As previously reported, the IRS and Treasury Department have issued final regulations regarding nonqualified deferred compensation arrangements under Section 409A of the Internal Revenue Code.  Section 409A was enacted as part of the American Jobs Creation Act in October 2004 and applies to a wide array of benefit and compensation arrangements.  Failure to comply with Section 409A also carries significant penalties for participants.  While operational compliance with Section 409A has been required since January 1, 2005, all plans must be rewritten or amended to comply with the final regulations by December 31, 2007.  Further guidance is expected regarding tax withholding and reporting issues related to Section 409A.

This article highlights some of the important topics addressed in the final regulations and action steps toward Section 409A compliance.  There will be future articles that address specific areas of interest, such as equity compensation.

In general, compensation generally is considered deferred for purposes of Section 409A when a plan, employment agreement or other arrangement gives an employee or other service provider a legally binding right in one taxable year to compensation that could be paid out in a later year (even if the right to payment is contingent on certain events, such as continued employment for a specified period or other type of vesting schedule).  If a nonqualified deferred compensation arrangement does not comply in form and operation with Section 409A’s requirements, then all vested amounts deferred under the arrangement for all tax years are currently included in the income of the taxpayer and subject to penalties. 

Among other things, the final regulations provide:

• plan documentation requirements, including specific provisions that must be included.  The final regulations also declare that a “savings clause” stating that the plan is intended  to comply with Section 409A will not be effective if the plan contains noncompliant  provisions.
• that certain voluntary terminations for “good reason” will be treated as involuntary separations and therefore may fall under certain exceptions under Section 409A (for example, an exception for certain severance payments and the short-term deferral exception).  The regulations set forth safe harbor standards for a qualifying “good reason” termination.
• modify and add flexibility to the definition of “separation from service” as a triggering event for distribution.
• that an extension of the exercise period for stock options or stock appreciation rights will not be considered an additional impermissible deferral as long as the exercise period is not extended beyond the original term of the option, or if earlier, 10 years from the grant date.  The exercise period of a stock right also can be extended if the extension is made when the exercise price exceeds the fair market value of the underlying stock (for example, an “underwater” option). 
• that reimbursements of post-employment medical expenses are not deferred compensation subject to Section 409A during the period in which the former employee would be entitled to COBRA coverage under the employer’s group health plan.
• guidance on other employer reimbursements, including tax gross-ups, litigation expenses, moving and relocation expenses and indemnification arrangements.
• rules to address initial deferral elections for rehires who are again eligible to participate in a plan.
• clarification on how to determine the “specified employees” of a public company who are subject to the six-month delay for payments triggered by a separation from service.

At this time, employers should work with their advisors and begin the following steps toward Section 409A compliance:

1.  Identify all nonqualified deferred compensation arrangements. As previously mentioned, these arrangements provide for the deferral of compensation and can include severance agreements, employment contracts, bonus plans, phantom stock, certain equity compensation and other arrangements that are not traditional nonqualified plans.  

2.  Review all plans for compliance and required changes.  All identified plans and arrangements should be reviewed for compliance with these final regulations and required changes.  Since the final regulations contain a number of revisions from the proposed regulations, this review is important even if plans were examined in response to the proposed regulations.

3.  Prepare documentation and formally adopt by December 31, 2007.  Draft amendments or new plan documents as needed to comply with the final regulations.  Identify the appropriate authority to adopt the documents and execute such documents by December 31, 2007.  For public companies, consider SEC reporting and shareholder approval requirements when the new documents are adopted.

4.  Review participant communications.  Communicate changes to participants.  Revise enrollment forms (including for 2008 enrollment) and any other plan materials, such as letters or plan summaries, to reflect the final regulations and amended documents.