IRS Issues Long-Awaited Proposed Regulations under Section 409A of the Internal Revenue Code

IRS Issues Long-Awaited Proposed Regulations under Section 409A of the Internal Revenue Code NOVEMBER 11, 2005 Background Code Section 409A On September 29, 2005, the Internal Revenue Service ( IRS ) and the Treasury Department issued longawaited additional guidance in the form of proposed regulations (the Proposed Regulations ), 1 which further interpret Section 409A of the Internal Revenue Code of 1986, as amended (the Code ). Code Section 409A was added to the Code on October 11, 2004 as part of the American Jobs Creation Act of 2004, which introduced significant changes to the tax rules that apply to nonqualified deferred compensation arrangements. Code Section 409A generally provides for harsh tax consequences if amounts deferred under a nonqualified deferred compensation arrangement do not meet the distribution, acceleration of benefit, and election requirements of Code Section 409A: the amounts deferred under non-complying arrangements not only are taxed immediately, but also are subject to an additional 20% excise tax. In addition, interest is charged on any underpayments of tax resulting from a failure to meet the requirements of Code Section 409A, at the underpayment rate plus one percent (1%). Code Section 409A generally became effective as of January 1, 2005 with respect to amounts deferred under a nonqualified deferred compensation arrangement on or after such date (as well as amounts previously deferred that were not yet vested as of January 1, 2005). Transitional Relief under Notice 2005-1 In December 2004, the IRS issued Notice 2005-1, which provided preliminary guidance in the form of Q&As on how to interpret and comply with Code Section 409A. In Notice 2005-1, the IRS provided transitional rules for calendar year 2005 with respect to certain of the Code Section 409A requirements. For a more detailed discussion of Notice 2005-1 and the general requirements of Code Section 409A, please see the March 2, 2005, Stroock Special Bulletin IRS Releases Guidance on Section 409A Transition Rules (www.stroock.com SiteFiles/Pub334.pdf). Importance of Reviewing Current Compensation Arrangements Although the Proposed Regulations extend some of the transitional relief provided under Notice 2005-1 until December 31, 2006, several important transitional rules were not extended and may only be taken advantage of until the end of this year. STROOCK & STROOCK & LAVAN LLP NEW YORK LOS ANGELES MIAMI 180 MAIDEN LANE, NEW YORK, NY 10038-4982 TEL 212.806.5400 FAX 212.806.6006 WWW.STROOCK.COM

Therefore, it is very important for you to review all of your compensation arrangements as soon as possible to determine if they are subject to Code Section 409A, and if so, whether they comply with Code Section 409A. This Stroock Special Bulletin focuses on the new guidance relating to compliance with Code Section 409A provided under the Proposed Regulations, as well as on the extension (or non-extension) of the Notice 2005-1 transitional rules. If you have any questions, or would like to discuss Code Section 409A, Notice 2005-1 or the Proposed Regulations in further detail, please feel free to contact any of the persons listed at the end of this article, at any time. In addition, the IRS is requesting comments on the Proposed Regulations by January 3, 2006. If you would like to submit comments to the IRS on the Proposed Regulations, we are available to assist you with your submission. I. Effective Dates and Grandfathered Amounts Code Section 409A. Code Section 409A is generally effective for amounts deferred in taxable years beginning after December 31, 2004. Earnings on amounts deferred on or before December 31, 2004 are subject to Code Section 409A to the extent that the amounts deferred are subject to Code Section 409A. For purposes of the effective date of Code Section 409A, an amount is considered deferred before January 1, 2005, only if the amount is earned and vested before such date. Notice 2005-1. Notice 2005-1 established a transition period of one year, from January 1, 2005 to December 31, 2005, during which taxpayers can rely on the special transition rules provided in the Notice to aid in compliance with Code Section 409A. Proposed Regulations. The Proposed Regulations generally will be applicable for taxable years beginning on or after January 1, 2007. Until such time, plans are not required to comply with the Proposed Regulations; however, taxpayers may rely upon the Proposed Regulations now, and until final regulations are effective, and such reliance will be deemed to be good faith compliance with Code Section 409A. Grandfathered Amounts. Amounts deferred in taxable years beginning before January 1, 2005 generally are grandfathered (i.e., not subject to Code Section 409A) unless the plan under which the deferral is made is materially modified after October 3, 2004. A plan is considered materially modified if a benefit or right existing as of October 3, 2004 is enhanced or a new benefit or right is added. With respect to amounts deferred before January 1, 2005, it is permissible to operate under the terms of a deferred compensation arrangement that complies with pre-code Section 409A law and has not been materially modified after October 3, 2004, as such amounts would not be subject to Code Section 409A. For example, subsequent deferrals with respect to amounts deferred before January 1, 2005, under a plan that is not materially modified after October 3, 2004, would be subject to pre-code Section 409A law and would not be subject to Code Section 409A. II.Transitional Relief Notice 2005-1 Transitional Relief Not Extended (Available Until December 31, 2005). Right to Terminate Participation or Cancel Deferral Elections. Notice 2005-1 provides that service recipients (generally, employers) may amend a plan to permit service providers (generally, employees) to terminate participation in the plan or to cancel outstanding deferral elections under the plan at any time until December 31, 2005 without having to comply with Code Section 409A.Amounts subject to the termination or cancellation must be includible in income in 2005 (or, if later, the year in which the amounts are considered earned and vested or not subject to a substantial risk of forfeiture 2 ). 2

Right to Terminate a Plan. Notice 2005-1 provides that service recipients may terminate a plan or stop all future deferrals under a plan on or before December 31, 2005 without causing a material modification of such plan (which would cause grandfathered amounts to become subject to Code Section 409A). All amounts under the plan being terminated must be includible in income in 2005. You should identify any nonqualified deferred compensation arrangements that you do not wish to continue and take action to terminate such arrangements prior to December 31, 2005. Timing of Initial Deferral Elections. Notice 2005-1 permitted initial deferral elections with respect to compensation relating to services to be performed on or before December 31, 2005, to be made on or before March 15, 2005 (instead of December 31, 2004). This relief has not been extended for calendar year 2006. Accordingly, initial deferral elections with respect to compensation relating to services to be performed in 2006 must generally be made on or prior to December 31, 2005. Notice 2005-1 Transitional Relief Extended (Available Until December 31, 2006). Plan Amendments. A plan generally must satisfy the requirements of Code Section 409A, to the extent applicable, both in its terms and its operations. Notice 2005-1 provides that plans adopted on or before December 31, 2005 must be amended on or before December 31, 2005 either to conform to the requirements of Code Section 409A or to provide for compensation that is not subject to Code Section 409A. The Proposed Regulations extend the plan amendment deadline until December 31, 2006, and provide that a plan will be treated as complying with Code Section 409A if the plan is operated through December 31, 2006, in good faith compliance with the provisions of Code Section 409A and Notice 2005-1. In addition, all plans must be reduced to writing by December 31, 2006. Compliance with the Proposed Regulations will be considered good faith compliance with Code Section 409A. Substitution of Compliant Non-Discounted Stock Options and Stock Appreciation Rights ( SARs ) for Non-Compliant Discounted Stock Options and SARs. Notice 2005-1 provides a means for bringing equity-based compensation plans that are not compliant with Code Section 409A into compliance during 2005 without being considered a material modification of the arrangement. Noncompliant stock options and SARs (e.g., options and SARs issued at below fair market value), may be cancelled and replaced with stock options and SARs that comply with Code Section 409A (e.g., options and SARs issued at what would have been fair market value on the original grant date). The Proposed Regulations extend the time to bring stock options and SARs into compliance with Code Section 409A until December 31, 2006 (however, the exercise of the non-compliant stock option or SAR in 2006 prior to being replaced will be a violation of Code Section 409A, whereas the exercise would be permissible in 2005). III. Plans and Compensation Generally Subject to Code Section 409A Code Section 409A generally applies to any nonqualified deferred compensation plan, 3 which includes any plan or arrangement (including any plan or arrangement that applies to only one person) that provides for the deferral of compensation, other than certain exempt plans and arrangements (exempt plans and arrangements are discussed in Section IV below). The Proposed Regulations take the position that all deferred compensation arrangements that are subject to Code Section 409A must be set forth in writing. A plan will be considered to provide for the deferral of compensation if, under the terms of the plan and the relevant facts and circumstances, the service provider has a legally binding right during a taxable year to compensation that has not been actually or constructively received 3

and included in gross income, and that, pursuant to the terms of the plan, is payable to the service provider in a later year. A service provider generally will not be considered to have a legally binding right to compensation if that compensation may be unilaterally reduced or eliminated by the service recipient after the services creating the right have been performed. However, the discretion to reduce or eliminate the compensation must have substantive significance based on the facts and circumstances and the guidance provided in the Proposed Regulations. Compensation paid upon vesting, generally will not be considered deferred compensation. Notice 2005-1 provides detailed rules with respect to the aggregation of plans of the same type (e.g., account balance plans, non-account balance plans or other arrangements) and the treatment of arrangements as separate plans covering each participant, for purposes of meeting the requirements of Code Section 409A. The Proposed Regulations generally retain the Notice 2005-1 plan aggregation rules, but also provide that separation pay plans are now a separate type of plan for these purposes. IV. Exempt Plans and Compensation Code Section 409A generally does not apply to: (i) a qualified employer plan (e.g., certain tax-favored plans such as a Code Section 401(k) plan); (ii) any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan; (iii) an arrangement with an unrelated independent contractor (other than a director), if the independent contractor is providing significant services (other than management services) to each of two or more service recipients that are unrelated, both to each other and to the independent contractor; (iv) certain foreign plans (e.g., mandated social security systems and certain tax equalization plans); (v) certain split dollar life insurance arrangements (e.g., arrangements that only provide for death benefits and certain arrangements structured as loans);(vi) statutory stock options, and other stock options and SARs granted at fair market value; and (vii) arrangements providing for only short-term deferrals (as discussed below). Short-term Deferrals. Under Notice 2005-1, there is no deferral of compensation subject to Code Section 409A if, absent an election to otherwise defer the payment to a later period, the terms of the plan at all times require payment by, and an amount is actually or constructively received by the service provider by, the later of (i) the date that is 21 2 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 (ii) the date that is 2 1 2 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. The Proposed Regulations clarify that the arrangement need not provide in writing that the payment must be made by the payment deadline, so long as the payment is actually made by such deadline. However, if the payment is not actually made by the payment deadline, and the arrangement is not in writing, then the late payment will be an automatic violation of Code Section 409A. In contrast, if the arrangement had provided in writing that the payment must be made by the relevant deadline, the Proposed Regulations provide that in certain circumstances a late payment will not violate Code Section 409A. In addition, the Proposed Regulations provide for an extension of the 2 1 2 month deadline for amounts paid after the deadline (even if the plan was not in writing) if the service recipient can establish that it was either administratively or economically impracticable to make a timely payment and such impracticability was unforeseeable. Stock Options, SARs and other Equity-Based Compensation. Notice 2005-1 provides an exemption from Code Section 409A for stock options and SARs (but only stock-settled SARs for publicly traded stock) where the exercise price is not less than the value of the underlying stock on the date of grant and where there are no additional features otherwise providing for the deferral of compensation. The Proposed Regulations extend the exemption to nondiscounted SARs regardless of whether they are settled in cash and regardless of whether they are 4

issued with respect to non-publicly traded stock. However, the Proposed Regulations require in each case that the type of stock made subject to such options and/or SARs is common stock with the highest aggregate value of any class of outstanding common stock. The Proposed Regulations clarify that for purposes of valuation, an average selling price may be used to value publicly traded stock, and set forth methods presumed to be reasonable for valuing the stock of private companies. For purposes of determining the date of grant, certain modifications, such as a reduction in the exercise price, will be treated as a new grant, but certain extensions will be treated as having had an additional deferral feature from the original date of grant. Under the modification provisions, an out-of-the-money stock option can be repriced without becoming subject to Code Section 409A; but an extension of the exercise period may cause an option or other stock right to become subject to Code Section 409A, if the exercise period is extended beyond the later of the 15th day of the third month following the date at which, or the December 31st of the calendar year in which, the stock right would otherwise have expired. In addition, certain substitutions and assumptions by reason of a corporate transaction will not be treated as new grants. With respect to partnership interests, pending further analysis by the IRS and the Treasury Department, taxpayers may continue to rely on the interim guidance under Notice 2005-1, which generally provides that the issuance of partnership interests or options thereon in connection with the performance of services may be treated under the same principles as are applicable to stock, and profits interests may be treated in accordance with the pre-existing rules governing their taxation. The Proposed Regulations also continue to provide that Code Section 409A will not apply to a transfer of restricted stock or other property merely because the stock or other property is not includible in income until substantial vesting under Code Section 83 or because it is includible solely pursuant to a Code Section 83(b) election. Separation Pay Arrangements (Severance Plans). Code Section 409A applies to many severance arrangements (referred to in the Proposed Regulations as separation pay arrangements ) including broad-based severance plans and individual severance arrangements (i.e., provisions of employment agreements). The IRS and the Treasury Department rejected comments requesting that all broadbased severance plans be exempt from Code Section 409A. However, the Proposed Regulations do provide that payments made upon an involuntary separation from service or pursuant to a window program are generally exempt from Code Section 409A if (i) the arrangement is collectively bargained, or (ii) (a) the entire amount of the payments does not exceed two times the service provider s annual compensation (or, if less, two times the Code Section 401(a)(17) limit on compensation that may be taken into account for qualified plan purposes ($210,000 for calendar year 2005; $220,000 for calendar year 2006)), and (b) the arrangement requires that all payments be made by no later than the end of the second calendar year following the year in which the service provider terminates service. In addition, amounts that are only payable upon an involuntary separation from service will not be considered to be vested until the separation from service occurs; therefore, such an arrangement may be structured to comply with the short-term deferral exception described above. The Proposed Regulations do not necessarily treat a termination for good reason by the service provider as an involuntary separation from service (the IRS has requested comments on this issue). Therefore, where a service provider has a right to a payment upon either an involuntary separation from service or upon a termination for good reason, such payment may be ineligible for the short-term deferral exception (i.e., the payment would be subject to Code Section 409A and, if the payment is being made to a key employee of a public company, it may have to be delayed for six months following such employee s separation from service). 5

Where the separation pay arrangement involves an agreement negotiated (i.e., bona fide, arm s length negotiations) with a specific service provider at the time of the involuntary separation from service, the Proposed Regulations provide that the election as to the time and form of payment may be at any time on or before the date the service provider obtains a legally binding right to the payment. The Proposed Regulations also provide a limited exemption for certain expense reimbursement arrangements that are part of a severance pay arrangement. Foreign Arrangements. The Proposed Regulations provide that an arrangement does not provide for a deferral of compensation subject to Code Section 409A where the compensation subject to the arrangement would not have been includible in gross income for U.S. Federal tax purposes if it had been paid to the service provider at the time that the legally binding right to the compensation first arose or, if later, the first time that the legally binding right was no longer subject to a substantial risk of forfeiture. The Proposed Regulations also specifically exempt the following from Code Section 409A: (i) amounts deferred under a government-mandated social security system and (ii) amounts paid under tax equalization plans that are paid within a certain time period. V. Initial Elections to Defer General Rule. Initial elections to defer are generally required to be made by the service provider before the beginning of the taxable year in which the services giving rise to the compensation are performed. Elections to defer an amount include an election both as to the time and form of payment. Elections will be treated as made as of the date the election becomes irrevocable. Certain evergreen elections are permissible. Nonelective Arrangements. Nonelective arrangements generally will not need to comply with the initial deferral election requirements, provided that the arrangement sets the time and form of payment no later than the time the service provider obtains a legally binding right to the compensation. Performance-Based Compensation. In the case of performance-based compensation that is based on services performed over a period of at least 12 months, a service provider s initial deferral election may be made no later than 6 months before the end of the service period. Performance-based compensation is defined under the Proposed Regulations as compensation the payment of which or the amount of which is contingent on the satisfaction of preestablished organizational or individual performance criteria (i.e., criteria established no later than 90 days after the commencement of the performance period) the outcome of which is not substantially certain at the time established. Performance-based compensation may be based solely upon an increase in the value of the stock of the service recipient. First Year of Eligibility. In the first year that a service provider becomes eligible for participation in a nonqualified deferred compensation plan or arrangement, the service provider s initial deferral election may be made within 30 days after the date that the service provider is initially eligible, provided that the election only applies to compensation with respect to services to be performed after the election is made. VI. Subsequent Elections to Defer Subsequent elections to delay the timing of a payment or change the form of a payment generally must: (i) not take effect until at least 12 months after the date on which the election is made; (ii) except with respect to elections relating to distributions on death, disability, or unforeseeable emergency, provide that the first payment with respect to which such election is made be deferred for a period not less than five years from the date such payment would otherwise have been made;and (iii) if related to a payment to be made at a specified time or pursuant to a fixed schedule, be made not less than 12 months prior to the date of the first scheduled payment. 6

The Proposed Regulations provide that a service provider may change his or her election from one type of annuity to another actuarially equivalent annuity before the annuity starting date. However, a change of election from an annuity to a lump sum may only be made if the lump sum is payable at least five years after the annuity payments are scheduled to commence. VII.Time and Form of Payment General Rule. The distribution requirements of Code Section 409A will be met if the plan or arrangement provides that the compensation deferred thereunder may not be distributed earlier than the occurrence of any of the following: (i) a separation from service (as determined under the Proposed Regulations) 4, except as described below with respect to key employees ; (ii) disability; (iii) death; (iv) a specified time (or pursuant to a fixed schedule) specified under the plan at the time of deferral; (v) a change in the ownership or effective control of the corporation (as determined under the Proposed Regulations); or (vi) an unforeseeable emergency. Where the time of payment is based upon the occurrence of a specified event (such as one of the permissible events listed above), the plan must designate an objectively determinable date or year following the event upon which the payment is to be made (e.g., 30 days following a separation from service). However, payments will be treated as made upon such designated date if the payment is actually made by the later of (i) the date that it is administratively feasible to make the payment on or after the designated date, or (ii) the end of the calendar year containing the designated date (or the end of the calendar year if only a year is designated). Acceleration of Time of Payment Generally Prohibited. The acceleration of payments before the specified time or schedule chosen at the time of deferral is generally prohibited (except in very limited circumstances, e.g., to comply with a qualified domestic relations order, to comply with certain conflicts of interest rules, payments intended to pay employment taxes, and certain de minimis payments related to the service provider s termination of his or her interest in a plan). This eliminates the practice of allowing acceleration with a haircut to the amount of the benefit. Six-Month Delay for Payments to Key Employees. Payments to key employees (as defined under Code Section 416(i)) of a publicly traded corporation may not be made in the first six months following such an individual s separation from service (or, if earlier, the date of death of the employee). The Proposed Regulations provide that in order to comply with the six-month delay requirement with respect to payments to be made in installments, the plan may provide that the aggregate amount of the first seven months of installments be paid at the beginning of the seventh month following the date of separation from service, or may provide that only the first installment payment be paid on the first day of the seventh month (or a combination of these provisions). The Proposed Regulations provide that an employee is a key employee if the individual meets the definition under Code Section 416(i) at any time during a 12-month period ending on an identification date determined by the employer. Multiple Payment Events. The Proposed Regulations permit a plan to provide that payments may be made upon the earlier of, or the later of, two or more specified permissible payment events or times, and a different form of payment may be elected for each potential payment event. Plan Terminations. The Proposed Regulations provide three circumstances under which a plan may be terminated at the discretion of the service recipient in accordance with the terms of the plan: (i) a plan may be terminated provided that all arrangements of the same type (e.g., account balance plans, non-account balance plans, separation pay plans or other arrangements) are terminated with respect to all participants, no payments other than those otherwise payable under the terms of the plan absent a termination of the plan are made within 12 months, all payments are made within 24 months, and the service 7

recipient does not adopt a new arrangement of such type for a period of five years; (ii) during the 12 months following a change in control 5 of a corporation, the service recipient may elect to terminate a plan and make payments to the participants; and (iii) a plan may provide that the plan terminates upon a corporate dissolution or with the approval of a bankruptcy court,as long as certain other requirements are met with respect to the timing of the inclusion in income by the participants of the amounts deferred under such a plan. By Abbey Keppler, Special Counsel in the Employee Benefits Practice Group of Stroock & Stroock & Lavan LLP, and Adam Scoll, an associate in Stroock s Employee Benefits Practice Group. For further information regarding this article or Code Section 409A, contact Mark Wintner 212.806.6020 (mwintner@stroock.com), Laurel Rotker 212.806.5980 (lrotker@stroock.com), Abbey Keppler 212.806.5845 (akeppler@stroock.com), Adam Scoll 212.806.5515 (ascoll@stroock.com), or Marissa Holob 212.806.5650 (mholob@stroock.com) of Stroock s Employee Benefits Practice Group. 1. The full text of the Proposed Regulations can be found on the Internet at www.ustreas.gov/press/releases/reports/reg15808004.pdf. 2. The Proposed Regulations generally adopt the same definition of a substantial risk of forfeiture as provided under Notice 2005-1. Compensation will be considered 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. An amount will not be considered subject to a substantial risk of forfeiture merely because the right to the amount is conditioned, directly or indirectly, upon refraining from the performance of services (i.e., non-compete arrangement). 3. For example, Code Section 409A applies to traditional elective and nonelective nonqualified deferred compensation plans, nonqualified supplemental retirement plans ( SERPs ), retention arrangements that are paid out over a period of years, excess benefit plans, certain equity-based compensation arrangements, and certain severance pay arrangements. 4. The Proposed Regulations provide that an employee experiences a separation from service upon death, retirement, or other termination of employment. Whether an employee experiences a termination of employment will be determined based upon the facts and circumstances. An employee s requirement only to provide insignificant services for an employer will not extend the employment relationship for purposes of Code Section 409A. An employer and employee will not be deemed to have intended for the employee to provide insignificant services if the employee provides services at an annual rate equal to at least 20% of the services rendered and the annual remuneration for such services is equal to at least 20% of the average remuneration earned during the immediately preceding three full calendar years (or such lesser period of actual employment). If the employee continues to provide services to the employer in a capacity other than as an employee, a separation from service will not be deemed to occur if the former employee is providing services at an annual rate that is 50% or more of the services rendered, on average, during the final three full calendar years of employment (or, if less, such lesser period) and the annual remuneration for such services is 50% or more of the average annual remuneration earned during the immediately preceding three full calendar years of employment (or, if less, such lesser period). The employment relationship will not be considered terminated during bona fide leaves of absence lasting less than six months, and during leaves of absence lasting longer than six months if the individual s right to reemployment is governed by statute or contract. 5. The provisions in the Proposed Regulations regarding a change in control of a corporation generally mirror the provisions of Notice 2005-1. The preamble to the Proposed Regulations provides that the IRS and the Treasury Department plan to issue regulations under Code Section 409A that will allow an acceleration of payments upon the change in the ownership of a partnership or in the ownership of a substantial portion of the assets of a partnership. 8

NEW YORK 180 Maiden Lane New York, NY 10038-4982 Tel: 212.806.5400 Fax: 212.806.6006 LOS ANGELES Floors 16 and 18 2029 Century Park East Los Angeles, CA 90067-3086 Tel: 310.556.5800 Fax: 310.556.5959 MIAMI Wachovia Financial Center 200 South Biscayne Boulevard Suite 3160 Miami, FL 33131-5323 Tel: 305.358.9900 Fax: 305.789.9302 www.stroock.com This Stroock Special Bulletin is a publication of Stroock & Stroock & Lavan LLP 2005 Stroock & Stroock & Lavan LLP. All Rights Reserved. Quotation with attribution is permitted.this Stroock publication offers general information and should not be taken or used as legal advice for specific situations, which depend on the evaluation of precise factual circumstances. Please note that Stroock does not undertake to update its publications after their publication date to reflect subsequent developments. Stroock & Stroock & Lavan LLP is a law firm with a national and international practice serving clients that include investment banks, commercial banks, insurance and reinsurance companies, mutual funds, multinationals and foreign governments, industrial enterprises, emerging companies, and technology and other entrepreneurial ventures. For further information about Stroock Special Bulletins, or other Stroock publications, please contact Richard Fortmann, Senior Director-Legal Publications, at 212.806.5522.