May 14, 2007
On April 10, 2007, the Treasury Department and the Internal Revenue Service released the final regulations interpreting section 409A of the Internal Revenue Code. Section 409A, which was effective January 1, 2005, has greatly expanded and complicated the tax rules governing nonqualified deferred compensation plans. The final regulations, which will be published in the April 17, 2007 federal register, are the culmination of the interim guidance that has been provided over the past 2½ years, the most important of which include IRS Notice 2005-1 and the proposed regulations at Prop. Treas. Reg. § 1.409A-1, et seq. The text of section 409A, the interim guidance and the final regulations can be found on our website dedicated to section 409A, www.409Alaw.com.
Given the number of affected arrangements and the complexity of the 397-page final regulation package, most employers will want to turn immediate attention to their nonqualified deferred compensation plans. Operational compliance with section 409A has been required since the January 1, 2005 effective date, and all documents must now be brought into compliance before the January 1, 2008 effective date of the final regulations.
Some of the key issues that the final regulations address include:
- Certain “good reason” separations from service will be treated as involuntary separations for purposes of the exception to section 409A coverage for involuntary separations and for the substantial risk of forfeiture definition. (See Q&A-4)
- Reimbursement of post-employment medical expenses for the period during which the former employee could elect COBRA coverage is not deferred compensation subject to section 409A. (See Q&A-5) The final regulations also provide a method by which payments of post-employment medical expenses that are subject to section 409A can be structured to comply with section 409A. (See Q&A-25)
- The final regulations address numerous other reimbursement arrangements, such as tax gross-ups, litigation expenses, moving and relocation expenses, and indemnification arrangements. (See Q&A-5 through -7)
- An extension of the exercise period for options and stock appreciation rights (stock rights) will not be considered an additional deferral if the extension is made at a timwhen the exercise price of the stock right exceeds the fair market value of the
underlying stock, or if the exercise period is not extended beyond the earlier of theend of the maximum original exercise period or the 10th anniversary of the originalgrant date. (See Q&A-15)
- The rules that govern initial deferral elections for newly eligible participants now address the treatment of former active participants who again become eligible to participate in a plan. (See Q&A-17)
- Additional flexibility is provided in the determination of who is a “specified employee” subject to the six-month delay of payments triggered by separation from service. (See Q&A-19) The final regulations also provide guidance on how to determine “specified employees” when there have been certain corporate changes (merger, IPO, etc.). (See Q&A-21)
- The final regulations add flexibility to and simplify the definition of “separation from service” for purposes of the permissible distribution trigger rules. (See Q&A-26)
- Although the final regulations do not specifically address “tandem elections” (e.g, the nonqualified benefit is paid when and perhaps in the form in which the qualified plan benefit is paid), it appears that payments cannot be made pursuant to tandem elections after December 31, 2007. (Q&A-24)
- The final regulations address some of the plan documentation requirements, including instances in which incorporation by reference is allowable. (See Q&A 27)
These issues and other significant developments in the final regulations are discussed further in the Q&A section of Sutherland Asbill & Brennan LLP's Legal Alert: IRS Issues Final Section 409A Regulations.