If you were wondering about the cheers coming from your tax lawyers on the afternoon of October 4, 2006, rest assured that they have some good news for you on the deferred compensation front. After delivering some tricky guidance under Section 409A of the Internal Revenue Code of 1986, as amended (the "Code") last fall, the IRS has offered up a treat this year in the form of Notice 2006-79.[1]
As readers of our prior Legal Updates will know, the compliance deadline for Section 409A, as imposed by the proposed Treasury regulations issued last fall, was to be January 1, 2007: by this date, all deferred compensation arrangements subject to Section 409A were supposed to have been updated and fully compliant in operation. However, in the absence of final regulations – which the IRS has been promising to deliver for some time now – it was becoming obvious that a delay was inevitable. Notice 2006-79 makes this delay official by extending the Section 409A compliance deadline to January 1, 2008, for most deferred compensation arrangements. As always, there are some details to consider with this extension, and the IRS has pointedly refused to extend a helping hand to many companies that are wrestling with stock option back-dating issues. We discuss both the treats and the tricks below.
Background
Having previously dealt with the basic and many of the more specialized requirements imposed by Section 409A,[2] we will limit our summary here to the key issues relevant to Notice 2006-79. In simplest terms, Section 409A is intended to impose significant restrictions on deferred compensation arrangements of all sorts by limiting the timing of elections to defer compensation by "service providers" (i.e., employees, directors, or contractors), the timing and form of subsequent payments of deferred compensation, and the timing of subsequent changes to either. Violating any of these broad requirements (or any of the more specific requirements included in the proposed regulations and other guidance) not only triggers income tax on the deferred amounts but also triggers an additional 20% income tax and interest at a prescribed rate. Section 409A and its related guidance impose more limited requirements on "service recipients" (i.e., employers or other entities that receive services from service providers) relating to tax reporting and withholding for deferrals of compensation and distributions of deferred compensation.
Section 409A Compliance Deadline
Both the IRS’s prior guidance – Notice 2005-1 – and the proposed regulations contemplated that all deferred compensation arrangements subject to Section 409A would be in both formal and operational compliance with its requirements by January 1, 2007.[3] Notice 2006-79 extends this final compliance deadline to January 1, 2008, but reaffirms that deferred compensation arrangements must be operated in good-faith compliance with Section 409A in the interim. Although compliance with either the proposed or the final regulations prior to the final compliance deadline is not required, the IRS notes that following the regulations will be deemed to constitute a reasonable and good faith interpretation of Section 409A.[4]
Section 409A Transition Rule
Mitigating the original compliance deadline somewhat, the proposed regulations included a transition rule that facilitated many changes to deferred compensation arrangements and deferral elections that would not have otherwise been permitted by Section 409A. With one notable exception (discussed below), Notice 2006-79 extends the expiration date for this transition rule from December 31, 2006, to December 31, 2007.
In general terms, the Section 409A transition rule permits the amendment of a deferred compensation arrangement and/or deferral election to modify the timing of previously-scheduled payments as long as the amendments do not delay the payment date for distributions that were already scheduled to be made in 2006 or accelerate into 2006 the payment date for distributions that were originally scheduled to be made in a later year. For example, if an employee previously elected to receive his pre-2005 deferrals on December 31, 2008, the transition rule would permit him to modify that election to accelerate the payment into 2007 (but not into 2006) or to further delay payment beyond 2008. However, if the prior payment election provided for a payment in 2006, the transition rule would not permit that election to be altered.
As extended by Notice 2006-79, the transition rule now permits such amendments to be made in 2007 as well, although they will be remain subject to the same limitations as 2006 amendments (i.e., for amendments adopted in 2007, no acceleration of payments into 2007 and no delays of payments originally scheduled to be made in 2007).
Application of Transition Rule to Stock Rights
The transition rule has proven to be of particular utility in dealing with stock options and other stock rights that are subject to Section 409A.
Repairing Discounted Stock Options and Other Stock Rights
An outstanding stock right that provides for a deferral of compensation (e.g., a discounted stock option) may also be amended under the transition rule to provide for a fixed payment date or to permit the optionholder to elect a fixed payment date. For purposes of this rule, a stock right is not deemed to be payable in a particular year solely because it is exercisable in that year if it is also reasonably expected to be exercisable in a subsequent year.
While the transition rule does offer significant help in repairing stock options and other stock rights than are subject to Section 409A, it is important to bear in mind that the transition rule does not provide any assistance where those stock options or stock rights that have been exercised.
Under Notice 2005-1, a stock option or stock appreciation right that otherwise would have been deemed to provide for a deferral of compensation (e.g., because it incorporated a deferral feature or was granted at a discount) would not be considered to have been "materially modified" if it was replaced with a stock option or stock appreciation right that did not contain the offending provision or characteristic, as long as the substitution occurred before December 31, 2005. The proposed regulations extended the deadline for such substitutions to December 31, 2006, but only to the extent the substitution did not result in an exchange for cash or vested property in 2006. Notice 2006-79 further extends this deadline to December 31, 2007, subject to limitations identical to those in the proposed regulations. Replacement stock options or stock appreciation rights that are not subject to Section 409A are deemed to have been granted on the date the replaced options or appreciation rights were originally granted.[5]
No Extension for Options Affected by Back-Dating
As we discussed in our recent Client Alert relating to the intersection of Section 409A and the stock option back-dating issues many public companies are currently addressing, back-dated options pose not only accounting issues but also the real potential for Section 409A violations.[6] The IRS has now officially turned the screws on the Section 409A issue by denying access to the transition relief provided by Notice 2006-79 in certain circumstances.
The expiration date for Section 409A transition relief is not extended for any stock option or stock appreciation right that was granted by a publicly-traded company[7] to any "insiders"[8] and for which that company has reported or reasonably expects to report a financial expense that was not timely reported according to generally-accepted accounting principles due to the issuance of the stock option or stock appreciation right at a discount from its fair market value on the date of grant. The original transition rule provided under the proposed regulations remains available, however. By refusing to extend the transition rule in this circumstance, the IRS has placed additional pressure on companies dealing with back-dating issues to promptly implement corrective action.
Other Transition Relief Provided by Notice 2006-79
Deferred Compensation Plans Linked to Qualified Plans
The IRS has also extended relief to deferred compensation arrangements that incorporate payment elections that are linked to qualified retirement plans such as pension plans and "401(k)" plans. Thus, an election as to the form or timing of a deferred compensation payment that is linked to a payment election made under a qualified retirement plan does not violate Section 409A as long as the form and timing election is made in accordance with the terms of the deferred compensation arrangement as in effect on October 3, 2004. For example, if on October 3, 2004, a deferred compensation plan provided for distributions to an employee at the same time and in the same form as the employee elected under the employer’s 401(k) retirement plan, there would be no Section 409A violation where the employer makes, or commences, payments under the plan prior to December 31, 2007. After this deadline, however, the more restrictive requirements imposed by the proposed regulations (as modified by the final regulations) will become applicable.[9]
Collectively-Bargained Deferred Compensation Arrangements
The notice extends the compliance deadline for collectively-bargained deferred compensation arrangements that were in effect on October 3, 2004, to the earlier of the date on which the collective bargaining agreement expires or December 31, 2009.
Amendments Relating to Initial Deferral Elections
In response to confusion over the application of limited transition relief provided by Notice 2005-1 relating to certain initial deferral elections,[10] the IRS clarifies that plans may be amended to take advantage of this relief through December 31, 2007. However, taxpayers bear the burden of showing that the related deferral elections were actually made on or prior to the March 15, 2005 deadline.
Section 409A Reporting and Withholding Requirements for 2006 and Beyond
Supplementing Section 409A’s substantive provisions is a requirement that service recipients provide information regarding deferrals of compensation and deferred compensation payments on the Forms W-2 or 1099 issued to service providers.[11] In addition, distributions of deferred compensation are subject to further reporting and withholding requirements. Notice 2005-94 suspended these reporting and withholding requirements for 2005 but indicated that corrected information returns might be required by subsequent IRS guidance.
At a recent practitioner conference, Daniel Hogans, one of the key IRS officials involved in crafting guidance relating to Section 409A, indicated that final regulatory guidance will be out by the end of 2006 and that service recipients will therefore be expected to comply with the reporting and withholding requirements outlined in Notice 2005-1 for deferrals and distributions made in 2006. Our expectation is that the final Section 409A regulations will provide additional detail about these reporting and withholding requirements.
Footnotes:
1. An advance version of Notice 2006-79 is available through the IRS website at http://www.irs.gov/pub/irs-drop/n-06-79.pdf.
2. Refer to our prior Legal Updates entitled Deferred Compensation Plans to Undergo Major Changes Under American Jobs Creation Act of 2004, June 2004; Deferred Compensation Update: IRS Issues Initial Guidance Notice 2005-1, January 2005; and Deferred Compensation Update: IRS Issues Proposed Regulations Under Code Section 409A, October 2005, for a more detailed and technical discussion of Section 409A’s general requirements. Additional analysis of more specialized Section 409A issues can be found in the following Legal Updates:Proposed Code Section 409A Regulations Prompt Reconsideration of Stock Valuations for Equity Compensation Programs, January 2006; IRS Notice 2006-4 Provides Interim Relief from Section 409A Valuation Requirements for Stock Options, December 2005; Upsetting the Apple Cart: New Deferred Compensation Rules Endanger Employment Agreements and Severance Plans, December 2005; and Tax Issues Arising Out of Stock Options Back-Dating Investigations, June 2006.
3. One of the fundamental issues under Section 409A involves the identification of the plans, agreements, and arrangements that are subject to its requirements. Section 409A uses an expansive definition of "deferred compensation arrangement" that can encompass any type of formal or informal plan, agreement, or other arrangement that has the effect of deferring the payment of compensation earned in one year until a later year, thereby delaying the imposition of income taxes on the deferred compensation. Given the breadth of this definition, Section 409A’s arm is long and can extend to all manner of obvious – and non-obvious – arrangements, including employment agreements, bonus programs, and severance plans, many common equity compensation practices such as stock options, restricted stock units, and phantom stock awards, and even to merger and acquisition agreements.
4. If the discretion provided by a plan is exercised in a manner that is not consistent with Section 409A, the plan will not be considered to have been operated in good-faith compliance with Section 409A. However, if the discretion at issue is exercised by a particular participant rather than on a plan-wide basis, the plan may still be operating in good-faith compliance with respect to its other participants. As an example, the IRS indicates that an individual participant’s decision to take an unscheduled distribution pursuant to a "hair-cut" provision – a type of provision that is proscribed by Section 409A – in a deferred compensation plan will impact that participant rather than all of the participants. The mere presence of the provision prior to January 1, 2008 is not itself a violation of Section 409A, although its use would be.
5. Various proposals dealing with compensation to optionholders for the value of lost discounts have been proposed. See Section XI.H of the preamble to the proposed Section 409A regulations.
6. See Tax Issues Arising Out of Stock Options Back-Dating Investigations, June 2006.
7. Notice 2006-79 refers to corporations the stock of which is required to be registered under Section 12 of the Securities Exchange Act of 1934 (the "’34 Act").
8. For this purpose, Notice 2006-79 refers to any persons subject to the disclosure requirements imposed by Section 16(a) of the ’34 Act. The class of persons encompassed by this definition includes any persons who hold beneficial ownership, directly or indirectly, of 10% of more of any class of equity security registered under the ’34 Act or who are directors or officers of the issuer of any such security.
9. See Section 1.409A-2(a)(8) of the proposed regulations for additional details about the operation of deferred compensation arrangements that are linked to qualified retirement plans.
10. Notice 2005-1 provided a limited initial transition rule applicable to deferral elections made for 2005. Section 409A ordinarily requires that deferral elections be made prior to the beginning of the year in which the deferred compensation would otherwise be payable. Under the transition rule, this requirement was relaxed for 2005 deferral elections under plans in existence on December 31, 2004, and the transition rule generally permitted such elections to be made as late as March 15, 2005.
11. Notice 2005-1, Q/A-29 through Q/A-38 explain in detail the reporting and withholding requirements for deferrals and payments of deferred compensation under arrangements subject to Section 409A for both employees and contractors.