In response to the requests of a nationwide coalition of law firms, the IRS has issued Notice 2007-86, which extends until Dec. 31, 2008 the deadline for complete compliance with Internal Revenue Code Section 409A. The Notice also reiterates issues that employers should consider in advance of the new deadline. This article outlines the effect of Notice 2007-86 and recommends how to prepare for the 2008 deadline.
The Notice is welcome news for legal practitioners and employers who have been struggling to identify all affected nonqualified deferred compensation plans and bring them into operational compliance with Code Section 409A by the end of 2007 (the prior deadline). As described in prior DWT advisories in June and September Code Section 409A imposes a complex set of requirements on nonqualified deferred compensation plans. The new law also defined the term “nonqualified deferred compensation plan” very broadly to include programs ranging from stock option plans to bonus commitments in individual employment agreements. The penalty for noncompliance is steep: all vested amounts deferred under the “plan,” plus any earnings, become immediately includable in the participant’s taxable income, along with a 20 percent penalty tax.
Key provisions of Notice 2007-86
- Continued good-faith compliance required: Plans must continue to operate in “reasonable, good-faith” compliance with Code Section 409A, the regulations issued thereunder and Notice 2005-1 throughout the transition period.
- New documentary compliance deadline: Plans must be amended before Jan. 1, 2009 to comply with Code Section 409A and the applicable guidance.
- Opportunity to change payment elections: A plan may allow, or be amended to allow, participants to make new payment elections as to the time and form of payment any time before Dec.31, 2008. The new election may apply only to amounts that otherwise would not be payable in 2008 and may not cause an amount to be paid in 2008 that otherwise would be payable in a later year. Also, participants who had previously elected to have deferred compensation paid in 2008 may now defer the receipt of such deferred compensation beyond 2008, if such election is made before Dec. 31, 2007.
- Substitution of non-discounted stock options and stock appreciation rights for discounted stock options and stock appreciation rights: Discounted stock options (which are subject to 409A) granted to employees and other service providers (other than certain directors and officers) may be cancelled, and non-discounted options substituted until Dec. 31, 2008, in accordance with the limitations set forth in Notice 2006-79.
- Payments linked to qualified plans: The ability to link a payment election under a nonqualified deferred compensation plan to an election under a qualified plan is extended through 2008.
Action steps in preparation for Dec. 31, 2008 compliance deadline
Although the extended transition relief of Notice 2007-86 is welcome news, we caution employers against delaying needed compliance efforts just because they now can. This seems especially true for employers who have been focusing on Section 409A compliance over the last few months—it makes sense to complete the task while the issues are fresh. But regardless of when an employer decides to tackle comprehensive compliance with Section 409A, we recommend the following:
- Inventory plans and arrangements: Identify potentially affected plans and arrangements by reviewing not only traditional nonqualified retirement plans such as supplemental executive retirement plans (SERPs), but also annual bonus plans, executive employment agreements, severance arrangements, stock options, restricted stock units, equity compensation awards, post-retirement reimbursements, and long-term incentive plans. Note that Section 409A applies not only to plans for employees, but also to arrangements covering non-employee directors and certain other independent contractors.
- Identify grandfathered benefits: Benefits that were accrued and vested by the end of 2004 and that have not been “materially modified” are grandfathered and exempt from Section 409A. Employers should identify whether any deferred compensation arrangements (or portions of deferred compensation arrangements) qualify for grandfathering. Where a portion of a plan’s benefit qualifies for grandfathering, employers should assess whether the advantages of avoiding Section 409A on that portion outweighs the administrative burden of separately accounting for the grandfathered portion.
- Determine if any exemptions apply: The 409A Regulations provide various exemptions for short-term deferrals, severance arrangements, equity compensation awards, etc. Employers should determine whether current deferred compensation arrangements qualify for an exemption.
- Amend covered plans: Plan documents subject to Section 409A must be modified by Dec. 31, 2008 to comply with the 409A Regulations. For example, plan documents must reflect the new rules controlling deferral elections, the timing and form of distributions, and subsequent changes to earlier elections.
- Take appropriate board action: Amendments to plan documents should be approved by the board of directors (or another appropriate body) by Dec. 31, 2008. To avoid an emergency year-end meeting, and holiday scheduling problems, board approval should be sought well in advance of the end of the year.