October 23, 2007
On October 22, the IRS issued Notice 2007-86, which extends to December 31, 2008 most of the transition relief under Section 409A of the Internal Revenue Code. The guidance greatly expands the scope of relief offered in Notice 2007-78, issued on September 10th. By extending to December 31, 2008 most of the Section 409A compliance deadlines, the IRS is allowing more time for employers and service providers to analyze all of their plans, make decisions regarding the time and form of payments, and amend the plans to comply with Section 409A.
Effective Date/Good Faith Reliance. Section 409A applies to compensation deferred on or after January 1, 2005. Previous deferrals generally are "grandfathered" unless the arrangement is materially modified. For these purposes, deferred compensation amounts that were not earned and vested as of December 31, 2004 are not protected by the grandfathering rules.
Final regulations interpreting Section 409A were issued in April 2007 (summarized at Gibson Dunn April 11, 2007 Update). The final regulations generally were to become effective on January 1, 2008, and plans were required to be amended by December 31, 2007 to reflect the regulations. The IRS issued limited relief in Notice 2007-78 that extended the plan amendment deadline to December 31, 2008, but most plan design decisions, as well as all payment elections, were required to be made by December 31, 2007 (see Gibson Dunn September 11, 2007 Update).
Under newly issued Notice 2007-86, the following rules apply for Section 409A compliance:
During 2008, taxpayers are not required to comply with the requirements of the final regulations. Rather, they are required to operate a nonqualified deferred compensation plan in compliance with the plan’s terms, to the extent consistent with Section 409A and applicable guidance issued by the IRS (including IRS Notice 2005-1). Where a provision of Notice 2005-1 is inconsistent with the final regulations, taxpayers may rely upon either Notice 2005-1 or the final regulations. To the extent an issue is not addressed in Notice 2005-1 or other applicable IRS guidance, taxpayers must apply a reasonable, good faith interpretation of the statute.
Through December 31, 2007, compliance with the proposed regulations or the final regulations will automatically constitute reasonable, good faith compliance with the statute. However, taxpayers may not rely upon the proposed regulations for periods after December 31, 2007.
During calendar 2008, compliance with the final regulations (but not the proposed regulations) will automatically constitute reasonable, good faith compliance with the statute.
Compliance with the final regulations is required beginning January 1, 2009.
Plan Amendments. Plans must be amended by December 31, 2008 to conform to the provisions of Section 409A and the final regulations. Amending a plan by this date is a condition to satisfaction of the reasonable, good faith reliance standard as well.
The application of the Section 409A plan amendment rules to "good reason" severance provisions was addressed in some detail in Notice 2007-78. Under the final regulations, if a good reason provision constitutes a "substantial risk of forfeiture," severance paid no later than 2-1/2 months after the year in which an employee terminates can qualify for the "short-term deferral" exclusion from Section 409A coverage. Alternatively, if the good reason provision is the equivalent of an involuntary termination provision, some portion of the severance (typically referred to as the "two times, two years" rule) is excluded from Section 409A coverage. These exclusions can avoid the six-month delay applicable to payments to "specified employees" (generally "top 50" officers) of public companies. A question that has frequently arisen is the scope of the ability to modify good reason provisions to take advantage of these exceptions to the six-month delay rule. The rules can be summarized as follows:
If a good reason provision currently constitutes a substantial risk of forfeiture ("SROF"), it generally can be changed to another good reason definition that also is a SROF (e.g., to the "safe harbor" good reason definition in the final regulations). This can allow continued reliance on the short-term deferral exclusion. Whether a good reason provision constitutes a SROF is determined under all the facts and circumstances. Although not explicitly addressed by Notice 2007-78, it presumably should be possible to treat a "double trigger" good reason severance provision as subject to a SROF if a change in control has not yet occurred and the amendment is adopted before the year in which the change in control occurs.
If the good reason provision is not a SROF — because it is so broad that the severance rights effectively are considered "vested" by the IRS — it cannot be modified to make it a SROF. Thus, the short-term deferral rule can never apply to severance paid under the agreement (whether the severance is paid due to a good reason termination, a termination by the employer without cause, or for any other reason).
However, a good reason provision that is not a SROF can be modified to be the equivalent of an involuntary termination provision so as to bring the severance arrangement within the scope of the two times, two years exclusion. This will generally allow at least a portion of a specified employee’s severance (possibly as much as $460,000 in 2008) to be paid out before the six month anniversary of termination of employment.
Changes in Payment Elections. With respect to deferrals subject to Section 409A, a plan may provide, or be amended to provide, for new payment elections on or before December 31, 2008, with respect to both the time and form of payment. Such an election may also apply to amounts that are short-term deferrals as long as the election is made before the year in which the amount otherwise would have been paid (and, in all events, no later than December 31, 2008). However, (i) election changes cannot be made in 2007 to defer payments that otherwise would be made in 2007 or to accelerate payments into 2007, and (ii) election changes cannot be made in 2008 to defer payments that otherwise would be made in 2008 or to accelerate payments into 2008.
One important caveat is that Notice 2007-86 provides relief only with respect to Section 409A. It does not provide relief from the "constructive receipt" rule or other tax doctrines. For example, offering an election on December 31, 2007 to receive a deferred compensation cashout on January 2, 2008 may implicate constructive receipt concerns even though the Section 409A transition relief is available. Thus, these rules outside of Section 409A itself need to be considered when offering employees and other service providers the ability to change payment elections.
Mirror Elections under Qualified Plans. Elections as to the timing and form of payment under a nonqualified plan or arrangement may be controlled by payment elections made under a corresponding qualified plan through December 31, 2008 (e.g., a Code section 415 excess benefit plan), provided that the payment is in compliance with the terms of the plan or arrangement as of October 3, 2004.
Substitution of Non-Discounted Stock Options and Stock Appreciation Rights ("SARs")/Addition of Fixed Exercise Date. Options and SARs with an exercise price that is lower than 100% of the fair market value of the underlying stock on the date of grant (often called "discounted" or "in the money" stock options or SARs) that were not vested and exercisable as of December 31, 2004 generally are subject to Code section 409A. Notice 2007-86 generally extends to December 31, 2008 the ability to cancel a discounted stock option or SAR and substitute a non-discounted option or SAR not subject to Code section 409A. (The revised exercise price is based on the fair market value of the stock on the original grant date, not the date of cancellation/regrant.) Subject to the same exception, Notice 2007-86 allows a corporation to "correct" a discount stock option grant by imposing a fixed exercise date, subject to the rules described above regarding changes in payment elections.
An important caveat is that the transition relief will not apply to discount options/SARs to the extent they are exercised before the Section 409A violation is corrected. For example, if discount options subject to Section 409A are exercised in 2008 before the Section 409A problem is corrected, those options generally will be subject to Section 409A. Another important condition is that cash or vested property may not be provided to the grantee in the year the discount option is corrected in order to compensate the grantee for the reduction in the option/SAR "spread" as a result of an increased exercise price. For example, cash or vested property may not be provided as a "make-whole" payment in 2008 in connection with the cancellation and reissuance in 2008 of stock options with an increased exercise price.
Finally, the December 31, 2006 deadline from IRS Notice 2006-79 for correction of discounted options/SARs issued to "Section 16" persons has not been extended. Thus, such options/SARs generally became taxable under Section 409A as of January 1, 2007 (or, if later, when they vested) if they were not corrected by December 31, 2006, and no corrective action is permissible at this time.
Conclusion. The IRS should be commended for listening to the practical concerns expressed by the executive compensation bar and extending the Section 409A plan amendment deadline and the payment election transition rules for another 12 months. This will give employers and service providers more time to make plan design decisions and to bring the documents into compliance with Section 409A. It can safely be assumed that there will not be any more extensions to the deadlines, so employers and service providers should be proactive in making plan design decisions and amending plans and arrangements subject to Section 409A.
Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or
Stephen W. Fackler (650-849-5385, [email protected]),
Charles F. Feldman (212-351-3908, [email protected]),
David West (213-229-7654, [email protected]),
David I. Schiller (214-698-3205, [email protected]),
Michael J. Collins (202-887-3551, [email protected]),
Sean Feller (213-229-7579, [email protected]),
Amber Busuttil Mullen (213-229-7023, [email protected]),
Jennifer Patel (202-887-3564, [email protected]),
Chad Mead (214-698-3134, [email protected]),
Kimberly Woolley (415-393-8225, [email protected]),
Jonathan Rosenblatt (650-849-5317, [email protected]), or
John C. Cook (202-887-3665, [email protected]).
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