Navigating the Proposed 409A Regulations-General Rules By Mary K. Samsa, Joyce L. Meyer, and Barbara A. Cronin

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1 Client Memorandum HR Law: Employee Benefits October 2005 Navigating the Proposed 409A Regulations-General Rules By Mary K. Samsa, Joyce L. Meyer, and Barbara A. Cronin On September 29, 2005, the Department of Treasury released proposed regulations pertaining to Code Section 409A. In general, the proposed regulations incorporate the guidance provided in IRS Notice and provide substantial additional guidance. The proposed regulations are voluminous (reaching 238 pages) and provide a number of clarifications regarding the application of Code Section 409A. The majority of the proposed regulations, as well as this alert, outline how the following terms are to be defined: Which plans are nonqualified deferred compensation plans Who is a service recipient Who is a service provider What constitutes a deferral of compensation and when discretion lack substantive significance Which severance arrangements are not a deferral of compensation When is an arrangement considered established for purposes of Code Section 409A When has an employee had a separation from service When has an independent contractor had a separation from service When and how is specified employee or key employee determined When does a substantial risk of forfeiture not exist when the service provider has control Additionally, the proposed regulations as well as this alert provide detailed explanations pertaining to: Initial deferral elections (when they become irrevocable, application of the fiscal year rule, application to nonelective arrangements as well as clarification of election rules where the nonqualified plan is tied to a qualified plan) Timing of deferral elections on Performance-Based Compensation (objective and subjective criteria) Numerous examples of the application of the subsequent change to time and form of distribution rule (12 month/5 year rule and its application to changes in form of payout as well as timing) Permissible payment events (including when plan terminations are permissible) Additional events where acceleration of payment is permissible (such as payment required due to failure to meet Code Section 409A, payment to prevent the occurrence of a nonallocation year under Code Section 409(p)) Transition Relief (including linked nonqualified and qualified plans, Code Section 409A amendments to plans due date and payment election revision extension) Each of these issues is covered in the following summary. However, please note that the proposed regulations do not cover three major subjects: (1) the Code Section 409A funding rules, (2) the computation of the income inclusion, interest and 20% penalty under Code Section 409A(a)(1), and (3) the reporting and withholding requirements. It has been informally stated that the IRS is working on regulations covering these three topics. The purpose of this alert is to highlight for employers what the proposed regulations clarified and their impact. We hope the attached assists our clients and friends in identifying the key areas of their nonqualified deferred compensation plans that will be affected by the proposed regulations once finalized. Note that until the regulations are finalized, they do not have the full force and effect of law. 1

2 Definition of nonqualified deferred compensation plan Code Section 409A does apply to any plan that provides for the deferral of compensation, including: Code Section 451 plans (including deferral arrangements contained in individual employment agreements); Code Section 457(f) arrangements for tax-exempt and governmental entities (including deferral arrangements contained in individual employment agreements); Stock Options in which the exercise price was less than fair market value ( FMV ) on the date of grant; Stock Appreciation Rights (SARs) in which the exercise price was less than FMV on the date of grant; Phantom Stock Plans to the extent they provide a deferral of compensation; Restricted Stock Units to the extent they provide a deferral of compensation; Supplemental Executive Retirement Plans (SERPs) (whether defined benefit or defined contribution types) that restore amounts to participants to which they are otherwise limited under tax-qualified retirement plans by application of IRS statutory limits (potentially including those that are nonelective); and Any other arrangement that includes a deferral of income feature. A nonqualified deferred compensation plan under Code Section 457(f) may constitute a nonqualified deferred compensation plan for Code Section 409A purposes. The rules of Code Section 409A apply to nonqualified deferred compensation plans separately and in addition to any requirements applicable to such plans under Code Section 457(f). Code Section 409A may apply to nonelective deferred compensation of nonemployees under Code Section 457(e)(12) and grandfathered arrangements under Regulation Section (k)(4). Code Section 457(f) plans, to the extent they have not done so already, must incorporate the applicable Code Section 409A requirements. 2

3 CONTINUED: Definition of nonqualified deferred compensation plan Code Section 409A does not apply to: tax-qualified plans (as described in Code Sections 401(a) (with a Section 501(a) trust), 403(a), 403(b), 408(k) or 408(p)); a bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan; any eligible Code Section 457(b) arrangement; Code Section 415(m) excess benefit arrangements for governmental entities; Code Section 220 Archer Medical Savings Accounts, Code Section 223 Health Savings Accounts or any other medical reimbursement arrangements (including those under Code Section 105 and 106); Code Section 423 plans; Incentive stock options subject to Code Section 422; or Nonqualified stock options with an exercise price of at least FMV on the date of grant. Application of Code Section 409A is not limited to arrangements between an employer and an employee. Code Section 409A also applies to arrangements between a service recipient and an independent contractor and arrangements between a partner and partnership. Code Section 409A does not apply to: any arrangement under which an active participant makes deductible contributions to a Code Section 501(c)(18) trust; a length of service award to a bona fide volunteer under Code Section 457(e)(11)(A)(ii); any arrangement maintained with respect to an individual, where contributions made by or on behalf of such individual to the arrangement are excludable by such individual for Federal income tax purposes pursuant to any bilateral income tax convention to which the U.S. is a party (i.e., a foreign plan); with respect to a nonresident alien or a resident alien classified as a resident alien solely under Code Section 7701(b)(1)(A)(ii), foreign retirement plans maintained by a person who is not a U.S. person that satisfy certain requirements (e.g., written, nondiscriminatory, etc.); with respect to a U.S. citizen or resident alien classified as a resident alien under Code Section 7701(b)(1)(A)(i) who is not eligible to participate in a U.S. tax-qualified retirement plan (as described in Code Sections 401(a) (with a Section 501(a) trust), 403(a), 403(b), 408(k) or 408(p)), broad-based foreign retirement plans that meet certain requirements and limitations (e.g., maintained by a service recipient that is not a U.S. person, amounts deferred do not exceed the applicable limits of Code Section 415(b) and (c), etc.); any social security system of a jurisdiction where the benefits provided under such system are subject to a totalization agreement under Section 233 of the Social Security Act with such jurisdiction or any foreign government mandated social security plan; and any foreign plan maintained by a service recipient that is not a U.S. person for a taxable year, to the extent that the amounts deferred under the foreign plan based upon the nonresident alien s services performed in the U.S. do not exceed us$10,000 for the taxable year. Review all foreign plans to identify any exclusions from Code Section 409A or modify the relevant plan to incorporate Code Section 409A requirements, if applicable. Review disability pay plans and death benefits plans to ensure that the total benefits payable under the plans for death or disability, respectively, will exceed the lifetime benefit payable under the respective plan for exclusion from coverage under Code Section 409A. Accordingly, any benefits that a nonqualified deferred compensation plan provides in the event of death or disability that is associated with an amount deferred are disregarded in determining any excess benefits. Definition of service recipient The service recipient is: the person for whom services are performed; and all persons with whom such person would be considered a single employer under Code Section 414(b) (controlled group of corporations) or Code Section 414(c) (partnerships, proprietorships, etc., which are under common control). Code Section 409A applies to a plan that provides for the deferral of compensation, even though the payment of the compensation is not made by the person for whom services are performed. The term service recipient does not include any corporation whose primary purpose is to serve as an investment vehicle with respect to the corporation s interest in entities other than the service recipient. Controlled group rules apply in determining who is the service recipient. 3

4 Definition of a service provider A service provider for purposes of Code Section 409A includes: an individual; a personal service corporation (as defined in Code Section 269A(b)(1)); a noncorporate entity that would be a personal service corporation if it were a corporation; a qualified personal service corporation (as defined in Code Section 448(d)(2)); or a noncorporate entity that would be a qualified personal service corporation if it were a corporation. In addition, a service provider for purposes of Code Section 409A includes: a corporation; a subchapter S corporation; or a partnership. The Proposed 409A Regulations definitively expand the definition of a service provider, which will need to be taken into account for specific arrangements. Code Section 409A does not apply to arrangements between taxpayers in which all of the taxpayers use the accrual method of accounting. Independent Contractor Exception: Code Section 409A does not apply to arrangements between a service provider and a service recipient if: the service provider is actively engaged in the trade or business of providing services, other than as an employee or as a director of a corporation; and the service provider provides significant services to two or more service recipients to which the service provider is not related and who are not related to one another. Definition of Significant Services: Whether a service provider is providing significant services is dependent on the facts and circumstances. However, a service provider that provides services to two or more service recipients to which the service provider is not related and that are not related to one another is deemed to be providing significant service to two or more of such service recipients for a given taxable year if the revenues generated from the services provided to any service recipient or group of related service recipients during such taxable year do not exceed 70% of the total revenues generated by the service provider from the trade or business of providing such services. Definition of Management Services: A service provider is treated as related to a service recipient if the service provider provides management services (as defined in the proposed regulations) to the service recipient. 4

5 Definition of a deferral of compensation A plan provides for the deferral of compensation only if under the terms of the plan and based on the facts and circumstances: the service provider has a legally binding right during a taxable year to the compensation; the compensation has not been actually or constructively received and included in gross income; and under the terms of the plan, the compensation will be payable to the service provider in a later year. The term deferral of compensation includes any reference to income (whether actual or notional) attributable to such compensation or such income. Property received by a service provider from a plan maintained by a service recipient does not constitute a deferral of compensation merely because such property: is not includable in income (under Code Section 83) in the year of receipt by reason of the property being substantially unvested; or is includable in income solely due to a valid Code Section 83(b) election. A plan under which a service provider obtains a legally binding right to receive property (regardless of whether the property will be substantially nonvested) in a future year may provide for the deferral of compensation and, accordingly, may constitute a nonqualified deferred compensation plan. When the right to earnings is specified under the terms of the arrangement, the legally binding right to earnings arises at the time of the deferral of the compensation to which the earnings relate. A plan may provide that the right to earnings is treated separately from the right to the underlying compensation (e.g., paid at a separate time or in a separate form). A transfer of property includes the transfer of a beneficial interest in a trust or annuity plan, or a transfer to or from a trust or under an annuity plan, to the extent such a transfer is subject to Code Section 83, Code Section 402(b) or Code Section 403(c). The vesting of substantially nonvested property subject to Code Section 83 may be treated as a payment for purposes of Code Section 409A, including for purposes of applying the Short-Term Deferral Exception (see next row of the chart immediately below). Where the promise to transfer the substantially nonvested property and the right to retain the substantially nonvested property are both subject to a substantial risk of forfeiture, the arrangement generally would constitute a Short-Term Deferral Exception because the payment would occur simultaneously with the vesting of the right to the property. This provision creates drafting flexibility but providing separate rights for earnings versus the underlying compensation would significantly increase the administration of the nonqualified deferred compensation plan. Providing an employee with the choice of two benefit alternatives (e.g., cash or restricted stock) where both alternatives are subject to a cliff vesting schedule that acts as the substantial risk of forfeiture, since payment would coincide with satisfaction of the vesting schedule, the arrangement would qualify under the Short-Term Deferral Exception. 5

6 CONTINUE: Definition of a deferral of compensation There is no deferral of compensation when: the compensation may be unilaterally reduced or eliminated by the service recipient or other person after the services creating the right to the compensation have been performed; the compensation is merely paid after the last day of the service provider s taxable year, pursuant to the timing arrangements under which the service recipient normally compensates service providers for services performed during a payroll period (e.g., year-end bonus) (referred to as Customary Payroll Practices ); and absent an election to otherwise defer the payment to a later period, at all times, the terms of the plan require payment by, and an amount is actually or constructively received by the service provider by, the later of: v the date that is 2½ months from the end of the service provider s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture; or v the date that is 2½ months from the end of the service recipient s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture (referred to as the Short-Term Deferral Exception ). A person will be considered to have a legally binding right to compensation: if the facts and circumstances indicate that the discretion to reduce or eliminate the compensation is available or exercisable only upon a condition or if the discretion lacks substantive significance. v Whether negative discretion exists depends on the facts v and circumstances of the arrangement; and No substantive significance will be found if the person who can exercise the discretion to reduce or eliminate compensation is controlled by the service provider, or the service provider has control over such person s compensation, or is a family member of the service provider; if the compensation may be unilaterally reduced or eliminated by operation of an objective term of the plan; or even if the amount of compensation is determined under a formula that provides for benefits to be offset by benefits provided under a plan that is qualified under Code Section 401(a) or investment losses, or in a final average pay plan, by subsequent decreases in compensation. Foreign arrangements [reserved]. A payment that otherwise qualifies as a Short-Term Deferral Exception but is paid after 2½ months following the end of the relevant taxable year may continue to qualify as a short-term deferral if the taxpayer establishes that it was administratively impracticable to make the payment by the end of the applicable 2½ month period or that making the payment by the end of the applicable 2½ month period would have jeopardized the solvency of the service recipient. Such impracticability or insolvency must have been unforeseeable as of the date upon which the legally binding right to the compensation arose; and The payment must instead be made as soon as reasonably practicable. Certain tax equalization and other foreign arrangements may not provide for a deferral of compensation if the requirements of the Proposed 409A Regulations are satisfied. If it is foreseeable(as of the date upon which the legally binding right the compensation arises) that the amount will not be paid within the applicable 2½ month period, then such payment will not qualify as a Short-Term Deferral Exception. The Proposed 409A Regulations provide a large exclusion for commonly used arrangements in short-term expatriate situations. 6

7 CONTINUE: Definition of a deferral of compensation - Severance Arrangements Which severance arrangements (or separation pay) are a deferral of compensation? [reserved] Severance plans are exempted from application of Code Section 409A for calendar year 2005, but such plans must be amended to be in compliance with Code Section 409A by December 31, The IRS will issue additional guidance governing severance arrangements covered by Code Section 409A. A plan that provides severance pay benefits and is either collectively bargained or covers no service providers who are key employees (as defined in Code Section 416(i)) will not be required to comply with Code Section 409A for calendar year 2005 with respect to such severance benefits. An arrangement is not removed from the definition of deferral of compensation merely because the right to payment of the compensation is conditioned upon separation from service. Any payment, benefit or entitlement to a payment or benefit, that acts as a substitute for, or replacement of, amounts deferred by the service recipient under a separate nonqualified deferred compensation plan constitutes a payment or a deferral of compensation under the separate nonqualified deferred compensation plan, and does not constitute a payment or deferral of compensation under a separation pay arrangement. A separation pay arrangement does not provide for a deferral of compensation if the arrangement: is a collectively bargained separation pay arrangement (i.e., a separation pay agreement that is contained within an agreement determined by the Secretary of Labor to be collectively bargained, that was the subject of arm s length negotiations between employee representatives and employer(s), and is evidenced by good faith bargaining between adverse parties) that provides for separation pay upon an actual involuntary separation from service or pursuant to a window program; is a plan that provides that separation pay may not exceed two times the lesser of: v the sum of the service provider s annual compensation for services provided to the service recipient as an employee and the service provider s net earnings from selfemployment for services provided to the service recipient as an independent contractor (each for the calendar year preceding the calendar year in which the service provider has a separation from service from such service recipient); or v the Code Section 401(a)(17) limit and the separation pay must be paid no later than December 31 of the second calendar year following the calendar year in which occurs the separation from service; and provides for certain expense reimbursements, in-kind benefit and other payments that do not exceed $5,000 in the aggregate. A program that has a pattern of repeatedly providing for similar separation pay in similar situations for substantially consecutive, limited periods of time will constitute a deferral of compensation. Factors to consider when determining whether the program has a pattern are the following: v whether the benefits are on account of a specific business event or condition; v the degree to which separation pay relates to the event or condition; and v whether the event or condition is temporary or discrete or a permanent aspect of the employer s business. Separation pay includes any amount of compensation where one of the conditions to the right to the payment is a separation from service, whether voluntary or involuntary, including payments if the form of reimbursement of expenses incurred and other taxable benefits due, regardless of whether payment is conditioned upon the execution of a release of claims, noncompetition or nondisclosure provisions, or other similar requirements. Any amount that acts as a substitute for, or replacement of, amounts deferred by the service recipient under a separate nonqualified deferred compensation plan constitutes a payment of compensation or deferral of compensation under the separate nonqualified deferred compensation plan, and does not constitute separation pay. Separation pay that does not provide for the deferral of compensation is not subject to the six (6) month delay for key employees of public companies. 7

8 Definition of a plan - Application of aggregation rules A plan includes any agreement, method or arrangement, including an agreement, method or arrangement that applies to only one person or individual. A plan may be adopted unilaterally by the service recipient (such as a defined benefit SERP) or may be negotiated among or agreed to by the service recipient and one or more service providers (such as a Code Section 451 deferred compensation plan). Whether or not the plan is governed by ERISA is irrelevant for Code Section 409A purposes. Code Section 409A is applied as if: a separate plan or plans is/are maintained for each service provider; all amounts deferred with respect to a particular service provider under an account balance plan (as defined in Code Regulation Section (v)(2)-1(c)(1)(ii)(A)), other than a separation pay arrangement, is treated as deferred under a single plan; v Account Balance Plan: Refers to a plan in which the amounts deferred for a period equal the principal amount credited to the employee s account for the period, increased or decreased by any income attributable to the principal amount through the date such amounts constitute wages. all amounts deferred with respect to a particular service provider under a nonaccount balance plan (as defined in Code Regulation Section (v)(2)-1(c)(2)(i)), other than a separation pay arrangement, is treated as deferred under a separate single plan; v Nonaccount Balance Plan: Refers to a plan in which the amounts deferred for a period equal the present value of the additional future payment or payments to which the employee has obtained a legally binding right under the plan during that period (such as a defined benefit SERP); and all amounts deferred with respect to a particular service provider under a plan, which is neither an account balance plan nor nonaccount balance plan is treated as deferred under a separate single plan; v Other: Refers to a plan in which the amounts deferred for a period relate to items such as discounted stock options, SARs or other equitybased compensation. An arrangement may constitute a plan regardless of whether it is an employee benefit plan under Section 3(3) of ERISA. Code Section 409A is applied: as if all amounts deferred with respect to a particular service provider under all separation pay arrangements (which is either an account balance plan or a nonaccount balance plan depending on how the benefits are calculated) of the service recipient due to an involuntary termination or participation in a window program are treated as deferred under a separate single plan; and so as not to aggregate arrangements in which a service provider participates to the extent the service provider participates in one set of arrangements due to status as an employee of the service recipient and another set of arrangements due to status as an independent contractor of the service recipient. All individual employment and similar agreements will need to be reviewed. If they are not grandfathered and do not comply under a good faith interpretation of the Proposed 409A Regulations or Notice , renegotiation of such agreements may be necessary. Aggregation rules are important for applying penalty provisions of Code Section 409A. Any penalty would apply to the aggregate value of all similar types of plans. 8

9 Definition of a plan - Establishment of an arrangement Not previously addressed in guidance. An arrangement must be established and maintained by a service recipient, in both form and operation, in accordance with the requirements of Section 409A and the proposed regulations. An arrangement (including an amendment to an arrangement that increases the amount deferred under the arrangement) is established on the latest of the following: the date on which it is adopted; the date on which it is effective; and the date on which the material terms of the plan are set forth in writing. Notwithstanding the above, an arrangement will be deemed to be established as of the date the participant obtains a legally binding right to the deferred compensation, provided that the arrangement is otherwise established under the Code Section 409A rules by the end of the calendar year in which the legally binding right arises (or with respect to an amount not payable in the year immediately following the year in which the legally binding right arises, the 15 th of the third month of the subsequent year). An arrangement will be deemed to be set forth in writing if it is set forth in any other form that is approved by the Commissioner of the Internal Revenue. The material terms of an arrangement include: the amount (or the method or formula for determining the amount) of deferred compensation to be provided; and the time when it will be paid. Transition Relief: An unwritten arrangement that was adopted and effective before December 31, 2006, is treated as established as of the later of: the date on which it was adopted, or the date on which it became effective, provided that the material terms of the arrangement are set forth in writing on or before December 31,

10 Definition of an employee separation from service Not previously addressed in guidance. An employee separates from service with the service recipient if the employee: dies; retires; or otherwise has a termination of employment with the employer. The employment relationship is treated as continuing intact while the individual is on: military leave; sick leave; or other bona fide leave of absence (such as temporary employment by the government) if the period of such leave does not exceed 6 months (or if longer, so long as the individual s right of reemployment with the service recipient is provided either by statute or by contract). v If the period of leave exceeds 6 months and the individual s right of reemployment with the service recipient is not provided either by statute or by contract, the employment relationship is deemed to terminate on the first date immediately following such 6-month period. Whether a termination of employment has occurred is determined based on all facts and circumstances. There is no termination of employment if the employee continues to provide services as an employee at an annual rate that is at least equal to 20% of the services rendered, on average, during the immediately three full calendar years of employment (or if less than three full years, such lesser period) and the annual remuneration for such services is at least equal to 20% of the average annual remuneration for that same time period. There is no termination of employment if the employee continues to provide services instead as an independent contractor where services are provided at an annual rate that is at least equal to 50% of the services rendered as an employee, on average, during the immediately three full calendar years of employment (or if less than three full years, such lesser period) and the annual remuneration for such services is at least equal to 50% of the average annual remuneration for that same time period. The Department of Treasury is clearly concerned about the separation from service distribution trigger being used to circumvent the Code Section 409A rules. Where an employee actually or purported continues in the capacity as an employee, such as through the execution of an employment agreement under which the employee agrees to be available to perform service if requested, by the facts and circumstances indicate that the employer and the employee did not intend for the employee to provide more than insignificant service for the employer, an employee will be treated as having a separation from service. 10

11 Definition of an independent contractor separation from service Not previously addressed in guidance. An independent contractor is considered to have a separation from service with the service recipient upon the expiration of all contracts under which services are performed for the service recipient if the expiration constitutes a good-faith and complete termination of the contractual relationship. An expiration does not constitute a good faith and complete termination of the contractual relationship if the service recipient anticipates a renewal of a contractual relationship or the independent contractor becoming an employee. A plan will be deemed to satisfy the requirement that no amounts deferred under the plan be paid or made available to the participant before the participant has a separation from service with the service recipient if, with respect to amounts payable to a participant who is an independent contractor, a plan provides that: no amount will be paid to the participant before a date at least 12 months after the day on which the contract expires under which services are performed for the service recipient (or, in the case of more than one contract, all such contracts expire); or no amount payable to the participant on that date will be paid to the participant if, after the expiration of the contract (or contracts) and before that date, the participant performs services for the service recipient as an independent contractor or an employee. Service recipient will be considered to have anticipated the renewal of the contractual relationship with an independent contractor if they intended to contract again for the services provided under the expired contract, and neither the service recipient nor the independent contractor has eliminated the independent contractor as a possible provider of services under any such new contract. A service recipient is considered to intend to contract again for the services provided under an expired contract if the service recipient s doing so is conditioned only upon incurring a need for the services, availability of funds, or both. 11

12 Definition of a specified employee or key employee Not previously addressed in guidance. Generally, a specified employee means a key employee (as defined in Code Section 416(i) subject to certain parameters in the regulations) of a service recipient any stock of whose is publicly traded on an established securities marked or otherwise. If a person is a key employee as of an identification date, the person is treated as a specified employee for the 12-month period beginning on the first day of the fourth month following the identification date. A service recipient may designate any date in a calendar year as the identification date provided that a service recipient must use the same identification date with respect to all arrangements, and any change to the identification date may not be effective for a period of 12 months. v If no date is identified, the identification date is December 31. v The service recipient may designate an identification date through inclusion in each plan document or through a separate document, provided that the service recipient will not be treated as having designated an identification date on any date before the execution of the document containing such designation. Special rules apply under the proposed regulations where a new corporation or entity is established as part of a corporate division governed by Code Section 355 from a corporation that is publicly traded on an established securities market or otherwise. Where two corporations are merged or become part of the same controlled group so as to be treated as a single service recipient, any employee of the merged corporation who was a key employee of either the pre-merger corporations immediately prior to the merger is a key employee of the merged corporation until the first day of the fourth month after the identification date of the merged corporation next following the merger. Whether any stock of a service recipient is publicly traded on an established securities market or otherwise must be determined as of the date of the employee s separation from service. Transition Relief: Any designation of an identification date made on or before December 31, 2006 may be applied to any separation for service occurring on or after January 1, For purposes of determining key employees, a service recipient generally must include all employees, including employees who are nonresident aliens. 12

13 Definition of a substantial risk of forfeiture Compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services by any person or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. A condition related to a purpose of the compensation must relate to the service provider s performance for the service recipient or the service recipient s business activities or organizational goals (e.g., the attainment of a prescribed level of earnings, equity value or a liquidity event). Any addition of a substantial risk of forfeiture after the legally binding right to the compensation arises, or extension of a period during which compensation is subject to a substantial risk of forfeiture, in either case whether elected by the service provider, the service recipient or other person, is disregarded for purposes of determining whether such compensation is subject to a substantial risk of forfeiture. In determining whether the possibility of forfeiture is substantial in the case of rights to compensation granted to a service recipient to a service provider that owns a significant amount of the total combined voting power or value of all classes of stock of the service recipient corporation or of its parent, all relevant facts and circumstances will be taken into account in determining whether the probability of the service recipient enforcing such condition is substantial, including: the service provider s relationship to the other equity holders and the extent of their control, potential control and possible loss of control of the service recipient; the position of the service provider in the service recipient and the extent to which the service provider is subordinate to other service providers; the service provider s relationship to the officer and directors of the service recipient (or similar positions with respect to the noncorporate service recipient); the person(s) who must approve the service provider s discharge; and past actions of the service recipient in enforcing the restrictions. The Department of Treasury is clearly concerned about an attempt to create a substantial risk of forfeiture for purposes of avoiding Code Section 409A application where the service provider has a substantial degree of control over whether the requisite conditions can be satisfied and hence payment made. An amount is not subject to a substantial risk of forfeiture merely because the right to the amount is conditioned, directly or indirectly, upon the refraining from performance of services. Conditioning forfeiture on whether a person refrains from performance of services relates to the use of a noncompete concept. An amount will not be considered subject to a substantial risk of forfeiture beyond the date or time at which the recipient otherwise could have elected to receive the amount of compensation, unless the amount subject to a substantial risk of forfeiture (ignoring earnings) is materially greater than the amount the recipient otherwise could have elected to receive. Salary deferrals, generally, may not be made subject to a substantial risk of forfeiture. 13

14 Initial Deferral Elections An initial deferral election must be made during the preceding taxable year prior to the services being performed. If a participant first becomes eligible during the plan year, he or she continues to have 30 days to elect to defer. The taxable year referred to is the service provider s taxable year. Deferral elections for new participants can only apply to amounts earned after the date of the election. This may require proration of bonus deferrals. Elections must be irrevocable for the entire taxable year. An election is considered made as of the day the election become irrevocable. Therefore, a participant can revise a deferral election up to the last day that such an election can be made. Evergreen deferral elections are permissible subject to the above rule. A plan may provide that a deferral election terminates if an employee obtains a payment upon an unforeseeable emergency. With respect to a legally binding right to a payment in a subsequent year that is subject to a forfeiture condition requiring the service provider s continued services for a period of at least 12 months from the date the service provider obtains the legally binding right, an election to defer such compensation may be made on or before the 30 th day after the service provider obtains the legally binding right to the compensation, provided that the election is made at least 12 months in advance of the earliest date at which the forfeiture condition could lapse. Initial deferral elections must specify the time and form of the distribution unless specified by the plan. Multiple payout events are permissible. Plan may allow for election of a different form of payment upon different distribution events (e.g., lump sum on death but installment upon disability). Fiscal Year Rule: Initial election to defer fiscal year compensation must be made on or before the end of the fiscal year immediately preceding the fiscal year in which any services are performed for which the compensation is paid. Fiscal year compensation means compensation relating to a period of service coextensive with one or more consecutive fiscal years of the service recipient, of which no amount is paid or payable during the service period. Where compensation is not specifically based upon the employer s fiscal year as the measurement period, the timing requirements default to the general rule for non-fiscal year companies. For example, bonuses paid after review of fiscal year performance is fiscal year compensation. Base salary reported on a calendar year basis is not fiscal year compensation. For nonelective arrangements (such as defined benefit SERPs) where the participant has no election (i.e., no choice) under any provision of the plan (e.g., the amount, time or form of payment), then no deferral election is required. To use the above rule, the plan must set the time and form of payment no later than the time the service provider obtains a legally binding right to the compensation. 14

15 CONTINUE: Initial Deferral Elections Where under the terms of a nonqualified deferred compensation plan the amount deferred is an amount determined based upon a formula under a tax-qualified retirement plan applied without regard to Code limitations or other applicable law (e.g, Code Section 401(a)(17)), or is determined as an amount offset by some or all of the benefits provided under the qualified plan, the operation of the qualified plan with respect to changes in benefit limitations applicable to qualified plans under the Code or other applicable law does not constitute a deferral election even if such operation results in an increase of amounts deferred under the nonqualified arrangement, provided that such operation does not otherwise change the time or form of payment under the nonqualified arrangement. The following actions or failure to act will not constitute a deferral election under the nonqualified arrangement (even if the amount deferred increases but assuming no change to the time or form of payment): v service provider s action or inaction with respect to electing to receive a subsidized benefit or an ancillary benefit under the qualified plan; v the amendment of a qualified plan to add or remove a subsidized benefit or an ancillary benefit, or to freeze or limit future accruals of benefits under the qualified plan; v service provider s action or inaction under a qualified plan subject to Code Section 402(g), including an adjustment to a deferral election under the qualified plan subject to Code Section 402(g), provided that such adjustment would not in essence cause a violation of Code Section 402(g); and v service provider s action or inaction under a qualified plan with respect to elective deferrals or after-tax contributions by the service provider to the qualified plan that affects the amounts that are credited under the nonqualified arrangement as matching amount or other amounts contingent on service provider elective deferrals or after-tax contributions. For separation pay due to an actual involuntary separation from service, where such separation pay is the subject of bona fide, arm s length negotiations, the initial deferral election may be made at any time up to the time the service provider obtains a legally binding right to the payment. For commission compensation, a service provider earning such compensation is treated as providing services to which such compensation relates only in the year in which the customer remits payment to the service recipient. Compensation payable after the last day of the service provider s taxable year solely for services performed during the final payroll period containing the last day of the service provider s taxable year, where such amount is payable pursuant to the timing arrangement under which the service recipient normally compensates service providers during a payroll period shall be treated as compensation for services performed in the subsequent taxable year. It appears that 401(k) spillover plans will continue to have viability. If the separation pay arrangement is subject to Code Section 409A, it appears that it may be difficult to renegotiate timing of payments during the termination process, where the original agreement contained alternative payment triggers, such as Good Reason. This provides a payroll period exception for paychecks that partially straddle a year-end. As such, the full amount of the paycheck will be considered to relate to the taxable year in which the paycheck is received. 15

16 CONTINUE: Initial Deferral Elections - Deferral Elections for Performance- Based Compensation Performance-based compensation refers to compensation where: the amount of, or entitlement to, the compensation is contingent on the satisfaction of preestablished organizational or individual performance criteria; and the performance criteria are not substantially certain to be met at the time a deferral election is submitted. Deferral elections relating to performance-based compensation (which is based on services performed over a period of at least 12 months) must be made no later than 6 months preceding the end of the performance period. For performance criteria to be considered preestablished, they must be: related to a performance period of at least 12 consecutive months where the employee performs service; and established in writing no later than 90 days after the commencement of the relevant performance period. Performance-based compensation may include payment based on performance criteria that are not approved by a compensation committee of the board of directors or by the stockholders or members of the service recipient. Generally, it does not appear that individuals who begin participation on other than the first day of the Plan Year can rely on the six (6) month deferral rule for Performance-Based Compensation, but will need to use the thirty (30) day rule. As long as certain specified criteria are met, bonus compensation may include payments based upon subjective performance. Performance criteria can be subjective criteria provided that: the subjective performance criteria relates to the performance of the participant employee, a group of employees that includes participant employee, or a business unit for which the participant employee works; and the determination as to whether subjective performance criteria has been met is not made by the participant employee or a family member of the participant employee, or a person under the supervision of the participant employee or such family member. Compensation is performance-based compensation if it is based solely on an increase in the value of the service recipient, or stock of the service recipient, after the date of a grant or award. If the amount of compensation to be received under a grant or award is not based solely on an increase in the value of the service recipient, or stock of the service recipient, after the date of a grant or award (e.g., a SAR with exercise price less than FMV on the date of grant), and that other amount would not otherwise qualify as performance-based compensation (i.e., the spread would not constitute performance-based compensation), then the compensation attributable to the grant or award is not performance-based compensation. An award of equity-based compensation may constitute performance-based compensation if entitlement to the compensation is subject to a condition that would cause the award to otherwise qualify as performance-based compensation, such as performance-based vesting. 16

17 Subsequent Changes to Time and Form of Payments For a plan that permits a subsequent election to delay a payment or to change the form of payment of an amount of deferred compensation, the following conditions must be met: such subsequent election may not take effect until at least 12 months after the date on which the election is made; such payment with respect to the subsequent election is deferred for a period of not less than 5 years from the date such payment would otherwise have been paid; and such subsequent election may not be made less than 12 months prior to the date payment is schedules to be paid. The Proposed 409A Regulations clarify that in the case of a life annuity or installment payments treated as a single payment: it is five (5) years from the date the first amount was scheduled to be paid; and it is 12 months prior to the date the first amount was scheduled to be paid. The term payment refers to each separately identified amount to which a service provider is entitled to payment under a plan on a determinable date, and include amounts applied for the benefit of a service provider. An amount is separately identified only if the amount may be objectively determined. A life annuity (i.e., a series of substantially equal periodic payments, payable not less frequently than annually, for the life of the service provider) is treated as a single payment. v A change in the form of payment from one type of life annuity to another (e.g., a 50% qualified joint & survivor annuity to a 75% qualified joint & survivor annuity) before any annuity payment has been made is not considered a change in the time and form of a payment so long as the annuities are actuarially equivalent applying reasonable assumptions. The entitlement to a series of installment payments that is not a life annuity is treated as the entitlement to a single payment, unless the arrangement provides, at all times, with respect to the amount deferred that the right to the series of installment payments is to be treated as a right to a series of separate payments. With respect to a plan that permits a payment upon each of a number of potential permissible payment event (such as the earlier of a fixed date or separation from service), the 12-month/5-year rule is applied separately to each payment due upon each payment event. Addition of a permissible payment event is still subject to the general rule regarding changes to time or form of payment. Even though a change in the form of a payment that results in a more rapid schedule for payments generally may not constitute an acceleration of a payment, the change in the form of payment must comply with the subsequent deferral rules. EXAMPLE: A participant can change the form of payment from a 10-year installment to a lump sum as long as: v the change to a lump sum will not v be effective for 12 months; and the lump-sum payment cannot be made until at least 5 years after the date the 10-year installment was scheduled to commence. Transition Relief: An arrangement adopted and effective before December 31, 2006, whether written or unwritten, that fails to make a designation as to whether the entitlement to a series of payments is to be treated as an entitlement to a series of separate payments, is treated as having made such designation as of the later of the date on which the arrangement was adopted or became effective, provided that such designation is set forth in writing before December 31, Addition of a permissible payment event could still trigger an impermissible acceleration under Code Section 409A. 17