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Current developments (Part I).


* The Service issued much-anticipated proposed regulations on the application of Sec. 409A to NDC, and other guidance on Sec. 409A and offshore trusts.

* A ruling provides insight on the commission-based exception to the Sec. 162(m) compensation limit as a possible alternative to the performance-based exception.

* Rev. Proc. 2006-31 explains when the IRS will grant a request to revoke a Sec. 83(b) election due to a mistake of fact.


This two-part article summarizes the major developments in compensation and employee benefits over the past year (August 2005-August 2006). Part I, below, deals with developments in executive compensation. Part II, in the February 2007 issue, will focus on fringe benefits and qualified retirement plans. The most significant development, the enactment of the Pension Protection Act of 2006, was the subject of an article in the November 2006 issue. (1)

Deferred Compensation

Proposed Regulations

In early October 2006, the IRS issued much-anticipated proposed regulations on the application of Sec. 409A to nonqualified deferred compensation (NDC) plans. (2) These rules implemented provisions enacted by the American Jobs Creation Act of 2004 (AJCA) and incorporated, changed and expanded initial guidance offered in Notice 2005-1. (3) Pursuant to Notice 2006-79, (4) the proposed regulations will not become effective before 2008, but can be relied on until then; compliance constitutes good-faith compliance with the statute. In addition, Notice 2005-1 remains outstanding until the regulations are finalized.

A complete discussion of the proposed regulations is beyond this article's scope; however, unless further extended, the deadline for formal compliance with Sec. 409A is Jan. 1, 2008. (Good-faith operational compliance has been required since Jan. 1, 2005.) In addition, under the proposed regulations' transition relief and Notice 2006-79, amounts cannot be paid in 2006 or 2007 that otherwise would have been payable in a later year.

Other Guidance

Sec. 409A technical correction on offshore trusts: The Gulf Opportunity Zone Act of 2005 (GO ZoneAct), approved by unanimous consent on Dec. 16, 2005 and signed by President Bush on Dec. 21, 2005, included a technical correction that significantly affects employers using trusts to fund deferred compensation. The correction provides that the Sec. 409A provisions on offshore trusts apply beginning in 2005, regardless of whether the NDC to which the trust relates was subject to Sec. 409A when the assets were contributed to the trust.

Sec. 409A(b)(1) provides that assets set aside in a trust for purposes of paying NDC are treated as Sec. 83 property when they are located outside of the U.S. There is an exception if the assets are held in the jurisdiction in which substantially all of the services to which the NDC relates are performed. Sec. 409A(b)(4) imposes an additional 20% tax on amounts required to be included in gross income under Sec. 409A(b)(1) and, under certain circumstances, an additional tax based on interest at the underpayment rate plus one percentage point.

AJCA Section 885(d) provides that Sec. 409A applies to amounts deferred after 2004. For this purpose, an amount is deferred after Dec. 31, 2004, unless it is fully earned and vested by that date and the plan under which it is deferred is not materially modified after Oct. 3, 2004. Thus, under the AJCA, only assets set aside as to amounts earned or vested after 2004 would be subject to Sec. 409A(b); amounts attributable to deferred compensation earned and vested before then would not be subject to Sec. 409A(b), even if they continued to be held in an offshore trust.

The technical correction provides that, notwithstanding AJCA Section 885(d)(1), Sec. 409A(b) took effect on Jan. 1, 2005. Thus, regardless of whether the related deferred compensation is subject to Sec. 409A, the trust is subject to Sec. 409A(b) and the penalties thereunder.

Example: A U.S. citizen worked for a Japanese corporation throughout Asia from 2000-2004 and earned vested deferred compensation during that time for which assets are held in a rabbi trust outside the U.S. Although the deferred compensation is not subject to Sec. 409A, under the technical correction, amounts not attributable to any services the employee performed in the same jurisdiction as the location of the trust are subject to Sec. 409A(b).

The new effective date also applies to assets held in a trust with financial-health trigger provisions subject to Sec. 409A(b).

Interim guidance on outstanding stock rights under Sec. 409A: Under Sec. 409A, amounts deferred under an NDC plan are included in income when deferred, or, if later, when no longer subject to a substantial risk of forfeiture, unless the plan complies with requirements for timing of elections and distributions, and funding arrangements. The definition of NDC is fairly broad, but the statute, Notice 2005-1 and the proposed regulations provide exceptions for certain arrangements. One such exception is for stock options, stock appreciation rights (SARs) and other stock-based compensation (collectively, stock rights).

To be exempted from Sec. 409A, a stock right must be issued with respect to service-recipient stock, have an exercise price that cannot be less than fair market value (FMV) on the grant date and include no deferral feature. For stock options, the exercise or disposition must be subject to tax under Sec. 83. For SARs to be exempted from Sec. 409A, the amount payable cannot be greater than the difference between the stock's FMV on the grant date and on the exercise date.

FMV determination: To meet this stock right exception, the FMV on the grant date must be determined. For stock readily tradable on an established securities market, the proposed regulations allow the use of any reasonable, consistently applied method for deriving FMV from actual transactions, including the last sale price before grant, first sale price after grant or closing price on the trading day before or after grant, as well as an average price over a period of up to 30 days before or after grant, if specified in advance. For this purpose, an established securities market can be a national securities exchange registered under Section 6 of the Securities Exchange Act of 1934 ('34 Act), an officially sanctioned foreign exchange or any over-the-counter market.

Determining FMV is more challenging for stock not traded on an established market. In general, the proposed regulations require use of a reasonable method based on reasonable assumptions, and establish several safe harbors. Use of one of the safe harbors on a consistent basis is presumed reasonable; to rebut the presumption, the IRS must show that the valuation method or its application was grossly unreasonable. The three safe-harbor methods are:

* An independent appraisal that meets the requirements for valuing stock held by an employee stock ownership plan (ESOP) and issued no more than 12 months before the relevant transaction;

* A formula-based valuation that would constitute a nonlapse restriction for purposes of Sec. 83, provided the formula is used both for compensatory and noncompensatory purposes (including issuances to and repurchases from nonemployee third parties); or

* For illiquid stock of start-up companies (generally, those that have been in business for less than 10 years, have no publicly traded class of securities and do not anticipate a change in control or a public offering within the next 12 months), a reasonable, good-faith valuation evidenced by a written report issued by someone who is qualified, but not necessarily independent.

Reasonable valuation method: Notice 2006-4 (5) addresses concerns that, although stock rights may have been intended to be granted at FMV, the issuers may not be able to demonstrate that the exercise price was determined using a reasonable valuation method in accordance with Notice 2005-1 or the proposed regulations. Notice 2006-4 permits stock rights granted before 2005 to rely on Regs. Sec. 1.422-2(e)(2), which provides that if there was a good-faith attempt to set the exercise price of a stock right at a price not less than the stock's FMV at the time it was granted, such exercise price will be treated as being not less than FMV. For stock rights granted after 2004, any reasonable valuation method used in accordance with Notice 2005-1 or the proposed regulations would be accepted. Thus, for awards granted after 2004, when a taxpayer can demonstrate that the (1) exercise price of the stock right was intended to be not less than FMV on the grant date and (2) price was determined using a reasonable valuation method, the valuation requirements will be satisfied.

Request for comments: Notice 2006-4 requests comments on the proposed regulations, specifically on how the standards proposed for determining the FMV of stock subject to stock rights may be improved. Comments are also requested on the definition of service-recipient stock as used in the stock-right exception. This request indicates that taxpayers may see more detailed standards for valuation than are currently available in Notices 2005-1 and 2006-4. In the interim, a good-faith attempt will be sufficient for grants prior to 2005, and a reasonable demonstration is required for grants after 2004.

Offshore trust transition relief: Notice 2006-33, (6) issued on March 21, 2006, gives employers until Dec. 31, 2007, to comply with the Sec. 409A(b) rules that prohibit use of offshore trusts or arrangements that use restrictions on assets in connection with a change in the service recipient's financial health (financial-health triggers) in conjunction with NDC plans. It does not offer transition relief for assets transferred to trusts subject to Sec. 409A(b) after March 21, 2006.

This guidance was required by the GO Zone Act, which made the Sec. 409A(b) trust rules effective starting in 2005. This effective date applies whether or not the trust assets related to NDC were earned and vested by the end of 2005.

Due to the retroactive effective date, Congress required Treasury to offer guidance and transition relief within 90 days after the enactment of the GO Zone Act; Notice 2006-33 provides this guidance. Specifically, it grants relief through Dec. 31, 2007, for assets and earnings credited to such assets (1) set aside or transferred to an offshore trust by March 21, 2006 or (2) placed in a trust with a financial-health trigger by that date.

If assets are located in the U.S. or are not subject to a financial-health trigger after March 20, 2006, subsequent transfer outside of the U.S. or addition of a financial-health trigger is not protected by Notice 2006-33. For example, assets located outside the U.S. as of Dec. 31, 2004, that were subsequently transferred and in the U.S. as of March 21, 2006, cannot be transferred back out of the U.S. to take advantage of the transition period. Additionally, if a financial-health trigger was removed from a mast to be in good-faith compliance with Sec. 409A, it cannot be added back to the mist, even if removed by the end of the transition period.

Plans can comply with Sec. 409A(b) by the end of 2007, by bringing grace-period assets back to the U.S. (or a proper service jurisdiction), using them to make payments of the NDC (including payments on termination), decoupling the assets from the plan or eliminating any applicable financial-health restriction.

Significantly, however, there is no relief for amounts not funded on March 21, 2006. Thus, no new contributions or transfers may be made to an offshore trust related to an NDC plan with participants who are U.S. taxpayers, or to a trust with a financial-health-trigger clause.

Notice 2006-33 does not provide further guidance on Sec. 409A(b), but states that such guidance is intended. Specifically, it does not provide rules on when trust assets are considered "offshore," or the requirements to bring them "onshore" or into a proper service jurisdiction. The statute also specifically allows Treasury to issue rules defining other arrangements that can be considered a trust. However, the notice does not include a determination that any other arrangement should be treated in the same way as a trust.

Sec. 162(m)

In October 2005, the IRS released the first letter ruling (7) to hold that compensation is exempt from the Sec. 162(m) $1 million limit, based on the commission-based exception in Sec. 162(m)(4)(B). This ruling provides insight into qualifying for this exception and offers taxpayers information on an alternative to the "performance-based" exception to Sec. 162(m).

The ruling involved an employee working for a publicly traded executive placement firm. The firm received fees for conducting searches for clients; it would receive a cash fee and, in some cases, would also be entitled to an "equity fee," typically consisting of warrants on company stock. If the firm received an equity fee, it converted it to cash as soon as possible and paid it to the consultants who were part of the team, according to an allocation formula determined in advance. As a direct result of the employee's efforts, the company was hired to fill an executive position. This search was successful, and resulted in the payment of a cash fee and an equity fee (warrants on the client's stock).When the warrant was exercised, the employee received his share of the equity fee, under the predetermined formula. By the time this fee was received, the employee was a "covered employee" for Sec. 162(m) purposes.

The Service ruled that the portion of the equity fee payable to the employee, a member of the placement team for the project, qualified for the commission-based exception to Sec. 162(m). This ruling is important, became the payments were made to an executive responsible for the client's commitment to use the company, with the performance of the obligations under the contract performed by another group of employees. The Sec. 162(m) regulations indicate that the commission-based exception applies only if compensation is paid based on the executive's individual performance. However, the ruling recognizes that there can be "individual performance" even if there is a project team that created the revenue and was entitled to a commission.

The ruling notes that there were "individual efforts" on the part of the executive in question. Thus, it suggests that the commission-based exception can apply when there are clearly delineated roles for each team member, even though there are other team members who also provide services to the client. Sufficient individual efforts in a particular situation might consist of making the sale or creating a relationship. In comparable circumstances, an employer can design a structure that provides compensation measured by revenues generated from a relationship created by an executive. Given the role that many high-ranking officers play in establishing contacts, the ruling renews interest in the commission-based exception that had previously been something of an afterthought.

There are aspects of the commission-based exception that are advantageous relative to the more commonly used performance-based exception to the Sec. 162(m) limit. The performance-based exception includes many requirements that make planning and monitoring necessary to protect against inadvertent failures. In contrast, there are no comparable requirements for the commission exception, as long as the basic commission structure fits within it.

Sec. 83

Revoking Sec. 83(b) Election Due to Mistake of Fact

The IRS issued Rev. Proc. 2006-31 (8) to explain the circumstances under which a request to revoke a Sec. 83(b) election due to a mistake of fact will be granted. The procedure clarifies that the mistake-of-fact exception is very narrow in scope and is available only if there is "an unconscious ignorance of fact that is material to the transaction." Also, it explains how a taxpayer may ask the Service for consent to revoke. The procedure was effective on June 13, 2006.

The procedure contrasts a mistake of fact with a mistake of law, which "occurs where a person is ignorant of, or comes to an erroneous conclusion as to, the legal effect of the facts." Thus, it specifies that an employee's or service provider's failure to understand the substantial risk of forfeiture associated with the property or the tax consequences of making a Sec. 83(b) election is not a mistake of fact.

Significantly, the procedure notes that the IRS "has recognized the principle that an election made under the Code or regulations may be revoked on or before the due date for making the election." In keeping with that principle, the Service generally will permit a taxpayer to revoke a Sec. 83(b) election if the request is filed by the due date (i.e., within 30 days of the transfer) for making the election, even if the mistake-of-fact exception otherwise would not apply.

Common Stock Option Inclusion and Deduction Mistakes

Facts: On Aug. 2, 2005, the IRS released Rev. Rul. 2005-48, (9) holding that income inclusion resulting from the exercise of a nonstatutory stock option (NSO) is not delayed by Securities and Exchange Commission (SEC) Rule 10b-5 or by contractual "lock up" or "trading window" periods. Because the ruling merely reiterates a prior Service interpretation, it implies that taxpayers may be making mistakes about deduction timing for Sec. 83 property transfers.

In Rev. Rul. 2005-48, an employee was granted an NSO to purchase shares of his employer's common stock on Jan. 2, 2005. The NSO was at-the-money, immediately exercisable and had no readily ascertainable FMV for purposes of Regs. Sec. 1.83-7. On May 1, 2005, the employer became a public company, and as part of the company's agreement with its underwriters, the employee agreed not to sell options on or shares of employer stock from May 1, 2005 to Nov. 1, 2005 (lock-up period). The employer also adopted an anti-insider-trading program that limited share trading to a one-month trading window, November 2005, but did not restrict option exercises. The program was enforced by threat of termination. On Aug. 15, 2005, the employee exercised the option, but could not sell the shares at that time, because such a sale would have subjected him to insider-trading liability under SEC Rule 10b-5. (10)

Analysis: The IRS discussed how, pursuant to Sec. 83(c)(3), the "short-swing profits" rule of Section 16(b) of the '34 Act works to delay income inclusion from the exercise of an option for up to six months from the grant date. The Service stressed that in enacting Sec. 83(c)(3), Congress concluded that the only securities law provision that should delay income taxation under Sec. 83 is '34 Act Section 16(b). By contrast, potential liability under SEC Rule 10b-5 does not enjoy the same statutory exception, and does not (by itself) render stock substantially nonvested for purposes of Sec. 83 inclusion. Thus, potential liability under SEC Rule 10b-5 does not delay income inclusion for service providers who have received employer stock pursuant to an option. Additionally, because the period of liability under SEC Rule 10b-5 is temporary, it is considered a "lapse restriction" which is ignored in valuing the shares for Sec. 83 purposes.

Similarly, the IRS reasoned that neither the contractual lock-up period nor the trading window made the shares the employee received on exercise substantially nonvested for Sec. 83 purposes. Neither of the contractual provisions conditioned rights on future performance of (or refraining from) substantial services or on a condition related to a purpose of the transfer of shares. Because the lock-up period was temporary and the insider-trading policy imposed no restriction during the trade window, the Service also considered these provisions to be nonlapse restrictions, ignored in valuing the shares.

The IRS had previously concluded (using almost identical language) that neither SEC Rule 10b-5 nor the contractual provisions delay income inclusion under Sec. 83. (11) Additionally, courts have agreed with this view of contractual provisions. (12) However, the Service noted that it intends to amend the Sec. 83 regulations to clarify these conclusions.

Income inclusion timing: As Rev. Rul. 2005-48's fact pattern and stated intent to clarify the regulations make dear, taxpayers often make mistakes in income-inclusion timing. These errors result in employers taking deductions in later years than is proper. In addition, many people have misunderstood these rules; the IRS is finding many errors in recent audits. By filing for a change in accounting method to correct improper deduction timing, the taxpayer secures audit protection and benefits from a four-year spread of the Sec. 481 adjustment.

In general, deductions are allowed under Sec. 162 for property transferred in connection with the performance of services. Pursuant to Sec. 83(h), employer deductions for property transfers are generally allowed in the tax year in which or with which ends the tax year of the service provider in which such amounts are included as compensation. However, an exception to the general timing rule is provided for property substantially vested at the time of transfer. In such circumstances, Regs. Sec. 1.83-6(a)(3) provides that an employer is allowed a deduction in accordance with its overall accounting method (typically, the accrual method).

The exception is not available for deductions related to stock option exercises within six months of the grant of the option by individuals who would be subject to suit under '34 Act Section 16(b), because that restriction makes the stock substantially nonvested until the six-month period has ended. However, stock obtained through option exercise by such individuals six months after grant (or later) is substantially vested; the resulting compensation deduction can be taken pursuant to the employer's normal accounting method under Regs. Sec. 1.83-6(a)(3). Similarly, consistent with the conclusion of Rev. Rul. 2005-48, employers whose employees exercised options, but cannot sell the underlying stock immediately because of either SEC Rule 10b-5 or contractual provisions, can deduct the compensation expense in accordance with their overall accounting method, because the amounts are considered substantially vested.

For many fiscal-year employers, the general Sec. 83 rule often works to delay that deduction for a year.

Example: A July 1 fiscal-year employer, X Corp., grants restricted stock to calendar-year employee Y in 2006. In January 2007, Y's restrictions lapse and he becomes substantially vested in the property. Y will include the amounts in income for 2007. However, X will not be able to deduct the compensation expense generated by the vesting until the year ended June 2008, because 2007 (Y's tax year of inclusion) ended within X's fiscal year ending June 30, 2008. This deduction is taken in the year ended June 2007, if the "substantially vested" exception applies.

Pension Plan Limits for 2007

Inflation-adjusted and statutory limits for 2007 are shown in the exhibit on p. 44.


Part II, in the February 2007 issue, will focus on fringe benefits and qualified plans,

(1) See Walker and LaGarde, "The Pension Protection Act of 2006--a Comprehensive Reform Package," 37 The Tax Adviser 650 (November 2006).

(2) REG-158080-04 (10/4/05).

(3) Notice 2005-1, IRB 2005-2, 274.

(4) Notice 2006-79, IRB 2006-43, 763.

(5) Notice 2006-4, IRB 2006-3, 307.

(6) Notice 2006-33, IRB 2006-15, 754.

(7) IRS Letter Ruling 200541033 (10/14/05).

(8) Rev. Proc. 2006-31, IRB 2006-27, 13.

(9) Rev. Rul. 2005-48, IRB 2005-32, 259.

(10) 17 CFR [section] 240.10b-5, Employment of manipulative and deceptive devices, states: It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

(11) See IRS Letter Ruling (TAM) 200338011 (9/19/03).

(12) See Paul A. Tanner, 117 TC 237 (2001), aff'd, 65 FedAppx 508 (5th Cir. 2003).

For more information about this article, contact Ms. Walker at or Mr. LaGarde at

Deborah Walker, CPA


Deloitte Tax LLP

Washington, DC

Stephen LaGarde

Tax Senior

Deloitte Tax LLP

Washington, DC
Exhibit: Pension plan limits for 2005-2007


Description 2007 2006 2005

Limit on elective deferrals to $15,550 $15,000 $14,000
Sec. 401(k), 403(b) and 457,
etc., plans

Age 50 catch-up contribution limit $5,000 $5,000 $4,000
for Sec. 401(k), 403(b) and 457

Limit on elective deferrals to $10,500 $10,000 $10,000
savings incentive match plan for
employees (SIMPLE) retirement

Age 50 catch-up contribution limit $2,500 $2,500 $2,000
for SIMPLE retirement accounts

Limit on annual benefit under $180,000 $175,000 $170,000
a defined-benefit plan

Limit on annual additions $45,000 $44,000 $42,000
to defined-contribution plans

Sec. 401(a)(17) "covered $225,000 $220,000 $210,000
compensation" limit

Definition of "key employee" $145,000 $140,000 $135,000
in a top-heavy plan

Definition of "highly $100,000 $100,000 $95,000
compensated employee"

Dollar amount for determining $915,000 $885,000 $850,000
maximum account balance in ESOP
subject to 5-year distribution period

Dollar amount used to determine $180,000 $175,000 $170,000
lengthening of ESOP 5-year
distribution period

Simple employee plan $500 $450 $450
(SEP) minimum compensation

SEP maximum compensation $225,000 $220,000 $210,000

Social Security taxable wage base $97,500 $94,200 $90,000

The compensation amount for determining a "control employee" in a
nongovernment employer for computing fringe-benefit valuations under
Regs. Sec.1.61-21(f)(5)(i), increased from $85,000 to $90,000 for
2007. The compensation amount under Regs. Sec.1.61-21(f)(5)(iii)
increased from $175,000 to $180,000.
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Title Annotation:Employee Benefits & Pensions
Author:LaGarde, Stephen
Publication:The Tax Adviser
Date:Jan 1, 2007
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