IRS Issues Proposed Regulations Relating to Application of Section 409a
to Non-Qualified Deferred Compensation Plans
View or download the PDF version of this Alert.
On September 29, 2005, the IRS issued a set of lengthy proposed non-qualified
deferred compensation plan regulations (the “Proposed Regulations”) that
interpret the provisions of Section 409A of the Internal Revenue Code of
1986, as amended (“Section 409A”).
At the end of last year, the IRS issued Notice 2005-1 (the “Notice”),
to provide initial guidance with regard to the application of Section 409A.
The Proposed Regulations address not only those issues discussed in the
Notice, but others as well, and also make certain changes to the guidance
contained in the Notice.
The Proposed Regulations are not effective until January 1, 2007, although
they may be relied on for purposes of demonstrating good faith compliance
with the requirements of Section 409A (which generally became effective
January 1, 2005).
The following is a brief overview of some of the most significant new
guidance contained in the Proposed Regulations. In the near future, we will
publish more detailed Alerts on specific topics to which the new rules relate
(e.g., the affect of the rules on deferred compensation plans generally
and the application of the rules to equity compensation, severance pay programs
and certain provisions in employment agreements).
1. Extended Deadline for Written Compliance. Under the Proposed Regulations,
a plan adopted on or before December 31, 2006, will be treated as complying
with the requirements of Section 409A if (a) it is amended on or before
December 31, 2006 (thus providing a one year extension of the December 31,
2005 deadline contained in the Notice) to comply with the requirements of
Section 409A and (b) is operated in good faith compliance with the provisions
of Section 409A, the Notice, and any other guidance published by the IRS
before January 1, 2007.
2. Other Extended Deadlines. The Proposed Regulations also extend through
December 31, 2006, the transition period:
- for replacing discounted stock options and stock appreciation rights
with stock rights that are not subject to Section 409A;
- during which a plan may be amended to change elections with regard
to the timing and form of distributions (as long as the participant’s
election is made prior to December 31, 2005 for amounts otherwise payable
in 2006 and prior to December 31, 2006 for amounts payable after 2006.)
3. Certain Section 409A Transition Rule Deadlines Unchanged. The Notice
provided that by December 31, 2005, a plan sponsor could terminate a plan
that had grandfathered deferrals (i.e. deferred compensation that was both
earned and vested on or before December 31, 2004) without Section 409A applying
to those deferrals. The Notice also provided that a participant could elect
to cancel any deferral election or to terminate plan participation that
would otherwise be subject to Section 409A, provided that the participant
was taxed on such deferred compensation in 2005 (or if later, when the compensation
was no longer subject to a substantial risk of forfeiture). These deadlines
have not been extended.
4. First Time Election to Defer 2006 Compensation. The Proposed Regulations
also did not extend the deadline for making initial elections to defer 2006
compensation. Therefore, unless some later date is permitted under the special
rules for fiscal year or performance based compensation (discussed below),
December 31, 2005 is the last date that a participant can elect to defer
5. Stock Appreciation Rights. The Proposed Regulations treat stock appreciation
rights (“SARs”) in a manner similar to stock options, regardless of whether
the SARs are settled in cash or stock and regardless of whether the employer’s
stock is readily tradable on an established securities market. Thus, SARs
generally are exempt from Section 409A if the measurement price for the
SAR cannot be less than the fair market value of the employer’s stock on
the date of grant and the SAR has no other deferral features.
6. Valuation of Employer Stock and Modifications to Outstanding Stock
Awards. The Notice and the Proposed Regulations provide that stock options
and SARs with an exercise price or measurement price that is (or can be)
less than fair market value on the date of grant are to be treated as nonqualified
deferred compensation subject to Section 409A. The Proposed Regulations
include valuation guidance for these purposes for readily tradable stock.
They also require that the value of private companies be determined by the
reasonable application of a reasonable valuation method and set forth a
list of relevant factors to be considered in determining whether the valuation
is reasonable. The Proposed Regulations also create a presumption that certain
methods of valuation are reasonable, including certain valuations by independent
appraisers, formula-based valuations (e.g. book value) that constitute “non-lapse”
restrictions under Section 83 and that are consistently used for compensatory
and non-compensatory purposes, and valuations of illiquid stock of start-up
corporations made in good faith by a person with significant knowledge and
experience or training in performing similar valuations. The presumption,
if applicable, can only be rebutted by a showing that the valuation is grossly
The new rules also describe the circumstances under which modifications
to existing stock awards will be treated as the granting of new awards that
could be subject to Section 409A (even if the initial award was not) if
the exercise or measurement price of the award is less than the fair market
value of the stock on the date of the modification.
7. Fiscal Year Compensation. Generally, the Proposed Regulations provide
that the initial election to defer fiscal year compensation (i.e. compensation
relating to a period of service that extends over at least one fiscal year
of the employer) is permitted on or before the end of the fiscal year immediately
preceding the first fiscal year in which any services are performed for
which the compensation is paid. Thus, for example, a participant wishing
to defer payment of a bonus for the employer’s fiscal year spanning July
1, 2006 through June 30, 2007, would have until June 30, 2006 within which
to make an initial deferral election.
8. Performance-Based Compensation. Section 409A provides that in the
case of any performance based compensation based on service performed over
a period of at least 12 months, a participant’s deferral election must be
made not later than 6 months before the end of the service period. The Proposed
Regulations generally define performance-based compensation as compensation,
the payment of which is contingent on the satisfaction of pre-established
organizational or individual performance criteria that were not substantially
certain to be met when the criteria were established. Unlike the rules applicable
to Section 162(m), the Proposed Regulations also provide certain rules under
which payments may be based upon subjective performance criteria.
9. Delay in Payment of Short-Term Deferrals. The Proposed Regulations
reaffirm the exception from Section 409A set forth in the Notice for short-term
deferrals (i.e., those in which the benefit is payable within 2 1/2 months
after the end of either the employer’s or the employee’s taxable year in
which the employee has a legally binding right to compensation that is not
(or is no longer) subject to a substantial risk of forfeiture). The Proposed
Regulations provide that the short-term deferral exemption applies even
if the payment is made after the 2 1/2 month deadline, if it is established
that it was administratively or economically impractical to avoid the delay,
the delay was unforeseeable, and the payment is made as soon as reasonably
10. Multiple Payment Events. The Proposed Regulations provide great flexibility
in structuring participant elections with respect to the timing or form
of benefit payments. Participants can elect that payments are to be made
on the earlier or later of two or more permissible events and that a different
form of payment can be elected for each possible payment. Thus, for example,
a plan can permit a participant to elect that a payment be made on the earlier
of separation from service (in which case, payment would be in installments)
or a change in control (in which case, payment would be made as a lump sum).
Also, participants can elect to treat all installments as a single payment,
or to treat each installment as a separate payment, for purposes of applying
the Section 409A rules relating to additional deferral of payment.
11. Delay of Fixed Date Payments. The Proposed Regulations provide that
a delayed payment will be deemed to have been made on a fixed payment date
if it is made by the later of the first date it is administratively feasible
to make the payment or the last day of the calendar year in which the fixed
date occurs. Plans also may permit delays in payments if the payment otherwise
would not be deductible under Section 162(m), would violate securities laws,
or would violate loan covenants or other contract terms and the violation
would result in material harm to the employer. The Proposed Regulations
also contain certain rules for avoiding violation of the Section 409A requirements
with respect to deferred payments that are in dispute or when the employer
otherwise refuses to pay.
12. Severance. The Proposed Regulations confirm that separation pay arrangements
generally are subject to Section 409A. However, they provide an exemption
for payments upon an involuntary termination or under a “window program”
if the payments do not exceed 2 times the service provider’s annual compensation
(or, if less, a dollar amount that is $420,000 for 2005) each for the calendar
year before the year of the termination, and are paid by the last day of
the second calendar year after the year in which the employee’s service
terminates. Certain payments upon termination also may be exempt under the
short-term deferral rule.
13. Reimbursements Related to Termination. The Proposed Regulations exempt
certain reimbursement arrangements related to a termination of services
if the reimbursement is made within 2 calendar years after the calendar
year in which the termination occurs. Expenses eligible for this exemption
include amounts that the employee could deduct as business expenses, outplacement
expenses, moving expenses, medical expenses, and other types of payments
that do not exceed $5,000 in the aggregate in any year.
14. Arrangements Between Partnerships and Partners. The Proposed Regulations
do not address arrangements between partnerships and partners. However,
the Preamble to the Proposed Regulations indicates that, until further guidance
is issued, taxpayers may continue to rely upon the limited guidance regarding
those arrangements that are contained in the Notice.
15. Change in Control Provisions. The Proposed Regulations retain, for
the most part, the provisions of the Notice that permit distributions to
be made on account of a change in control. They also provide that until
further guidance, the principles applicable to a change in control of a
corporation may be applied by analogy to changes in ownership or the sale
of a substantial portion of the assets of a partnership.
16. Payments Linked to Qualified Plans. The Proposed Regulations adopt
rules under which a non-qualified plan that is linked to a qualified plan,
may continue to operate. Thus, for example, amendments to increase or decrease
benefits under a qualified plan that have the affect of increasing or decreasing
benefits under a nonqualified plan to which it is linked will not violate
Section 409A. In addition, changes in deferral elections by participants
in a 401(k) plan that result in an increase or decrease in amounts deferred
under a nonqualified plan will not violate Section 409A if the affected
deferrals do not exceed the maximum 401(k) deferral amount ($14,000 in 2005).
17. Plan Terminations after 2005. The Proposed Regulations state that
an employer will not be considered to have impermissibly accelerated payment
of benefits under the plan as a result of the plan termination (a) if the
employer terminates all arrangements of the same type (e.g. (i) all account
balance plans, (ii) all non-account balance plans, (iii) all separation
pay plans, or (iv) all other arrangements) with respect to all participants,
(b) no payments other than those otherwise payable under the plan absent
a termination of the plan are made within 12 months of the termination,
(c) all payments are made within 24 months of the termination, and (d) the
employer does not adopt a new arrangement of the same type within 5 years.
The Proposed Regulations also permit an employer to terminate a plan within
12 months after a change in control, upon a corporate dissolution, or with
the approval of a bankruptcy court.
18. Independent Contractors. The Proposed Regulations generally exempt
deferred compensation arrangements with independent contractors (other than
directors and contractors who provide management services), if the contractor
provides significant services to two or more unrelated service recipients.
This test will be deemed met if revenues from any client (or group of related
clients) do not exceed 70% of the revenues of the independent contractor’s
In the upcoming weeks, we anticipate issuing additional Alerts providing
more detailed information regarding the Proposed Regulations and their application
to various types of arrangements that are treated as deferred compensation
arrangements subject to Section 409A. In the interim, if you would like
more information about these new rules, and how they apply to your plans,
please contact a member of our Executive Compensation and Employee Benefit
This Alert was written by the Firm’s Executive Compensation and Employee
Benefits Group. Please contact any of the below group members or your Greenberg
Traurig liaison if you have any questions regarding this Alert.
© 2005 Greenberg Traurig
For more information, please review our Executive Compensation and Employee
Benefits Group description, or feel free to contact one of our attorneys.
This GT ALERT is issued for informational purposes only and is not intended
to be construed or used as general legal advice. Greenberg Traurig attorneys provide
practical, result-oriented strategies and solutions tailored to meet our clients’
individual legal needs.