Global Benefits & Compensation July 2007 ALBANY AMSTERDAM ATLANTA BOCA RATON BOSTON CHICAGO DALLAS DELAWARE DENVER FORT LAUDERDALE HOUSTON LAS VEGAS LOS ANGELES MIAMI NEW JERSEY NEW YORK ORANGE COUNTY ORLANDO PHILADELPHIA PHOENIX SACRAMENTO SILICON VALLEY TALLAHASSEE TAMPA TOKYO TYSONS CORNER WASHINGTON, D.C. WEST PALM BEACH ZURICH Strategic Alliances with Independent Law Firms BRUSSELS LONDON MILAN ROME TOKYO Notice 2007-34: Guidance on Application of 409A to Split Dollar Insurance Arrangements On April 10, 2007, in conjunction with the issuance of the final regulations under Internal Revenue Code 409A, the IRS issued Notice 2007-34, which provides guidance on the classification and treatment of employment related split dollar insurance arrangements (SDAs) as nonqualified deferred compensation for purposes of Code 409A. This GT Alert provides a summary analysis of this new guidance. Background Section 409A, added to the Code by the American Jobs Creation Act of 2004, generally provides that, unless certain requirements are met, amounts deferred for all years under a nonqualified deferred compensation plan are currently includible in gross income to the extent that they are not subject to a substantial risk of forfeiture and have not been previously included in gross income. In general, the rule applies to amounts deferred after December 31, 2004, and to amounts deferred prior to January 1, 2005, pursuant to agreements that are materially modified after October 3, 2004. For purposes of 409A, an amount is considered deferred prior to January 1,2005, if the service provider had a legally binding right to be paid the amount, and such right was earned and vested. In addition to current inclusion in gross income, the taxable amounts also are subject to a 20 percent additional tax and interest at the underpayment rate plus 1 percent on any federal income tax underpayment. The 409A regulations indicate that 409A may apply to certain types of SDAs, since such arrangements essentially provide for deferred compensation. Notice 2007-34 provides additional guidance in this area. Application to SDAs Under Notice 2007-34, the application of 409A to SDAs depends, in part, on whether the SDAs are subject to the final split dollar regulations under 1.61-22, effective as of September 18, 2003, (the Final Split Dollar Regulations ) or are grandfathered arrangements subject to tax under Notice 2002-8 ( grandfathered SDAs ). In addition, 409A does not apply to SDAs that only provide death benefits to or for the benefit of the employee/insured (the death benefit exception ), or that fall under the short term deferrals exception to 409A provided under the regulations (the short term deferral exception ). In general, the guidance under Notice 2007-34 provides as follows:
SDAs Under the Final Split Dollar Regulations SDAs generally fall under two regimes: (1) the economic benefit regime, regulated under Treas. Reg. 1.61-22 and (2) the loan regime, primarily governed by Treas. Reg. 1.7872-15. The type of regime that governs an SDA may affect the applicability of 409A. Economic Benefit Arrangements. Under these SDAs, the employer generally owns the insurance policy and pays the premiums, with a portion of the death benefit endorsed to the employee/insured. These SDAs may also be classified as equity or non-equity arrangements. Non-Equity: In a non-equity plan, the employee/insured is entitled solely to a portion of the death benefit and has no additional rights in the policy. Section 409A does not apply to this type of SDA, based on the death benefit exception. This exception includes the right to compensation, described as the cost of current life insurance protection (as described in the Final Split Dollar Regulations). Equity: In an equity agreement, the employee/insured has access to the policy s cash value, either currently or at a future time. Section 409A applies to this arrangement if, under the terms of the SDA and the relevant facts and circumstances, the employee/insured has a legally binding right during any tax year to access the policy s cash value (as described in the Final Split Dollar Regulations) or to receive any other economic benefits (other than the cost of current life insurance protection) that are payable to (or on behalf of) the employee in a later year, and to which the short-term deferral exception does not apply. Loan Arrangements. Generally, in this type of SDA, the employee/insured owns the policy and the employer pays the premiums. The employer s payment of premiums is treated as a loan to the employee/insured, usually secured by a collateral assignment of the policy to the employer. The premiums are repaid to the employer upon termination of the SDA. Section 409A does not apply to this type of SDA, assuming that the employer has not agreed to and does not waive, cancel or forgive all or any portion of the loan. In addition, if the SDA provides that the employee/insured is entitled solely to death benefits from the policy, 409A does not apply, based on the death benefit exception. Grandfathered SDAs Grandfathered SDAs are those entered into prior to September 18, 2003 (the effective date of the Final Split Dollar Regulations) that have not otherwise been materially modified. Under Notice 2007-34, a grandfathered SDA provides for deferred compensation within the meaning of 409A if, under the terms of the SDA and the relevant facts and circumstances, the employee has a legally binding right during a tax year to compensation that is payable to (or on behalf of) the employee in a later year (e.g., upon
termination of the split-dollar arrangement), and neither the death benefit nor short term deferral exceptions apply. However, Notice 2002-8 governs the tax treatment of grandfathered SDAs and provides that so long as the parties to the SDA continue to treat and report the value of the life insurance protection provided under the SDA as an economic benefit to the employee, the IRS will not treat the arrangement as having been terminated. Accordingly, if all the requirements of Notice 2002-8 are satisfied and the SDA has not been materially modified, the IRS will not (1) treat the right to the economic benefit of current life insurance protection as deferred compensation under 409A nor (2) assert that there has been a transfer of property to or on behalf of the employee by reason of termination of the SDA for purposes of 409A. In addition, for SDAs that may be classified as loan arrangements under Notice 2002-8, the SDA will not be treated as deferred compensation for purposes of 409A, provided that the employer does not agree to waive, cancel or forgive the loan. 409A Grandfathered Benefits Section 409A does not apply to amounts deferred in tax years beginning before January 1, 2005, nor to earnings on such amounts, even if accrued after the January 1 date, unless the plan is materially modified after Oct. 3, 2004 ( 409A grandfathered benefits ). For purposes of a SDA, increases in an insurance policy s cash value that are attributable to 409A grandfathered benefits will be considered earnings on such benefits, and thus will not be subject to 409A. However, increases in cash value that are attributable to the continued performance of services, to compensation earned, or to premium payments or other contributions made on or after January 1, 2005, will not qualify as earnings on 409A grandfathered benefits, and thus 409A will apply to such increases in cash value. For SDAs that have both 409A grandfathered benefits and non-grandfathered benefits, any increases in a policy s cash value must be allocated between both types of benefits. Although any reasonable allocation method is acceptable, Notice 2007-34 provides a safe harbor if the proportional allocation method described in the notice is used. Material Modifications of SDAs Notice 2007-34 provides transitional relief pursuant to which certain modifications made to grandfathered SDAs in order to comply with, or avoid application of, 409A will not result in a loss of grandfathering under the split dollar rules. For this purpose, a modification of a SDA is considered necessary to bring such arrangement into compliance with 409A only if all the following requirements are met: The service recipient or provider determines that (1) 409A applies to the SDA, and (2) in its current form, the SDA does not comply with the requirements of 409A;
The service recipient or provider determines that the modification, alone or as a necessary part of a series of actions, causes the SDA to comply with 409A or results in 409A no longer being applicable to the arrangement; The modification of the SDA consists solely of changes to (1) the applicable definitions (e.g., definition of a separation from service), (2) the payment timing requirements, including election provisions related to the time and form of payment, or (3) the conditions under which all or part of the benefit under the arrangement will be forfeited (e.g., acceleration of a vesting requirement), which are reasonably intended to conform the arrangement to the requirements of, or to qualify for an exclusion from, 409A; The modification establishes a time or times and a form or forms of payment that are consistent with times and forms of payment under which the benefits could have been paid under the terms of the SDA before the modification (including through the exercise of the service recipient s or service provider s discretion in accordance with the terms of the unmodified SDA); The modification does not materially enhance the value of the benefits to the service provider under the SDA. Conclusion Notice 2007-34 clarifies and expands on the provisions set forth in the 409A regulations regarding the treatment of SDAs for deferred compensation purposes. If an existing SDA qualifies as deferred compensation under 409A, then all the 409A requirements, including the rules regarding timing of initial deferral elections, payments of deferred compensation and changes to times and forms of payments, must be satisfied to avoid current taxation of the deferred amounts and earnings thereon (unless another exception applies). Thus, employers and employees should have all existing SDAs reviewed by competent legal counsel in order to assess their exposure to 409A and to take any steps necessary for compliance with the applicable requirements.
This GT Alert was written by Jennifer M. Smith in Tysons Corner and Steven B. Lapidus in Miami. Questions about the content of this Alert can be directed to: Jennifer M. Smith (703.903.7541; smithjenn@gtlaw.com) Steven B. Lapidus (305.579.0509; lapiduss@gtlaw.com) Any member of our Global Benefits & Compensation Group in the GT offices listed below Albany 518.689.1400 Amsterdam + 31 20 301 7300 Atlanta 678.553.2100 Boca Raton 561.955.7600 Boston 617.310.6000 Chicago 312.456.8400 Dallas 972.419.1250 Delaware 302.661.7000 Denver 303.572.6500 Fort Lauderdale 954.765.0500 Houston 713.374.3500 Las Vegas 702.792.3773 Los Angeles 310.586.7700 Miami 305.579.0500 New Jersey 973.360.7900 New York 212.801.9200 Orange County 714.708.6500 Orlando 407.420.1000 Philadelphia 215.988.7800 Phoenix 602.445.8000 Sacramento 916.442.1111 Silicon Valley 650.328.8500 Tallahassee 850.222.6891 Tampa 813.318.5700 Tokyo + 81 3 3264 0671 Tysons Corner 703.749.1300 Washington, D.C. 202.331.3100 West Palm Beach 561.650.7900 Zurich + 41 44 224 22 44 This Greenberg Traurig Alert is issued for informational purposes only and is not intended to be construed or used as general legal advice. The hiring of a lawyer is an important decision. Before you decide, ask for written information about the lawyer s legal qualifications and experience. Greenberg Traurig is a trade name of Greenberg Traurig, LLP and Greenberg Traurig, P.A. 2007 Greenberg Traurig, LLP. All rights reserved.