Section 409A Compliance:
Action Required NOW On Deferred Compensation Plans  
(October 31, 2005)

Brief Overview of Section 409A
Future Alerts  
Section 409A Planning Steps
Checklist of Actions Required by December 31, 2005
Checklist of Actions Required by December 31, 2006 

On September 29, 2005, the Treasury Department and IRS issued long-awaited proposed regulations regarding deferred compensation agreements under Section 409A of the Internal Revenue Code.  The proposed regulations provide additional guidance and generally extend transitional relief for compliance with Section 409A to December 31, 2006.  However, there are still important actions that plan sponsors must take on or before December 31, 2005 in order to comply with Section 409A.

This alert, the first in a series regarding Section 409A compliance, provides a brief overview of Section 409A, the related IRS guidance, and a checklist of planning and action steps that plan sponsors should take by year-end to ensure compliance with Section 409A.

Brief Overview of Section 409A

Section 409A imposes strict new rules on nonqualified deferred compensation arrangements.  The new rules include restrictions on the timing of elections to defer income, and the time and form of payment of deferred compensation.  If a deferred compensation arrangement violates the new rules (in form or operation), all amounts deferred must be included in the participant's income at that time (or, if later, when the amounts are no longer subject to a substantial risk of forfeiture).  In addition, the violation will trigger severe penalties, as discussed further below.

Effective Date and Grandfathered Benefits

Amounts deferred before January 1, 2005 are grandfathered and not subject to Section 409A so long as the plan is not materially modified after October 3, 2004.  An amount is considered deferred before January 1, 2005, if before January 1, 2005, the participant had a legally binding right to be paid the amount and such right did not require the performance of further services and was not subject to a substantial risk of forfeiture. 

Section 409A is generally effective for amounts deferred on or after January 1, 2005.  Operational “good faith” compliance with Section 409A is required during 2005 and 2006 for benefits that are not grandfathered.  The deadline for amending documentation to comply with Section 409A has been extended to December 31, 2006.

What is Subject to Section 409A?

Section 409A applies to amounts deferred under a nonqualified compensation plan.

A nonqualified compensation plan is broadly defined to mean any agreement or arrangement that provides for the deferral of compensation.  A plan provides for the deferral of compensation if a service provider has a legally binding right during a taxable year to compensation that (i) has not been actually or constructively received and included in gross income, and (ii) pursuant to the terms of the plan, is payable to (or on behalf of) the service provider in a later year. This includes voluntary deferral and 401(k) wrap plans, supplemental executive retirement plans (SERPs), and severance and separation pay arrangements.  It can also include employment agreements, bonus and performance pay arrangements, and equity compensation.

Certain types of plans are exempt from Section 409A including:

• Qualified plans, including profit sharing, 401(k), defined benefit pension plans, ESOPs, 403(b) tax-deferred annuity plans, SEPs, SIMPLEs, eligible deferred compensation plans under Section 457(b), Section 501(c)(18) trusts, and governmental excess plans under Section 415(m); and

• Certain welfare plans, including any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan.

In addition, the IRS has issued guidance providing that Section 409A does not apply to:

• Certain short-term deferrals.

•  Stock options and stock appreciation rights (SARs) where the exercise price can never be less than the fair market value of the underlying stock at the date of the grant (i.e., non-discounted stock options).

• Severance or separation pay that falls within the IRS-prescribed safe harbor.

• Certain split-dollar life insurance, including death benefit only arrangements and certain arrangements treated as loans.

Deferral Elections

In general, an election to defer compensation for services performed during a taxable year must be made by the end of the preceding taxable year, including the election as to the time and form of payment.  A deferral election will be deemed made as of the date the election becomes irrevocable.  The regulations provide a number of exceptions to the general deferral election rule, including exceptions for performance-based compensation, newly eligible participants, nonelective arrangements, short-term deferrals, certain forfeitable rights, fiscal year compensation, and commissions.

Restrictions on Payments

The new rules limit when a deferred compensation arrangement may pay benefits.  The arrangement must provide for payments (i) on a fixed date, (ii) under a fixed schedule, or (iii) upon a separation from service, death, disability, change in ownership or control, or an unforeseeable emergency.

The regulations permit a subsequent election to delay a payment or change a form of payment if the election is made at least 12 months before payment would have been made and delays payment for at least 5 years from the date such payment otherwise would have been made.  In addition, a plan may not permit the acceleration of the time or schedule of any payment except under limited specified circumstances generally intended to alleviate unanticipated or hardship-type situations.  A limited exception also is provided to allow a plan to be terminated and benefits distributed if certain requirements are met.

Taxes and Penalties for Violations

If at any time during the year a nonqualified deferred compensation plan fails to satisfy the requirements of Section 409A, all amounts deferred under the plan for such year and all preceding years by any participant to whom the failure relates are included in such participant’s gross income for the year to the extent such amounts are not subject to a substantial risk of forfeiture and have not previously been included in gross income.  In addition, amounts included in gross income as a result of violation of Section 409A are subject to a 20 percent tax penalty and an interest penalty.

For an employee who participates in more than one deferred compensation plan, the tax and penalty provisions of Section 409A are compounded by the plan aggregation rules.  Under the aggregation rules, all account balance (defined contribution type) plans are treated as a single plan, all nonaccount balance plans are treated as a single plan, all involuntary termination and window program separation pay arrangements are treated as a single plan, and all other types of plans (e.g. discounted options, SARs) are treated as a single plan.  For example, assume an executive participates in an employer-sponsored 401(k) wrap plan, an account balance SERP, and has an employment agreement that allows for bonuses payable under the employment agreement to be deferred.  If the employment agreement provisions violate the payment requirements of Section 409A, the executive’s deferred amounts under all three arrangements are treated as a single plan and are subject to tax, penalty, and interest.

Impact on Section 457(f) Plans

Future Alerts

Section 409A Planning Steps

1. Identify plans, agreements or other arrangements subject to Section 409A.  Plan sponsors should consult with legal counsel to identify the plans, agreements or other arrangements subject to Section 409A.

2. Evaluate plans, agreements and other arrangements for compliance with Section 409A requirements.  Some plans may already comply with Section 409A or require only minor modifications while others will require extensive revision.

3. Identify useful transitional relief provisions.  The transitional provisions that many plan sponsors may find useful are only available through 2006, with some expiring earlier at the end of 2005.  Because these transitional provisions will expire shortly, sponsors should immediately review whether they wish to utilize those provisions.

4. Determine action plan for 409A compliance.  For plans that do not already comply with the Section 409A requirements, plan sponsors should work with legal counsel and other service providers to determine a plan of action for compliance, including amending, terminating, or adopting new nonqualified deferred compensation plans.

Checklist of Actions Required by December 31, 2005

1. Change election forms and other communication materials to reflect compliance strategy.  Election forms and communication materials provided to employees at the end of 2005 should reflect the changes that are going to be made to the plans and the overall Section 409A compliance strategy.

2. Amend plans to allow actions taken in 2005 under the transitional relief provisions.  Under the transition rules, an employer may allow deferred compensation participants to cancel existing deferral elections or to terminate participation in a plan, provided that the amounts deferred are paid and reported as income in 2005 or, if later, when such amounts are no longer subject to a substantial risk of forfeiture.  Employers also may terminate a grandfathered plan and distribute all benefits by the end of 2005.  For the transitional relief to apply, the plan documents must be amended no later than December 31, 2005.

3. Identify ‘Key Employees’.  While Notice 2005-1 provides transitional relief to avoid compliance with the six-month delay on payments to key employees who terminate employment in 2005, publicly-traded companies will need to identify their key employees to begin compliance in 2006.

4. Operate the plan in good faith compliance with Section 409A.

5. Avoid material modifications to grandfathered plans.  While the regulations provide some further guidance about what constitutes a material modification, employers should be cautious about any changes to plans that could cause a loss of grandfathered status.

Checklist of Actions Required by December 31, 2006

1. Plan documents must be amended to comply with Section 409A.

2. Participants must make elections regarding the time and form of distributions for deferrals made in 2005 and 2006.

3. Plans may be amended to provide for new payment elections during 2006 without violating Section 409A.

4. Non-discounted stock options and SARs may be substituted for discounted stock options and SARs in most cases during 2006.

5. Avoid material modifications to grandfathered plans.

If you have any questions regarding this alert or other Employee Benefits Law related issues, please contact one of our Employee Benefits attorneys.

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