IRS Issues Limited Extension to Section 409A Amendment Deadline; Provides Little Relief for Employers and Other Plan Sponsors

September 11, 2007

On September 10, the IRS issued Notice 2007-78, which provides limited relief from the December 31, 2007 deadline to amend arrangements subject to Section 409A of the Internal Revenue Code. Under the Notice, arrangements generally may be amended by December 31, 2008 to incorporate required changes, as long as the amendment is retroactive to January 1, 2008 and the arrangement is operated in accordance with the final regulations under Section 409A during 2008. However, a key condition to this relief is that the time and form of payment still must designated in writing by December 31, 2007. In addition, because plan amendments must be retroactive to January 1, 2008, employers generally will need to make all key plan design decisions by December 31, 2007. Thus, despite the "extension" of the deadline, employers will still need to take action by December 31, 2007 with respect to most arrangements, so the extension offers little real relief to employers. Rather, this extension simply allows employers an additional year in most cases to incorporate these actions into their written plans and agreements (other than the time and form of payment, which generally must be designated in writing by December 31, 2007).

The Notice also declines to extend various transition rules that expire on December 31, 2007. In particular, the ability to change payment elections in 2007 as long as no distributions are moved into or out of 2007 has not been extended. Finally, the Notice provides limited guidance on a few ambiguous items in the Section 409A final regulations issued last April and states that the IRS plans to implement a voluntary program to allow correction of inadvertent operational violations of Section 409A.

Limited Extension of Plan Amendment Deadline

Section 409A imposes a number of requirements that deferred compensation arrangements must satisfy in order to avoid current taxation of participants (and a possible 20% "additional tax" and an interest charge). Under the final regulations, the material terms of plans subject to Section 409A are required to be in writing. The terms that must be in writing include the amount of deferred compensation (or an objectively determinable formula for calculating the amount), the time when deferral elections become irrevocable, the payment events, and, for publicly-traded companies, the six-month delay applicable to distributions made upon separation from service to "specified employees."

Prior to the issuance of Notice 2007-78, plans were required to be amended by December 31, 2007 to incorporate all of the requirements of the final regulations. Failure to timely amend would have resulted in an automatic violation of Section 409A on January 1, 2008, with the resulting adverse tax consequences for participants.

Notice 2007-78 provides some limited relief from this amendment deadline. However, plans must be operated in accordance with the final regulations commencing on January 1, 2008 in all events. The "reasonable good faith" operational compliance standard applicable through December 31, 2007 (which has allowed taxpayers to rely on authority other than the final regulations, such as the proposed 409A regulations and various IRS Notices (such as Notice 2006-79 and Notice 2005-1)) has not been extended.

The plan amendment deadline extension to December 31, 2008 is subject to the following key conditions:

A 409A-compliant time and form of payment must be designated by December 31, 2007. In other words, payment must be designated to occur upon one or more of the service provider’s separation from service, disability or death, a change in control event, an unforeseeable emergency, or a specified date or fixed schedule. Furthermore, although the Notice is not explicit on this point, it would appear that the requirement under the final regulations that the schedule of payments made upon the occurrence of one of these events must be objectively determinable and nondiscretionary at the time that the event occurs also needs to be satisfied by December 31, 2007.
If amounts are paid upon a specified date or pursuant to a fixed schedule (e.g., reimbursement of medical expenses and certain other amounts), subject to some limited exceptions, the written terms of the arrangement must reflect the date or schedule by December 31, 2007. This may require many employment agreements and similar arrangements to be amended by December 31, 2007. For example, if an employment agreement provides for reimbursement of up to $30,000 of country club dues in the two years following termination of employment, the agreement will need to be amended by December 31, 2007 to make this reimbursement arrangement 409A-compliant (e.g., by stating that up to $15,000 may be reimbursed in either year, so that reimbursements in the first year do not affect the amount available for reimbursement in the second year).
One relaxation of the payment designation rule is that the six-month delay for specified employees does not have to be in writing until December 31, 2008. However, the final regulations provide a number of alternatives for determining the group of specified employees, and the alternative essentially must be chosen by January 1, 2008 because the ultimate plan amendment addressing this issue must reflect the methodology actually used.
In addition, the regulations provide some flexibility for determining when a separation from service occurs. The chosen alternative need not be set forth in writing by December 31, 2007 as long as the plan amendment reflects that chosen alternative and the parties comply in practice until the written amendment is adopted in 2008.

Thus, in order to take advantage of the transition relief, virtually all key plan design decisions need to be made by December 31, 2007. In addition, many key payment terms must be adopted and put in writing by that date. Thus, the main complaint about the December 31, 2007 amendment deadline — that it requires plan design decisions to be made and adopted too quickly while "best practices" are still developing — is not addressed by Notice 2007-78, and employers will still be required to act this year to avoid violations of Section 409A. In sum, this "extension" of the plan amendment deadline offers little real relief to employers.

Other Issues Addressed by the Notice

The Notice also provides guidance on some other issues raised by Section 409A:

The payment election transition rule that allows new payment elections by December 31, 2007 as long as no amounts are moved "into" or "out of" 2007 has not been extended.
The relief under IRS Notice 2006-33 from the application of Section 409A(b) (which prohibits the use of offshore trusts and certain other funding arrangements to pay deferred compensation) to "grace period assets" has not been extended past December 31, 2007. However, since the IRS has issued little guidance on Section 409A(b), and has signaled that any further guidance is not likely to be issued until 2008, the Notice does indicate that taxpayers may continue to rely on a "reasonable good faith" interpretation of the statute.
A key rule under Section 409A is that once a substantial risk of forfeiture lapses (i.e., an amount becomes vested), a new risk of forfeiture cannot be added. This can be an issue for certain employment agreements that include "good reason" provisions that do not fall under the "safe harbor" in the final regulations and do not impose conditions that are equivalent to an involuntary termination of employment. Beginning January 1, 2008, it generally will not be possible to amend overbroad definitions of good reason to bring them within the safe harbor or otherwise make them equivalent to an involuntary termination provision, thereby precluding the use of the "short-term deferral rule" or the "two year, two times" rule to pay out severance to specified employees of public companies without having to impose a six-month delay. However, the Notice appears to provide that it generally is permissible to change the good reason provision by December 31, 2007 and have the desired effect with respect to terminations of employment that occur after that date. Thus, employment agreements and other arrangements with overbroad good reason provisions need to be revised by December 31, 2007 if there is a desire to avoid or limit the application of Section 409A to severance payments under those agreements and arrangements.
Under the final regulations, the payment of an amount as a substitute for a payment of deferred compensation will be treated as a payment of the deferred compensation. This rule significantly limits the ability to "replace" one deferred compensation arrangement with another that provides different payment terms with no adverse tax implications under Section 409A. The Notice provides that if a right to deferred compensation payable only upon an involuntary separation from service under an employment agreement would automatically be forfeited at the end of the term of the employment agreement, then the grant of a right to deferred compensation in an extended, renewed or renegotiated employment agreement will not be treated as a substitute for the right that was forfeited upon the termination of the prior employment agreement. In other words, once an employment agreement expires, there generally is an ability to substitute new and different severance provisions as long as the original agreement paid out only upon an involuntary separation (including pursuant to a good reason provision that is equivalent to an involuntary termination provision) and the agreement did not provide that an employer’s failure to renew the agreement would be deemed to be an involuntary termination of employment which triggers severance payments.
The final regulations allow an automatic lump sum cashout of benefits that otherwise would be paid in the form of installments if the present value of the benefits fall below a predetermined amount. Under the regulations, whether a cashout is required must be determined with each payment, and cashout of remaining installments must be made once the present value of the remaining payment stream falls below the threshold. Under the Notice, the cashout threshold can be applied only once, at the time of benefit commencement, so that once installments commence, payments can continue to be made in that form.

Voluntary Compliance Program

The Notice states that the IRS plans in the future to establish a limited voluntary compliance program that will apply to certain unintentional operational failures to comply with Section 409A. The IRS anticipates that the program will provide methods by which certain unintentional operational failures may be corrected in the same taxable year in which the operational failure occurred to avoid application of Section 409A, and other methods by which certain unintentional operational failures may result in only limited amounts becoming includible in income and subject to additional taxes under Section 409A.

Conclusion

The Notice provides helpful guidance on a few issues. In addition, the forthcoming voluntary compliance program may allow employees and other service providers to avoid the draconian tax treatment that results if there is a Section 409A violation. However, the main focus of the Notice — a purported extension of the plan amendment deadline — is subject to so many conditions that it will provide little relief to most employers, who will have to make all important plan design decisions by year-end and implement most payment-related amendments by December 31, 2007. Thus, employers should not be misled by the purported extension of the plan amendment deadline, but rather should be aware that they will still need to take action this year to amend plans to bring them into compliance with the final regulations.

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