FINAL 409A REGULATIONS REQUIRE ACTION BY YEAR-END FOR MANY NONQUALIFIED DEFERRED COMPENSATION PLANS

by Jackson W. Seal

On April 10, 2007, the Internal Revenue Service and the U.S. Department of Treasury issued final regulations regarding the treatment of nonqualified deferred compensation arrangements under Section 409A of the Internal Revenue Code. Section 409A, which was added to the Internal Revenue Code on October 22, 2004, is a sweeping rewrite of the rules for nonqualified deferred compensation ("NQDC"). The key date by which every NQDC arrangement must be in compliance with 409A is January 1, 2008.

I. IMPACT OF 409A RULES

A. Inclusion in Income. All amounts deferred under a NQDC arrangement after December 31, 2004 will be taxable in 2008 (except to the extent the amount is subject to a substantial risk of forfeiture) unless the requirements of 409A are satisfied.

B. Substantial Penalties for Failure to Comply with 409A. All NQDC arrangements must be in writing ("Plan"). If a Plan fails to satisfy the 409A requirements as written or in operation, all deferred compensation for each affected participant under the Plan, and all deferred compensation for each affected participant under each Plan aggregated with the failing Plan (discussed in greater detail below), including interest or earnings, will be included in gross income. In addition:

• an additional 20% tax will be imposed on the amount includable in income
• interest calculated at the underpayment rate plus 1 % will be due, measured from the date on which the compensation was first deferred or the deferred compensation became nonforfeitable.

C. Plan Aggregation. In general, Plans are aggregated by type into separate categories by 409A and the failure of one Plan to comply with 409A with respect to a participant will cause all of the other Plans in the same category to be deemed to fail to comply with 409A with respect to such participant.

II. EFFECTIVE DATES & COMPLIANCE

A. General Effective Date. The 409A requirements apply to amounts deferred in taxable years beginning after December 31, 2004. An amount is considered as "deferred" before January 1, 2005, only if the amount is earned and vested before that date (i.e. is not subject to a substantial risk of forfeiture). For example, 409A will apply to:

• deferrals of compensation payable for services rendered in 2005 and thereafter
• amounts deferred before January 1, 2005, if the right to payment was not vested at such time.

B. Material Modification. The 409A rules do not apply to amounts deferred in taxable years prior to January 1, 2005, unless the Plan is materially modified. The addition of any benefit, right, or feature will be deemed a material modification.

C. Transition Period. To the extent necessary, a Plan must be amended prior to January 1, 2008, to comply with, and avoid the substantial penalties of, 409A. There is no need to amend a Plan if it is not subject to 409A.

III. NONQUALIFIED DEFERRED COMPENSATION PLAN

The 409A definition of a nonqualified deferred compensation plan is extremely broad, and includes almost any Plan or arrangement that defers the receipt of compensation other than:

• qualified employer plans, including eligible deferred compensation plans maintained under Code Section 457(b)
• certain foreign plans
• bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plans.

In general, if all payments under a Plan must be made no later than 2½ months of the end of the first year in which the right to the payment is no longer subject to a substantial risk of forfeiture, 409A does not apply to the Plan. Virtually all other arrangements between employers and employees, directors and independent contractors that provide for the deferral of compensation must comply with 409A. 409A applies to public and private companies, tax-exempt organizations, and certain governmental entities. A "Plan" can be a broad-based arrangement or an agreement covering only one person.

Common types of arrangements covered by 409A include:

• elective salary or bonus deferrals
• supplemental executive retirement plans ("SERPs")
• excess benefit or restoration plans
• phantom stock
• stock appreciation rights ("SARs")
• stock options issued at a discount
• restricted stock units.

Generally, the rules governing stock grants and stock options granted at fair market value do not have to comply with 409A.

IV. INITIAL DEFERRAL ELECTIONS

409A requires an election to defer compensation to be made before the beginning of the taxable year in which the compensation is earned. For example, an election must be made not later than December 31, 2007, with respect to services rendered and compensation earned during 2008. In the first year that a participant becomes eligible, the election to defer income for future services may be made within thirty (30) days after becoming eligible to participate in the Plan. In the case of an election relating to "performance-based" compensation (based on services performed over at least 12 months), the election must be made no later than six months before the end of the service period.

V. SUBSEQUENT CHANGES TO DEFERRAL ELECTIONS

The time and manner of payment must be specified in the Plan at the time of the initial deferral. A participant can designate the time and manner of payment at the time his or her deferral election is made or the Plan can specify the time and manner.

A Plan may permit a subsequent election to delay a payment, or make a change in the manner of payment, only if the Plan requires that:

• the election may not take effect until at least 12 months after the date the election is made
• the additional deferral must be for a period of not less than five years from the date the payment would otherwise be made (this requirement does not apply to distributions on account of death, disability or unforeseeable emergency)
• any election related to payment at a specified time or fixed schedule may not be made less than 12 months prior to the date of the first scheduled payment.

VI. TIME OF DISTRIBUTIONS

A Plan must provide that distributions/payments may not be made earlier than:

• separation from service (distributions to key employees of publicly?traded companies must be delayed at least six months)
• the date the participant becomes disabled
• death
• the occurrence of an unforeseeable emergency (severe financial hardship)
• a specified time (or fixed schedule) specified under the Plan at the time of deferral
• upon a change in ownership or effective control of the employer.

Amounts payable upon the occurrence of an event (i.e., when an executive's child begins college) are not treated as amounts payable at a specified time.  A Plan cannot allow distributions other than upon these permissible distribution events.

VII. ACCELERATION OF DISTRIBUTIONS

A Plan cannot permit acceleration of the time or schedule of any payment except in certain limited circumstances permitted in the Final regulations. For example, accelerated distributions subject to a penalty or "haircut" (i.e., 10% of the amount involved) are not permitted.  Acceleration of payment is permitted for a "Change in Control" of the employer.

VIII. RESTRICTIONS ON FUNDING

409A contains two rules related to funding of deferred compensation arrangements: a prohibition on the use of off-shore rabbi trusts and disallowance of funding triggers related to the financial health of the company.