United States: Update On 409A: What To Do Now And What Can Wait

Recently, the Internal Revenue Service issued Notice 2006-79 (the "Notice"), providing additional transition relief for deferred compensation arrangements covered by Section 409A of the Internal Revenue Code ("Section 409A").

As discussed in our previous Alerts available on our website, Section 409A covers a wide range of nonqualified deferred compensation plans and arrangements—including discounted stock rights,¹ separation pay arrangements, and certain bonus plans—and imposes a number of strict election and distribution requirements that such plans and arrangements must satisfy in order for participants to avoid immediate taxation, an additional 20% tax, and interest on underpayments of tax.

When will the final regulations be issued? According to the Notice, the IRS and Department of Treasury anticipate issuing final regulations before the end of 2006.

When will the final regulations be effective and what do we do until then? The effective date of the final regulations is expected to be January 1, 2008. Until that time, any plan or arrangement adopted on or before December 31, 2007 will not be treated as violating Section 409A if the plan is operated through that date in "reasonable, good faith compliance" with the provisions of Section 409A and applicable guidance, and the plan or arrangement is amended on or before December 31, 2007 to conform to the provisions of Section 409A and the final regulations.

Until the final regulations are effective, how do we operate in "reasonable, good faith compliance" with Section 409A? The Notice states that compliance with the proposed regulations or the final regulations prior to the effective date of the final regulations is not required. However, for periods before January 1, 2008, compliance with Notice 2005-1, the proposed regulations or the final regulations will constitute reasonable, good faith compliance with the Section 409A. We recommend that companies operate their deferred compensation plans and arrangements in compliance with the proposed regulations and, after they are issued, the final regulations.²

Does this mean that we should wait to amend deferred compensation plans until after the final regulations are issued? This means that you may wait until after the final regulations are issued. Remember, though, that you must operate your deferred compensation plans and arrangements in reasonable, good faith compliance with Section 409A, and that you may demonstrate "reasonable, good faith compliance" by operating your plan in compliance with the guidance set forth in the proposed regulations. Therefore, you will need to be aware of the terms of your deferred compensation plans and arrangements and the operational requirements of Section 409A. Some clients may prefer to amend their plans to comply with the proposed regulations in order to assist them in complying with the operational requirements of Section 409A, while others may prefer to wait to amend their plans until the final regulations are issued. Either approach is acceptable under the Notice.

What must we do by December 31, 2007? You have until December 31, 2007 to:

• amend your deferred compensation plan to come into documentary compliance with Section 409A;

• permit plan participants to make changes to payment elections³ (e.g., to change the time and/or form of payments under the plan), provided that:

• if the change in the payment election is made in 2006, the change may apply only to amounts that would not otherwise be payable in 2006 and may not cause an amount to be paid in 2006 that would not otherwise be payable in 2006; and
• if the change in the payment election is made in 2007, the change may apply only to amounts that would not otherwise be payable in 2007 and may not cause an amount to be paid in 2007 that would not otherwise be payable in 2007;

• fix eligible⁴ outstanding discounted stock rights (i.e., discounted stock options and stock appreciation rights);

• change an existing payment provision in the plan or payment election by a participant that provides that the time and form of payment under the nonqualified plan is the same as the payment election made by the participant under a qualified plan.

How may we fix discounted stock options? The Notice discusses three common methods of fixing discounted stock options:

• amending the option to provide for fixed payment terms (or to permit holders to elect fixed payment terms) consistent with Section 409A⁵;
• exchanging the discounted stock option for other deferred compensation that complies with Section 409A, provided that the payment of the deferred compensation may not commence in the same year as the exchange; and
• substituting a non-discounted stock option for the discounted stock option (in effect, increasing the exercise price for the option to the fair market value of the underlying stock as of the date of the original grant).

Discounted stock appreciation rights are subject to similar fixes.

What must we do by December 31, 2006? Certain discounted stock rights are not eligible for the transition relief provided in the Notice and therefore must be fixed on or before December 31, 2006. These discounted stock rights generally include those that:

• were granted with respect to the stock of a public company (at the time of grant);
• were granted to persons who were Section 16 persons of that public company (at the time of grant); and
• with respect to such grants, the company has reported or expects to report a financial expense due to the discounted stock right that was not timely reported on financial statements or reports for the applicable period when such financial expense should have been reported.

Note that there is no relief from Section 409A or the transition rules for stock rights with only de minimis discounts; the Notice does not contain a materiality threshold for purposes of its transition relief. Accordingly, public companies should act quickly to determine whether they have granted discounted stock rights to Section 16 persons so that they may decide whether and how to fix such stock rights on or before December 31, 2006.

May the company make a payment—a quid pro quo—for an employee’s agreement to increase a stock option exercise price (or substitute a non-discounted stock option for a discounted stock option)? Yes, provided that the payment complies with Section 409A. For example, if, in 2006, the company grants non-discounted stock right in exchange for the cancellation of discounted stock rights, the company may make a cash payment or stock grant to make up for the lost discount, provided that the payment is made in a subsequent taxable year. There is no requirement that the payment be subject to vesting.

In a prior Alert, you stated that discounted stock options may be fixed through an exercise by the participant on or prior to December 31, 2005. What if we exercise discounted stock options after December 31, 2005? Representatives from the IRS have recently stated that the exercise of a discounted stock option after December 31, 2005 will not be entitled to transition relief from Section 409A, regardless of whether the holder was aware that the option had been granted at a discount.

Circular 230 disclosure

The following disclosure is provided in accordance with the Internal Revenue Service’s Circular 230 (21 CFR Part 10). This Alert is not intended to constitute tax advice to any specific taxpayer or for any specific situation. Any tax advice contained in this Alert is intended to be preliminary, for discussion purposes only, and not final. Any such advice is not intended to be used for marketing, promoting or recommending any transaction or for the use of any person in connection with the preparation of any tax return. Accordingly, this advice is not intended or written to be used, and it cannot be used, by any person for the purpose of avoiding tax penalties that may be imposed on such person.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.