Greenberg Traurig, LLP



GT Alert

IRS Issues Proposed Regulations Relating to Application of Section 409a to Non-Qualified Deferred Compensation Plans

October 2005

Click for information on Adobe Acrobat.  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 2006 compensation.

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 unreasonable.

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 practicable.

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 business.

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 Group.


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

Additional Information:

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.