Action Items for Compliance with Section 409A Final Regulations
June 12, 2007
On April 10, 2007, the Treasury Department and the Internal Revenue Service (IRS) issued final regulations under Internal Revenue Code Section 409A (Section 409A), which go into effect January 1, 2008. The final regulations confirm that December 31, 2007, remains the deadline for employers to execute amendments to bring any plans, contracts, or other arrangements subject to Section 409A (collectively, deferred compensation plans) into compliance.
We issued previous Client Alerts covering various aspects of the final regulations in detail, including highlights, stock rights, separation pay arrangements, and traditional nonqualified deferred compensation plans. In this Client Alert, we focus on the specific actions employers need to take by year-end to comply with Section 409A.
Importance of December 31, 2007, Deadline
Compliance with Section 409A will be imperative beginning in 2008. Employers almost certainly will be asked to make representations and warranties regarding Section 409A compliance in acquisition and financing documents. Violations will be extremely costly for employees or other service providers, particularly in California, which imposes an additional 20 percent state tax on Section 409A income. Violations may disproportionately impact key management and sales employees, who are more likely to participate in plans subject to Section 409A.
Unfortunately, there currently is no IRS program to correct Section 409A violations as there is for qualified retirement plans (the limited program in place with respect to a 2006 exercise of discount stock options does not have an expansive scope). Consequently, employers with noncompliant arrangements may have to report and withhold on income recognized under Section 409A as payments vest and employees may incur unexpected taxable income plus a 20 percent penalty tax and interest.
December 31, 2007, also is the deadline for amending payment elections under special transition rules (see Task 4 below) and for restructuring stock options or stock appreciation rights (SARs) subject to Section 409A (see Task 5 below). Once the final regulations become effective, no further transition relief is available. After January 1, 2008, for example, participants can change payment elections only under the strict, highly unappealing anti-acceleration and subsequent deferral rules of the final regulations.
Section 409A Action Items
Employers should create a timetable and allocate the tasks listed below. Organizing a working group may be helpful because identifying, reviewing, and amending agreements likely will involve a number of various individuals including the board of directors and/or compensation committee, human resources executives and departments, internal and external legal advisors, and the affected employers. The good news regarding the final Section 409A regulations is that they generally relaxed the rules set out in the proposed regulations, which means plans already in compliance with the proposed regulations may not need to make major changes.
Task 1 - Identify Arrangements Subject to Section 409A
First, employers need to review all compensatory arrangements (other than tax qualified retirement plans and certain other categorically excluded plans) involving deferred compensation to identify which ones are covered by Section 409A. Section 409A defines "nonqualified deferred compensation plan" quite broadly, generally including any compensation arrangement that results in the deferral of taxation on compensation, even if the arrangement currently is not documented in writing. Common types of arrangements that may be subject to Section 409A include:
- traditional deferred compensation plans;
- discounted stock options and discounted SARs;
- restricted stock units, performance share awards, phantom stock, and other equity awards (other than restricted stock, which generally is exempt);
- annual and multi-year bonus and commission plans;
- offer letters and employment agreements, change in control and severance agreements and/or plans; and
- reimbursement arrangements covering multiple years.
Task 2 - Amend for Documentary Compliance
By December 31, 2007, arrangements subject to Section 409A will need to be in writing and the document(s) comprising the plan must comply with the requirements of the final regulations. It is essential that employers plan ahead because any amendments will need to be adopted by the corporate body with the authority to amend the relevant arrangement (e.g., the compensation committee) by December 31, 2007, and also might need the consent of any adversely affected participants. This may require the scheduling of a special meeting. Arrangements can be amended either to bring them into compliance with the Section 409A final regulations or to take the arrangement out of the scope of Section 409A (e.g., by using the short-term deferral rule). Note that the IRS specifically has stated that so-called "savings clauses" purporting to amend and interpret the plan as necessary to satisfy Section 409A will not by themselves bring an arrangement into compliance with Section 409A. Also, employers should be aware that required changes to arrangements with executives may require public companies to file Forms 8-K and 4. When looking for potential areas that may require amendment, employers may want to pay particular attention to the following:
- Tax Gross-Up Payments. In the final regulations, a tax gross-up payment that provides an employee with the right to a payment of taxes otherwise payable by the employee, as well as any additional taxes resulting from such payment, constitutes a right to deferred compensation that generally satisfies the fixed time and form of payment requirements of Section 409A. However, this is the case only if the arrangement provides that the tax gross-up payment will be made, and the payment actually is made by the end of the employee's taxable year following the taxable year in which the related taxes are remitted to the taxing authority.
- Good Reason Definitions. The final regulations provide that a separation from service for good reason may be treated as an involuntary separation of service in certain circumstances, and therefore may not be subject to the penalties of Section 409A. If properly structured, the amount payable on account of such a termination will be treated in the same manner as an amount payable on account of an actual involuntary separation from service. See our April Client Alert on separation pay for a full discussion of good reason definitions.
- Using the Short-Term Deferral Exemption. This exemption to Section 409A is lost if a payment "may occur" beyond the two-and-one-half month period following the year in which the right to payment vests (e.g., due to separation from employment or a change in control). As a result, for periods after 2007, it makes sense to document the short-term exemption by expressly requiring payment no later than two-and-one-half months after the year in which the right to payment vests.
Task 3 - Ensure Operational Compliance
Employers should review the administrative procedures of deferred compensation plans subject to Section 409A to ensure that their plans are operated in compliance with the final regulations. Even if the plan documents are in order, an operational failure will subject the service provider to the adverse tax treatment under Section 409A. Procedures should be put in place to ensure ongoing operational compliance and agreements with outside service providers should be reviewed to determine whether any changes are necessary.
Employers also should consider creating a record of operational compliance during the transitional "good faith" compliance period beginning January 1, 2005, until the effective date of the final regulations. This evidence may be helpful in the event of an IRS audit or legal due diligence investigation.
Task 4 - Consider Changing Payment Elections
Generally, Section 409A places severe restrictions on the ability to amend payment elections once made. However, IRS Notice 2006-79 provides a transition rule that generally permits changes as long as no election is made to accelerate payment to 2007 or delay a payment otherwise payable in 2007. The transition rule applies only through December 31, 2007. If appropriate, employers should assist participants in deferred compensation plans to change their timing and payment elections prior to year-end to prevent any violations of the Section 409A restrictions and make any other desired changes allowed under the transition rule.
Task 5 - Fix Discounted Options and SARs
Any stock options and SARs 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, either by 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). If this is going to be done for options held by more than a few individuals, careful consideration should be given as to whether the changes must be conducted under the tender offer rules of the securities laws. If this is the case, the process will be complicated and should be started by the end of September to ensure completion by year-end. Please note, however, that discount options and SARs granted to Section 16 officers generally had to be fixed by December 31, 2006.
For More Information
This Client Alert is intended only as a general summary of the steps required to comply with the final Section 409A regulations by year-end. We strongly advise you to seek professional assistance with respect to your specific issues.
If you have any questions regarding this Client Alert, please contact any member of the Wilson Sonsini Goodrich & Rosati Employee Benefits & Compensation practice:
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