After months of anticipation, the U.S. Treasury Department has issued final regulations under Section 409A of the Internal Revenue Code. The final regulations confirm that all nonqualified deferred compensation plans must be amended by December 31, 2007 to comply with Section 409A. The Employee Benefits and Executive Compensation Group at Ballard Spahr is ready to assist you in analyzing Section 409A issues and amending your plan documents. Please contact any member of the Employee Benefits and Executive Compensation Group for more information. If you do not already have a contact within our Group, please contact Brian M. Pinheiro at 215-864-8511, Barry L. Klein at 215-864-8415, or Mary J. Mullany at 215-864-8631.
Section 409A Requirements. Section 409A imposes restrictions on deferred compensation arrangements. Compensation is deferred if an employee or independent contractor has a legally binding right to compensation that is or may be payable in a future year. Section 409A affects the timing of deferral elections, as well as the timing and form of distributions from nonqualified deferred compensation plans. For example, key employees of publicly-traded companies must wait six months before receiving distributions from a nonqualified deferred compensation plan triggered by a separation from service. The restrictions apply to any amounts that were deferred or became vested on or after January 1, 2005. Section 409A applies to a broad range of arrangements, including arrangements that historically might not have been treated as deferred compensation, such as change in control agreements, discounted stock options and stock appreciation rights, severance arrangements, and even certain expense reimbursement arrangements.
Penalties for Noncompliance. The penalties for Section 409A violations are significant, and are imposed directly on the executive who receives the deferred compensation. Penalties include immediate taxation of all vested deferred compensation of the same type, an interest penalty based on underpayment of Federal income tax and a 20% additional tax on the amount included in income. Some states have enacted equivalent provisions at the state tax level. While employers are not directly subject to penalties for Section 409A violations, they may face associated tax reporting and withholding penalties.
Highlights of the Final Regulations. The final regulations generally follow the proposed regulations that were issued in October 2005 with certain modifications. Some of the more significant modifications and clarifications are described below.
- Written Plan Document Requirement and Effective Date. The final regulations expressly provide that each nonqualified deferred compensation plan must be in writing, and must reflect the requirements of Section 409A. At a minimum, this means that the plan must specify the amount to be paid, the payment schedule, any payment trigger events, and the conditions for any elections under the plan. If the sponsoring employer is a publicly-traded company, the plan must expressly provide that benefits owed to key employees upon separation from service must be delayed at least six months. Neither the Treasury Department nor the IRS intends to issue model amendments for this purpose. All plans must be amended by December 31, 2007 to comply with Section 409A. Due to constructive receipt concerns arising with respect to elections made close in time to actual payment, we recommend that clients not wait until the end of 2007 to amend their plans.
- Treatment of Separation Pay. One of the biggest concerns arising from the proposed regulations was the potential for common separation pay arrangements to become subject to, and possibly violate, Section 409A. The final regulations expand the separation pay exclusion in a few significant ways. First, where payments under a separation pay arrangement are made by the end of the second calendar year following the year of involuntary separation, any amounts so paid up to two times compensation (capped at two times the Section 401(a)(17) limit, or $450,000 for 2007) are exempt from Section 409A, even if the total amount of separation pay exceeds the two-times compensation limit. Amounts in excess of the two-times compensation limit would be subject to Section 409A.
- Second, the final regulations provide that certain executive-initiated separations for "good reason" can qualify for the involuntary separation pay exclusion. The separation must result from a material negative change in the employment arrangement, and the final regulations include a safe harbor as to what will constitute sufficient good reason. The good reason safe harbor should be considered for all employment agreements where separation pay could become subject to Section 409A.
- Third, the final regulations include a series of miscellaneous rules exempting de minimis separation payments and certain expense reimbursement arrangements. These rules may be useful depending on the terms of your separation pay arrangements.
- Treatment of Stock Rights. Under the proposed regulations, stock options and stock appreciation rights (SARs) issued with an exercise or base price equal to the fair market value of the underlying stock on the date of grant were deemed to be exempt from Section 409A. However, the options and SARs had to be issued with respect to a class of common stock of the employer (or a parent or subsidiary) with the highest aggregate value of any class of stock outstanding, or a class substantially similar to such stock. If the employer had a publicly-traded affiliate, the common stock of the affiliate had to be used. The final regulations provide that any class of common stock of the employer (or a parent or subsidiary) may be used, even if that class of stock is not publicly-traded or is subject to transferability restrictions. However, the common stock used cannot have any preferences, other than a liquidation preference.
- Even if an option or SAR is issued at full fair market value, it can become retroactively subject to Section 409A if the exercise period is subsequently extended. The proposed regulations had provided an exception for extensions through the end of the year in which the option or SAR would expire (or 2-1/2 months after expiration, if later). The final regulations expand this exception so that option and SAR exercise periods which are cut short due to separation from service or some other event may be extended back to the original exercise period (or 10 years from the date of grant, if earlier). Also, if the option or SAR is underwater, the exercise period may be extended to any date without implicating Section 409A.
- Valuation Issues. The final regulations generally reflect the proposed rules for determining the fair market value of the stock underlying options and SARs. For stock that is readily tradable on an established securities market, the final regulations indicate that a stock price based on a 30-day average may be used, provided that the commitment to grant the stock right on a particular day is irrevocable before the 30-day period begins. For privately-held stock, the final regulations reiterate that there must be a reasonable application of a reasonable valuation method, and reflect the three valuation safe harbors set forth in the proposed regulations—an independent appraisal, a non-lapse repurchase formula and the illiquid start-up method. In the case of an illiquid start-up corporation, the employer may rely on a valuation by a qualified individual when no change in control is anticipated within the next 90 days, and no public offering is anticipated in the next 180 days.
- Definition of Separation from Service. The final regulations adopt a simpler standard for determining whether a separation from service, one of the permitted Section 409A payment trigger events, has occurred. Under the final rules, a separation from service occurs when the employer and a service provider (i.e., an employee or independent contractor) reasonably anticipate that either the service provider will provide no future services after the separation date, or the level of services to be provided after the separation date will permanently decrease to a level that is 20% or less of the services provided by such individual over the preceding 36-month period. There is a presumption of separation if the post-separation services are actually 20% or less, and a presumption of no separation if the post-separation services are actually 50% or more.
- In addition, the final regulations permit a plan to define a separation from service as a permanent reduction in services to a level that is 20% - 50% of the services provided over the last 36 months of service. This provision allows a plan to adopt a “phased retirement” policy for its executives.
- Plan Termination and Liquidation. The proposed regulations concluded that the termination and immediate liquidation of a nonqualified deferred compensation plan would constitute a prohibited acceleration of payments under Section 409A. However, the proposed regulations also provided an exception if all plans of the same type were terminated, benefits were paid out 12-24 months after termination, and no new nonqualified deferred compensation plans of the same type were adopted by the employer for a period of five years. The final regulations adopt the same rule, except that the period after which an employer can adopt a new nonqualified deferred compensation plan of the same type is reduced from five to three years.
- Annuities as a Single Form of Payment. Under Section 409A, the time and form of payment generally must be specified at the time the deferral is made. Certain annuities of equivalent actuarial value were treated as a single form of payment under the proposed regulations, thereby allowing an employee to choose from among those annuity forms at the time payments were scheduled to commence. The final regulations generally expand the types of annuities that may be treated as a single form (assuming they are actuarially equivalent) to include annuities with term certain features, pop-up features (which increase the annuity benefit upon the death of a beneficiary), cash refund features, leveling options and cost-of-living increases. Also, subsidized qualified joint and survivor annuities (QJSAs) and single life annuities are treated as a single form, so long as the subsidized QJSA does not pay more than 100% of the single life annuity benefit to either the primary annuitant or the beneficiary.
- Nonqualified Plans Linked to Qualified Plans. Nonqualified deferred compensation plans that are linked to qualified plans (sometimes referred to as restoration or excess plans) are subject to the Section 409A requirements. The proposed regulations provided certain limited relief which allowed for changes in deferrals to the nonqualified plan based on developments in the qualified plan. The final regulations essentially adopt the same relief as provided in the proposed regulations, but clarify that the linked plan relief provided for elective deferrals in the nonqualified plan (up to the Section 402(g) annual deferral limit) also applies separately to matching contributions in the nonqualified plan.
- Split-Dollar Life Insurance. In conjunction with the final Section 409A regulations, the IRS published Notice 2007-34, which generally provides that split dollar life insurance arrangements which are subject to Section 409A may be modified to comply with Section 409A (or to become exempt from Section 409A), and such modification will not be treated as a “material modification” which would cause the final split dollar regulations to apply to arrangements entered into on or prior to September 17, 2003. Notice 2007 34 provides guidance as to which portions of a split dollar life insurance arrangement may be subject to Section 409A.
- Partnerships and Other Non-Corporate Entities. The final regulations provide no further guidance as to how Section 409A applies to equity interests in non-corporate entities such as partnerships. Existing guidance indicates that such interests should be treated in the same manner as equity interests issued by corporate entities, and may be eligible for the Section 409A exclusions for options and SARs.
- Guidance on Income Inclusion, Reporting and Withholding. The final regulations do not include any further information as to how to calculate the amount to be included in income in the event of a Section 409A violation, or the corresponding reporting and tax withholding obligations of the employer. Previously-issued guidance may continue to be relied upon until further guidance is issued.
Copyright © 2007 by Ballard Spahr Andrews & Ingersoll, LLP. This newsletter is a periodic publication of Ballard Spahr Andrews & Ingersoll, LLP and is intended to alert the recipients to new developments in the law. It should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer concerning your situation and specific legal questions you have.