In October 2004, the American Jobs Creation Act

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1 Long-Awaited Final Regulations Under Code Sec. 409A Are Issued As Transition Relief Nears an End * By David G. Johnson and Elizabeth Buchbinder ** Dave Johnson and Elizabeth Buchbinder discuss the new Code Sec. 409A regulations and the compliance challenges ahead. In October 2004, the American Jobs Creation Act ( AJCA or the Jobs Act ) 1 was signed into law, putting into effect the most significant tax legislation in two decades. New Internal Revenue Code Section ( Code Sec. ) 409A was no insignificant part of the Jobs Act. Code Sec. 409A provides new rules as to the timing of elections and payouts with respect to nonqualified deferred compensation. Failure to comply with these rules in either form or operation will cause plan participants to be taxed at the time their deferred compensation becomes vested and for the taxable amount to be subject to a 20-percent surtax and, potentially, interest at the underpayment rate plus one percentage point. Many employers were surprised by the substantial impact of Code Sec. 409A on compensation arrangements. Although it s now 2007, employers continue to digest the broad scope and implications of this provision. It is safe to say that Code Sec. 409A has impacted virtually every nonqualified deferred compensation plan in the United States, not to mention certain foreign arrangements. In addition, many arrangements not typically thought of as nonqualified deferred compensation nonetheless comes under the Code Sec. 409A definition. David G. Johnson is a Partner in Ernst & Young s Human Capital practice in Cleveland, Ohio. Mr. Johnson has 20 years experience specializing in the areas of domestic and international executive compensation, tax and executive planning for compensation and benefits. He can be reached at david. johnson2@ey.com. Elizabeth Buchbinder leads Ernst & Young s Washington, D.C. National Tax Performance & Reward group. Ms. Buchbinder has over 25 years of experience in the employee benefits field. She can be reached at elizabeth.buchbinder@ey.com. With the issuance of lengthy final regulations in April of 2007 and the fast approaching plan amendment deadline and conclusion of the transition relief period, understanding and complying with Code Sec. 409A is more critical than ever. As a result of the changes necessary to comply with Code Sec. 409A, some plans may lose their effectiveness whether because they no longer fulfill the company s underlying business objectives or because they simply cease to be appealing to employees. Consequently, deferred compensation programs now require reassessment, reevaluation and employee re-education. From a strictly technical perspective, most employers have been working to understand and analyze the implications of the recently issued final regulations. This article provides a high-level overview of some of the key aspects of these new regulations to help employers gain a better understanding of the implications and compliance challenges of Code Sec. 409A. Basic Definition of Nonqualified Deferred Compensation The final regulations follow earlier IRS guidance and provide that, for purposes of Code Sec. 409A, a plan provides nonqualified deferred compensation if, under the relevant facts and circumstances, a service provider has a legally binding right during a tax year to compensation that, pursuant to its terms, is or may be payable in a later year. A legally binding right may exist notwithstanding that an employee s right to the compensation is contingent upon satisfying a vesting provision (such as the requirement that the employee perform substantial services for the 2007 D. Johnson and E. Buchbinder JOURNAL OF RETIREMENT PLANNING 57

2 Final Regulations Under Code Sec. 409A employer for a specified number of years) or compliance with a covenant not to compete. Further, the fact that a bonus is based on the amount the employer will receive in selling property and that the employer may or may not sell the property, or that the amount the employer will receive upon a sale is uncertain, does not mean that the employee s right to the bonus is not legally binding. Overall, this definition generally pulls within the scope of Code Sec. 409A elective and nonelective deferred compensation, such as bonus deferral plans, supplemental executive retirement plans (SERPs), and excess plans. It also potentially pulls in many severance pay and change in control agreements and many types of equity compensation arrangements, such as phantom stock plans, restricted stock units, stock options and stock appreciation rights. The definition also applies regardless of whether the compensation at issue is documented in a formal plan or is set forth in an employment contract, letter, or other medium (including an oral agreement) that establishes an employee s legally binding right to the compensation. Because of the potential scope of Code Sec. 409A, the exemptions provided in both the statute and final regulations are of particular importance. We will cover only some of the applicable exemptions. Short-Term Deferrals One of the most important exemptions from Code Sec. 409A is for so-called short-term deferrals. Compensation falls within this exemption if the plan does not provide for deferred payments, and the employee actually or constructively receives payment during the applicable 2 1/2 month period. The applicable 2 1/2 month period is the period ending on the 15th day of the third month following the later of (1) the end of the employee s tax year in which the right to the payment is no longer subject to a substantial risk of forfeiture, or (2) the end of the employer s year in which the right to the payment is no longer subject to a substantial risk of forfeiture. For calendar-year employers, the applicable 2 1/2 month period will generally end on March 15 of the year following the calendar year of vesting. Thus, for example, if an employee s right to an annual bonus vests if the employee is still employed on December 31, the bonus is a short-term deferral if it is paid by March 15 of the following year. Similarly, if restricted stock units (RSUs) cliff vest three years from the date of grant of July 1, 2007, the RSUs will be considered short-term deferrals if they are paid by March 15, 2011 (assuming a calendar-year employer). It is important to note, however, that if the plan provides for deferred payment for example, the RSUs are payable five years from the date of grant even though they vest at the end of three years then paying them within the applicable 2 1/2 month period will not qualify the RSUs for the short-term deferral exemption but rather will generally cause an impermissible acceleration that will violate Code Sec. 409A. Stock Options and Stock Appreciation Rights Stock options that qualify as incentive stock options under Code Sec. 422 or that are granted under a employee stock purchase plan that qualifies under Code Sec. 423 are exempt from Code Sec. 409A. In addition, stock options and stock appreciations rights (collectively referred to in the final regulations as stock rights ) are exempt if they are granted in service recipient stock, they are granted at no less than the stock s fair market value (FMV) on the date of grant, and they do not include a deferral feature other than the ability to exercise the option during its term. The definition of service recipient stock is the first hurdle that must be overcome before a stock right can qualify for exemption from Code Sec. 409A. Service recipient stock includes any class of stock of the service recipient that is common stock. Importantly, although the common stock may have preferences as to liquidation rights, it cannot have any other preferences, such as preferential dividend rights. Preferred stock cannot qualify as service recipient stock. Under the proposed regulations, service recipient stock of a private company could not qualify as service recipient stock if any company in the same controlled group of companies as the private company had stock that was publicly traded. This limitation was eliminated in the final regulations so that service recipient stock now includes any common stock of the company for which the employee was providing services at the date of grant or any company up the chain in the controlled group from that employer company. Thus, parent company common stock is service recipient stock not only for employees of the parent but also for all subsidiaries down the chain from the parent. In contrast, subsidiary stock cannot qualify as service recipient stock for parent employees or for any other company up CCH. All Rights Reserved.

3 the chain from the subsidiary. For purposes of these rules, a controlled group can be based on a control test of up to 80 percent and as low as 50 percent without any elections required. It may be possible to use a control test below 50 percent and as low as 20 percent if the grant of stock to the employee is based on legitimate business criteria. The second requirement for the stock rights exemption is that the stock rights be granted with an exercise price no lower than the FMV of the underlying service recipient stock on the date of grant. For publicly traded stock, the determination of FMV typically is not problematic under the final regulations, the valuation must be based on contemporaneous prices established in the securities market. In addition, FMV can be established by using an average selling price over a specified period that is within 30 days before or after the date of grant. However, the final regulations make clear that the use of such an average requires that the commitment to grant the stock right be irrevocable before the beginning of the averaging period and that, in order to satisfy this requirement, the employer generally must designate the recipient of the stock right, the number of shares that may be purchased under the stock right, and the method for determining the exercise price (including the averaging period) before the averaging period begins. For stock that is not readily tradable on an established securities market, the challenge of determining FMV is much greater. In addition to providing general principals for determining FMV based on the application of a reasonable valuation method, the final regulations provide three safe harbors that can be rebutted by the IRS only by a showing that the valuation is grossly unreasonable. As under the proposed regulations, the presumption of FMV applies where the valuation is based upon an independent appraisal by a qualified appraiser, a generally applicably repurchase formula (used for all compensatory purposes and generally for all noncompensatory purposes) that would be treated as FMV under Code Sec. 83, and, in the case of an illiquid stock of a start-up corporation, a valuation by a qualified individual applied at a time the corporation did not otherwise anticipate a change in control event or public offering of the stock. The only significant changes in the final regulations relate to the safe harbor for illiquid stock of a start-up corporation. Under the proposed regulations, this safe harbor could not be used if the employer or the employee could reasonably anticipate at the time of the valuation that the employer would undergo a change in control event or make a public offering of securities within the 12 months following the event to which the valuation applied. The final regulations adopt a more workable standard, providing that the safe harbor for illiquid stock of a start-up corporation will not apply if the change in control is anticipated within the next 90 days or an initial public offering within the next 180 days. Perhaps the most significant change with respect to stock rights in the final regulations relates to extensions of the exercise period. Under the proposed regulations, an extension of a stock right beyond the end of the calendar year in which it would have otherwise expired (or, if later the 15th day of the third month following the date the stock right would have otherwise expired) would have caused the stock right to be treated as if it had never been exempt from Code Sec. 409A. In contrast, under the final regulations, the extension of the exercise period for a stock right will not cause the stock right to lose its exempt status as long as the extension does not go beyond the later of the original maximum term of the option or 10 years from the original date of grant. Since many stock rights cut short the otherwise applicable exercise period when an employee terminates employment, this favorable change in the final regulations means that an employer can exercise discretion to allow the regular exercise period to ride out. This is particularly useful where terminations are involuntary or negotiated. Separation Pay Plans As will be discussed later in this article, if nonqualified deferred compensation is payable by reason of separation from service, then Code Sec. 409A requires that any specified employee of a public company wait six months after separation from service to receive payment. Accordingly, an exemption from Code Sec. 409A for payments made upon separation from service to a specified employee is necessary in order to avoid the six-month wait. One important exemption applies to a separation pay arrangement paying only upon an involuntary separation from service, but only if the payments must be made by the end of the second year following separation from service, and only to the extent the payments do not exceed $450,000 (or, if less two times the employee s annual compensation). Because the $450,000 threshold is determined by reference to two times the limit on compensation taken into account under Code Sec. 401(a)(17) (which is $225,00 for 2007), this threshold will JOURNAL OF RETIREMENT PLANNING 59

4 Final Regulations Under Code Sec. 409A increase for cost-of-living adjustments in the future. What is important to note is that, under the final regulations, if all other requirements are met (i.e., the two-year limit and the involuntary separation requirement), the exemption will apply up to the applicable dollar threshold even if total payments exceed that threshold. The final regulations provide that whether a separation from service is involuntary will generally be based on the fact and circumstances. However, the characterization of the separation by the employer and employee in the relevant documentation will be rebuttably presumed to be correct. In a major departure from the proposed regulations, the final regulations also provide that a payment paid upon a voluntary separation for good reason is treated as paid upon involuntary separation where the good reason condition is such that the separation is effectively involuntary. The good reason condition must require actions by the employer resulting in a material negative change in the employment relationship, such as a material negative change in the duties to be performed by the employee, the conditions under which the duties are to be performed, or the compensation to be received. The regulations provide extensive additional guidance, including a safe harbor, with respect to the definition of voluntary separation for good reason. Recognition of good reason separations as involuntary can be important, not only in the context of the two-year/$450,000 exemption, but in establishing whether separation pay becomes vested upon the separation or was vested earlier. This in turn is critical in determining whether the separation pay is exempt from Code Sec. 409A as a shortterm deferral. Consider, for example, a separation pay plan that provides that a specified employee will be paid a lump sum of $1 million only if she is involuntarily terminated not for cause or if she voluntarily separates from service for good reason. If the good reason condition results in treatment as an involuntary termination, then the plan would constitute a short-term deferral and the specified employee could receive the lump sum immediately upon the specified separation from service, without a six-month wait. On the other hand, if the good reason condition does not result in treatment as an involuntary termination, then the plan would not constitute an exempt short-term deferral and there would be a required six-month waiting period. Reimbursement and Fringe Benefit Plans The final regulations provide clarification with respect to reimbursements and fringe benefits that are considered exempt from Code Sec. 409A. The final regulations allow nontaxable fringe benefits, taxable reimbursements of medical expenses made by the end of the COBRA period, and certain reimbursements for outplacement and moving expenses to be excluded from the definition of nonqualified deferred compensation for Code Sec. 409A purposes. In addition, legal settlements or awards, including the payment or reimbursement of legal fees incurred in connection with such claims and educational benefits consisting solely of educational assistance provided for the education of the employee are also exempt. Plan Aggregation Rules The final regulations continue to require similar plans to be treated as a single plan for purposes of Code Sec. 409A. However, the regulations have expanded the number of categories of nonqualified deferred compensation plans to include elective account balance plans, nonelective account balance plans, nonaccount balance plans, separation pay plans, reimbursement plans, split-dollar life insurance plans, foreign plans, stock plans and all other plans that do not fall in the categories listed above. The expansion of the plan aggregation categories is generally favorable for taxpayers because, with respect to an employee, all plans within the same category of plan will be treated as a single plan for the purposes of Code Sec. 409A. Thus, if one arrangement under a category is not in compliance with Code Sec. 409A, all arrangements in the same category will also be treated as noncompliant. Because plans in other categories are not adversely affected by noncompliance of a plan in another category, the increase in the number of categories generally will protect more plans from being tainted by another noncompliant plan. Substantial Risk of Forfeiture The final regulations have adopted a different definition of substantial risk of forfeiture than the definition applicable under Code Sec. 83. For example, a covenant not to compete can never be a substantial risk of forfeiture under Code Sec. 409A, but, depending CCH. All Rights Reserved.

5 on the facts and circumstances, may be a substantial risk of forfeiture under Code Sec. 83. The regulations specify that conditions under the discretionary control of the employee (other than the decision whether to continue to provide services) are not treated as creating a substantial risk of forfeiture. Further, an elective extension of a forfeiture period generally will be disregarded unless there is substantial additional consideration for the extension. Payments that are conditioned on an involuntary separation not for cause (including good reason separations) may be treated as subject to a substantial risk of forfeiture if there is a substantial risk that the employee will not be involuntarily separated without cause. Initial Deferral Elections As indicated above, Code Sec. 409A provides entirely new rules relating to nonqualified deferred compensation. Key among these are new rules relating to the timing of elections to defer compensation. Generally, a plan complies with the Code Sec. 409A requirements only if an election to defer compensation for services performed during the tax year is made before the beginning of the year. The election must generally fix not only the time of payments under the plan, but the form of payments as well. For performance-based compensation, the initial deferral election can be made as late as six months prior to the end of the performance period, but must be made before the amount is readily ascertainable. Numerous other special rules apply to the timing of initial elections to defer compensation. Under the final regulations, the special rule allowing an initial deferral of separation pay (subject to arm s-length negotiations) any time before the employee obtains a legally binding right to the payment has been extended to payments made on voluntary separations as well as involuntary. However, this provision is not applicable to preexisting legally binding rights to deferred compensation, including legally binding rights that are subject to a substantial risk of forfeiture. The final regulations also clarify the application of the election timing rules to plans that are nonelective that is, plans that do not provide It is safe to say that Code Sec. 409A has impacted virtually every nonqualified deferred compensation plan in the United States, not to mention certain foreign arrangements. employees with any elections as to the timing and form of benefits. For nonelective plans, the time and form of payment must be fixed by the later of when there is a legally binding right to the compensation or when the time and form of payment would be required to be fixed under an elective plan. Time and Form of Payment The final regulations clarify that payments from a nonqualified deferred compensation plan are generally allowed only upon a specified date, according to a fixed schedule, or upon death, disability, a separation from service, an unforeseeable emergency or a change in control. Importantly, if a payment to a specified employee of a public company is triggered by separation from service, the payment cannot begin until six months following the specified employee s separation from service. 2 A plan must generally designate a single time and form of payment for each permissible payment event. However, a plan can provide for different times and forms of payment based on whether the payment event occurs before or after a specified date (such as reaching a specified age). If a specified date (rather than a specific calendar year) is used, payment cannot be made earlier than 30 days before the specified date. In addition, where a specified date is used, a plan can use a deadline for payment after that specified date, as long as the deadline is no later than December 31 of the year in which the specified date occurs. Under the final regulations, the deadline may also be a period of not more than 90 days after the specified date, but if the 90 day period would cross over into a second tax year, the employee cannot be not given an election as to the tax year of payment. Code Sec. 409A also allows the payment of nonqualified deferred compensation to be made pursuant to a fixed schedule. The final regulations provide guidance on what types of schedules will be treated as fixed. For example, a schedule of payments based on payments to the employer will qualify as a fixed schedule only in limited circumstances. In addition, a schedule with a fixed or objective formula limitation on the amount that may be paid during any JOURNAL OF RETIREMENT PLANNING 61

6 Final Regulations Under Code Sec. 409A particular period will qualify as a fixed schedule only if, among other requirements, the limitation is based on a fixed or nondiscretionary, objectively determinable formula where all the factors relevant to the determination of the limit are beyond the control of the employee and not subject to any exercise of discretion by the employer. A number of special rules apply in the context of a change in control. If there is a sale of assets to an unrelated buyer that constitutes a change in control, the seller and buyer can specify whether an employee who will become an employee of the buyer has separated from service. However, the spin-off of a subsidiary generally would not result in a separation from service for an employee of the subsidiary who continues to be employed by the subsidiary post spin-off. Subsequent Elections to Defer Compensation Under Code Sec. 409A, once compensation has been deferred, a subsequent election to change the time or form of payment is allowed only under limited circumstances. Generally, such a change must be made at least 12 months in advance of when the compensation would otherwise have been paid and must defer the payment at least an additional five years. However, the regulations provide a number of exceptions to this rule. Notably, if pursuant to a change in control, compensation payable pursuant to an employer s purchase of stock or a stock right generally will comply with Code Sec. 409A if paid under the same conditions that govern payments to other shareholders, but the amounts must be paid no later than five years after the change in control. The payment period can extend beyond five years if the payment is subject to a substantial risk of forfeiture and is structured as a short-term deferral. Note that, for this purpose, the voluntary imposition or extension of a risk of forfeiture will be respected as a substantial risk of forfeiture. Delays in payments will also be allowed in certain circumstances, such as where the payment would jeopardize the ability of the employer to continue as a going concern and where the payment would be nondeductible by reason of Code Sec. 162(m). Acceleration of Payments Code Sec. 409A provides that a plan may not generally permit the acceleration of the time of a payment of nonqualified deferred compensation. However, the final regulations permit acceleration in limited circumstances, such as compliance with domestic relations order, certain de minimis deferral amounts, payments made to pay employment taxes on deferred compensation, payments for income tax withholding on deferred compensation, or if the plan fails to satisfy Code Sec. 409A. In addition, under very limited circumstances, a termination and liquidation of a nonqualified deferred compensation plan will not be an impermissible acceleration following a change in control. Under the final regulations, the termination and liquidation must occur within the 30 days preceding or the 12 months following a change in control event. In addition, all substantially similar plans of the employer must be terminated. Absent a change in control, the termination and liquidation of a plan generally will violate the antiacceleration rules of Code Sec. 409A unless it is in connection with the employer s insolvency or unless all plans within the same controlled group of employers that are required to be aggregated are also terminated and liquidated. In addition, all payments must occur after 12 months from the date of the termination and no later than 24 months after the termination, and no plan that would be required to be aggregated with the terminated plan(s) can be established within three years. Written Plan Requirement The final regulations provide that a plan does not have to be contained in a single document. However, at the time of deferral, the document or documents that constitute the plan must specify the amount to which the employee has the right to be paid (or the terms of the objective, nondiscretionary formula used) and the payment schedule or triggering event that will result in payment. The plan must also specify the conditions under which a deferral election may be made no later than the time an election becomes irrevocable. In addition, the plan must also provide in writing for the six-month delay requirement for specified employees upon a separation from service no later than the time the employee become s a specified employee. If the plan does not contain or fails to contain terms necessary to meet the requirements of Code Sec. 409A, the plan will violate Code Sec. 409A. As a result, savings clauses will no longer be sufficient to ensure compliance with Code Sec. 409A. Despite requests CCH. All Rights Reserved.

7 for model language, the Treasury and the IRS will not publish model amendments at this time. Effective Date and Transition Rules The final regulations are effective April 17, 2007, but generally are not applicable until January 1, The preamble to the final regulations explains that pre-existing transition relief continues to apply and is not intended to be modified by the final regulations. However, plans must be amended to comply with Code Sec. 409A by December 31, Operational Failures During the Transition Period Where an operational failure occurs in 2006 or 2007 and no operational failure occurred in an earlier year, the final regulations provide that income will only need to be reported in the year of violation. In addition, where a plan complied with the transitional guidance but fails to be amended by December 31, 2007, to comply with the final regulations, the Code Sec. 409A violation will be deemed to occur on January 1, The final regulations also provide that the plan aggregation rules will apply during the transition period. Business Implications It is critical that companies analyze the impact of the final regulations on any preliminary analysis that was prepared under earlier guidance and evaluate any year-end planning and actions relating to the transition rules that will expire on December 31, Plan amendments must be adopted by December 31, In addition, companies should also determine if there are any plans that should be terminated before year-end, keeping in mind that, under the transition rules, payments cannot be made until January 1, Companies should then finalize any new plan designs and communicate new plan provisions and restrictions to their affected employees. Other Issues Nonqualified deferred compensation programs in the United States take many forms, including voluntary and involuntary deferral programs, equity-based compensation with deferral features and supplemental retirement plans to name a few. From a risk and governance perspective, the evaluation of these plans goes well beyond compliance with the new Code Sec. 409A tax rules, and includes the necessity of articulating the ongoing business purpose of the plans, the financial planning considerations for participants, the need to educate participants, potential implications to international assignees, and the broader issue of the appropriateness of the program and its features given the overarching compensation philosophy and strategy of the enterprise. Against this backdrop, many companies and their boards are reassessing not only compliance from a tax perspective but the broader strategic aspects as well as the cost and risk issues associated with nonqualified deferred compensation plans. * This article originally appeared in TAXES THE TAX MAGAZINE, Vol. 85, No. 9. ** The views expressed herein are those of the authors and may not necessarily reflect the views of Ernst & Young LLP. 1 American Jobs Creation Act of 2004 (P.L. ENDNOTES ). 2 A specified employee is an individual who is a key employee under the Code Sec. 416 top-heavy rules. This generally is any morethan-five percent owner, any more-than-one percent owner who has annual compensation greater than $150,000, or one of the top-paid 50 officers of the company (or, if less, the greater of three or 10 percent of all employees) with compensation greater than $145,000 (for 2007). This article is reprinted with the publisher s permission from the JOURNAL OF RETIREMENT PLANNING, a bi-monthly journal published by CCH, a Wolters Kluwer business. Copying or distribution without the publisher s permission is prohibited. To subscribe to the JOURNAL OF RETIREMENT PLANNING or other CCH Journals please call or visit All views expressed in the articles and columns are those of the author and not necessarily those of CCH. JOURNAL OF RETIREMENT PLANNING 63