Employee Benefits Advisory Bulletin
IRS Extends Deadline for Non-Qualified Deferred Compensation Plans
By Jeff Belfiglio, Stuart Harris and Anne L. Northrup
[October 2006]
On Oct. 4, 2006, the IRS and the Treasury Department issued Notice 2006-79 and again delayed the deadline for amending plan documents to comply with Section 409A of the Internal Revenue Code (the “Code”).
Background
As previously described in a prior advisory bulletin, the American Jobs Creation Act added Section 409A to the Code, which effectively overhauled the rules relating to non-qualified deferred compensation. The changes applied prospectively, governing deferred compensation that accrued or first vested on or after Jan.1, 2005. The IRS and Treasury then issued interim guidance in the form of Notice 2005-1, followed by proposed regulations. As part of this interim guidance, employers were allowed to rely on a good faith interpretation of Section 409A until final regulations were issued; the interim guidance also delayed any need to amend plan documents until Dec. 31, 2006.
What’s New?
Delayed Deadline of Dec. 31, 2007 for Plan Amendments
Notice 2006-79 acknowledges that final regulations are not ready, but the IRS still intends to try and issue them by the end of 2006. In light of the lack of final guidance, the Notice extends the deadline for amending plan documents by an additional year, until Dec.31, 2007. Although plan documents need not currently incorporate the rules of Section 409A, the plans must operationally comply. As a result, many employers will be operating differently than what the plan document anticipates. Prior to final regulations, operational compliance is based on reasonable, good faith compliance.
Extended Period for Revised Distribution Elections
Plan participants also have until Dec. 31, 2007 to revise their distribution elections, if the employer decides to offer this flexibility. Revised elections will not be deemed to violate Section 409A, provided the changes do not:
- accelerate into the current calendar year (i.e., the calendar year in which the revised election is made) a payment that would otherwise have been paid in a subsequent year, or
- defer into any later calendar year a payment that would otherwise have been paid in the current calendar year (i.e., the calendar year in which the new election is made).
Example:
Jack, Jill and Bob all participate in a non-qualified deferred compensation plan. Under their respective prior elections, Jack will be paid out his account balance in a lump sum in calendar year 2006; Jill will be paid out her account balance in a lump sum in 2007; and Bob is scheduled to receive a distribution in 2012. If the employer facilitates new elections during the current interim period, Jack could not make an election to defer payment into a subsequent year, since his payment is already scheduled to be made in the current calendar year (2006). On the other hand, Jill could make an election in 2006 to further defer her payment beyond 2007, but she could not elect to accelerate the payment into 2006, and could not wait until 2007 to make an election to further defer. Bob could make an election, up until Dec. 31, 2007, to accelerate the scheduled payment into a year earlier than 2012 (but later than the year in which he makes the revised election) or further defer the payment into a year beyond 2012.
Exchange of Stock Options and Stock Appreciation Rights
One of the fallouts of Section 409A is that discounted stock options or stock appreciation rights (i.e., options or rights with an exercise price less than the fair market value of the underlying stock on the date of grant) are extremely problematic. The IRS acknowledged that some of these options or appreciation rights may have been granted prior to the passage of Section 409A, but are nonetheless subject to the new rules because the options or appreciation rights first vested after the grandfather date of Jan. 1, 2005. For these situations, the IRS authorized employers to substitute the discounted options or appreciation rights with corresponding non-discounted options or rights. Under the extended deadline, this substitution can now take place up until Dec. 31, 2007. Note that if a discounted option or appreciation right is exercised before the substitution, there may well be a violation of Section 409A, which a subsequent corrective substitution could not fix. In addition, this transition relief does not apply to discounted stock options or stock appreciation rights with respect to situations involving the following three factors:
- stock of a publicly traded company;
- granted to a person who must report any sales or exchanges of the stock to the SEC; and
- where the grant resulted in the underlying company reporting, or reasonably expecting to report, a corresponding financial expense, which expense was not timely reported on financial statements and reports under generally accepted accounting principles.
Next Steps for Employers
Notice 2006-79 reiterates the IRS’ intention to issue final regulations before the end of calendar year 2006. Many employers will choose to wait for the final regulations before amending their plans because the final regulations may offer greater flexibility. But even without corresponding amendments, plans must currently comply with Section 409A in operation. Some employers, particularly those who have had to change their historical practices to operationally comply with Section 409A, may want to move ahead with amending their plan documents to avoid a prolonged state of limbo, where their plan documents do not reflect what they are doing in actual practice.
For more information, please contact:
This Advisory is a publication of the Employer Services Department of Davis Wright Tremaine LLP. Our purpose in publishing this Advisory is to inform our clients and friends of recent developments in employment law. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may be given only in response to inquiries regarding particular situations.
Copyright © 2006, Davis Wright Tremaine LLP.
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