Deferred Compensation for Dummies: The Section 409A Compliance Clock is Ticking

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1 Deferred Compensation for Dummies: The Section 409A Compliance Clock is Ticking OCTOBER 17, 2008 PUBLICATIONS Most of us involved in the practice of law are familiar with the benefits of tax deferral. We routinely contribute a portion of our salary to our employer s Section 401(k) or 403(b) retirement plan on a pre-tax basis, and in many cases our employer makes additional tax-deferred contributions to those plans on our behalf. Even if we don t have access to an employer-sponsored retirement arrangement, many of us make tax-deductible contributions to an individual retirement arrangement ( IRA ). In both cases, we are deferring the full use and enjoyment of the money to a later date, and in the process we are deferring the taxation of what would otherwise be currently taxable compensation. In the employee benefits realm, these types of vehicles are generally referred to as tax-qualified or simply qualified deferred compensation arrangements. So long as we (and our employer) follow the tax qualification rules governing these plans (including the limitations on the amount that can be contributed and the timing of distributions from such plans), we are not required to report the amounts deferred (or the earnings on those amounts) as taxable income until those amounts are distributed to us, generally at retirement. This provides a significant tax benefit to taxpayers participating in such arrangements, particularly those in the higher marginal income tax brackets. AUTHORS Robert A. Browning RELATED ATTORNEYS Robert A. Browning RELATED PRACTICES Employee Benefits However, there is another category of deferred compensation arrangements that is much broader than the qualified plans described above. This category includes less formal arrangements, such as long-term incentive plans, severance pay plans, phantom stock, stock appreciation rights, certain types of stock options and other executive compensation practices. Prior to 2005, these arrangements, which are generally referred to as nonqualified deferred compensation arrangements, were not subject to any particular section of the Internal Revenue Code. Instead, the federal income tax treatment of amounts deferred under such nonqualified arrangements was based on certain tax principles, including the doctrines of constructive receipt [1] and economic benefit. [2] The tax treatment of amounts deferred under such nonqualified deferred compensation arrangements has long been based on these decades-old principles, as shaped by various administrative rulings, judicial holdings, and a small number of statutory rules (primarily under Code Section 83, which deals with the taxation of property, such as stock or an option to purchase stock, that is transferred in connection with the performance of services, and Code Section 451, which governs the appropriate taxable year of inclusion in income). In 2004, partly in response to the abuses by certain corporate executives associated with the collapse of Enron, Congress adopted a new statutory scheme for the regulation of nonqualified deferred compensation arrangements. The American Jobs Creation Act of 2004 [3] made sweeping changes to the federal income tax treatment of deferred compensation arrangements through the enactment of Section 409A of the Internal Revenue Code (the Code ). Section 409A did not merely replace or codify the existing doctrines of constructive receipt and economic benefit. Instead, it created a new layer of regulation in the form of statutory rules and definitions that apply in addition to the existing principles of constructive receipt and economic benefit. As a result, many arrangements that were not previously considered to result in a deferral of compensation are now subject to the new statutory scheme, and many existing deferred compensation arrangements that were previously understood not to result in constructive receipt may now be subject to early taxation, penalties and interest unless they are modified to comply with Section 409A. History of Section 409A As noted above, Section 409A was added to the Code on October 3, 2004, as part of the American Jobs Creation Act of The statute is generally effective for amounts deferred after December 31, Amounts deferred prior to January 1, 2005 are generally exempt from the new regulatory scheme so long as those amounts were earned and vested by December 31, (However, these grandfathered amounts remain subject to the same tax principles, administrative rulings and court holdings that governed nonqualified deferred compensation plans

2 prior to Section 409A.)In addition, amounts deferred prior to 2005 will become subject to Section 409A if the arrangement is materially modified after the date the statute was enacted (i.e., after October 3, 2004). Thus, Section 409A applies to: 1. all amounts deferred after 2004; 2. amounts deferred before 2005 that were not vested by December 31, 2004; and 3. amounts deferred before 2005 where the arrangement is materially modified after October 3, Since the statute was enacted, the IRS has issued no less than twelve Notices [4] regarding various aspects of the new statutory scheme. In October of 2005, the IRS and the Treasury Department issued proposed regulations [5] interpreting Section 409A, and on April 10, 2007, these regulations were published in final form [6]. Although the final regulations were initially designed to become effective as of January 1, 2008, the effective date was later postponed until January 1, 2009 [7]. Because the January 1, 2009 compliance date is nearly two years after the date the regulations were finalized, it is extremely unlikely that there will be any further extension of the effective date of the regulations.consequently, the clock is ticking! All plans, agreements, practices or arrangements that provide for the deferral of compensation (as that term is defined in the final 409A regulations) must comply with Section 409A and the final regulations, both in form and in operation, by no later than the end of General Framework of Section 409A Section 409A itself (i.e., the statutory language) is actually quite short and simple. The statute basically provides that, in order to avoid deferred compensation being included in gross income for any particular year, the arrangement must meet three requirements, both in form and in operation: 1. Distributions amounts deferred must be payable only upon one of the following events: separation from service, a specific date or time, death, disability, change of control, or unforeseeable emergency; [8] 2. Acceleration the plan must not permit the acceleration of the time or schedule of any payment under the plan (except as provided in regulations); [9] and 3. Elections any election to defer compensation for services performed in a given tax year must be made prior to the beginning of that tax year, and elections regarding the time and form of payment must generally be made by that date. [10] The consequences for failure to comply with Section 409A are severe. If at any time during a given taxable year a nonqualified deferred compensation plan fails to meet the requirements described above (i.e., if there is no written plan, or if the plan does not include the basic statutory requirements), or if the plan is not operated in accordance with those requirements, then there are three adverse consequences: 1. Income Inclusion all compensation previously deferred under the plan is includible in the participant s gross income to the extent that (i) the amounts are not subject to a substantial risk of forfeiture, and (ii) the amounts have not previously been included in gross income; 2. Interest the participant is also subject to interest, calculated at the underpayment rate plus one percent, based on the underpayment that would have occurred had the deferred compensation been includible in income in the year first deferred (or, if later, the first taxable year the deferred amounts were no longer subject to a substantial risk of forfeiture); and 3. Penalty the participant must pay a penalty equal to 20% of the amount required to be included in income above. [11]

3 Although these tax consequences fall on the service provider (the individual or entity providing the services for which the compensation is being deferred), there may also be consequences to the service recipient (the person or entity paying the deferred compensation) for both (i)failure to withhold and pay federal employment taxes, and (ii) failure to withhold federal, state or local income taxes. Thus, both service providers (i.e., employees or independent contractors) and service recipients (employers or persons hiring a contractor) have a vested interest in making sure that any arrangement that results in the deferral of compensation is either (i) exempt from, or (ii) in compliance with, the requirements of Section 409A. Definition of Nonqualified Deferred Compensation Plan The statute and the final regulations provide that a nonqualified deferred compensation plan includes any plan or arrangement (other than those specifically exempted below) that provides for the deferral of compensation. A plan provides for the deferral of compensation if, under the terms of the plan and the relevant facts and circumstances, a service provider obtains a legally binding right, during one taxable year, to compensation that is or may be payable to the service provider in a later taxable year. [12] The regulations point out that, although there is no legally binding right where the service recipient has the discretion to unilaterally reduce or eliminate the amount of compensation to be paid, the same is not true where the compensation may be reduced or eliminated by operation of the objective terms of the plan, such as the application of a nondiscretionary, objective provision that creates a substantial risk of forfeiture. For example, if an employer and an employee agree, during 2008, that the employer will pay the employee a bonus, in 2009, equal to 5% of the employee s annual salary for services performed in 2008, that is an arrangement that provides for the deferral of compensation (because the employee obtained the right, in 2008, to compensation payable in a later tax year). If the parties make the same agreement, but the employer has unilateral discretion regarding the amount of the bonus (i.e., the employer may legally elect not to pay any bonus at all), then the arrangement does not provide for the deferral of compensation. However, if the amount of the bonus is tied to certain objective performance criteria (of the service provider or of the company), then the arrangement provides for the deferral of compensation, even though there is a substantial risk that the performance criteria may not be met, and as a result, some or all of the bonus may not be paid. As you can see, this is a very broad definition of deferred compensation. It sweeps in almost any nondiscretionary promise to pay compensation at a later date, whether that be in the form of a bonus or incentive plan, an employment agreement, a severance agreement, a supplemental retirement arrangement, an expense reimbursement arrangement, or a multitude of other equity based and non-equity based compensation arrangements. Therefore, any type of contract or agreement that provides for compensation, benefits or reimbursements in a future year may be subject to Section 409A. If those promises constitute a legally binding right to future payment of compensation, once must generally presume that the deferred amounts will be subject to Section 409A unless the arrangement meets one of the statutory or regulatory exemptions. Plans and Arrangements Exempt from Code Section 409A The following types of plans are exempt (by statute) from Section 409A, even though they may provide for the deferral of compensation: 1. Qualified retirement plans under Code Sections 401(a) or 401(k); 2. Qualified annuity plans under Code Section 403(a); 3. Tax-sheltered annuity arrangements under Code Section 403(b); 4. Eligible deferred compensation plans under Code Section 457(b); 5. Qualified governmental excess benefit arrangements under Code Section 415(m); 6. SEPs, SARSEPs and SIMPLE plans under Code Section 408; 7. Plans involving deductible contributions to a Code Section 501(c)(18) trust; and 8. Bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plans. [13] The final regulations also detail several additional exceptions from 409A (each of which is explained in more detail elsewhere in this article), including:

4 1. Short-term Deferral Exemption generally, where the plan does not provide for deferred payment, and the deferred amounts are paid within 2 1/2 months after the end of the tax year in which the amounts are no longer subject to a substantial risk of forfeiture; [14] 2. Involuntary Separation Pay Exception generally, for amounts that are payable solely upon a service provider s involuntary severance of employment, but only to the extent that the amounts paid do not exceed an indexed dollar limit (currently $460,000), and are paid by the last day of the second taxable year following the year of separation; [15] and 3. Stock Options and Stock Appreciation Rights Exception generally, for options to buy stock of the service recipient, where the exercise price can never be less than the fair market value of the stock on the date of grant (or for stock appreciation rights where the amount payable cannot exceed the increase in the fair market value of a share of stock between the date of grant and the date of exercise) [16]. Generally, incentive stock options will qualify for this exemption from Section 409A. Nonqualified stock options will qualify only if the exercise or strike price is not less than the fair market value of the underlying shares of service recipient stock on the date the option is granted. The Exception for Short-term Deferrals The final regulations provide that a deferral of compensation does not occur if (i) the plan under which a payment is made does not provide for a deferred payment, and (ii) the compensation is actually or constructively received by the service provider on or before the last day of the applicable 2 1/2 month period. [17] A plan provides for a deferred payment if it provides that any payment will be made or completed on or after any date (or upon or after the occurrence of any event) that will or may occur later than the end of the applicable 2 1/2 month period. The applicable 2 1/2 month period is the period ending on the later of (i) the 15th day of the third month after the end of the service provider s taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture, or (ii) the 15th day of the third month after the end of the service recipient s taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture. There are two different ways a plan may qualify for the short-term deferral exception: 1. The plan is silent as to when payment will occur, and payment actually occurs within the applicable 2 1/2 month period; or 2. The plan provides for payment within the applicable 2 1/2 month period, and payment is actually made within that same time period. By way of example, if in November of 2008 an employee (who is employed by a calendar-year employer) obtains a legally binding right to a bonus for services performed during 2008, but the plan does not specify when payment will be made, the bonus plan will not be considered to provide for a deferral of compensation if the bonus is paid or made available to the employee on or before March 15, 2009 Likewise, if a long-term compensation plan provides for a bonus to be payable at the end of a 3-year performance period, but only if the participant is employed on the last day of that performance period, and the plan specifically provides for payment within 2 1/2 months after the end of the calendar year which includes the last day of the three year performance period, the arrangement will be exempt from Section 409A so long as payment is actually made within that 2 1/2 months period (because the requirement to be employed on the last day of the performance period constitutes a substantial risk of forfeiture which extends the applicable 2 1/2 month period). If a plan provides for a series of payments upon the lapse of a substantial risk of forfeiture, and the plan specifically provides that each installment payment will be treated as a separate payment for purposes of Section 409A, then those payments that are made within the applicable 2 1/2 month period will qualify for the short-term deferral exception, and will not be subject to tax, penalties and interest even if the arrangement otherwise fails to comply with Section 409A. The short-term deferral exception is one of the most powerful tools for keeping nonqualified deferred compensation arrangements outside the reach of Section 409A. When you are reviewing a client s existing plans and arrangements for compliance with Section 409A, if you encounter a plan that is subject to, but not in compliance with, Section 409A, your very first consideration should be, Can I restructure the payment provisions of the plan in a manner that will qualify for the short-term deferral exception, such that the plan will not even be subject to 409A? For example, if an employer has an annual bonus plan that pays a 10% bonus at the end of the first quarter of the following calendar year, that arrangement will be subject to 409A. However, if the plan is modified to either (i) be

5 silent as to when the bonus will be paid, or (ii) specifically provide for payment no later than March 15 of thefollowing year, then the plan will be exempt from Section 409A so long as the bonus is actually paid by March 15 of the following year. The Separation Pay Exception The second important exception from treatment as deferred compensation under Section 409A is for amounts that are payable solely upon the service provider s involuntary separation from service (as defined below), but only to the extent the amount of severance pay does not exceed a specific indexed dollar limit ($460,000 for 2008), and only to the extent the severance pay is paid by the last day of the second taxable year of the service provider following the year of the service provider s separation from service. [18] Under the final regulations, an involuntary separation from service means a separation from service due to the independent exercise of the service recipient s unilateral authority to terminate the service provider s services (other than due to the service provider s implicit or explicit request) where the service provider was willing and able to continue performing services. [19] Generally, whether a separation from service is voluntary or involuntary is based on the facts and circumstances. However, any characterization of the separation by the parties in the documentation of the separation is presumed to properly characterize the nature of the separation from service. This presumption may be rebutted where the facts and circumstances indicate otherwise. Importantly, the final regulations also provide that, under the proper circumstances, a separation from service for good reason may be treated as an involuntary separation for purposes of the separation pay exception. [20] These circumstances generally include a showing that (i)avoidance of Section 409A was not a purpose of the inclusion of the good-reason termination provision, (ii) the termination was based on actions by the service recipient that resulted in a material negative change to the service provider in the service relationship, such as in the duties to be performed, the conditions under which those duties are performed, or the compensation to be received for performing such services, (iii) the payments due upon termination for good reason are not greater than those payable upon an actual involuntary termination, and (iv) the service recipient has an opportunity to cure the condition. This treatment of payments upon termination for good reason was a significant change from the proposed regulations, which would have subjected any severance pay arrangement that provided for compensation upon termination for good cause to full 409A compliance (and the risk of early taxation, penalties and interest if the arrangement did not comply). The final regulations actually go so far as to create a safe harbor under which a voluntary termination for good cause will be deemed to be an involuntary termination for purposes of the separation pay exception. [21] Under the safe harbor, the separation from service for good reason must occur during a pre-determined limited period of time (not to exceed two years) following the initial existence of one or more of the following conditions, assuming such conditions arise without the consent of the service provider: 1. a material dimunition in the service provider s base compensation; 2. a material dimunition in the service provider s authority, duties or responsibilities; 3. a material diminution in the authority, duties or responsibilities of the supervisor to whom the service provider is required to report; 4. a material dimunition in the budget over which the service provider retains authority; 5. a material change in the geographic location at which the service provider must perform the services; or 6. any other action or inaction that constitutes a material breach by the service recipient of the agreement under which the service provider provides services. The safe harbor also requires that: 1. the amount, time and form of payment upon termination for good cause must be substantially identical to the amount, time and form of payment payable due to an actual involuntary separation from service (if such a right exists); and

6 2. the service provider must provide notice to the service recipient of the existence of the conditions giving rise to the termination for good cause within 90 days from the initial existence of the condition, and the service recipient must have at least 30 days to remedy the condition, such that if the condition is remedied, the service recipient will not be required to pay the amount. By creating a safe harbor, the final regulations basically provide drafters of employment agreements with a blueprint for how to structure severance pay provisions to be exempt from Section 409A. So long as the severance amounts are (i) payable only upon involuntary termination without cause or voluntary termination for good cause (under terms and conditions that are consistent with the safe harbor), (ii) paid on or before the last day of the second taxable year following the year of separation, and (iii) do not exceed the applicable dollar limit (which is defined as two times the annual compensation limit under Code Section 401(a)(17)), then the severance pay provisions are exempt from Section 409A. The Exception for Fair Market Value Stock Options and Stock Appreciation Rights The third significant category of nonqualified deferred compensation plans that is exempt from Section 409A includes nondiscounted stock options and certain stock appreciation rights that involve service recipient stock. Under the final regulations, an option to purchase service recipient stock is not subject to Section 409A if: 1. The exercise price may never be less than the fair market value ( FMV ) of the underlying stock on the date the option is granted; 2. The number of shares of stock subject to the option is fixed on the date the option is 3. The exercise of the option is subject to tax under Code Section 83 and the regulations and 4. The option does not include any feature for the deferral of compensation (other than the deferral of recognition of income until the later of the date the option is exercised or the date the stock acquired pursuant to the exercise of the option first becomes substantially vested). [22] Similarly, the right to compensation that is based on the appreciation in the value of a specified number of shares of service recipient stock between the date of grant and the date of exercise of such right (i.e., a SAR) is exempt from Section 409A if: 1. the amount payable with respect to the SAR does not exceed the difference between the FMV of the service recipient stock on the date of exercise and the price (the exercise price ) established at the time the SARs were granted; and 2. the exercise price of the SAR cannot be less than the FMV of the service recipient stock as of the date the SAR is granted; and 3. the SAR does not include any feature for the deferral of compensation (other than the deferral of recognition of income until the exercise of the SAR). [23] For purpose of these exemptions, service recipient stock means a class of stock that is considered common stock under Code Section 305, and that is issued by either (i) the corporation for which the service provider provides direct services, or (ii) any corporation or entity in the chain of entities (where each entity has a 50% or more interest in the next entity in the chain) ending with the entity that owns at least 50% of the corporation for which the service provider is providing services. [24] The 50% threshold for determining the entities to include in the chain may be reduced to as low as 20% if the use of such stock is based on legitimate business criteria (i.e., if there is a sufficient nexus between the service provider and the actual issuer of the stock). As noted above, whether stock options and SARS are exempt from 409A turns on whether the exercise price of the option or SAR is equal to or greater than the FMV of the underlying service recipient stock as of the date of grant. If nonqualified stock options are issued with an exercise price that is less than the FMV of the underlying stock, the options will be subject to 409A. Options that are subject to 409A cannot have an open exercise period, as this would violate the requirement that distributions be made only upon a permissible distribution event. If nonqualified stock options are issued with an exercise price that is equal to or greater than the FMV of the underlying stock, the options will generally be exempt from 409A, and may be exercised at any time (i.e., they may have an open exercise period). The final 409A regulations provide that, for stock that is readily tradable on an established securities market, the FMV of the stock may be determined on the basis of the last sale before or the first sale after the grant date, the

7 closing price on the last trading day before or the trading day of the grant, or any other reasonable method that is based on actual transactions in such stock as reported by such market. [25] For stock that is not readily traded on an established securities market, FMV must be determined by the reasonable application of a reasonable valuation method. [26] A reasonable valuation method must generally take into account such factors as: 1. the value of tangible and intangible assets of the corporation; 2. the present value of anticipated future cash-flows of the corporation; 3. the market value of stock or equity interests in similar corporations or other entities engaged in substantially similar trades or businesses; 4. recent arm s length transactions involving the sale of such stock or equity interests; and 5. factors such as control premiums and discounts for lack of marketability. [27] The use of a valuation method is not reasonable if the method does not take into consideration all available information material to the value of the corporation. The valuation is not reasonable as of a later date if it fails to reflect subsequent information that may materially affect the value of the corporation, or if the valuation is more than 12 months old. The consistent use of a particular valuation method for other purposes, including purposes unrelated to compensation of service providers, is also a factor supporting the reasonableness of that valuation method. The regulations also provide three safe harbors for determining the value of a non-publicly traded corporation. [28] Use of these methods creates a presumption of reasonableness, which is rebuttable by the IRS only upon a showing that the method was grossly unreasonable. Those safe harbors include: 1. Independent Appraisal if the stock is appraised in a manner that would satisfy the requirements under Code Section 401(a)(28)(C) for employee stock ownership plans ( ESOPs ), and the valuation is no more than 12 months before the relevant date; 2. Nonlapse Restriction Method if the stock value is based on a formula (such as book value or a multiple of earnings) that, if used as part of a nonlapse restriction with respect to the stock, would be considered to be the FMV of the stock under Treas. Reg. Section (regarding incentive stock options), provided that the stock is valued in the same manner for purposes of any nonlapse restriction applicable to the transfer of any shares of such stock, and provided further that any stock acquired pursuant to the exercise of the stock right is subject to such nonlapse restriction; or 3. Start-up Corporation Method if the value of the illiquid stock of a start-up corporation is determined reasonably and in good faith, and is evidenced by a written report that takes into account the relevant factors listed above where the term start-up corporation means a corporation that has no material trade or business that it or any predecessor has conducted for a period of 10 years or more, and neither the service provider nor the service recipient reasonably anticipate a change in control event within 90 days, or a public offering of the stock within 180 days. A different valuation method may be used for each separate action for which a valuation is relevant, provided that a single method is used for each separate action, and the valuation is not retroactively altered. For example, one valuation method may be used to determine the exercise price of a stock option, and another method may be used to determine the value of stock at the time of exercise (or other put or call right). If a non-publicly traded company becomes publicly traded after options are granted, the value at the time of exercise must be determined on the basis of the rules for valuation of publicly traded companies, even though a different method may have been used to determine the exercise price on the date of grant. Generally, the modification, extension, substitution or assumption of a stock right is treated as the grant of a new stock right. However, a change in the terms of a stock right shortening the period during which the stock right is exercisable is not a modification for purposes of this rule. In addition, the extension of the term of a stock right is not treated as an additional deferral feature so long as it is not extended beyond the earlier of (i) 10 years from the original grant date, or (ii) the latest date upon which the stock right could have expired by its original terms. Certain extensions made prior to April 10, 2007, as well as extensions of underwater stock rights (i.e., where the exercise price is less than the FMV of the underlying stock at the time of the extension) are also exempt from this rule.

8 Other Amounts that are Exempt from 409A In addition to the statutory exemptions and the exemptions for short-term deferrals, involuntary separation pay, and fair market value stock rights, the final regulations also provide that the following types of compensation are not subject to Section 409A: 1. Amounts that are not taxable when received, such as retiree health benefits provided through insurance (note that discriminatory benefits paid under a self-funded plan are taxable, and thus subject to Section 409A); [29] 2. Deductible business expenses, such as outplacement services and moving expenses, paid after termination of employment, so long as such expenses are incurred by the end of the second calendar, and are paid by the end of the third calendar year, following termination of employment; [30] 3. Reimbursement for taxable medical expenses incurred during the period that the employee could have elected COBRA coverage under the employer s medical plan (i.e.,18-36 months after termination); [31] 4. Other reimbursements that do not in the aggregate exceed $15,500 (2008 figure, indexed for inflation); [32] 5. Indemnification agreements (i.e., the right to payments to cover an employee s legal expenses arising from claims associated with the employee s duties), to the extent the reimbursement is permissible under applicable law; and [33] 6. Restricted stock. [34] Complying with Section 409A Generally, it is best to avoid Section 409A, if it is possible to do so. Therefore, in structuring compensation arrangements, service recipients should first consider whether there is a plausible design or alternative that is not subject to 409A. For example, when considering stock-based deferred compensation, the service recipient may wish to consider restricted stock or full FMV stock options or SARs (which if properly structured will not be subject to 409A), whereas discounted options, phantom stock or stock rights that do not involve service recipient stock (or that include some additional deferral feature) will be subject to 409A. When designing bonus plans and incentive compensation arrangements, the inclusion of a substantial risk of forfeiture provision may allow the amounts deferred to be exempt under the short-term deferral rule. In drafting employment agreements or severance agreements, employers may wish to take advantage of the involuntary separation pay exception, the safe harbor for good reason terminations, and the exceptions for certain post-termination expense reimbursements and indemnification. In addition, care should be taken not to materially modify grandfathered amounts (i.e., amounts that were deferred and vested as of December 31, 2004). Doing so avoids the possibility that, by failing to comply with Section 409A, either in form or in operation, the amounts deferred will be subject to early taxation, interest and a 20% penalty. If a particular compensation arrangement cannot be structured to be exempt from Section 409A, then it must comply with both the statutory and regulatory requirements. As noted above, there are three primary requirements for deferred compensation arrangements that are subject to Section 409A: (i) limited distribution events, (ii) a prohibition on the acceleration of the time of payment, and (iii) specific rules regarding the timing of deferral elections. There are additional rules, including: 1. a requirement that the arrangement be set forth in writing, and that the arrangement be operated in accordance with that written plan; [35] 2. a six-month delay in payments to specified employees (i.e., those who are considered key employees of publicly-traded corporations); [36] 3. special timing rules for expense reimbursements that are not exempt from 409A [37] ; and 4. special rules for payments based on the timing of payments to the service provider (such as post-separation payments based on the employer s accounts receivable). [38] Permissible Distribution Events

9 One of the most restrictive aspects of Section 409A is that nonqualified deferred compensation arrangements must limit the payment of deferred amounts to one of following six permissible distribution events: 1. separation from service (as defined in the final regulations); 2. a specific date or time (i.e., a date or an age, but not an event); 3. death; 4. disability (as defined in the statute and the regulations); 5. change of control (as defined in the regulations); or 6. unforeseeable emergency (as defined in the regulations). [39] Under the final regulations, an employee separates from service if the employee dies, retires, or otherwise has a termination of employment with the employer. Whether a termination of employment has occurred is based on whether, under the facts and circumstances, the employer and employee reasonably anticipated that no further services would be performed after termination, or that the level of services the employee would perform after termination would permanently decrease to no more than 20% of the average level of services performed over the preceding 36-month period. [40] Relevant facts and circumstances include whether the employee continues to be treated as an employee for other purposes (such as salary continuation and benefits), whether other service providers have been treated similarly, and whether the employee is permitted to perform services for other employers. The employee is presumed to have separated from service where the level of services performed after termination decreases to 20% or less of the pre-termination level, and is presumed not to have separated from service where the level of services after termination is 50% or more of the level prior to the termination. There is no presumption either way for levels of service between 20% and 50%, although a plan may provide that a level of service below some specific percentage (that is greater than 20% but less than 50%) will be treated as a separation from service for purposes of the plan. For purposes of Section 409A, a service recipient is considered disabled if either: 1. the individual is unable to engage in any substantial gainful activity by reason of amedically determinable physical or mental impairment that can be expected to result in death, or can be expected to last for a continuous period of at least 12 months; 2. the individual, by reason of an impairment described above, is receiving benefits for atleast 3 months under the employer s disability plan; or 3. the individual has been determined to be totally disabled by the Social Security Administration. [41] A service recipient may receive payment upon a change of control if there is either: 1. a change in ownership of the service recipient (which generally requires a change in the ownership of 50% of the total market value or total voting power of the stock of the corporation); 2. a change in effective control of the service recipient (which generally requires a change in at least 30% of the total voting power of the stock of the corporation, or a change in the majority of the board members of the corporation, during any 12-month period); or 3. a change in the ownership of a substantial portion of the assets of the service recipient(which generally requires a change in the ownership of at least 40% of the assets of the corporation during a 12-month period). [42] A service recipient may also receive payment upon an unforeseeable emergency, which is defined as either: 1. a severe financial hardship to the service provider resulting from an illness or accident of the service provider, the service provider s spouse, the service provider s beneficiary, or the service provider s dependent (as defined in Code Section 152, but without regard to Section 152(b)(1)); 2. loss of the service provider s property due to casualty; or 3. other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the service provider s control. [43] Examples of unforeseeable emergencies include imminent foreclosure or eviction from the service provider s primary residence, the need to pay for medical expenses or prescription drugs, or the need to pay for the funeral expenses of a spouse, a beneficiary or a dependent. However, the need to purchase a home, or the need for funds for college

10 tuition, are not considered unforeseeable emergencies. In addition, an unforeseeable emergency withdrawal may not be made to the extent that the emergency may be relieved through reimbursement or compensation from insurance, by liquidation of the service provider s assets, (to the extent that the liquidation of such assets would not itself cause severe financial hardship), or by cessation of deferrals under the plan. A plan may provide for payment upon the earlier of or the later of two or more permissible distribution events. It also may provide for payment at an objectively determinable time following a permissible distribution event. Payment will generally be deemed to be timely if payment is made within 30 days prior to the event, or by the later of (i) the last day of the calendar year that includes the date of the event, or (ii) 2 1/2 months following, the date of the event. Deferral Elections The second primary restriction regarding nonqualified deferred compensation arrangements subject to Section 409A is that any election to defer compensation must generally be made prior to the first day of the calendar year in which the amounts to be deferred will be earned. [44] Therefore, if a service recipient wishes to make an elective deferral of compensation that will be earned during the 2009 calendar year, the individual must make such election, in writing, by no later than December 31, There are exceptions to this rule for newly eligible participants (who may make such an election within the first 30 days of eligibility, but only with respect to amounts not yet earned), and for certain performance-based compensation that is payable for performance periods of 12 months or more (for which the election may be made as late as six months prior to the end of the performance period, if certain additional requirements are satisfied). Any election regarding the time and form of payment must generally be made at the time of the election to defer compensation. However, a plan may permit subsequent changes in elections regarding the time and form of payment if: 1. under the plan the election will not take effect for at least 12 months; 2. under the plan the new payment date is at least five years later than the date payment would have been made (or the date payments would have commenced) as originally elected; and 3. the election is made at least 12 months before the date payment was to have been made or the date payments were to have commenced). [45] In addition, during the transition period between the effective date of the statute (January 1, 2005) and the effective date of the final regulations (January 1, 2009), participants may change previous elections regarding the time or form of payment, but only if the new election does not: 1. relate to amounts that would have been payable in the year the election change is made; or 2. result in amounts that would have been payable in a later year being paid in the year the election change is made. [46] Prohibition on Acceleration of Payment Section 409A forbids the early payment of deferred compensation. [47] Thus rule (along with the six-month delay rule for specified employees of publicly-traded corporations) was designed to prohibit key executives from causing the corporation to pay their deferred compensation shortly before a significant economic downturn (or insolvency) of the company. Thus, any early payment will be considered a violation of Section 409A (and will trigger both the interest and the 20% penalty) unless the payment falls under one of the following exceptions: 1. payments to alternate payees pursuant to qualified domestic relations orders; 2. payments to comply with ethics or conflicts of interest laws; 3. payments necessary to pay the tax on amounts that become taxable, under Section 457(f), because they are no longer subject to a substantial risk of forfeiture; 4. payments necessary to pay federal employment taxes (such as FICA taxes);

11 5. payment of amounts that become taxable under Section 409A (because the plan fails to satisfy 409A in form or in operation); 6. payments to cash-out the service recipient s entire interest in the plan, if that amount is less than $15,5000 (2008 figure, indexed for inflation); or 7. payments on account of plan termination, but only if certain additional requirements are satisfied. [48] In generally, a plan subject to 409A may be liquidated (and all amounts distributed to plan participants) on account of termination of the plan only if: 1. the termination is not proximate to a downturn in financial health of the employer; 2. the employer terminates all similar nonqualified deferred compensation plans; 3. no payments are made within 12 months of the termination of the plan; and 4. all payments are made within 24 months of the termination of the plan. [49] Six-Month Delay for Payments to Specified Employees An additional important restriction for deferred compensation arrangements that involve officers or executives of publicly-traded companies is the six-month delay rule. Under this rule, if a payment of deferred compensation is to be made to a specified employee upon separation from service, such payment (or payments) may not be made before the date that is six months after the date of separation from service (or if earlier, upon the death of the specified employee). [50] A specified employee is an employee who, as of the date of separation, is a key employee of a publicly traded corporation. Key employees are determined under the rules for determining the topheavy status of qualified plans under Section 416. Therefore, a key employee generally includes any person who owns more than 5% of the company, and any officer or 1% owner who makes more than $150,000 per year. [51] The final 409A regulations provide that the term specified employee includes any employee who was a key employee at any time during the 12-month period ending on a specified employee identification date. Unless another date is specified, the specified employee identification date is December 31. If an individual was a key employee as of the specified employee identification date, they are treated as a specified employee (for purposes of 409A) for a 12-month period beginning on the specified employee effective date. Unless another date is specified, the specified employee effective date is the first day of the fourth month following the specified employee identification date. Thus, if the identification date is December 31, the default effective date will be April 1, meaning anyone who was a key employee during 2008 would be treated as a specified employee for the period beginning April 1, 2009 through March 31, Special Rules for Reimbursements As noted above, an agreement to reimburse expenses incurred in the future (such as following termination of employment) is generally subject to Section 409A unless one or several exceptions applies (such as the exceptions for non-taxable amounts, medical expenses incurred during the COBRA period, and amounts not exceeding $15,500 in the aggregate). There is also an exception for outplacement expenses and moving expenses if those expenses are both incurred and paid within specific time frames. For all other types of expense reimbursements, in order to comply with Section 409A, the following requirements must be satisfied: 1. the expense must be incurred over an objectively defined period; 2. the service provider cannot carry over unused reimbursement limits from one year to the next; 3. payment must be made by the end of the following calendar year; and 4. the right to reimbursement cannot be subject to liquidation or exchange for another benefit. [52] The final regulations also provide that tax gross-ups and reimbursement of taxes or audit expenses are generally subject to Section 409A, but will be treated as complying with Section 409A if the agreement provides that payment will be made by the end of the taxable year following the year in which the taxes are remitted to the taxing authority (or the audit expense is paid). Written Plan Requirement One of the most urgent aspects of the final regulations is the requirement that a nonqualified deferred compensation plan must comply with Section 409A in both form and operation. [53] Therefore, every plan, agreement, arrangement

12 or practice that is considered deferred compensation under Section 409A must be reduced to writing, and that written plan document must comply with Section 409A, by no later than December 31, The final regulations clarify that the material terms of the plan (such as the amount deferred and the time and form of payment) must be in writing. Plans of publicly traded employees must include the six-month delay rule for payments (on account of separation from service) to specified employees. Amounts that are not being deferred beyond December 31, 2008, and the special transition rules applicable to such amounts, need not be reflected in the written plan, but taxpayers must be able to demonstrate operational compliance with Section 409A during the transition period. Recommended Course of Action Before December 31, 2008, employers and other service recipients should take the following steps to comply with Section 409A: 1. Identify all arrangements, agreements, plans and policies that may constitute deferred compensation, as defined in Section 409A; 2. Determine which arrangements are exempt from Section 409A, or that may be modified to be exempt from 409A; 3. Determine whether any arrangements, or any parts of arrangements, may be grandfathered from Section 409A. 4. Prepare amendments (or documents, if not previously in writing) to either (i) make the arrangement exempt from Section 409A, or (ii) bring the arrangement into compliance with Section 409A; 5. If necessary, obtain approval from the company s board of directors or the compensation committee; 6. If necessary, obtain approval from the affected executive or plan participant; 7. Review and revise employee communications, enrollment forms and election forms to comply with Section 409A, and to take advantage of all options afforded under Section 409A; 8. Allow employees/participants to make new time/form of payment elections before 2009,as applicable. Summary We are entering a whole new world with respect to the tax treatment of nonqualified deferred compensation arrangements. The scope of Section 409A is very broad, and is not limited to abusive or complex arrangements. The consequences are severe, and can affect both the service provider and the service recipient. Therefore, it is imperative that clients, with the help of their attorneys, make every effort to identify deferred compensation arrangements, and to bring them into compliance with these new requirements, by the end of 2008.