June 26, 2008
The "good faith" transition period for compliance with Section 409A of the Internal Revenue Code expires on December 31, 2008, and the final Section 409A regulations become fully effective on January 1, 2009. In addition, arrangements subject to Section 409A must be amended to reflect the final regulations no later than December 31, 2008. Thus, all employers and other service recipients need to (i) inventory their compensation arrangements and amend them as needed by year-end, and (ii) ensure that procedures are in place for operational compliance going forward.
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). The IRS issued final regulations in 2007 that provide guidance on many key issues raised by Section 409A (see our April 11, 2007 client alert, "IRS Releases Final Section 409A Regulations on Deferred Compensation"). In order to avoid a Section 409A violation, the terms of the arrangement must satisfy Section 409A’s requirements and the arrangement must be operated in accordance with those requirements.
In Notice 2007-86 (summarized in Gibson Dunn’s October 23, 2007 client alert, "IRS Extends Most Section 409A Transition Relief to December 31, 2008"), the IRS addressed two key issues regarding compliance with Section 409A. First, during 2008, taxpayers are not required to comply with the requirements of the final regulations, although compliance with the final regulations is a permissible alternative. Rather, they are required to operate a nonqualified deferred compensation plan in compliance with the plan’s terms, to the extent consistent with Section 409A and applicable guidance issued by the IRS (including IRS Notice 2005-1). However, the final regulations become "fully effective" on January 1, 2009.
Second, plans must be amended by December 31, 2008 to conform to the provisions of Section 409A and the final regulations. Amending a plan by this date is a condition to satisfaction of the reasonable, good faith reliance standard as well. Under the final regulations, the material terms of arrangements 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."
In our April 26, 2007 client alert, "Nine Action Steps to Implement the Section 409A Deferred Compensation Regulations," we described some key steps that must be taken to ensure compliance with Section 409A. Summarizing the requirements that are critical at this point, these are the steps that all employers and other service recipients need to take by year-end to avoid the harsh treatment that Section 409A violations impose on employees:
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. 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;
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.
2. Amend Arrangements to Bring Them into Compliance with Section 409A. Arrangements subject to Section 409A should be amended no later than December 31, 2008 so that they either (i) reflect the requirements of Section 409A, or (ii) fall outside the coverage of Section 409A.
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, highlighting the need to ensure that the review process is well underway.
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, 2008 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). Failure to implement one of these fixes to discount options by year-end generally will result in a Section 409A violation on January 1, 2009.
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 2007-86 provided a special transition rule that generally permits any changes as long as no distributions are moved into or out of 2008. This will be the last "bite at the apple" for allowing participants flexibility in changing distribution elections.
6. 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.
There will not be another extension of the various Section 409A transition rules beyond the December 31, 2008 deadline. Employers and other service recipients that have not already brought their arrangements into compliance with Section 409A should act now to ensure that this critical deadline is not missed.
Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or any of the following:
Stephen W. Fackler (650-849-5385, email@example.com)
Charles F. Feldman (212-351-3908, firstname.lastname@example.org)
David West (213-229-7654, email@example.com)
David I. Schiller (214-698-3205, firstname.lastname@example.org)
Michael J. Collins (202-887-3551, email@example.com)
Sean Feller (213-229-7579, firstname.lastname@example.org)
Amber Busuttil Mullen (213-229-7023, email@example.com)
Jennifer Patel (202-887-3564, firstname.lastname@example.org)
Chad Mead (214-698-3134, email@example.com)
Meredith C. Shaughnessy (213-229-7857, firstname.lastname@example.org)
Jonathan Rosenblatt (650-849-5317, email@example.com)
John C. Cook (202-887-3665, firstname.lastname@example.org)
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