On September 10, 2007, the Treasury Department and IRS issued Notice 2007–78 (the “Notice”), which provides transition relief and additional guidance on the application of Internal Revenue Code section 409A and the related regulations (“Section 409A”) to nonqualified deferred compensation plans.
Section 409A generally applies to amounts deferred under a nonqualified deferred compensation plan that were not earned and vested prior to January 1, 2005. Section 409A requires that the plan specify its material terms in writing and include the following:
- At the time of deferral, the amount of the payment to which the service provider has a right (or the terms of a formula for amounts determinable under an objective, nondiscretionary formula);
- The specified date of payment, payment schedule or distribution events that will result in a payment of deferred amounts;
- The six-month delay rule applicable to specified employees of a publicly-held service recipient;
- The conditions under which a deferral election may be made; and
- Certain conditions under which the accelerated payment will be made in accordance with Section 409A, e.g., limited cashouts.
The above requirements do not have to be solely in the formal plan document, but may be in the documents that define the participants’ rights. For instance, the election form may include some or all of the information required above.
Extension for Compliance with Writing Requirement
With the exception of designation of the time and form of payment, as explained below, the Notice extends the deadline to adopt the documentation necessary to meet the requirements of Section 409A to December 31, 2008; however, plans must be in operational compliance with Section 409A after December 31, 2007. A plan will be treated as meeting the requirements of Section 409A if:
- by December 31, 2008 the plan contains all of the writing requirements set forth in the final regulations;
- the plan as written accurately reflects the operation of the plan on and after January 1, 2008; and
- the plan is otherwise operationally in compliance with Section 409A.
Note that a plan subject to Section 409A cannot be retroactively changed after 2007 to enable the plan to qualify for an exclusion from Section 409A. For example, amending a plan so that deferred amounts are only paid upon a participant’s death would not cause the plan to become a death benefits plan exempt from Section 409A.
No Extension of the Writing Requirement for Time and Form of Payment
WRITING DEADLINE FOR TIME AND FORM OF PAYMENT
Before January 1, 2008, a plan must designate in writing a time and form of payment compliant with the final regulations for amounts deferred under a plan prior to January 1, 2008, unless the final regulations provide otherwise. For amounts deferred during the 2008 calendar year, a plan must also include in writing, prior to the writing deadline provided in the final regulations, a Section 409A compliant time and form of payment for such deferrals.
A plan will be considered to provide a compliant time and form of payment in writing, even if the plan provides a non-compliant term (such as a haircut provision), if such non-compliant term is disregarded operationally and removed from the plan prior to January 1, 2009. A plan may also comply through the adoption of a separate written document that provides a time and form of payment under arrangements that are:
- specifically identified (e.g., amounts deferred under XYZ Company Deferred Compensation Plan);
- not specifically identified (e.g., amounts deferred under any arrangement subject to Section 409A); or
- a combination of both; however, the deferred amounts to which each designated time and form of payment must be objectively determinable.
A plan provides a compliant time and form of payment if a distribution is scheduled to be made upon a permitted distribution event (separation from service, change in control, unforeseeable emergency, specified date or fixed schedule of payments, death or disability) or a combination of events that is permissible under the final regulations. If a distribution event is added or removed as a potential payment event, except as provided in the Notice, then such addition or removal will be subject to the anti-acceleration and the subsequent deferral election provisions in the final regulations. Installment payments will be treated as a single payment unless the plan designates prior to the deadlines provided in the final regulations or Notice that the installments will be treated as a series of separate payments.
- Separation From Service, Change In Control, Disability Or Unforeseen EmergencyAlthough prior to January 1, 2008 a plan must specify the distribution event(s) upon which payment under the plan will be made, the distribution event (separation from service, change in control, disability or unforeseen emergency) applied under the plan in 2008 need not be specifically defined prior to January 1, 2009; however, the operational applications of such distribution event must be permissible under the final regulations. For example, a plan may provide that a distribution may be made upon disability but not specify the definition of disability prior to January 1, 2009; however, a participant may receive a distribution only if he or she meets the disability definition under the final regulations. Prior to January 1, 2009, the plan must accurately reflect the disability provision applied during 2008.If a distribution event has been timely designated, a later adoption of an alternative of the same distribution event, on or before December 31, 2008, will not be treated as a change in the time or form of payment, even if the alternative definition results in a payment being made earlier or later than the previously designated distribution event. Once the new designated distribution event has occurred in 2008, the plan must reflect the applicable change by the end of 2008.
- Specified Payment Date or Fixed Schedule of PaymentThe designation of a specified payment date or a fixed schedule of payments, including the use of a specified payment date or a fixed schedule of payments after a distribution event or lapse of a substantial risk of forfeiture, must comply with the final regulations by the end of 2007. Specifically, the plan must meet the requirements of the final regulations by December 31, 2007 for amounts distributed as follows:
- a specified time or fixed schedule, generally;
- payment schedules with formula and fixed limitations;
- payment schedules determined by the service recipient’s receipt of payments;
- reimbursements or in-kind benefits; or
- tax gross-up payments.
The Notice provides an exception to January 1, 2008 compliance with the writing requirement for tax gross-up payments. The plan does not have to specify that tax gross-up payments must be made by the end of the service provider’s tax year following the year in which the related taxes are remitted, provided that the plan specifies such timing prior to the end of 2008 and the plan is in operational compliance as to the tax gross-up payments.
If a specified payment date or a fixed schedule of payments has been timely designated, a later addition or deletion of a specified payment date or a fixed schedule of payments in 2008, which is compliant with the final regulations and does not affect the taxable year in which the distribution will be made, will not be treated as a change in the time or form of payment. Furthermore, an addition, deletion or modification of a provision that provides that a distribution is to be made during a designated period at the time the distribution event occurs will not be treated as a change in the time or form of payment, if such designated period is not more than 90 days and the service provider does not have the right to designate the taxable year in which the distribution is made (except by a subsequent deferral election as provided in the final regulations). For example, if a plan provides that a lump sum payment will be made upon a separation from service, and the company modifies the plan prior to January 1, 2009 to provide that the payment will be made within 90 days following the separation from service, as determined in the company’s sole discretion, the modification will not be treated as a change in the time and form of payment.
The writing requirement for the six-month delay for specified employees of a publicly-held service recipient is extended to the end of 2008; however, during 2008 the plan must operationally comply with the six-month delay. If any method other than the default method for identifying specified employees is used during the Notice’s transition period, then the service recipient must demonstrate the method used to identify specified employees and that such method was applied consistently.
GOOD REASON CONDITIONS
There are two important concepts to consider when determining if separation pay is subject to Section 409A:
- timing of the payment in connection with the lapse of a substantial risk of forfeiture; and
- whether the payment is due to an involuntary separation from service.
If payment of separation pay is made during the short-term deferral period (see Treasury Regulations section 1.409A–1(b)(4)) and by the terms of the plan cannot be made at, or completed on or after, a later date, then the separation pay is exempt from Section 409A. If payment of separation pay is due to an involuntary separation from service, then the pay is excluded from Section 409A if it is made within the specified time period following the separation from service; this exclusion extends only to limited amounts (the lesser of two times the service provider’s salary or two times the Code section 401(a)(17) limit).
The final regulations provide a definition of an involuntary separation from service and permit certain voluntary separations for good reason to be characterized as involuntary if the separation occurs within a specified period of time and if the service recipient is given notice and a right to cure. The final regulations also provide safe harbor provisions for good reason conditions which will be deemed an involuntary separation from service.
The Notice states that a good reason condition in an existing agreement may be modified to conform to the final regulation safe harbor good reason conditions only if the separation pay continues to be subject to a substantial risk of forfeiture. Furthermore, the modification of an existing good reason condition prior to the end of 2007 will not be treated as an extension of a substantial risk of forfeiture, even if the modification creates such an extension. Finally, if the separation pay is not subject to a substantial risk of forfeiture, a modification, addition or removal of a good reason condition or conditions will not cause such separation pay to be treated as subject to a substantial risk of forfeiture.
Keep in mind, however, that the transition rules that allow a new payment election by the end of 2007 with respect to the time and form of payment may still be used for separation pay, as long as the payments are not payable in 2007 and the election does not cause payments that would not otherwise be payable this year to be paid in 2007. This transition rule will allow separation pay agreements to be modified to except payments from Section 409A. For example, an agreement may be modified to provide that payments will be made during the short-term deferral period (as long as the amounts are not payable in 2007 or cause payments that would not otherwise be payable in 2007 to be payable this year).
Until further guidance is provided, if a right to deferred compensation payable upon an involuntary separation from service under an employment agreement would automatically be forfeited at the end of the agreement’s term, then the grant of a right to deferred compensation in an extended, renewed or renegotiated employment agreement will not be treated as a substitute for the right that was forfeited at the termination of the prior employment agreement.
Until further guidance is provided, a plan may provide for a cashout provision at a specified threshold at the time of the original payment in accordance with a schedule that is objectively determinable and nondiscretionary based on a permissible distribution event, as long as the applicable terms are fixed at the time the permissible distribution event is designated. The cashout provision may also be used after the distribution event has occurred, e.g., a company can use this cashout provision to distribute accounts that are being paid in installments when the present value falls below the threshold amount. It must be demonstrated that the plan’s cashout provision is operated in an objective, nondiscretionary manner and does not provide either the service provider or service recipient with a discretionary right to elect or determine the time and form of payment.
Alternatively, a plan may provide for the service recipient to have discretionary ability to cash out an account, including an account in pay status, provided that the present value of the account does not exceed the Code section 402(g)(1)(B) limit and the payment results in the termination and liquidation of the service provider’s entire interest under the plan (including any other plans with which the plan is aggregated). Note that, under the final regulations, when determining whether a cashout is within the Code section 402(g)(1)(B) limit, the service recipient must take into account all plans which are required to be aggregated with the plan from which the cashout is being paid.
Voluntary Compliance Program
The Treasury Department and IRS anticipate issuing guidance that will establish a limited voluntary compliance program that will apply to certain unintentional operational failures to comply with Section 409A. The voluntary compliance program is expected to provide methods both to correct uninten- tional operation failures in the same taxable year in which such operational failures occurred and to limit amounts subject to the Section 409A penalties.
Section 409A(b) — Restrictions on Certain Trusts and Other Arrangements
Section 409A(b) generally prohibits the protection of funds that may be used to pay non-qualified deferred compensation through the use of offshore trusts or asset protection in connection with the change in a service recipient’s financial status. Section 409A(b) also prohibits the transfer of assets to a trust used for the purposes of paying nonqualified deferred compensation plan obligations, during any of the following periods:
- any period during which the single-employer defined benefit plan is in at-risk status;
- any period during which the plan sponsor is a debtor in bankruptcy; and
- the 12-month period beginning on the date which is six months before the termination of the defined benefit plan, if that plan is underfunded on such termination date.
If there is a transfer of assets in violation of Section 409A(b), the assets will be treated as distributed to the participants, includible in income when the violation occurs, and subject to Section 409A penalties.
The Notice allows taxpayers to continue to rely on Notice 2006–33 until further guidance is issued. Notice 2006–33 provides that taxpayers may rely upon a reasonable, good faith interpretation of Section 409A(b) to determine whether the use of a trust or other arrangement causes an amount to be included in income under Section 409A(b). The Notice also provides guidance with respect to assets that were transferred in violation of Section 409A(b) prior to March 22, 2006, to which Notice 2006–33 provided a grace period. This grace period has not been extended beyond December 31, 2007.