Statement of Mark D. Wincek Kilpatrick Stockton LLP at the Hearing on the Section 409A Proposed Regulations January 25, 2006

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1 Suite th St., NW Washington DC t f MWincek@KilpatrickStockton.com Statement of Mark D. Wincek Kilpatrick Stockton LLP at the Hearing on the Section 409A Proposed Regulations January 25, 2006 I must begin by expressing my profound respect for the caliber of work that went into producing the proposed regulations. The regulations reflect a pattern of working to resolve problems (rather than to create them) and of not picking unnecessary fights. To all who were involved my compliments on the quality of the work, and my sympathy for the quantity. At the same time, given the enormous range of compensation structures that are affected by Section 409A, and the complexity that results, it will not be a surprise that I come before you today with suggestions. I appear on behalf of my law firm, Kilpatrick Stockton LLP, and the many large and many emerging companies that we represent with respect to Section 409A issues. I will review several broader suggestions, and mention a few of the more detailed items that are listed and briefly summarized at the end of my statement. Good Faith Compliance The good faith compliance period for Section 409A currently is scheduled to terminate at the end of this year. Informal comments by government personnel have suggested that a reasonable, good faith position taken in 2005 and 2006 will immediately cease being protected on January 1, This suggests a regime where basic interpretations related to a plan sponsor s 409A compliance strategy would require quite rapid revision once final regulations are issued later this year. For example, it appears there will be a period of no more than six months to address problems that arise from finalizing the current proposed regulations. Further, it appears there will be even a shorter period to address problems that arise from the additional 409A regulations that are expected to be proposed later this year (and that are unlikely to be finalized until relatively late in the year). The need to make changes during these periods will be additionally complicated by the fact that the changes may relate to arrangements with terminated employees that can only be changed by bilateral agreement, by the fact that board action may be necessary, and by the fact that the right to cancel deferrals under Q&A-20(a) of Notice is no longer available. The challenges will be compounded by an 1

2 affected employer s need to complete its documentary compliance for all arrangements at the same time, including those less fundamentally impacted by the final regulations. It seems clear that if good faith compliance ends abruptly on January 1, 2007, many employers will not have an adequate opportunity to restructure affected arrangements in time. With the loss of Q&A-20(a) relief, many may not have sufficient tools to do so quickly. If the release schedule for final regulations is delayed, as happened in the case of the proposed regulations, the difficulty will be increased. It is likely that the Service and Treasury will not even hear of some problems until the final regulations are released and digested. This is a case where the Service and Treasury should take the long view. Given the breadth and complexity of 409A, the Service and Treasury should permit a reasonable transition out of good faith compliance, i.e., a transition that would extend beyond January 1, A 409A Corrections Program Is Needed A program for sponsors of nonqualified deferral plans to correct 409A compliance errors is needed. The Service currently may not have the resources for a supervised corrections program. That is a challenge, because it would be natural for the Service to want to proceed as it did under EPCRS, i.e., to begin with an IRS supervised program in order to obtain experience and to develop a level of comfort on what could be self corrected. However, given the pressures on plan sponsors in connection with 409A, we think the Service should move forward with a corrections program without regard to whether it has sufficient resources for a program of supervised corrections. If resources are a constraint, the Service should push forward with a self-correction program. Certainly there are a range of basic errors for which self-correction guidance could be provided, errors such as -- a payroll system hiccup results in salary deferral amounts not being deducted for a month, or a distribution check is cut and sent to the wrong participant. There may be concern that implementing a selfcorrection program without the benefit of prior experience under a supervised program may result in standards for self correction that are too generous. We do not think that should be a barrier. First, the Service s extensive experience under EPCRS will help it in crafting a program under 409A. For example, the time limit on self-correcting significant errors could be carried over from EPCRS. Second, it is natural and appropriate to gradually ramp up compliance expectations and enforcement on sweeping new statutory requirements. In connection with the enactment of ERISA, the Service did exactly that. If the Service offers a self-correction program and then determines that its initial guidelines have been a bit too generous, they can be tightened prospectively. That would be completely consistent with gradually ramping up compliance expectations related to Section 409A. 2

3 Merely announcing and committing to a corrections program would be an important step forward. Therefore, as part of publishing final regulations, we suggest that the Service should announce its intention to establish a 409A self-corrections program and to request comments on the kinds of errors that should be included in the initial program, as well as the appropriate corrections for these errors. We believe there are a set of errors that are likely to occur more frequently and that have reasonable corrections. Therefore, even a somewhat limited program of self-correction could make a major difference. Information Reporting Q&A-29 of Notice provided guidance on reporting the total amount of each service provider s deferrals for a year. For 2005, Notice has cancelled the obligation to report these amounts. With regard to reporting, much of the discussion has focused on the difficulty of other reporting, i.e., reporting amounts that become taxable under 409A. However, the need to report taxable amounts is clear. It is much less clear that the Service will be able to make real use of reports regarding the amount deferred each year. Presumably for this information to be useful, the Service would need a system that could store the information for years into the future and then retrieve it easily by service provider and recipient. It seems unlikely that any such system exists or that it will exist any time soon. At the same time, providing these reports to the Service will be burdensome for many employers. The total cost of providing these reports across the entire economy will be substantial. These burdens and costs should not be imposed unless there is an adequate justification for them. Therefore, we suggest that the Service and Treasury announce in the final regulations that the requirement to report on the amount of each year s deferrals is suspended indefinitely. We believe past practice indicates that this is within the power of the Service and the Treasury, even though there is a statutory requirement for this reporting (Sections 6041(g)(1) and 6051(a)(13)). For example, in the welfare benefit area, the Service suspended reporting required by Section 6039D in Notices and There the Service applied the principle that it should not require the reporting of information that it cannot currently use. We believe that represents a sound policy to guide the administration of reporting requirements, and on this basis the Service should not hesitate to suspend indefinitely the requirement to report the amount of each year s deferrals. Changing Forms of Payment The proposed regulations contain valuable extensions of the transition relief set forth in Notice For example, Q&A-19(c) makes it possible to give participants the right to make new payment elections with respect to compensation covered by 409A, 3

4 and the proposed regulations extend this transition relief until December 31, Changes in payment elections under Q&A-19(c) require the involvement of participants. The extent to which employers may unilaterally change available payment forms is less clear than it should be. There is considerable interest in this in connection with nonqualified defined benefit plans, particularly those that linked payout to a qualified plan or that accepted elections near to retirement. Because of the impracticality of taking advance payment elections in nonqualified defined benefit plans, many employers wish to designate the lump sum as the default form of payment, and they will only offer alternative forms pursuant to subsequent elections. This may involve changing either plan terms or a pre-409a participant election. Either way, we believe it is implicit in Notice that an employer may unilaterally make such a change for a plan as a whole. In addition, because it does not involve an employee election, it would not be subject to constructive receipt. However, such a basic transition question deserves an explicit answer. We are aware that some have felt uncertain whether any transitional changes in payment are permitted without a participant election. However, it makes no sense to constrain employers in this manner. Perhaps even less clear is whether a plan amendment adopted in 2006 can be the basis for paying as a lump sum a benefit that would otherwise commence as an annuity in However, if the participant does not have an election and the change affects the form (but not the time) of payment, we believe this reasonably can and should be permitted. In any case, the final regulations should provide additional guidance on the extent to which a plan sponsor may unilaterally revise its deferral plans pursuant to the basic power to amend plans during 2006 to comply with 409A. Additional Suggestions In General Examples: In several areas, the proposed regulations include helpful examples. The clarity of the final regulations would be significantly enhanced by the more extensive use of examples. Grandfathered Benefits Determining Grandfathered Benefits: Consider a 2004 bonus that, if not deferred, would have been paid in early If no service after December 31, 2004 was required to be paid the bonus, and it was paid pursuant to an objective formula that was fixed as of December 31, 2004, the deferred bonus should be grandfathered. However, the proposed regulations state that the 4

5 grandfathered portion equals the portion of the service provider s account balance as of December 31, 2004, the right to which is earned and vested.... This has caused some to question whether the bonus in this example is grandfathered, because it would not be reflected in the participant s account balance until sometime in This implication should be eliminated. Amendments to Linked Qualified Plans: The proposed regulations extend the period during which payments under a nonqualified plan may be linked to a qualified plan. If the linked qualified plan is amended (as permitted by applicable regulations) to eliminate the requirement to deliver the Section 417 notice at least 30 days in advance, this change should not be a material modification that affects the grandfathered status of the related nonqualified plan. Stock Options Exercise Period Extension: Informal comments by representatives of Treasury/IRS have suggested that the insignificant services rule of Prop. Reg A-1(h)(1)(ii) applies in determining if the exercise period of a stock option has been extended. In other words, if the right to exercise the option ends upon termination of employment, the insignificant services rule would be applied in determining when employment terminates. However, the insignificant services rule is, by its terms, applicable only for purposes of Prop. Reg A-1(h)(1), which defines separation from service for purposes of Section 409A s distribution rules. It is not applicable for purposes of Prop. Reg A-1(b)(5). The final regulations should acknowledge this, or if the insignificant services rule is extended to Prop. Reg A- 1(b)(5), its application there should be prospective. Reimbursement of Post-Separation Expenses Tax Excludible Benefits: Currently, Prop. Reg A-1(b)(9)(iv)(A) implies that excludible reimbursements are not generally excepted from Section 409A, by conditioning the exception for such reimbursements on their continuing for only a limited period. We understand this implication to be unintended (provided there is no choice between excludible benefits and deferred compensation), and it should be eliminated. Payment Disputes: A provision similar to the special rule in Prop. Reg A-3(e), which extends the time for making payment of amounts in dispute, should apply with respect to determining if the reimbursement of postseparation expenses meets the time of payment requirement to be excepted from Section 409A. 5

6 Health Expense Reimbursements: The current exception for reimbursements of health expenses is conditioned on the reimbursements ending within a permitted period. In general, health expenses payments are time limited based on when the expenses are incurred, rather than based on when payments are made. It would be preferable to have the time limit for health expenses expressed based on when expenses are incurred, even if this means a shorter time limit (e.g., until December 31 of the first calendar year beginning after separation). It would be simplest to have no limit on the time of reimbursement, but to accommodate most existing systems at least two years should be allowed for reimbursement once a health expense is incurred (with the extension for disputed payments noted above). Pre-Separation Health Reimbursements: Health expense reimbursements need to be addressed more broadly in order to solve a related problem that can arise when reimbursing health expenses of active employees in the ordinary course. Currently, any failure to satisfy Section 105(h) automatically implicates Section 409A, unless all reimbursements are made within the short-term deferral period, which is impractical. Given the inherent imprecision and antiquated nature of Section 105(h), this is an undesirable result. Therefore, a general rule should be adopted that would exempt health expense reimbursements so long as the coverage does not extend more than a permitted period beyond separation from service (i.e., the period applicable under the exception for post-separation health reimbursements). Alternative Compliance Strategies for Post-Separation Health Benefits: Many arrangements (including, for example, change-in-control arrangements) provide for extended post-separation health benefits that will continue beyond the current permissible period (or a modified permissible period, as describe above). Service recipients obligated to provide these benefits would like to switch to providing payments based on the cost of coverage, and to make the service provider purchase health coverage on an after-tax basis (so that the benefits may be excludible under Section 104(a)(3) and, therefore, Section 105(h) will not cause there to be taxable benefits). For example, the service recipient would periodically pay the service provider an amount that is sufficient to allow the service provider to pay the cost of the health coverage for the period. The issue is whether this payment is considered objectively fixed for purposes of Section 409A. In this regard, it should be permissible to vary the payment based on objective changes in the service providers status (e.g., marriage, divorce, and birth of a child). So long as this variation is applied without regard to whether the service provider changes enrollment, the payment formula should be considered fixed. In addition, varying the payment based on changes in the cost of coverage should be permissible where the plan is a broadly based plan, covering a significant number of active employees. The fact that the employer retains the right to amend the terms of 6

7 the plan should not be a significant concern in light of the broadly based character of the plan. Severance Pay Arrangements Good Reason: Many difficult issues arise in applying the new rules to severance pay arrangements. One key issue relates to individually negotiated employment agreement provisions that permit the employee to resign for "good reason" and receive severance pay. This is a standard provision in executive employment agreements. Typically, the definition of "good reason" covers situations such as demotion and relocation of the executive's principle place of employment. The proposed regulations withhold judgment on whether severance pay will be deemed subject to a substantial risk of forfeiture and thus eligible for the short-term deferral rule if it is conditioned on resignation for good reason. We recommend that the final regulations include a safe harbor under which certain standard good reason formulations will constitute substantial risks of forfeiture in this context and also permit other good reason formulations to qualify for similar treatment based on a facts and circumstances analysis. We also recommend that the severance pay exception set out in Prop. Reg A-1(b)(9)(iii) be expanded to include resignation for good reason along similar lines. Compliance Issues: We recommend that the final regulations set out clear guidance as to how existing employment agreements may be revised to comply with Section 409A. For example, if an ongoing employment agreement contains good reason language that will cause the severance pay provisions of the agreement not to be subject to a substantial risk of forfeiture, may the employment agreement be revised as part of the Q&A-19(a) transition period to delete or revise this good reason language and thereby qualify for the short-term deferral rule? Does it matter whether such an amendment is made at the time of employment termination? In addition, we recommend that the regulations provide that it is permissible to delay the commencement of severance pay until such time as the employee signs a release of claims and the revocation period for such release has expired. Deferral Elections Elections upon First Year of Eligibility: In the case of an annual bonus, the rules for elections in connection with the first year of eligibility provide for prorating a bonus that is earned for the service period based upon the portion of the performance period that is left. This formulation ignores the fact that the bonus for the performance period often has already been prorated down to reflect the shortened service period. In such a case, the statutory requirement that the election only apply to compensation earned after the election can be met by prorating the bonus based on the portion of the service 7

8 period that remains after the date of the election. Thus, for example, assume an employee who is hired half-way through a twelve-month performance period, and who makes an election 30 days later. Also assume the employee s bonus is one half of a twelve-month bonus, based on his/her sixmonth service period. In this case, the employee should be permitted to defer approximately 5/6ths of his/her bonus. Impact of Section 125 Salary Reduction: Prop. Reg A-2(a)(8) allows limited changes in elections under a qualified plan to be made without violating Section 409A, even though these qualified plan elections impact the election under a nonqualified plan. Similar rules should apply to salary reduction elections under section 125 cafeteria plans. Cafeteria plans have nondiscrimination rules, and they must restrict mid-year changes in elections. These features will provide appropriate safeguards for purposes of Section 409A. Separation from Service Different Forms of Payment for Retirees: Many nonqualified plans allow expanded form of payment choice to employees who separate from service through retirement. In general, retirement eligibility is based on attaining both a minimum age and minimum service. The proposed regulations should be revised to make clear that different forms of payment may be paid in this case, even though both age and service conditions are imposed (rather than just age). The failure to permit this would have a sweeping impact employer plans, and it would conflict with long established practices. On the other hand, allowing the inclusion of a reasonable service condition (in addition to age) will not lead to abuses. Retirement During a Window: Plans that provide different forms of payment for employees who separate from service through retirement often extend this to employees who retire during a window program. Under a declared window program, the standards for retirement status are often modified (the age and/or service requirements typically are liberalized). To the extent that the window program meets the criteria of Prop. Reg A-1(b)(9)(v) and the plan prespecifies that window program retirement will be treated as a regular retirement for distribution purposes, it should be permissible to provide the retirement forms of distribution for retirement during a window. Different Forms of Payment for Voluntary and Involuntary Terminees: The proposed regulations already recognize a distinction between voluntary and involuntary separation from service in connection with separation pay. Because this is an established distinction, it would be appropriate to permit different forms of payment in connection with a separation from service depending on whether it is voluntary or involuntary. 8

9 Transfers to Affiliates: In connection with the definition of service recipient s stock, the proposed regulations permit a plan to specify a level of affiliation below 80% that will be used to identify the service recipient (i.e., 50% or, where there is a legitimate business justification, 20%). This same flexibility should apply for purposes of determining whether a separation from service has occurred. This would facilitate the maintenance of deferred compensation for employees who, for example, are transferred to a joint venture. Terminal Leaves: Employers sometime provide leaves of absences to employees that are separating from service (terminal leaves). Under the proposed regulations, leaves of not more than six months are generally recognized. At the same time, the proposed regulations contain rules that disregard a period of employment where only insignificant services are provided. To the extent that there is a bona fide business reason for providing a terminal leave, unrelated to the time of payment of deferred compensation, the final regulations should clarify that a terminal leave of not more than six months can be a bona fide leave of absence. 9