IRS Extends Section 409A Compliance Deadlines

Scott E. Vincent
Vincent, Fontg & Hansen, L.L.C.
Kansas City

The Internal Revenue Service recently issued Notice 2007-78 to provide transition relief and additional guidance on the application of Code § 409A to nonqualified deferred compensation plans. Many practitioners had been attempting to prepare for the application of § 409A to these plans effective January 1, 2007; the IRS has generally extended the compliance deadline to the end of 2008 for certain elements of § 409A compliance. The transition relief and additional guidance includes:

• Extension to December 31, 2008, of the deadline to adopt documents that comply with § 409A, subject to limited requirements regarding the timely written designation of a time and form of payment.

• Guidance and additional relief addressing certain issues raised by the application to employment agreements and cashout features of § 409A and the final regulations.

• Announcement that the Treasury Department and the IRS anticipate issuing guidance containing a limited voluntary compliance program that will permit taxpayers to correct certain unintentional operational violations of § 409A and limit the amount of additional taxes due.

• Announcement that previously provided IRS relief from the application of § 409A(b) (which prohibits the use of certain types of arrangements to pay for nonqualified deferred compensation) with respect to certain “grace period assets,” which expires December 31, 2007, is not being extended, and thereby requiring taxpayers to comply with a reasonable, good faith interpretation of § 409A(b) with respect to all assets in such arrangements effective January 1, 2008.

Background

Internal Revenue Code § 409A imposes specific requirements applicable to nonqualified deferred compensation plans. If a plan does not meet those requirements, the plan participants are required to immediately include amounts deferred under the plan in income and pay additional taxes on this income.

Final regulations under § 409A were issued earlier this year for application to taxable years beginning on or after January 1, 2008. The final regulations generally require that the material terms of a nonqualified deferred compensation plan be in writing, with several other specific requirements. Commentators have expressed extensive concerns regarding the expected difficulties that taxpayers will experience in formally amending existing plans to comply with the final regulations by the January 1, 2008 deadline. There have also been questions raised regarding the application of the final regulations to certain types of plans. The recent IRS notice attempts to respond to these comments and questions, and provide transition relief and additional guidance regarding the application of § 409A and the regulations.

Transition Relief

Section 409A generally applies to amounts deferred under a nonqualified deferred compensation plan to the extent the amounts deferred under the plan were not earned and vested before January 1, 2005. The final regulations are applicable for taxable years beginning on or after January 1, 2008, and a nonqualified deferred compensation plan must meet the requirements set forth in the final regulations as of the first day of the taxable year. The current IRS notice provides limited transition relief, until December 31, 2008, with respect to the plan document requirements. The transition relief in the IRS notice does not extend previous IRS transition relief. In addition, after December 31, 2007, taxpayers may not change the time and form of payment in their plan except as permitted under the final regulations and the current IRS notice. The IRS transition relief addresses both a retroactive amendment period and the methods for designating compliant times and forms of payment.

Retroactive Amendment Period

The written provisions of a plan may fail to meet the requirements of § 409A, the final regulations, and any other applicable guidance, because the plan includes a provision that causes the plan to fail to satisfy the requirements of § 409A, or because the plan fails to include a written provision that is required to satisfy the requirements of § 409A. However, under the transition relief provided in the IRS notice, a nonqualified deferred compensation plan will not violate the requirements of § 409A on or before December 31, 2008 merely because the written provisions of the plan fail to meet the requirements of the § 409A guidance, provided that the plan is operated in accordance with the requirements of the § 409A guidance and is amended on or before December 31, 2008 to comply with the § 409A guidance retroactively to January 1, 2008.

A plan is treated as having been amended to comply with the § 409A and the relevant guidance retroactively to January 1, 2008, only if the amended written plan contains all of the written provisions required by the final regulations and accurately reflects the operation of the plan on and after January 1, 2008, through the date of the amendment, including the terms and conditions under which any initial deferral elections or subsequent deferral elections were permitted, and how the operation of such plan met the requirements of § 409A on and after January 1, 2008, through the date of the amendment.

Designation of a Compliant Time and Form of Payment

The IRS notice also provides detailed guidelines under which, for periods on or before December 31, 2008, a nonqualified deferred compensation plan will be treated as meeting the requirement to timely designate a time and form of payment of an amount deferred under the plan. If there have been deferrals of compensation under a plan as of January 1, 2008, but the deferred compensation has not been paid, the plan will not comply with § 409A after December 31, 2007, unless the plan designates in writing before January 1, 2008, a compliant time and form of payment of such deferred compensation. Amounts deferred after December 31, 2007, and before January 1, 2009, will not comply with § 409A unless the plan designates in writing a compliant time and form of payment of such amounts on or before the applicable deadline under the final regulations. For purposes of these provisions, a plan will designate a compliant time and form of payment for a deferred amount only if the plan provides for an objectively determinable form of payment payable upon:

• A separation from service;

• A change in control event;

• An unforeseeable emergency;

• A specified date or fixed schedule of payments;

• Death; or

• Disability.

Additional IRS Relief for Employment Agreements

Good reason provisions

The IRS notice recognizes that commentators have considered modifying employment arrangements that currently provide for a payment upon a voluntary separation from service under certain conditions (often referred to as “good reason conditions”), including modifying the good reason conditions under which an employee could voluntarily terminate employment and receive payments to conform to the requirements of the definition of an involuntary separation from service under the regulations. Accordingly, to the extent that a right to a payment subject to an existing good reason condition is subject to a substantial risk of forfeiture, the current IRS notice provides that modification of the good reason condition on or before December 31, 2007 to conform to some or all of the conditions set forth in the § 409A regulations will not be treated as an extension of the substantial risk of forfeiture. The IRS notice provides further details and guidance that should be consulted with respect to the specific amendments being considered.

Substitution Rule

Commentators have also asked the IRS to address conditions under which rights to deferred compensation under an extension of an employment agreement, or a negotiation of a new employment agreement, will constitute a new legally binding right to compensation rather than a substitution for rights to deferred compensation contained under a previous agreement. Until further guidance, if a right to deferred compensation payable only upon an involuntary separation from service at all times under an employment agreement would automatically be forfeited at the end of the term of the employment agreement, then the grant of a right to deferred compensation in an extended, renewed or renegotiated employment agreement will not be treated as a substitute for the right that was forfeited at the termination of the prior employment agreement.

Predetermined Cashouts

The § 409A regulations provide a limited ability for the cashout of all remaining installments under an installment payment provision when the present value of the remaining payments falls below the predetermined threshold. A similar rule applies with respect to annuity payments. Commentators have asked the IRS whether a plan may provide for a lump sum payment at the payment date only if the present value of the payments at that date is below a predetermined amount, but continue to make any properly elected installment payments or annuity payments if the present value of the payments at the original payment date is above the predetermined amount, even if the present value of the remaining payments falls below the predetermined amount at a future date. In other words, the cashout threshold would apply only at the time of the original payment date, and not at any future date.

The IRS notes that use of this type of a cashout provision may, in certain circumstances, be subject to manipulation, so that this type of provision is not an objectively determinable and non-discretionary schedule of payments. However, until further guidance, the IRS has allowed a taxpayer to treat such a provision as part of an objectively determinable and nondiscretionary payment schedule if the payment schedule would otherwise meet the requirements of the regulations, including that the cashout threshhold be fixed at the time the permissible payment event is designated, and if the taxpayer can demonstrate that the provision operated in an objective, nondiscretionary manner and did not operate so as to provide either the service provider or the service recipient with rights having substantially the effect of a right to a late election as to the time and form of payment. Any subsequent change in a cashout threshold applicable to a deferred amount is subject to the rules governing subsequent deferral elections and the acceleration of payments. The current IRS notice provides additional details to consider carefully in connection with any provisions of this nature.

Anticipated Limited Voluntary Compliance Program

The Treasury Department and the IRS anticipate issuing guidance in the near future to establish a limited voluntary compliance program that will apply to certain unintentional operational failures to comply with § 409A. This guidance is expected to provide methods by which certain unintentional operational failures may be corrected in the same taxable year in which the operational failure occurred to avoid application of

§ 409A, and other methods by which certain unintentional operational failures may result in only limited amounts becoming includible in income and subject to additional taxes under § 409A.

Restrictions on Certain Trusts and Other Arrangments

Prior IRS guidance has indicated that until further guidance is issued, taxpayers may rely upon a reasonable, good faith interpretation of § 409A(b) to determine whether the use of a trust or other arrangement causes an amount to be included in income under § 409A(b). The Treasury Department and the IRS intend to issue further guidance regarding the application of § 409A(b), but until such guidance is issued, taxpayers may continue to rely upon a reasonable, good faith interpretation of § 409A(b) to determine whether the use of a trust or other arrangement causes an amount to be included in income, including the application of § 409A(b)(3) to transfers of assets during restricted periods.