IRS Provides Transition Relief until December 31, 2008, for Section 409A Compliance
October 24, 2007
On October 22, 2007, the Internal Revenue Service (IRS) issued guidance extending until December 31, 2008, the period for employers to be compliant with the final Section 409A regulations.
Under the new transition guidance (IRS Notice 2007-86), employers generally are given one more year to analyze all deferred compensation plans, stock rights, employment offer letters, employment agreements, severance arrangements, and other plans potentially subject to Section 409A of the Internal Revenue Code and to make informed and reasoned decisions regarding changes that are necessary to bring existing arrangements into compliance with the final Section 409A regulations.
Previous IRS guidance provided only limited relief, as discussed in our Client Alert of September 13, 2007, for delayed documentary compliance with the final regulations. The prior guidance continued to require employers to operationally comply with the final Section 409A regulations as of December 31, 2007.
Under the new transition guidance, employers will not be required to comply with the final Section 409A regulations during 2008. Arrangements subject to Section 409A that were adopted on or before December 31, 2008, must follow the provisions of Section 409A (and other prior IRS guidance) and generally operate in "good-faith" compliance with Section 409A. All arrangements subject to Section 409A must be amended on or before December 31, 2008, to comply with the final regulations.
If an arrangement is subject to Section 409A and does not operationally comply with the final regulations or it is not amended to be in documentary compliance on or before December 31, 2008, then the employer and affected employees will be subject to the obligations and tax penalties discussed below.
The new guidance also extends transition relief in three other important ways:
- Discounted stock options may be replaced with non-discounted stock options, provided that replacement occurs on or before December 31, 2008, and no additional consideration is paid in the same year in which the replacement occurs.
The new transition guidance does not extend relief with respect to the correction of discount stock options granted to individuals who were insiders of publicly traded companies at the time of grant.
- Amounts subject to Section 409A may be corrected through new payment elections (which may alter both the time and method of payment) made on or before December 31, 2008. Therefore, payment elections to make an arrangement not covered by Section 409A will be permitted under the new transition guidance. However, elections made in 2008 may not apply to amounts otherwise payable in 2008 and may not cause an amount payable in a later year to be paid in 2008. Accordingly, if an employee wants to elect to receive payment in 2008, that election should be in place on or before December 31, 2007.
- Payments made under a traditional deferred compensation plan (e.g., a SERP or "top-hat" plan) on or before December 31, 2008, pursuant to a linked payment election under a tax-qualified retirement plan (e.g., a 401(k) plan or a defined-benefit plan) will not violate Section 409A, provided that the linked election was in place prior to October 3, 2004, and that from December 31, 2007, through December 31, 2008, certain rules regarding linked plans in the final Section 409A regulations are followed.
Reminder of Section 409A Tax Impact
The penalties for violating Section 409A include immediate income tax inclusion, an additional 20 percent federal penalty tax, and interest charges (and in California, an additional 20 percent state penalty tax). For example, employees and certain service providers in California could be subject to total potential taxation rates of approximately 84 percent.
Employers have wage reporting and withholding obligations if compensation of an employee is includible in gross income due to Section 409A. On October 23, 2007, the IRS issued new interim guidance for 2007 on the reporting and withholding of income and employment taxes, which generally extends the reporting and withholding rules of 2005 and 2006. That is, employers are not yet required to report amounts deferred under a plan or arrangement subject to Section 409A, but employers are required to report and withhold on amounts includible in gross income due to Section 409A.
We strongly encourage all of our clients, after reading this alert, to continue to inventory and review all arrangements to assess Section 409A applicability and compliance. Despite the relief provided in the new transition guidance, we encourage employers to bring plans into compliance with Section 409A as soon as reasonably practicable because good-faith compliance is required through December 31, 2008, and amending plans and agreements for Section 409A establishes a basis proving compliance with the good-faith standard.
You can assess the applicability of Section 409A by reviewing our previous Client Alerts covering various aspects of Section 409A and the final Section 409A regulations in detail, including highlights, stock rights, separation pay arrangements, traditional deferred compensation arrangements, and action items for compliance, or you may contact any member of the Employee Benefits & Compensation practice at Wilson Sonsini Goodrich & Rosati:
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|Jessica Janov||(858) email@example.com|
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Circular 230 Compliance: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this memorandum is not intended or written to be used, and cannot be used, for the purpose of (a) avoiding penalties under the Internal Revenue Code, or (b) promoting, marketing, or recommending to another party any transaction or matter addressed herein.