U.S. Treasury and IRS Issue Proposed Regulations Under Section 409A
September 30, 2005
One-Year Extension Provided For Plan Documents, But Action May Still Be Desirable Before Year End
On September 29, 2005, the U.S. Treasury Department and the Internal Revenue Service (IRS) issued long-awaited proposed regulations regarding the treatment of nonqualified deferred compensation under Internal Revenue Code Section 409A. (For a detailed discussion of the American Jobs Creation Act of 2004 and its impact on nonqualified deferred compensation plans, please see http://www.mwe.com/info/news/wp1004a.pdf). The new regulations (totaling 238 pages) can be viewed at the following link: http://www.treas.gov/press/releases/reports/reg15808004.pdf.
The proposed regulations expand in detail upon the guidance provided in Notice 2005-1 and, in many cases, interpret Code section 409A more favorably for taxpayers. Most notably, the proposed regulations generally provide a one-year extension of time for employers to amend their nonqualified deferred compensation plans to comply with Section 409A. In addition, until December 31, 2006, employees, directors and other service providers will be allowed to (1) amend their payment elections for nonqualified deferred compensation (not otherwise payable in 2006 or any earlier period) subject to Section 409A and (2) commence nonqualified plan distributions at the same time as the participant begins receiving distributions from the related tax-qualified plan.
Until the Treasury and the IRS issue final regulations, employers are required to comply in operation with Section 409A in “good faith” notwithstanding the delayed effective date for plan amendments. Taxpayers may rely on the proposed regulations as good faith compliance with Section 409A until the issuance of final regulations.
The proposed regulations do not provide for any extension of time for a participant to terminate participation or cancel elections under Q&A-20 of Notice 2005-1 or for an employer to amend applicable nonqualified deferred compensation plans for any termination or cancellation election. As a result, in some instances, actions to terminate a deferral for 2005 may need to be taken before December 31, 2005 to comply with Section 409A.
This publication highlights some of the key items addressed in the proposed regulations. If you are interested in receiving additional communications, including event notifications, from McDermott on this topic, please e-mail Megan Wilkinson at mwilkinson@mwe.com. In the meantime, here are our initial thoughts on some of the highlights of the proposed regulations.
Deadlines for Action
Employer Action. The proposed regulations extend the deadline for employers to amend their plans to comply with 409A,
and the “good faith” compliance period, to December 31, 2006.
Participant Action. The proposed regulations also allow participants until December 31, 2006 to revise the time and form of their distribution elections without violating 409A’s prohibition on accelerations and without having to comply
with its otherwise applicable rules regarding changes in the time and form of payments.
- Note: 2005 Action Item. However, in 2006, a service provider cannot (1) change payment elections with respect
to payments that the service provider would otherwise receive in 2006 or (2) cause payments to be made in 2006. Along these same lines, the relief provided in Notice 2005-1 allowing plans to give participants a right to terminate participation in the plan or to cancel an outstanding deferral election with regard to amounts subject to section 409A is not being extended to 2006. As a result of the greater flexibility available in 2005 that will not be available in 2006, some participants may wish to take action before the end of this year.
“Linked” Qualified and Nonqualified Distributions. Many nonqualified plans provide that distributions start at the same time as the participant begins receiving distributions from the related qualified plan. Although such provisions must be eliminated eventually, Notice 2005-1 authorized the continued use of such provisions in 2005, and the proposed regulations extend that relief through the end of 2006.
Amounts Subject to 409A
Stock Appreciation Rights (SARs) and Stock Options. The legislative history to Section 409A states that stock options shall not be treated as “nonqualified deferred compensation” where the exercise price can never be less than the fair market value of the underlying stock at the date of grant. Notice 2005-1 extended this relief to SARs but only in limited circumstances. The proposed regulations exempt SARs issued by public companies and private entities from Section 409A whether or not the SAR is settled in cash. Anti-abuse rules are proposed that define what type and class of stock—so-called “service recipient stock”—is eligible for this exemption as well as rules for valuing service recipient stock. The proposed regulations also provide additional flexibility to modify stock options and SARs in connection with mergers and acquisitions.
Severance. Notice 2005-1 provided limited relief for severance pay under Q&A-19 that did not apply in many situations. The proposed regulations expand the types of arrangements that will not be considered to be nonqualified deferred compensation.
- The proposed regulations generally exempt severance arrangements (including early retirement windows) when the amount of payment does not exceed the lesser of two times the service provider’s annual compensation or two times the applicable Code Section 401(a)(17) limit (that limit is $210,000 for calendar year 2005) if the payments are completed no later than the end of the second calendar year following the year in which the service provider separates from service. The key impact of this change is that payments under an eligible severance arrangement made to key employees of public companies will not be subject to a six month delay.
- The proposed regulations provide that where separation pay due to an involuntary termination has been the subject of bona fide, arm’s-length negotiations, the election as to the time and form of payment of any severance arrangement that does not qualify with the severance exception described above may be made on or before the date the service provider obtains a legally binding right to the payment.
- The proposed regulations establish severance plans as a separate type of deferred compensation plan, i.e., separate from account balance plans, nonaccount balance plans, and other types of plans (generally equity-based compensation arrangements) under Section 409A. The key impact of this change is that violating Section 409A with respect to covered severance benefits will not “taint” the other deferred compensation amounts.
Split Dollar Life Insurance. The Treasury and IRS recently have issued comprehensive guidance regarding the treatment of split dollar life insurance in the form of final regulations under Sections 62 and 7872 of the Code and Notice 2002-8 with respect to arrangements not subject to the final regulations. The Treasury and IRS have left open the possibility that certain types of these arrangements may also be subject to additional requirements under Section 409A. Most notably, “equity” split dollar life insurance arrangements subject to Notice 2002-8 and loan arrangements that do not provide for interest payments at the applicable federal rates appear to be the target of the proposed regulations.
457(f) Arrangements of Nonprofit Employers. Notice 2005-1 indicated that nonqualified deferred compensation arrangements of tax-exempt organizations would be subject to additional restrictions under Section 409A. After the IRS issued Notice 2005-1, it was uncertain whether the IRS’s interpretation of a “substantial risk of forfeiture” for 409A purposes might be imported into its interpretation of that same phrase for 457(f) plans. The proposed regulations attempt to calm those fears by providing: “These proposed regulations are intended solely as guidance with respect to the application of section 409A to such arrangements, and should not be relied upon with respect to the application of section 457(f).”
Application of 409A to Arrangements with Non-Employees. Like Notice 2005-1, the proposed regulations make it clear that 409A applies to directors, although the regulations provide some relief so that a failure under a director’s nonqualified arrangement with one company will not taint the nonqualified plans of another company where that same individual serves as a director. The proposed regulations also provide detailed rules that can be used to exempt from 409A deferred payments to independent contractors that provide significant services to each of two or more unrelated service recipients.
Short-Term Deferrals. Notice 2005-1, Q&A-4(c) provided that certain arrangements referred to as short-term deferrals would not be subject to Section 409A if paid within two-and-one-half months after the year of vesting. The proposed regulations retain this rule, but add one important twist to protect against unintentional violations of Section 409A. If no payment date is specified in a written agreement or plan and payment is made outside of the two-and-a-half month period, such payment will result in automatic violation of Section 409A because a payment date or permissible payment event must be specified in a nonqualified deferred compensation plan. In contrast, if a payment date is specified in a written agreement or plan, the rules contained in the proposed regulations generally permitting the payment to be made in the same calendar year as the fixed payment date (as described below) become applicable and will prevent participants from incurring penalties.
Foreign Arrangements. The regulations provide guidance with respect to the application of Section 409A to various foreign arrangements, generally attempting to limit the reach of 409A by exempting items like tax equalization plans for expatriates. However, with respect to U.S. citizens working abroad, and with respect to resident aliens in the United States, the provisions of section 409A generally will apply unless the arrangement can fit within an exception for foreign, broad-based retirement plans where the benefit does not exceed the equivalent amount of benefits or contributions that could be provided under a U.S. qualified retirement plan consistent with the limitations of Code Section 415.
New Guidance on Deferral Elections
“Evergreen” Elections. Commentators had questioned whether an “evergreen” deferral election (a deferral election as to future compensation that remains in place unless the service provider changes the election) would be effective for purposes of section 409A. The proposed regulations allow such an election if the election becomes irrevocable with respect to future compensation no later than the last permissible date an affirmative initial deferral election could have been made with respect to such compensation.
Performance-Based Pay. Section 409A(a)(4)(B)(iii) provides that in the case of any performance-based compensation based on services performed over a period of at least 12 months, a participant’s initial deferral election may be made no later than six months before the end of the period. Under the proposed regulations, performance-based compensation is defined as compensation the payment of which or the amount of which is contingent on the satisfaction of preestablished organizational or individual performance criteria. Like regulations issued under Code Section 162(m), the new proposed regulations allow the performance criteria to be established up to 90 days after the commencement of the period of service to which the criteria relates, provided that the outcome is not substantially certain at the time the criteria are established. However, unlike the Section 162(m) regulations, the proposed 409A regulations provide that performance-based compensation generally may include payments based upon subjective performance criteria. The proposed regulations reverse a position initially taken in Notice 2005-1 and provide that performance-based compensation may be based solely upon an increase in the value of the service recipient, or the stock of the service recipient, after the date of grant or award.
Application to “Ad Hoc” Awards. The proposed regulations establish a new rule for ad hoc awards, such as restricted stock units, that occur in the middle of a taxable year and often were unforeseeable by the service provider. Under those circumstances, an initial deferral election could not be made by the service provider during the taxable year before the year in which the award was granted, unless the service recipient had the foresight to request such an election in the prior year. To address this situation, the proposed regulations provide that an initial deferral election can be made even after the award has been granted, provided that it is made no later than 30 days after the date of grant and at least 12 months in advance of the end
of the service period.
Cancellation of Deferral Elections After a Financial Emergency Distribution. The regulations provide that a plan may provide that a deferral election terminates if a service provider (1) obtains a payment from the nonqualified plan upon an unforeseeable emergency (in which case the suspension would be optional) or (2) a hardship distribution from the employer’s 401(k) plan (in which case the suspension would be required to comply with the 401(k) regulations). Note that the deferral election must be terminated, and not merely suspended.
Earn-Outs. The proposed regulations provide that compensation payable pursuant to a change in control of a company may be treated as paid at a specified time or pursuant to a fixed schedule in conformity with the requirements of section 409A if the amounts are paid on the same schedule and under the same terms and conditions as payments to other shareholders and no event later than five years after the change in control event.
Wrap Plans. The proposed regulations authorize the continued use of so-called “wrap plans” whereby the amounts deferred under the nonqualified deferred compensation plan are linked to amounts deferred under a 401(k) arrangement, but only to the extent the amount of affected deferrals under the nonqualified deferred compensation plan does not exceed the maximum amount that ever could have been electively deferred under the qualified plan.
New Guidance on Distributions
Multiple Payment Events and Distribution Forms. The regulations permit a plan to provide that payments may be made upon the earlier of, or the later of, two or more specified permissible payment events or times. In addition, a plan may provide that a different form of payment may be elected for each potential payment event.
Rules of Administrative Convenience. The regulations incorporate the statutory requirement that payments be made at a fixed date or under a fixed schedule, or upon any of five events. A payment will be treated as made upon the designated date if the payment is made by the later of the first date
it is administratively feasible to make such payment on or after the designated date, or the end of the calendar year containing the designated date (or the end of the calendar year if only a year is designated). Also, for a plan that does not designate a specific date, but rather only the year in which the payment is to be made, the first scheduled payment is deemed to be scheduled to be paid as of January 1 of such year for this purpose.
What Is a “Payment”? Commentators had requested clarification whether the individual amounts paid in a defined stream of payments, such as installment payments, are treated as separate payments or as one payment. This affects the application of the rules governing subsequent deferral elections, particularly the five-year rule. The regulations provide that an arrangement can specify whether to treat the installments as one payment or separate payments. For example:
- If a five-year installment payment is treated as a single payment and is scheduled to commence on July 1, 2010, then consistent with the five-year rule, a service provider generally could change the time and form of the payment to a lump sum payment on July 1, 2015.
- In contrast, if a five-year installment payment is designated as five separate payments scheduled for the years 2010 through 2014, then the service provider could not change the time and form of the payment to a lump sum payment to be made on July 1, 2015 because the separate payments scheduled for the years 2011 through 2014 would not have been deferred at least five years. Rather, the service provider generally could change the time and form of payment to a lump sum payment only if the payment were scheduled to occur no earlier than 2019 (five years after the last of the originally scheduled payments).
Limited Payments Based Upon an “Event.” The proposed regulations provide that a plan provides for payment at a specified time or fixed schedule of payments if the plan provides, at the time of the deferral, that the payment will be made at a date or dates that are objectively determinable based upon the date of the lapsing of a substantial risk of forfeiture. So, for example, if payments vested upon the occurrence of an IPO, the payments could be made in accordance with a fixed schedule after the occurrence of such an event.
Distributions Upon Change in Control Can Apply to Partnerships. The Treasury Department and the IRS plan to issue regulations under Section 409A(a)(3) that will allow an acceleration of payments upon a change in the ownership of a partnership or in the ownership of a substantial portion of the assets of the partnership. Until further guidance is issued, the Section 409A rules regarding permissible distributions upon a change in the ownership of a corporation may be applied by analogy to changes in the ownership of a partnership.
Payment Delays by Employer. Certain company-initiated delays in payments of deferred compensation amounts will be permitted. In the case of payments (1) that are limited to preserve a deduction under Code Section 162(m), (2) that would violate securities laws or (3) that would violate loan covenants or other contractual terms and result in material harm to the service recipient, the plan may provide that the payment will be delayed. Plans may be amended to add such provisions, but such an amendment cannot be effective for a period of at least 12 months. However, if a plan is amended to remove such a provision with respect to amounts deferred previously, the amendment will constitute an impermissible acceleration of the payment. A similar rule permits payment delays where either the obligation to make the payment, or the amount of the payment, is subject to a good-faith dispute.
Payment Upon Violation of 409A Permitted. The proposed regulations provide that a plan may permit the acceleration of the time or schedule of a payment to a service provider to pay the amount the service provider includes in income as a result of the plan failing to meet the requirements of Section 409A.
Payment Upon Plan Termination. The Treasury Department and the IRS are considering further guidance establishing criteria or circumstances under which a plan could be terminated. In the meantime, the proposed regulations provide three circumstances under which a plan may be terminated at the discretion of the service recipient in accordance with the terms of the plan. The first situation is where a service recipient wants to cease providing a certain category of nonqualified deferred compensation, such as account balance plans, entirely. In that circumstance, a plan may be terminated provided that (1) all arrangements of the same type (account balance plans, nonaccount balance plans, separation pay plans or other arrangements) are terminated with respect to all participants, (2) no payments other than those otherwise payable under the terms of the plan, absent a termination of the plan, are made within 12 months of the termination of the arrangement, (3) all payments are made within 24 months of the termination of the arrangement and (4) the service recipient does not adopt a new arrangement that would be aggregated with any terminated arrangement under the plan aggregation rules at any time for a period of five years following the date of termination of the arrangement. The other two exceptions relate to events that are both objectively determinable to have occurred (a change in control or a corporate liquidation) and are of such independent significance that—from the IRS/Treasury perspective—they are unlikely to be related to any attempt to impermissibly accelerate payments.
Material Modifications
“No Harm, No Foul” Rule. Notice 2005-1 provides that any “material modification” to a grandfathered arrangement will result coverage under Section 409A. A troublesome aspect of Notice 2005-1 was that minor, unintended actions could result in a “material modification.” Given the significant amount of money potentially involved in a grandfathered plan, the proposed regulations include a provision stating that to the extent a material modification to a grandfathered plan is rescinded before the earlier of (1) the date any additional right granted under the modification is exercised or (2) the end of the calendar year in which the modification was made, the modification will not be treated as a material modification of the plan (and the plan’s grandfathered status will be preserved).
Investment Changes. The proposed regulations confirm that it is not a material modification to change a notional investment measure to or to add an investment measure that qualifies as a predetermined actual investment within the meaning of the FICA regulations.
