate whether any changes to such arrangements are necessary and to assure that they are operating such arrangements in good faith compliance with the new rules.
In general, Section 409A (i) provides detailed rules for the timing of deferral elections; (ii) prohibits acceleration of payments of deferred compensation; (iii) permits payments only upon the occurrence of certain events; and (iv) substantially limits the ability to make further deferrals. For a more comprehensive discussion of deferred compensation arrangements affected by Section 409A and what was required under Section 409A prior to the issuance of the final regulations, see our client update from October 2005 entitled "Proposed Regulations Governing Nonqualified Deferred Compensation Under Section 409A"
What's New in the Final Regulations?
Prior to the issuance of the final regulations, the IRS had issued proposed regulations under Section 409A in September 2005. The final regulations generally adopt the provisions of the proposed regulations, although further guidance and clarity has been provided in a number of areas, a few of which are summarized below. The guidance provided by the final regulations is extensive. The following is only a summary of a few key issues that have been addressed in the final regulations and is not intended to be comprehensive in nature.
Short-Term Deferrals Exempt From Section 409A
. The final regulations generally adopt the short-term deferral rule that was contained in the proposed regulations. That is, a deferral of compensation does not occur for purposes of Section 409A if the arrangement does not provide for a payment to be made (and no payment is made) later than the 15th day of the third month following the end of the taxable year in which the payment becomes vested. The final regulations provide that, regardless of whether a payment is actually made within the short-term deferral period, if the payment could have been made under the arrangement at a later time, the arrangement is subject to Section 409A.
Stock Options and SARs
- Fair Market Value Options and SARs Excluded From Section 409A. Stock rights (both stock options and SARs) granted over common stock are generally excluded from the application of Section 409A, as long as the exercise price/grant value of the stock right is no less than the fair market value of the stock on the date of grant. The final regulations retain the "reasonable application of a reasonable method" rule to determine the fair market value of the stock of a private company on the date of grant, but have slightly liberalized the valuation safe harbors for private companies in some respects. Even so, we still expect that most private companies that want to benefit from a valuation safe harbor will seek an independent appraisal of their stock when granting stock options or SARs.
- Extension of Option or SAR Exercise Periods. Unlike the proposed regulations, the final regulations are more flexible in allowing employers to extend a stock option or SAR exercise period without triggering a modification of the stock right that would be viewed as a new grant. Under the final regulations, if a stock right is "in the money" at the time of an extension, the extension of the exercise period must be limited to a date no later than the earlier of (i) the original maximum term of the stock right or (ii) 10 years from the original date of grant of the stock right in order to comply with Section 409A. For options that are "underwater" at the time of the extension, there is no such limitation.
- Service Recipient Stock Requirement Liberalized. In order to grant a fair market value stock option or SAR that will be exempt from Section 409A, the stock right must be over "service recipient stock" as defined in the regulations (generally, common stock of the employer company). The final regulations have expanded the types of stock that will qualify as service recipient stock and remove the need for companies to make a formal election where the common ownership interest between the employing company and issuer of the stock is less than 80%. Employers should consult with counsel before granting options or SARs over stock in a corporation with less than a 50% common controlling interest with the employer company or when granting options or SARs in lower-tier subsidiaries of the employer company. As well, the definition has been relaxed so that common stock with liquidation preferences (but not dividend preferences) will now qualify as service recipient stock.
Certain Severance Agreements and Post-Termination Benefits Exempt from Section 409A
- Excluded Separation Pay Plans. The final regulations have retained the exclusion from Section 409A for severance programs or agreements that provide for separation pay upon an involuntary termination or as part of a window program to the extent (i) the severance pay does not exceed two times the lesser of (a) the service provider's annual compensation for the calendar year prior to the separation or (b) the maximum amount that may be taken into account for qualified plan purposes ($225,000 for 2007) and (ii) the severance payments are made no later than December 31 of the second calendar year following the year of the separation. However, the final regulations provide that to the extent severance pay would otherwise meet the above exclusion, but the total amount of the severance pay exceeds the maximum amount permissible, payments up to the limit ($450,000 or less, depending on the service provider's annual compensation) would not be treated as Section 409A deferred compensation, while any excess payments would be subject to the rules of Section 409A.
This is an important exception for severance paid to specified employees of public companies. The amount exempted from Section 409A described above is thus not subject to the six-month delay after a separation from service.
Note that the exception is generally not available for severance programs that also provide for benefits upon a voluntary termination of employment.
- Good Reason Terminations. Contrary to the statements made in the preamble to the proposed regulations, the final regulations provide that amounts payable to an employee upon a separation from service for good reason may in certain circumstances be treated as payments for involuntary terminations and also may be treated as subject to a substantial risk of forfeiture (thus allowing the payments to avoid the application of Section 409A under either the short-term deferral rule or under the separation pay exception described above). Generally, the determination of whether a good reason condition will be treated the same as an involuntary termination condition will be made on the basis of all the facts and circumstances, including whether the good reason condition requires actions to be taken by the employer which would result in a material negative change in the employment relationship, as well as whether the employee is required to give the employer notice of the existence of the good reason condition and a reasonable opportunity to remedy the condition. In response to requests from commentators, the final regulations provide a safe harbor definition of good reason conditions that will be treated as providing for a payment upon involuntary termination. Employers may want to consider using the safe harbor definition from the final regulations, especially public company employers who would otherwise be required to impose a six-month delay after a separation from service for severance payments to specified employees.
- Reimbursement and Benefit Continuation Plans. The final regulations provide further clarity to employers regarding common provisions in employment and severance agreements such as health benefit plan continuation and reimbursement of certain expenses after a termination of employment. In certain situations (e.g., continuation of health benefits that are excludible from income under Section 105 of the Code, reimbursement of taxable medical expenses limited to the period during which the employee would have been eligible for COBRA continuation coverage, or expense reimbursements incurred by the end of the second calendar year following the year in which the termination of employment occurs), the regulations exempt the payments from the application of Section 409A. In other situations (e.g., lifetime health benefit continuation or long-term expense reimbursement plans), the final regulations clarify how to design such arrangements to comply with the payment timing requirements of Section 409A.
Plan Documentation Requirements
- In Writing Requirement for Plans. The final regulations clarify what types of provisions must be contained in a plan document in order to comply with the requirements of Section 409A. Specifically, a plan must specify, at the time an amount is deferred, the amount the employee is entitled to receive under the plan (or an objective formula, where applicable) and the payment schedule or payment triggering event. For public companies, a plan must provide for a six-month delay requirement for specified employees (which provision must be binding on the employee). Finally, for plans where deferral elections are permitted, the plan must specify, no later than the time at which the deferral election is required to be irrevocable, the conditions under which the election must be made by the employee. Savings clauses in plan documents will not prevent an otherwise non-compliant plan from violating Section 409A. A plan document can include a plan, a grant or deferral agreement, an election form or any other written materials that are binding on the company and the employee with respect to the plan.
- Effective Date of Amendments to Plan Documents. The final regulations clarify that amendments to nonqualified deferred compensation plans need only bring the plan document into compliance effective January 1, 2008 and are not required to incorporate any amendments made or actions taken under the transitional rules. However, employers and employees must be able to demonstrate the plan was operated in compliance with the transition guidance since the effective date of Section 409A on January 1, 2005.
Payment Dates and Distribution Elections
- Separation From Service. It has been our experience that one of the most commonly-used permissible distribution dates under Section 409A in deferred compensation arrangements is upon a "separation from service." While seemingly straight-forward, whether a "separation from service" has occurred under Section 409A may not be clear in certain circumstances. Employers and employees should pay close attention to the rules contained in the final regulations governing what constitutes a separation from service, especially in situations where an employee (i) continues to provide services as an independent contractor, (ii) leaves to work for a subsidiary or affiliate company, or (iii) is transferred to another employer as a result of a merger or acquisition transaction.
- Designated Flexible Payment Dates. The final regulations clarify that for a plan that does not designate a specific date for payment of deferred compensation, the plan will only be treated as having a "specified payment date" as required under Section 409A if the period during which the payment can be made is limited to either (i) a specified taxable year or (ii) a period of not more than 90 days, where the employee is not provided with an election as to the taxable year of the payment.
- 2007 Distribution Election Deadline. The deadline for employees (or in the case of non-elective arrangements, for employers) to make changes to their distribution elections as to the timing and form of payment or to make such elections is December 31, 2007. Such an election may apply to all amounts subject to Section 409A, deferred both before and after the election is made. However, in 2007, an election cannot change a payment election (i) to defer a payment that would otherwise be made in 2007 or (ii) to otherwise cause a payment to be made in 2007.
- Change of Control Definition. The final regulations generally retain the definition of a change of control which would qualify as a permissible distribution event for payments of deferred compensation under Section 409A, but reduce the threshold for determining when there is a "change in the effective control of a corporation" from a 35% shift in stock ownership to a 30% shift.
- Employer Discretion To "Cash Out" Payments. The final regulations expand the employer's ability to use its discretion to "cash out" an employee who is a participant in a deferred compensation plan. While previously limited to a situation where an employee's amount deferred under a plan was less than $10,000 and only permitted at the time the employee terminated from employment, the final regulations now allow the employer to exercise such discretion while the employee is employed and the $10,000 amount has been replaced to match the limit on elective deferrals under Section 402(g) of the Code ($15,500 for 2007)
Deferrals of Performance-Based Compensation
- Qualification as Performance-Based Compensation
. Under Section 409A, participants have more flexibility in making deferral elections with respect to "performance-based compensation." The final regulations provide enhanced guidance on whether compensation will qualify as performance-based and when such elections need to be made. An important clarification in the final regulations was that where compensation would be paid regardless of the satisfaction of performance-criteria upon any event other than death, disability (as defined in the regulations), or a change of control, such compensation will not
qualify for the performance-based compensation deferral rule. Employers who are taking advantage of the performance-based compensation deferral rule for deferrals of bonus or incentive plan amounts should confirm that their incentive plans do not provide for payment of such compensation upon a retirement or certain terminations (e.g., involuntary or after a change of control), as such amounts will not qualify as performance-based compensation for Section 409A purposes.
Mergers & Acquisitions
- Tax-Gross Ups Covered By Section 409A. The final regulations confirm that tax gross-ups on payments to employees will generally be treated as deferred compensation. The gross-up payments will comply with Section 409A as long as the payment must be made by the end of the employee's tax year following the tax year in which the tax payments are due to the applicable federal, state, local or foreign tax authorities.
- Asset Acquisitions - Same-Desk Rule. Unlike the proposed regulations, the final regulations provide that the "same desk" rule (a rule treating a successor employer who has obtained all or substantially all of the assets of the original employer as the same employer) may apply for purposes of determining whether an employee has separated from service for purposes of triggering a payment under a deferred compensation plan subject to Section 409A. Under the final regulations, an employer can elect whether it will use the "same desk" rule for a particular transaction, provided it makes such decision before the transaction occurs and provided that the same decision be consistently applied to all employees under all deferred compensation plans sponsored by the employer at the time of the transaction.
- Identification of Specified Employees. The final regulations provide taxpayers with detailed rules regarding the identification of specified employees (up to 50 persons) for purposes of the six-month delay in payment for certain employees of public companies. In cases where such companies have entered into a corporate transaction with another entity (public or private), there are special rules. For employees who terminate employment in connection with a transaction or shortly thereafter, it is important that the employer is able to apply the appropriate test to identify whether a six-month delay of payments is necessary.
Split-Dollar Life Insurance Arrangements
- Covered Split-Dollar Arrangements. Certain split-dollar life insurance arrangements that provide the employee with equity in the policy and which are not taxed under the split-dollar loan regime may be subject to Section 409A. As some of these arrangements are grandfathered for purposes of the split-dollar regulations issued in 2003, employers must be cautious in making any amendments that would cause a material modification that would cause an arrangement to lose its grandfathered status for purposes of those regulations. The IRS has published Notice 2007-34 regarding the conditions under which required changes for Section 409A purposes (e.g., removing the discretion of both parties to terminate the arrangement at any time) should not be treated as material modifications for purposes of the 2003 split dollar regulations.
Although we continue to use the terms "employee" and "employer" throughout this article, Section 409A can also apply to arrangements with independent contractors.