Final IRC Section 409A Regulations

IRS Issues Final 409A Regulations

On April 17, 2007, the IRS issued its long-awaited final regulations under Section 409A of the Internal Revenue Code. The comprehensive regulations (over 400 pages in length) make numerous changes to the proposed regulations in an effort to make compliance less burdensome.

While the final regulations aren't effective until taxable years beginning on or after January 1, 2008 (later for collectively bargained plans), employers may rely on them immediately. Alternatively, employers may rely on the Service's prior guidance until the effective date.

Employers must amend their plans to comply with Section 409A no later than December 31, 2007. The plan document needs only to bring the plan into compliance as of January 1, 2008. Retroactive amendment to reflect pre-2008 plan administration (including reliance on any transition rules) isn't required (although taxpayers must be able to demonstrate that amounts were deferred or paid in compliance with any applicable transition rules).

The following summarizes some of the key provisions of the final regulations (focusing on areas where the final regulations differ from the proposed rules). For a general discussion of Section 409A, see our full topic discussion Internal Revenue Code Section 409A (Governing Nonqualified Deferred Compensation Plans).

Nonqualified deferred compensation in general

IRC Section 409A applies only to plans that provide for a deferral of compensation. Deferred compensation is compensation that a service provider has a legally binding right to receive from a service recipient, and that is payable to, or on behalf of, the service provider in a later year. (Since in most cases the relationship between the service provider and the service recipient will be that of employer/employee, for convenience these terms are used throughout the rest of this update. Keep in mind, however, that Section 409A applies to other relationships as well.)

• The final regulations clarify that a deferral of compensation exists if a payment will be made upon an event that could occur after the year in which the legally binding right to the payment arises. For example, where an employee has a right under a plan to payment upon separation from service, a deferral of compensation exists even if the employee separates from service and receives the payment in the same year as the grant (because payment is conditioned on an event that could occur in a subsequent year).
• The final regulations contain an anti-abuse rule that allows the IRS to treat any plan as a nonqualified deferred compensation subject to Section 409A if the IRS determines that a principal purpose of the plan is to achieve a result that's inconsistent with the purposes of Section 409A.

Independent contractors

Section 409A generally doesn't apply to an amount deferred under an arrangement between a independent contractor and an unrelated employer in any tax year if the independent contractor provides significant services to two or more employers (who are unrelated to the independent contractor and to each another). Under a safe harbor in the proposed regulations, an independent contractor is deemed to provide significant services to two or more employers if no more than 70% of the contractor's total revenues during the year come from any one employer.

The IRS recognized that the safe harbor was of limited value, as independent contractors might not know if they actually satisfied the safe harbor requirements any particular year until the end of that year. As a result, the final regulations provide a new lookback rule: an independent contractor that has satisfied the 70% threshold in the three immediately previous years is deemed to meet the 70% threshold for the current year. However, this lookback rule is available only if, at the time compensation is deferred, the independent contractor doesn't know, or have reason to anticipate, that he or she will fail to meet the 70% threshold in the current year.

Short-term deferrals

Under the proposed and final regulations Section 409A doesn't apply to short-term deferrals. A short-term deferral generally exists if payment is made no later than 2½ months following the end of the tax year in which the compensation vests (in technical terms, when the compensation is no longer subject to a substantial risk of forfeiture). However, the short-term deferral exception is only available if the plan doesn't provide for a deferral of the payment beyond the 2½ month deadline.

The final regulations clarify that the short-term deferral exclusion is not available if the plan specifies a payment event or date that will or may occur after the end of the short-term deferral period. For example, if an arrangement provides that compensation will be paid upon an employee's separation from service, which may occur in a future year, the arrangement will be deemed to provide for a deferred payment, and the short-term deferral rule will not be available, even if payment is in fact made within the applicable 2½ month period.

Stock options and stock appreciation rights

Nonqualified stock options are generally exempt from Section 409A if: (a) the exercise price is never less than the fair market value of the underlying stock on the grant date; (b) taxation of the options is governed by IRC Section 83; and (c) there are no deferral features (other than the deferral of recognition of income until the exercise or disposition of the option). Stock appreciate rights (SARs) are generally treated the same as nonqualified stock options for Section 409A purposes. The regulations refer to nonqualified stock options and SARs collectively as "stock rights." For the exclusion from Section 409A to apply, a stock right must relate to "service recipient stock."

• The final regulations expand the classes of stock that qualify as "service recipient stock," generally providing that any class of stock that qualifies as common stock under IRC Section 305 may be used, regardless of whether another class of common stock is publicly traded or has a higher aggregate value outstanding, and regardless of whether the class of stock is subject to transferability restrictions or buyback rights.
• The final regulations also provide that "service recipient stock" includes not only stock of the corporation for which the employee was providing services at the date of grant, but also the stock of any upstream corporation in the employer's controlled group. For this purpose, control is generally determined using a 50% ownership interest (rather than the 80% general rule), although 20% can be used if the employer establishes that use of the stock is based upon legitimate business criteria (as defined in the regulations). The stock of a downstream member of the controlled group, or of a brother/sister corporation, can't be used.
• The final regulations provide that a stock right won't become subject to Section 409A solely because the stock right's exercise period is extended, but not beyond the earlier of (a) the original maximum term of the stock right or (b) 10 years from the original date of grant. However, if a stock right is "underwater" (i.e., the fair market value of the underlying stock at the time of the extension is less than or equal to the exercise price) the exercise period can be extended without limit.

Separation pay plans

Separation pay plans are generally exempt from Section 409A if the separation pay (a) is payable no later than two years after the year separation from service occurs, and (b) is limited to the lesser of two times the employee's annual compensation or two times the section 401(a)(17) compensation limit. This exception applies only where the payment is made due to the employee's involuntary separation from service or participation in a window program. The exception doesn't apply to a plan providing for a payment upon voluntary separation from service or other event. The proposed regulations also provide that Section 409A doesn't apply to separation payments that don't exceed $5,000 in the aggregate.

• The final regulations provide that where a plan qualifies for this exemption, except that the separation pay exceeds the "two times pay" limit, only the excess over the limit will be subject to Section 409A. The right to payment up to the applicable limit will not be subject to Section 409A. As a result, the six month delay for payments to specified employees on account of separation from service will not be required for payments up to the "two times pay" limit.
• The final regulations clarify that separation pay refers only to compensation that an employee is entitled to upon a separation from service (including a separation from service due to death or disability) and not to compensation he or she could have received without separating from service (such as an amount that's also payable to the employee upon a change in control, as a result of an unforeseeable emergency, or on a date certain).
• The final regulations expand the separation pay exemption by permitting a voluntary termination for good reason to be treated as an involuntary separation if certain requirements are met (and avoidance of Section 409A is not the goal).
• The final regulations increase the small benefit exemption amount from $5,000 to the IRC section 402(g) deferral limit ($15,000 in 2007).

Reimbursement plans

The proposed and final regulations generally provide that Section 409A will not apply to an employer's reimbursement of certain expenses (such as reasonable outplacement expenses, reasonable moving expenses, and medical expenses). The regulations generally require that eligible expenses be incurred by the employee no later than the end of the second year following the year in which the employee terminates employment.

• The final regulations clarify that the right to a nontaxable benefit (for example, reimbursement of nontaxable medical expenses) is not subject to Section 409A.
• The final regulations extend the period of time that taxable medical expenses may be reimbursed. These reimbursements will not be subject to Section 409A during the period the employee would be entitled to COBRA coverage if he or she elected such coverage and paid the applicable premiums.
• Even though reimbursed expenses must generally be incurred by the end of the second year following separation from service, the final regulations generally extend the period during which reimbursements can be paid to the end of the third year following separation from service.
• The regulations clarify that reasonable moving expenses include the reimbursement of a loss incurred by an employee due to the sale of his or her primary residence.

Plan aggregation rules

The proposed regulations generally provide that all amounts deferred with respect to an employee under all plans of an employer of the same type are treated as deferred under a single plan. The proposed regulations defined four types of plans for purposes of these aggregation rules: account balance plans, non-account balance plans (for example, defined benefit plans), separation pay plans, and all other plans (for example, non-exempt stock right plans).

The final regulations provide additional categories for split-dollar life insurance arrangements, certain reimbursement plans, certain foreign plans, and stock right plans subject to Section 409A. The final regulations also generally require that account balance plans be subdivided into elective and non-elective arrangements.

Written plan requirement

Section 409A requires that a nonqualified deferred compensation plan be in writing.

• The final regulations generally provide that a plan will satisfy this requirement if the document or documents constituting the plan specify the amount of compensation the employee has a right to be paid, the payment schedule or payment triggering events, the conditions under which a deferral election may be made, and provisions describing the six-month delay applicable to payments to "specified employees" upon separation from service.
• A plan generally doesn't need to specify the conditions under which accelerated payments may be made, but the employer must demonstrate that an accelerated payment complies with the requirements of Section 409A and the final regulations.

• The final regulations clarify that a "savings clause" contained in a plan document will not protect a plan that contains provisions that don't meet Section 409A's requirements.

Deferral election rules

In order to be a valid deferral, an employee's initial election to defer compensation must be made prior to the year the compensation is earned. The proposed regulations contain a special rule for newly eligible employees. The individuals can make an initial deferral election within 30 days after first becoming a participant. Elections to defer performance-based compensation may be made up until six months before the end of the performance period.

• The final regulations expand the new-participant rule in two ways. First, if an employee was formerly a participant in the plan, was paid all amounts deferred under the plan, and was not eligible to continue to participate in the plan after the last payment, the plan can treat that employee as a new participant if he or she again becomes eligible to participate in the plan. Second, a plan participant who becomes ineligible to participate in the plan for a period of at least 24 months may be treated as a new participant if he or she again becomes eligible to participate (regardless of whether or not the employee has separated from service and regardless of whether or not the employee has received payment of his or her account balance).
• The final regulations clarify that a portion of an award can be performance-based compensation even if the award contains a non performance-based component, but only if the portion that qualifies as performance-based compensation is separately identifiable under the terms of the plan.

• The final regulations require that an election to defer performance-based compensation must be made before the amount of the compensation is readily ascertainable (as defined in the regulations). The proposed regulations had required that the election be made before the compensation had become substantially certain to be paid.

Time and form of payment

An employee's initial deferral election must specify the time and form of distribution. Alternatively, the plan itself can specify when and how payment will be made. Section 409A provides that distribution from a NQDC plan can occur upon separation from service, death, disability, change in control, unforeseeable emergency, or at a fixed date or pursuant to a fixed schedule. In general, a plan can't make a distribution on account of an unforeseeable emergency if the hardship need can be satisfied from the individual's other assets (unless liquidation of those assets would itself cause a severe financial hardship).

• The proposed regulations provide that a payment is treated as made on a fixed date if the payment is made by the end of the calendar year containing that date or, if later, the 15th day of the third month following that date. The final regulations clarify that the same flexibility applies when making a payment on account of a payment event. So, for example, where a payment is scheduled to be made upon an employee's death, the payment is timely if made on or before the later of December 31 of the calendar year in which death occurs, or the 15th day of the third month following the date of death.
• The final regulations provide that a right to a tax gross-up payment will satisfy Section 409A if the plan provides that payment will be made, and the payment is actually made, by the end of the year following the year the related taxes are paid to the taxing authority.
• The final regulations simplify the rules for determining when an employee separates from service. In general, whether the employee has terminated employment is based on whether the employee and employer reasonably anticipate either that (a) no further services will be performed after a certain date, or (b) that the level of bona fide services the employee will perform after that date (whether as an employee or as an independent contractor) will permanently decrease to no more than 20% of the average level of services performed over the immediately preceding 36-month period (or the full period the employee provided services to the employer if the employee has been providing services for less than 36 months). A plan can substitute a percentage ranging from 20% to 50% under certain conditions.
• The final regulations clarify the definition of "employer" for purposes of determining whether a separation from service has occurred. The employer is defined as including all entities that would be treated as part of the employer's controlled group under section IRC section 414(b) and (c), but using a 50%, instead of 80%, ownership level. A plan may instead use an ownership level ranging from 20% to 80%, but an ownership level of less than 50% may be used only where such use is based on legitimate business criteria, as defined in the regulations.
• Plans can adopt a "same desk" rule for Section 409A purposes under the final regulations, allowing unrelated parties to an asset purchase agreement to decide whether employees of the selling corporation that continue in their same positions with the purchaser of the assets will be treated as separating from service. The plan must treat all employees consistently (regardless of position at the seller), and that treatment must be specified no later than the closing date of the asset purchase transaction. For this purpose, a sale of assets refers to a transfer of substantial assets, such as a plant or division or substantially all of the assets of a trade or business.
• The final regulations clarify that elections with respect to the time and form of payment to a beneficiary after an employee's death are subject to the general rules governing subsequent deferrals and accelerated payments, whether those elections may be made by the employee or the beneficiary (special rules apply to qualified domestic relations orders).
• A domestic relations order may provide for a new time and form of payment to an employee's spouse or former spouse, or may give the spouse or former spouse the discretion to elect the time and form of payment. Section 409A rules will not apply.
• The final regulations provide that a payment due to an unforeseeable emergency may be made even though the financial need could instead be satisfied through an available distribution from a grandfathered nonqualified deferred compensation plan, or from another nonqualified deferred compensation plan that's subject to Section 409A.
• The Pension Protection Act of 2006 provides that where an event would constitute an unforeseeable emergency under the plan if it occurred with respect to the employee's spouse or dependent, such event will (if the plan so provides) also constitute an unforeseeable emergency if it occurs with respect to the employee's plan beneficiary. The final regulations reflect these new rules.

6-month delay for specified employees on separation from service

Under Section 409A a payment of deferred compensation to a "specified employee" on account of separation from service generally must be delayed for six months following the date of separation from service. A specified employee is a key employee of a corporation whose stock is publicly traded.

• The final regulations clarify that the six-month delay applies to an employee of a company whose stock is publicly traded solely on a foreign exchange, or is traded on a U.S. exchange only as ADRs.
• In order to avoid undercounting specified employees, a plan may provide that payments to all plan participants upon separation from service will be delayed for six months, regardless of whether the employee is a specified employee.
• The final regulations let a plan use an alternative method for identifying specified employees, provided that the alternative method (a) is reasonably designed to include all specified employees, the alternative method, (b) is an objectively determinable standard, (c) doesn't provide a direct or indirect election to any employee regarding the application of the rule, and (d) results in no more than 200 employees being identified as specified employees as of any date.
• The final regulations significantly alter the proposed rules governing the identification of specified employees following a corporate transaction, such as a merger or spin-off.
• The final regulations clarify that where a payment is made to a specified employee on account of disability, a change in control event, or an unforeseeable emergency, the payment need not be delayed merely because that individual separates from service after incurring the disability or unforeseeable emergency, or after the change in control event.
• The final regulations also provide that Section 409A is not violated where payment to a specified employee is made before the end of the six-month period due to a domestic relations order, to satisfy a Federal, state, local, or foreign ethics law, or to pay certain employment taxes.

Anti-acceleration rule

Section 409A prohibits a plan from accelerating the payment of an employee's plan benefit except as permitted by the IRS. The proposed regulations allow the acceleration of benefits from a plan in the following limited circumstances:

1. To satisfy a qualified domestic relations order (QDRO)
2. To comply with a conflict of interest divestiture
3. To pay certain FICA taxes relating to the deferred compensation
4. To pay income taxes due to the vesting of benefits in a Section 457(f) plan
5. To cash out small benefits ($10,000 or less) upon an employee's separation from service.

• The final regulations provide that a plan may give the employer, but not the employee, the discretion to accelerate a deferred payment upon the occurrence of one of the permitted acceleration events.
• The final regulations provide that benefit payments can also be accelerated to pay state and local taxes, RRTA taxes, and foreign taxes.
• The final regulations increase the small benefit limit from $10,000 to the limit on elective deferrals under IRC Section 402(g) ($15,000 in 2007). The final regulations, unlike the proposed regulations, provide that an employer can cash out the employee's benefit even if the employee hasn't separated from service--the employer may exercise its discretion any time an employee's benefit is less than the 402(g) limit. The plan aggregation rules apply, so an employer can't use this rule to cash out an amount under one arrangement but not another arrangement where the two arrangements are treated as a single plan.
• The final regulations generally provide that where an employer makes a payment to an employee that's a substitute for a payment of deferred compensation, then that payment will be treated as a payment of deferred compensation subject to section 409A and its anti-acceleration provisions. Similarly, if an employee's rights to deferred compensation are subject to anticipation, alienation, sale, transfer, assignment, pledge, encumbrance, attachment, or garnishment by creditors of the service provider or the service provider's beneficiary, the employee's benefits are treated as having been paid to the employee, again invoking Section 409A's anti-acceleration rules.
• The final regulations provide that the addition of death, disability, or an unforeseeable emergency as a potentially earlier payment event is a permissible acceleration. This rule does not apply to the addition of death, disability, or an unforeseeable emergency as a potentially later payment event. Nor would it allow a plan to substitute, for example, an employee's death as a new payment event instead of a fixed payment date. The regulations provide that in those cases, the rules governing subsequent deferral elections (i.e., "second elections") apply.

Plan termination and liquidation

Under the proposed regulations an employer may generally terminate a plan if the employer (a) terminates all plans of the same type, (b) distributes benefits to all participants within 12 months of the termination date, and (c) doesn't adopt a new plan of the same type within 5 years. A termination covered by this rule would not be treated as violating Section 409A's anti-acceleration provisions.

• The final regulations clarify that the termination and liquidation of a nonqualified deferred compensation plan involves both the amendment of the plan to cease deferrals under the plan, and to provide for payment of all benefits accrued under the plan.
• The final regulations shorten the period of time during which an employer may not establish a new plan after terminating and liquidating a nonqualified deferred compensation plan has been shortened from five years to three years. The regulations also provide that a discretionary plan termination and liquidation will not qualify for this exception if it is proximate in time to a downturn in the financial health of the employer.
• The final regulations clarify the rules under which a deferred compensation plan may be terminated and liquidated upon a change in control event.

Information is derived from sources we believe to be reliable however its accuracy cannot be guaranteed.

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