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The new deferred compensation rules: an increasingly complex solution to a relatively simple problem.

In October 2005, the Internal Revenue Service issued proposed regulations that provide further guidance regarding the deferred compensation rules in Section 409A of the Internal Revenue Code of 1986. The Proposed Regulations add 238 more pages of guidance on top of the 36 pages of guidance issued by the Treasury Department and the IRS last December ("Notice 2005-1"), and more guidance is coming. This might be a good point to stop and take a look at where we are one year after the enactment of Section 409A.

When did Section 409A become law? Congress enacted Section 409A as part of the American Jobs Creation Act of 2004, which President Bush signed into law on Oct. 22, 2004.

What does Section 409A say? Section 409A provides that amounts deferred under a "qualified deferred compensation plan" are includible in income currently if such amounts were not previously included in income and are not subject to a "substantial risk of forfeiture" ("SRF"), unless the plan meets certain design and administrative requirements. Hence, the "need" for 274 pages (and counting) of guidance to address a relatively small number of perceived abuses with respect to the pre-Section 409A deferred compensation rules.

Why should I care about Section 409A if I don't participate in a deferred compensation plan? You should care for two reasons. First, many compensation arrangements that would not, at first blush, appear to be deferred compensation arrangements are treated as such under Section 409A. Second, if Section 409A applies and the deferred compensation does not comply with Section 409A, then the amount deferred for the year and all preceding years is includible in the recipient's income currently, along with interest (at the IRS underpayment rate plus 1 percent), plus a 20 percent additional tax penalty.

What types of deferred compensation plans are subject to Section 409A? Section 409A potentially covers any plan or individual agreement between a service recipient (such as an employer) and service provider (such as an employee) that provides for the deferral of compensation, including traditional deferred compensation plan, certain stock rights (see below), severance pay, annual or multi-year bonuses, supplemental executive retirement plans (SERPs), and any other compensation arrangement that defers the payment of compensation beyond the taxable year in which the service provider is legally entitled to it. Section 409A applies to employee deferred compensation as well as director and independent contractor programs.

Does Section 409A apply to stock options, restricted stock, stock appreciation rights ("SARs") and puts/calls (together, "Stock Rights")? Section 409A applies to nonqualified stock options, restricted stock and SARs issued below fair market value on the grant date. The determination of fair market value must comply with consistency requirements set forth in the Proposed Regulations. However, Section 409A does not apply to: (1) incentive stock options; (2) restricted stock and nonqualified stock options with an exercise price that can never be less than fair market value of the underlying stock on the grant date of the nonqualified stock option; (3) employee stock purchase plans qualified under Section 423 of the Code; (4) nondiscounted SARs with respect to stock of private as well as public companies' stock; and (5) puts/calls if the purchase price is at fair market value.

What happens if the parties modify, extend or renew a Stock Right? Under the Proposed Regulations, modifications of a Stock Right to achieve the following results generally are not considered modifications that result in a new grant:

* accelerating vesting;

* extending the exercise period of a Stock Right to a date that is no later than the later of the 15th day of the third month following the date, or December 31 of the calendar year in which the Stock Right would otherwise expire;

* permitting the holder to exchange the Stock Right for a cash amount that would be available if the Stock Right were exercised;

* permitting payment of the exercise price with pre-owned stock;

* facilitating the payment of employment taxes or required withholding taxes associated with the exercise of the Stock Right; and

* providing limited tolling of the expiration of the Stock Right if the exercise would violate securities laws.

Other changes in the terms of a Stock Right that may provide the holder with a direct or indirect reduction of the exercise price or an additional deferral feature or an extension or renewal of the Stock Right will generally be deemed a modification resulting in a new grant.

Are partnership interests subject to Section 409A? Until additional guidance is issued, the same principles that apply to the issuance of stock by corporations can be used for the issuance of partnership interests. The nontaxable issuances of partnership profits interests will not be treated as deferred compensation.

Is there ongoing transition relief and when do these rules apply? The Proposed Regulations extend most, but not all, of the Notice 2005-1 transition relief periods until Dec. 31, 2006, including:

* the deadline for adopting conforming amendments to plans and arrangements;

* the period for operating plans and arrangements in good faith compliance with the provisions of Section 409A and the Notice 2005-1 (compliance with the Proposed Regulations, or any final regulations issued prior to Jan. 1, 2007, will also be treated as good faith compliance with Section 409A);

* the period for changing payment elections, except that payments otherwise payable in 2006 cannot be changed in 2006, and in 2006 payments payable later cannot be accelerated to 2006;

* the period for allowing an election as to the timing and form of payment under a nonqualified deferred compensation plan to be controlled by a payment election made under a qualified pension plan; and

* the period for substituting nondiscounted Stock Rights for discounted Stock Rights (although there can be adverse consequences to participants if the substitution of vested rights does not occur until 2006).

The Proposed Regulations do not extend the following transition relief:

* Notice 2005-1 provides limited relief for initial deferrals relating to services performed during 2005, but the Proposed Regulations do not contain similar relief for 2006; and

* the period for participants to cancel deferral elections or terminate participation in a plan ends Dec. 31, 2005, as provided in Notice 2005-1 (and plans may need to be amended by this date if either of these rights is, in fact, provided).

Did the Proposed Regulations provide any other pro-taxpayer changes? The Proposed Regulations supplemented the definition of covered "nonqualified deferred compensation plans" and the exceptions to treatment as deferred compensation. The Proposed Regulations clarify the treatment under Section 409A of:

* short-term deferrals, including permitting involuntary separation pay within this category;

* separation pay, including, among other things, an exemption for involuntary separation pay not exceeding the lesser of two times annual compensation or $420,000 (although the preamble suggests that the limit may be $410,000), as indexed, paid by the end of the second calendar year following termination of employment;

* split dollar insurance; and

* foreign arrangements.

What didn't you tell me about Section 409A? This article barely scratches the surface of Section 409A. Other issues you need to be concerned about under Section 409A include:

* the timing of an initial deferred compensation election;

* distribution elections;

* timing, and changes to the timing, of receipt of deferred compensation distributions;

* prohibitions on acceleration of payment of deferred compensation;

* requirements for payments upon a change in control; and

* short-term deferrals.

In conclusion, the Section 409A rules are complex and becoming more complex each time the IRS issues further guidance. Section 409A affects arrangements that no one ever thought of as deferred compensation arrangements prior to its enactment. And, the IRS seems committed to expanding the reach of Section 409A with every new announcement.

If you have questions concerning Section 409A, please contact Michele Rowland or Chris Piazzola at Perkins Coie LLP, (303) 291-2300.

[ILLUSTRATION OMITTED]

PERKINS COIE LLP

MICHELE ROWLAND

Ms. Rowland's practice focuses on mergers and acquisitions, corporate finance, commercial finance, and restructurings and workouts. She currently serves on the board of Denver SCORES and is a member of the New York Bar Association, Colorado Bar Association and the American Bar Association. She is also a member of the Denver Women's Restructuring Professionals Group. Ms. Rowland received her law degree from Brooklyn Law School.
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Author:Rowland, Michele
Publication:ColoradoBiz
Geographic Code:1USA
Date:Dec 1, 2005
Words:1360
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