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New IRS Guidance on Section 409A Affects All Nonqualified Deferred Compensation Plans
October 20, 2005
Benefits Alert
Author(s): Brian Kopp, Thomas J. McCord

The Treasury Department has issued its long-awaited follow-up guidance on the taxation of nonqualified deferred compensation plans under Code Section 409A. The new guidance takes the form of 230 pages of proposed regulations. While the proposed regulations are not scheduled to be effective until January 1, 2007, and are expected to be further expanded and revised, taxpayers can rely on them to show their good-faith compliance with the new rules. Through December 31, 2006, the earlier preliminary guidance of IRS Notice 2005-1 can also be relied upon in the alternative.
By Brian Kopp, Esq., and Thomas J. McCord, Esq.

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In addition to providing much-needed clarification on Section 409A, perhaps the most important provision is that the regulations extend the deadline to December 31, 2006, for amending deferred compensation plans to comply with the new rules. But good-faith operational compliance remains required retroactively to January 1, 2005.

Section 409A sets forth special tax rules for nonqualified deferred compensation plans. In brief, the new Section 409A rules:

  • limit the flexibility in the timing of elections to defer compensation;
  • restrict distributions while employed to fixed dates, certain changes of control, or extreme financial hardship;
  • prohibit accelerated distributions of deferred compensation;
  • prevent key employees of public companies from receiving deferred compensation due to severance from service until six months after such severance; and
  • prevent deferrals of distribution dates or changes in the form of payment unless made at least one year in advance of the scheduled distribution date and the new distribution date is at least five years after the prior distribution date.

If these rules are not followed, a participant is immediately taxed on the value of his/her deferred compensation once it is no longer subject to a substantial risk of forfeiture. Additionally, the participant will have to pay a 20% excise tax on the amount that is included in his/her income, as well as an interest penalty. The interest penalty is calculated at the IRS underpayment rate plus one percent from the date the amount was deferred or, if later, the date it was no longer subject to a substantial risk of forfeiture.

Section 409A does not supplant the traditional tax rules that apply to deferred compensation, such as the constructive receipt and economic performance doctrines, which continue to apply. Also, tax-exempt employers that maintain nonqualified deferred compensation arrangements for executives must also comply with the preexisting requirements of Section 457(f) of the Internal Revenue Code, in addition to the new requirements of Section 409A.

What Arrangements Are Subject to the New Law?

Section 409A generally applies to amounts deferred or vested after December 31, 2004. To avoid the new rules of Section 409A, prior amounts must be both earned and vested by December 31, 2004. A plan’s old rules can continue to apply to such pre–January 1, 2005, deferrals (and earnings on such deferrals). There is, however, a significant catch to this rule. If an employer materially modifies a grandfathered plan, the plan will become subject to the new rules.

The Section 409A rules apply to independent contractors and other persons or entities providing services to the business that is paying the deferred compensation (and receiving the services). In the parlance of the proposed regulations, Section 409A applies to all “service providers” (e.g., employees) and to “service recipients” (e.g., employers). In this summary, we will use the terms “employee” (or “participant”) and “employer,” but it is important to remember that the rules apply to other business service relationships.

The proposed regulations adopt the same broad definition of deferred compensation that was set forth in IRS Notice 2005-1. Under this definition, a plan provides for the deferral of compensation if an employee has a legally binding right during a taxable year to compensation that has not been actually or constructively received and included in gross income and that, pursuant to the terms of the plan, is payable to (or on behalf of) the employee in a later year. This is an enormously broad definition and is narrowed through statutory and regulatory exceptions. The statutory exceptions include “qualified” plans, such as:

  • Defined benefit, money purchase, profit sharing, 401(k), and other plans that are qualified under Section 401(a) of the Code
  • Section 403(a) and 403(b) annuity plans, Section 457(b) plans, simplified employee pension plans, and SIMPLE plans
  • Bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plans
  • Archer Medical Savings Accounts, health savings accounts, and certain other medical reimbursement arrangements exempt from taxation under Code Sections 105 and 106

Recognizing that the definition of deferred compensation is still too broad to be manageable, the proposed regulations set forth a number of arrangements that are excluded from Section 409A’s application, including:

  • short-term deferrals;
  • fair market value stock options and stock appreciation rights;
  • restricted property;
  • certain foreign plans; and
  • certain severance plans.

Short-Term Deferrals

The proposed regulations continue the exception recognized by Notice 2005-1 that “short term deferrals” are exempt from Section 409A. More specifically, a payment will not be treated as deferred compensation if it is actually or constructively received by, or required in writing to be paid to, the participant by the later of: (i) the 15th day of the third month following the participant’s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture; or (ii) the 15th day of the third month following the end of the employer’s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture. For employees, this means that a “short-term deferral” is a payment made by March 15 of the year following the calendar year in which the right vests (or if the employer is on a fiscal year, the 15th day of the third month following the end of the employer’s fiscal year in which the right vests, if later).

Compensation is subject to a substantial risk of forfeiture if entitlement to the compensation is conditioned on the performance of substantial future services or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. An amount will not be subject to a substantial risk of forfeiture beyond the date the participant could elect to receive the compensation, unless the amount subject to a substantial risk of forfeiture (ignoring earnings) is materially greater than the amount the participant otherwise could have elected to receive. For example, where a bonus arrangement provides an election between a cash payment and restricted stock units with a materially greater value that will be forfeited absent continued services for a period of years, the right to the restricted stock units generally will be treated as subject to a substantial risk of forfeiture. Note: an amount will not be subject to a substantial risk of forfeiture merely because it may be forfeited if the participant violates a noncompete. Also, amounts subject to “rolling vesting” are not subject to a substantial risk of forfeiture.

The regulations recognize that there may be instances when the payment does not occur within the 2-1/2 month rule described above. If this occurs, the payment will still be considered a short-term deferral if the taxpayer establishes that it was administratively impracticable to make the payment by that date or that making the payment would have jeopardized the solvency of the employer. But to take advantage of this rule, such impracticability or insolvency must have been unforeseeable on the date the legally binding right to the compensation arose and the payment must be made as soon as reasonably practicable.

The short-term deferral exception has widespread application. For example, some employers have multiple-year bonus programs that require an employee to continue employment until the end of the bonus period when the bonus is paid out. Because the bonus will be forfeited if the employee terminates employment before the end of the bonus period, the bonus is subject to a substantial risk of forfeiture. If the bonus is paid out by March 15 of the year following the end of the bonus period, it will be treated as a short-term deferral that is not subject to Section 409A. Also, lump-sum severance amounts paid out by March 15 of the year following the date when an employee is involuntarily terminated would generally qualify as a short-term deferral.

Fair Market Value Stock Option and Stock Appreciation Rights

The stringent rules of Section 409A do not apply to grants of stock options where the exercise price can never be less than the fair market value of the underlying stock at the date of grant. However, discounted stock options generally are subject to Section 409A, except in the unusual circumstance where the terms of the option require its exercise by March 15 of the calendar year following the year in which the option vests. Valuation of stock at the date of grant thus becomes critical in determining whether Section 409A applies to an option grant. The regulations provide extensive rules regarding valuation methods. For publicly traded stock, a valuation may be based on the closing price on either the trading day before or the trading day of the grant, or alternatively the grant price valuation may be based on an average of the stock price over a specified period that must occur within the thirty days before and thirty days after the grant date.

For stock that is not publicly traded, the regulations provide that fair market value must be determined through the reasonable application of a reasonable valuation method. Factors to be considered under a reasonable valuation method include, as applicable, the value of tangible and intangible assets of the corporation, the present value of future cash-flows of the corporation, the market value of stock in similar businesses, and other relevant factors such as control premiums or discounts for lack of marketability. The valuation method must take into consideration all available information material to the value of the corporation and its stock.

The regulations propose additional conditions under which the valuation of illiquid stock in a start-up corporation will be presumed to be reasonable. Such a start-up valuation will be presumed reasonable if made reasonably and in good faith and evidenced by a written report that takes into account the relevant factors described for valuations generally under the regulations. For this purpose, a start-up corporation refers to a business in the first ten years of the active conduct of a trade or business, where its stock is not subject to any put or call right or obligation to purchase such stock (other than a right of first refusal upon an offer to purchase by an independent third party). The valuation must be performed by a person with significant knowledge and experience or training in performing similar valuations.

The regulations treat stock appreciation rights (SARs) similarly to stock options, regardless of whether the SAR is settled in cash and regardless of whether or not the SAR is based upon stocks that are publicly traded. The same valuation rules described above apply.

The exception from Section 409A for nondiscounted stock options and stock appreciation rights is available only with respect to common stock, and only to the class of common stock that has the highest aggregate value of any class of common stock outstanding (but ignoring differences in voting rights). Also, the exception applies only to stock rights granted to employees of entities in which the issuing corporation owns at least a 50% interest. But in certain joint venture contexts, the exception for nondiscounted stock options and SARs can apply to employees of entities in which the issuing corporation owns as little as a 20% interest, where the use of such stock is due to legitimate business criteria. For example, the use of stock with respect to stock rights issued to employees of a joint venture who were former employees of a corporation that holds at least a 20% interest in the joint venture would generally qualify as a legitimate business criterion.

Restricted Property

Property that is taxed under Code Section 83, such as restricted stock, is not in itself subject to Code Section 409A. However, a plan under which a participant obtains a legally binding right to receive property in a future year may provide for the deferral of compensation and, accordingly, may constitute a nonqualified deferred compensation plan. This would occur, for example, where an employer promises to issue restricted stock to an employee if the employee continues employment through the end of the year, and such restricted stock vests upon the employee’s two years of continuous service after it is issued. But in instances where the promise to transfer substantially nonvested property and the right to retain the substantially nonvested property are both subject to a substantial risk of forfeiture, the arrangement would constitute an exempt short-term deferral because the payment would occur simultaneously with vesting. Therefore, in the above example, while the arrangement may constitute deferred compensation, it would fall within the short-term deferral exception because the stock would be deemed to be “paid” to the employee when the substantial risk of forfeiture lapses (i.e., when the stock vests), which means the payment occurs within the 2-1/2 month rule.

Foreign Plans

The Treasury recognized that it would be inappropriate to subject certain foreign plans to Section 409A. Accordingly, the proposed regulations provide an exception for foreign plans where contributions are excludible from U.S. taxes pursuant to tax treaties, broad-based plans maintained by foreign taxpayers, totalization agreements, and certain other arrangements. For example, if a foreign citizen works outside the U.S. and then retires to the U.S., the compensation deferred and vested while working outside the U.S. would not be subject to Section 409A.

Severance Plans

In IRS Notice 2005-1, the Treasury Department indicated that it was considering the application of the deferred compensation rules to severance plans. Many taxpayers argued that severance plans should not be treated as deferred compensation. The proposed regulations do not take that approach. Instead, severance plans (or, in the parlance of the proposed regulations, “separation pay plans”) are generally subject to Section 409A. Fortunately, the Treasury has excluded certain types of common severance plans from Section 409A, including the following types of plans:

  • Collectively bargained severance plans that trigger payments due to an involuntary termination or termination under a window program
  • Severance plans that trigger payments due to an involuntary termination or termination under a window program, provided that: (i) the pay does not exceed two times the lesser of the employee’s previous year’s compensation or $210,000 (this amount is indexed for inflation); and (ii) the severance must be paid by the end of the second calendar year following the calendar year in which the severance occurs
    Note: This exception will exempt many broad-based severance programs but may not protect executive severance plans that pay benefits in excess of $420,000.
  • Certain reimbursement arrangements or in-kind benefits are excluded from being treated as severance benefits that are subject to Section 409A. Specifically, a former employee may receive the following benefits by the end of the second calendar year following the calendar year in which the severance occurs without such benefits being subject to Section 409A: (i) reimbursements for expenses that the employee can deduct under Section 162 or Section 167 as business expenses incurred in connection with the performance of services (ignoring any applicable limitation based on adjusted gross income); (ii) reasonable outplacement expenses; (iii) reasonable moving expenses; and (iv) deductible medical expenses. Additionally, a severance plan that provides an employee with reimbursements or other payments or benefits that do not exceed $5,000 in the aggregate is not subject to Section 409A.

Payments triggered by an involuntary termination under a severance plan can also be structured to satisfy the short-term-deferral exception to Section 409A (i.e., payments made within a short time after they are no longer subject to a substantial risk of forfeiture). For example, if an employee is terminated involuntarily and is paid severance before March 15 of the year following when his or her termination occurs, such payments would not be subject to Section 409A. In applying this rule, the Treasury makes a distinction between payments triggered by an involuntary separation versus payments triggered by the employee for “good reason.” Some executive employment agreements, change in control agreements, and executive severance plans allow an employee to trigger a severance payment if the employee quits employment for “good reason” (e.g., the employee is demoted or the employee’s job changes in some material way). Note: The regulations do not currently treat a termination for “good reason” as an involuntary termination or as a right that is subject to a substantial risk of forfeiture that could avoid the application of Section 409A as a short-term deferral. The IRS is seeking comments on this issue.

What Limits Apply to Participants’ Initial Deferral Elections?

Generally, an employee electing to defer compensation for services performed during a taxable year must make his/her deferral election before the year in which the services are rendered. In other words, an election to defer compensation relating to services performed in 2006 must be made on or before December 31, 2005. The election to defer must specify both the timing and form of payment, but need not specify the medium (e.g., cash or property). If the employee is not given the right to elect the timing or form of payment, the agreement must specify the timing and form of payment no later than the date the employee has a legally binding right to the compensation.

There are a number of exceptions to this rule. First, an exception applies for performance-based compensation that is paid based on services performed over a period of at least twelve months. This exception permits deferral elections for such compensation to be made up to six months before the end of the performance period. Generally, performance-based compensation is a payment that is contingent on the satisfaction of preestablished criteria relating to a performance period of at least twelve consecutive months during which the employee performs services. Organizational or individual performance criteria are considered preestablished if established in writing by not later than ninety days after the commencement of the period of service to which the criteria relate, provided that the outcome is substantially uncertain at the time the criteria are established.

Second, if an employee has a legally binding right to a payment in a subsequent year that is subject to a forfeiture condition requiring the employee’s continued services for a period of at least twelve months from the date the employee obtains the legally binding right, an election to defer such compensation may be made on or before the 30th day after the service provider obtains the legally binding right to the compensation, provided that the election is made at least twelve months in advance of the earliest date at which the forfeiture condition could lapse. For example, if on March 1, 2006, an employer grants an employee a $10,000 bonus, payable on March 1, 2008, provided that the employee continues performing services through March 1, 2008, the employee may make an initial deferral election on or before March 31, 2006 (within thirty days after obtaining a legally binding right), because at least twelve months of additional services are required after the date of election for the risk of forfeiture to lapse.

Third, if the employer has a fiscal year other than the calendar year and pays a bonus based on its fiscal year, a plan may allow an employee to defer the bonus up until the close of the employer’s fiscal year next preceding the first fiscal year in which the employee performs services related to the bonus. Note: This provision will allow fiscal year employers to establish a time for employees to defer to their fiscal year bonuses that is different than the deferral election that will apply to their base compensation (e.g., an employer with a fiscal year beginning on July 1 can allow employees to elect to deter next year’s fiscal bonus on or before June 30, but deferrals of next year’s base compensation must be made on or before December 31).

Fourth, an exception applies for individuals who first become entitled to participate in the plan. This exception permits the deferral election to be made within thirty days of the date the individual first becomes eligible and only applies to compensation earned after the election.

Fifth, the proposed regulations’ inclusion of severance pay in the definition of deferred compensation created a problem under the timing rules for electing deferrals. After all, how could a participant make a prior-year election on when to receive a severance benefit if the benefit was negotiated in connection with the severance? The regulations address this fact pattern by providing that when involuntary separation pay is the subject of bona fide, arm’s-length negotiations, the initial deferral election may be made at any time up to the time the employee obtains a legally binding right to the payment.

What Rules Apply to Subsequent Deferrals?

Section 409A offers employees a limited opportunity to change their initial election as to timing and form of the payment of their deferred compensation. Generally, the new rules permit such changes only if the subsequent election does not become effective until twelve months after it is made; the election is accompanied by a new payment commencement date that is at least five years later than original payment date; and, in the case of an election to defer payment until a specified date, the election must be made at least twelve months before the first scheduled payment under the previous election. For example, if a participant who initially elected to receive his or her benefit in the form of a lump sum at termination of employment wants to change the form to installment payments, the first installment payment could not commence until five years after the participant terminates employment.

The proposed regulations provide that a life annuity is treated as a single payment for purposes of these rules. The regulations also provide that a change in the form of a payment from one type of life annuity to another type of life annuity before any annuity payment has been made is not considered a change in the time and form of a payment, provided that the annuities are actuarially equivalent applying reasonable actuarial assumptions. Note: This would suggest that a defined benefit SERP could allow participants to choose among actuarially equivalent annuity payment options without have to delay the payment date five years.

A plan can treat an installment payment option as a single payment or the right to a series of separate payments. For example, suppose an employee participates in a nonqualified deferred compensation arrangement that provides for payment in a series of five equal annual amounts each of which is treated as a separate payment and the first payment is scheduled to be made on January 1, 2008. If the employee makes the election on or before January 1, 2007, the employee may elect for the first payment to be made on January 1, 2013. If the employee makes that election, the remaining payments may continue to be due upon January 1 of the four calendar years commencing on January 1, 2009.

Some plans contain multiple payout provisions (e.g., benefits will be paid in a lump sum on the earlier of separation from service or a specified age). It was unclear how the five-year rule would apply to plans with such provisions. The regulations provide that in the case of a plan that permits a payment upon a number of different permissible payment events, the application of the five-year deferral rule is applied separately to each payment event. For example, suppose an employee initially elects to be paid in a lump-sum payment at the earlier of age 65 or separation from service, but subsequently decides that he or she will work after age 65 and wishes to defer payment to a later date. Provided that the employee continues in employment and makes the election by the employee’s 64th birthday, the employee may elect to receive a lump-sum payment at the earlier of age 70 or separation from service.

The regulations also allow an employer to delay paying deferred compensation without complying with the five-year rule for certain special circumstances (provided that the plan document calls for such delays), such as to ensure the employer will not lose a deduction under Code Section 162(m) or the payment will not violate a loan covenant or applicable securities law.

When Can Deferred Compensation Benefits Be Paid?

Amounts may be distributed from a nonqualified deferred compensation plan only upon separation from service, disability, death, a specific date established when the deferral election is made, a change in control, or an unforeseeable emergency that causes a severe financial hardship to the participant. Other distribution triggers are not permitted. For example, it would be impermissible for a participant to elect a payout when the participant’s child goes to college (although the participant could elect a specific payment date intended to coincide with this event). The proposed regulations provide helpful guidance on the application of these rules.

Separation from Service

The proposed regulations define when an individual has a separation from service. An employee separates from service with the employer if the employee dies, retires, or otherwise has a termination of employment with the employer. In drafting this definition, the Treasury was apparently worried that employers and employees may collude as to when an employer will be treated as separating from service. Therefore, the regulations provide that whether an employee has terminated is determined based on all of the facts and circumstances. For example, suppose an employee appears on the books as an employee but the parties really intended for the employment relationship to end and the employee only to provide insignificant services. Under those circumstances, the rules treat the employee as having incurred a separation from service. An employee will not be treated as providing insignificant services where the employee continues to provide services as an employee at an annual rate that is at least equal to 20% of the services rendered, on average, during the immediately preceding three full calendar years of employment (or, if employed less than three years, such lesser period) and the annual remuneration for such services is at least equal to 20% of the average annual remuneration earned during the final three full calendar years of employment (or, if less, such lesser period).

The regulations also protect against situations where an employer ostensibly terminates an employee but keeps the worker on to provide significant services as a consultant or other independent contractor. Under these facts, no separation from service will be deemed to have occurred if the former employee is providing services at an annual rate that is 50% or more of the services rendered, on average, during the immediately preceding three full calendar years of employment (or if employed less than three years, such lesser period) and the annual remuneration for such services is 50% or more of the annual remuneration earned during the final three full calendar years of employment (or if less, such lesser period).

Disability

Deferred compensation benefits can become payable if the employee becomes disabled. A participant will be considered disabled if he/she (i) is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment that can be expected to result in death or can be expected to last for a continuous period of not less than twelve months, or (ii) is, by reason of any medically determinable physical or mental impairment that can be expected to result in death or can be expected to last for a continuous period of not less than twelve months, receiving income replacement benefits for a period of not less than three months under an accident and health plan covering employees of the participant’s employer. Plans can limit the disabilities that trigger payment as long as the triggering disability satisfies the above requirements. Also, the disability test will be deemed to be satisfied if the Social Security Administration determines the employee is disabled.

Specified Date

Generally a plan will be deemed to provide for a specified time or fixed schedule of payments where, at the time of the deferral, the specific date upon which the payment or payments will be made may be objectively determined. The regulations also state that a plan may allow payments to commence at a specified time after the lapse of a substantial risk of forfeiture. For example, a plan could provide that payments will be made in three installment payments, payable each December 31 following an initial public offering, where the condition that an initial public offering occur before the employee is entitled to a payment constitutes a substantial risk of forfeiture.

Change in Control

Plans may permit a payment upon the occurrence of a change in the ownership of a corporation, a change in the effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation. The regulations provide detailed definitions for each of these change in control events. Employers can tailor their plans to select which change in control events trigger payout. Payouts do not have to be triggered by all events that qualify as change in control.

Neither the statute nor the legislative history refers to changes of control for entities other than corporations. However, the Treasury and IRS plan to issue regulations will allow acceleration of payments upon change of ownership of a partnership with rules that analogous to those for corporations.

Unforeseeable Emergency

An unforeseeable emergency is defined as a severe financial hardship: (i) resulting from an illness or accident of the participant or the participant’s spouse or a dependent; (ii) the loss of the participant’s property due to casualty, or (iii) some other extraordinary and unforeseeable circumstances arising as a result of events beyond the participant’s control. A hardship withdrawal cannot exceed the amount needed to meet the expense that creates the hardship, plus the amount necessary to pay taxes reasonably anticipated as a result of the distribution. Furthermore, the participant must not have any other source for the funds required to satisfy the hardship.

How Does the Prohibition on Acceleration of Benefits Work?

The new rules generally prohibit the acceleration of any distribution in advance of the originally specified payment date. However, the regulations coordinate this general rule with the recognition that plans may have multiple permissible payment events. For example, suppose a plan provides that a participant will receive six installment payments commencing at separation from service, and also provides that if a participant dies, any unpaid benefits will be paid in an immediate lump sum. Under these facts, the acceleration of payments triggered by a participant’s death would not be prohibited.

The regulations also provide that payments for the following reasons are not treated as impermissible accelerations:

  • Payments necessary to satisfy a domestic relations order
  • Lump-sum payments of $10,000 or less to completely pay off all of a participant’s interest in a plan and all similar plans when he separates from service, but only if lump-sum payments are not otherwise permitted under the plan
  • Amounts includible in the participant’s income as a result of a plan’s failure to comply with Section 409A
  • Amounts necessary to pay FICA taxes on the deferred compensation
  • Amounts necessary to pay income taxes triggered by the vesting of benefits under a Section 457(f) plan of a tax-exempt organization

Under What Circumstances Can a Nonqualified Deferred Compensation Plan Be Terminated?

Generally, a plan cannot be terminated without violating the provisions of Section 409A that restrict changing the timing of distributions and prohibit the acceleration of payments. But the proposed regulations provide three circumstances under which a plan may be terminated at the discretion of the employer or other service recipient in accordance with the terms of the plan.

First, a plan may be terminated provided that all arrangements of the same type (account balance plans, nonaccount balance plans, separation pay plans, or other arrangements) are terminated with respect to all participants, no payments other than those otherwise payable under the terms of the plan absent a termination of the plan are made within twelve months of the termination of the arrangement, all payments are made within twenty-four months of the termination of the arrangement, and the employer does not adopt a new arrangement that would be aggregated with any terminated arrangement under the plan aggregation rules at any time for a period of five years following the date of termination of the arrangement.

Second, the regulations also provide that during the twelve months following a change in control of a corporation, the employer may elect to terminate a plan and make payments to the participants.

Finally, a plan may provide that the plan terminates upon corporate dissolution for tax purposes or with the approval of a bankruptcy court, provided that the amounts deferred under the plan are included in the participants’ gross incomes by the latest of (i) the calendar year in which the plan termination occurs, (ii) the calendar year in which the amount is no longer subject to a substantial risk of forfeiture, or (iii) the first calendar year in which the payment is administratively practicable.

Can Participants Continue to Take Advantage of the Special Transition Rules Set Forth in Notice 2005-1?

The proposed regulations extend some, but not all of the transitional rules provided in Notice 2005-1. Here is a summary of those rules:

  • As discussed above, employers have until December 31, 2006 to amend their plans to bring them into compliance with the new rules (this extends the December 31, 2005, deadline provided in Notice 2005-1).
  • Plans that pay benefits under the same form and at the same time as benefits are paid under a qualified plan can continue to do so until December 31, 2006.
  • Notice 2005-1 provided generally that, with respect to amounts subject to section 409A, a plan could be amended to provide for new payment elections without violating the subsequent deferral and antiacceleration rules, provided that the plan was amended and the participant made the election on or before December 31, 2005. The regulations extend through December 31, 2006, the period during which a plan may be amended and a participant may be permitted to change payment elections, except that a participant cannot in 2006 change payment elections with respect to payments that the participant would otherwise receive in 2006, or cause payments to be made in 2006.
  • Notice 2005-1 provides a limited time during which a plan adopted before December 31, 2005, may provide a participant a right to terminate participation in the plan or cancel an outstanding deferral election with regard to amounts subject to section 409A. This transition rule has not been extended.

What Actions Should Employers Take Now?

Many employers delayed amending their plans until the Treasury issued additional guidance on Section 409A. Now that the guidance is issued, we believe it is time for employers to review their plans thoroughly and begin taking steps to amend them. Accordingly, we strongly encourage employers to take the following actions:

  • Identify all deferral arrangements subject to the new law including, potentially, bonus plans, employment agreements, and severance arrangements.
  • Decide by the end of 2005 whether any deferred compensation arrangements should be terminated and paid out.
  • Revise now any deferral election procedures to comply with the new law.
  • Determine whether or not to modify any grandfathered plans to be consistent with the terms of new deferred compensation arrangements.
  • Develop an action plan to bring plans in compliance with the new regulations.
  • Monitor compliance of plans with the new rules.
  • Develop communications materials to explain to participants the new rules.
  • Consider what design changes are appropriate in light of the new rules.
  • Amend existing plans to comply with the new rules.

Finally, the proposed regulations are complicated. In fact, this lengthy alert is an attempt to hit just the highlights of the regulations and does not discuss many of the nuances and special rules that may apply to your company or to different fact patterns. In this environment, we encourage you to consult your benefits attorney or other advisors if you have any questions or concerns.


The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.