In newly issued Notice 2007 78, the IRS sets Dec. 31, 2008 as the deadline for amending documents to comply with Section 409A; however, the extended deadline does not apply to a plan’s obligation to designate, in writing, the timing and form of payment of current benefits, which for existing deferred compensation amounts must be done no later than Dec. 31, 2007. Similarly, the Notice does not extend the requirement to operationally comply with the final 409A regulations beginning Jan. 1, 2008.
As previously reported, the IRS issued final Section 409A regulations in April 2007. The final regulations provided an effective date of Jan. 1, 2008, and gave plan sponsors until Dec. 31, 2007 to amend plan documents to bring them into compliance. This summer, a number of business associations and law firms lobbied the IRS for an extended deadline. Given the wide range of programs affected by Code Section 409A, many plan sponsors and tax practitioners worried it would be physically impossible to review and amend all applicable documents by the 2007 deadline. In addition, many argued that an inflexible application of Section 409A, with no mechanism for repairing unintended missteps, was too severe and did not serve the original goal of preventing abusive arrangements. IRS Notice 2007 78 is a direct response to those concerns.
In summary, Notice 2007 78 provides:
- If certain steps taken, complete plan documentation compliance deferred until Dec. 31, 2008. Subject to the limitations described below, a plan sponsor need not make all the final changes to a nonqualified deferred compensation plan until Dec. 31, 2008. For example, if a plan contained an improper “haircut” provision, that provision would not need to be removed from the plan until Dec. 31, 2008.
- No Extension for operational compliance. As stated in prior notices, 2007 serves as a transitional year, during which taxpayers may rely on a good faith interpretation of Code Section 409A. Beginning Jan.1, 2008, the IRS will require strict compliance; a good faith interpretation will no longer be a defense. Therefore, even though an employer has until Dec. 31, 2008 to remove (for example) an improper “haircut” provision from a plan document, the employer must currently comply with Section 409A and may not use the haircut provision.
- Plans must designate timing and form of payment prior to 2008. Although final plan amendments may generally be deferred until Dec. 31, 2008, the extended period does not apply to the time and form of payment; for current deferred compensation, they must be designated in writing, no later than Dec. 31, 2007. This applies as well to deferred compensation related to services performed in 2008 (to the extent Section 409A and the final regulations would require the designation by Dec. 31, 2007).
Notice 2007 78 provides additional guidance on how a plan may specify a payment date or schedule of payments prior to the plan’s complete amendment for compliance with Code Section 409A. In essence, the guidance permits a broad-brush designation. For example, the documentation could specify a lump-sum payment upon a “separation from service”—even if the plan is then later amended in 2008 to more completely define what constitutes a separation from service—in compliance with the final regulations under Section 409A. In addition, a separate written document may operate in conjunction with the plan document to satisfy the requirement of fixing the schedule and form of payment. In this manner, a separate participant election form could designate the payment form and schedule.
- Changes to employment agreements and severance arrangements. Notice 2007 78 clarifies a number of concerns involving terminations of employment. For example, under the final 409A regulations, a payment that is contingent on an involuntary termination of employment is subject to a substantial risk of forfeiture, and therefore qualifies for a short-term deferral exception. And a voluntary termination of employment for “good reason” may be treated as an involuntary termination.
The final regulations provide some safe harbors for determining when a voluntary termination for good reason will be treated the same as an involuntary termination. Many employers may wish to modify their agreements to conform to the final regulations. Yet the regulations also state that the addition or modification of a substantial risk of forfeiture will not be respected. Notice 2007-78 provides that amendments to take advantage of the final rules regarding “good reason” terminations will not be viewed as improper additions or modifications of a substantial risk of forfeiture.
- Announcement of anticipated voluntary compliance program. The Notice also announces that in the “near future” (a murky concept, when used by the IRS), the IRS will issue a limited voluntary compliance program to cover certain unintentional operational failures under Code Section 409A.
- Application of 409A(b). Finally, the Notice announces an extended period for relying on a reasonable, good faith interpretation of Code Section 409A(b) to determine whether the use of a trust or other arrangement causes an amount to be included in income. Code Section 409A(b) generally prohibits the use of offshore trusts for the payment of nonqualified deferred compensation, or the imposition of restrictions that protect payments in connection with a change in the employer’s financial health.
What should employers do?
The extended deadline is welcome relief because it enables employers and their advisors to stop worrying about significant penalties that might arise if plans are not completely and perfectly amended by Dec. 31, 2007. However, plans must operationally comply with the final Section 409A regulations beginning in 2008, and the extended deadline does not relieve an employer from designating, in writing and no later than Dec. 31, 2007, the date and form of payment of deferred compensation. For these reasons, we recommend that employers promptly proceed with making final decisions regarding plan mechanics, and with amending and restating their plan documents before the 2007 deadline. After all, if an employer must focus on operational compliance and fix payment decisions by the end of 2007, it seems that the most efficient strategy is to continue with any plan amendments at the same time. Of course, if time is short, Notice 2007-78 allows some extra to complete most amendments next year.