Nine Action Steps to Implement the Section 409A Deferred Compensation Regulations Before the Deadline of December 31, 2007

April 26, 2007

On April 10, the IRS issued final regulations interpreting the rules and standards under Section 409A of the Internal Revenue Code ("Section 409A").  Our client memorandum of April 11 summarizes key provisions of the regulations.  Section 409A provides various rules that "deferred compensation" must satisfy in order to avoid unfavorable tax treatment of employees, directors and other service providers, including immediate income tax, a 20% penalty tax, and an interest charge.  In addition, some states (including California) have implemented similar rules, and deferred compensation payments that do not comply with Section 409A can be taxed at marginal rates exceeding 75%.

The sweep of Section 409A is extremely broad, and reaches far beyond traditional nonqualified deferred compensation arrangements.  Subject to a few exceptions, Section 409A applies whenever a legally binding right is created to receive compensation in a later year.  A "legally binding right" arises when an arrangement is created, whether or not the individual has satisfied any requirements (e.g., vesting, achievement of performance criteria, etc.) that are prerequisites to eventual payment.  Employers’ compensation plans and agreements can be expected to raise many issues where a failure to properly address Section 409A can have disastrous tax consequences for executives and other service providers.

Arrangements subject to Section 409A must be brought into documentary compliance with the final regulations no later than December 31, 2007.  A failure to do so will subject payments promised under the arrangement to the adverse tax treatment under Section 409A on January 1, 2008 (or, if later, when rights under the arrangement vest), even if the arrangement is operated in compliance with Section 409A and payments are not made until a later date.  Thus, employers have only eight more months to determine which arrangements are subject to Section 409A and bring them into compliance if they are.

Employers will need to take the following steps to ensure Section 409A compliance:

1.  Identify Arrangements Subject to Section 409A.  Employers should review all compensation arrangements for Section 409A compliance.  We recommend using the nine categories of "plans" set forth in the final regulations as a basis for organization and classification.^[1] Some of the types of arrangements that potentially are subject to Section 409A absent a regulatory exception include:

• Traditional SERPs and other deferred compensation plans, including "wrap-around" 401(k) plans;
• Employment, change in control and severance agreements;
• Severance plans;
• Stock options, stock appreciation rights, restricted stock units and other equity awards, including substitution or assumption of such awards upon a reorganization or a similar corporate transaction;
• Post-retirement reimbursement and in-kind benefit arrangements (e.g., retiree medical benefits, outplacement services, first-class travel rights, continued payment of country club dues);
• Annual bonus and long-term incentive plans;
• Non-U.S. benefit plans that cover U.S. employees;
• Employee stock purchase plans not covered by Section 423 of the Code; and
• "Earn-outs" and other arrangements entered into in connection with corporate transactions.

It should be noted that Section 409A generally applies to arrangements with all employees and directors, and possibly other service providers as well.  Coverage is not limited to employees.  For example, Section 409A generally applies to arrangements that cover directors (but the six-month delay in payments to specified employees does not apply to directors) if those arrangements provide for the deferral of compensation.

2.  Amend Arrangements to Bring Them Into Compliance with Section 409A.  Arrangements subject to Section 409A should be amended no later than December 31, 2007 so that they either (i) reflect the requirements of Section 409A, or (ii) fall outside the coverage of Section 409A (e.g., by using the "short-term deferral rule," pursuant to which compensation generally is exempt from Section 409A coverage if it is paid no later than March 15 of the year following the year in which it is first no longer subject to a substantial risk of forfeiture (i.e., it "vests")).  Note that some arrangements may require employee consent to be amended (e.g., employment agreements and plans that circumscribe the employer’s amendment rights).

401(k) plan wrap-around plans will require special attention.  Many such plans tie their distributions to payouts under the related 401(k) plan.  However, this is no longer permissible beginning on January 1, 2008.  Rather, a 409A-permissible payment event (e.g., termination of employment/separation from service) must be used.  If participants are to be given a choice as to the timing and/or form of distributions under such plans, they generally will need to make their elections by December 31, 2007.

The Section 409A regulations specifically provide that a "savings clause" is insufficient.  In other words, the terms of the plan document must affirmatively conform to the requirements of Section 409A, and a provision stating that Section 409A requirements apply in the event of any conflict with plan provisions will not be effective by itself to avoid a violation.

3.  Adopt Amendments.  The corporate body with authority to amend the relevant arrangements (e.g., the board of directors or the compensation committee) should adopt the amendments.  Since many boards meet only a few times a year, this may require advance planning.

4.  Review Stock Option and SAR Grants and Take Any Necessary Corrective Action.  Any  stock options and stock appreciation rights that were issued on or after January 1, 2005 and any such stock rights that were issued before that date but were not vested as of December 31, 2004 generally are subject to Section 409A if the exercise price was less than the fair market value of the underlying stock on the date of grant ("discount options").  Most discount options can be "fixed" by December 31, 2007 by either raising the exercise price to fair market value as of the date of grant or "hard-wiring" the exercise date to a single, specified date or a Section 409A-compliant event (such as termination of employment).  However, discount options and SARs granted to Section 16 officers generally had to be fixed by December 31, 2006.

5.  Change Payment Elections Under Transition Rule.  Section 409A generally places severe restrictions on the ability to amend payment elections once made.  However, IRS Notice 2006-79 provided a special transition rule that generally permits any changes as long as no distributions are moved into or out of 2007.  This will be the last "bite at the apple" for allowing participants flexibility in changing distribution elections.

6.  Preserve "Grandfathering".  Deferred compensation that was "earned and vested" as of December 31, 2004 is exempt from Section 409A coverage as long as there is no material modification after December 31, 2004.  This means that pre-2005 amounts generally can be administered in accordance with their terms even if they are no longer permitted under Section 409A (e.g., "haircut" provisions that permit in-service distributions at any time if the participant forfeits 10% of his or her benefit).  Care should be taken to avoid losing grandfathered status where the intent is to preserve it.

7.  Communicate with Affected Service Providers.  Because the changes may affect service providers’ expectations, a communications strategy should be implemented to inform affected service providers and reduce discontent as much as possible.

8.  Make Any Necessary SEC Filings.  Section 409A-required changes to arrangements with executives may require public companies to file Forms 8-K or to make other filings.

9.  Implement Procedures for Operational Compliance.  Even if the plan documents are in order, an operational failure will subject the employee or other service provider to the adverse tax treatment under Section 409A.  Thus, procedures should be put in place to ensure operational compliance.  In this regard, agreements with outside service providers should be reviewed to determine whether any changes are necessary.

Although December 31 may seem a long way off, the process of reviewing arrangements for Section 409A compliance will be time consuming, especially for large companies.  We recommend that companies begin this process as early as possible to avoid a December rush when something may be overlooked.  Unlike tax-qualified retirement plans, there is no IRS correction program for Section 409A violations, so employers that miss the December 31 deadline are likely to have unhappy employees with no way to fix any problems other than through expensive "gross-up" payments.