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As outlined in a prior client update (Deferred Compensation Plans To Undergo Major Changes Under American Jobs Creation Act of 2004, October 2004), new Section 409A of the Internal Revenue Code, adopted as part of the American Jobs Creation Act of 2004 ("AJCA") enacts a major overhaul to the tax treatment of deferred compensation. New Section 409A generally regulates (i) the date by which deferred compensation elections must be made; (ii) the permissible dates on which deferred compensation may be paid to employees and other service providers; and (iii) timing rules for changing distribution elections.

The Internal Revenue Service issued its first guidance under these new rules, IRS Notice 2005-1, in December 2004, and updated that guidance on January 4, 2005 (referred to herein as the "Notice"). The Notice does not attempt to answer all of the questions and issues generated by Section 409A. Rather, it begins what is expected to be an extended series of guidance by addressing several pressing themes:

• What kinds of arrangements are, or are not, covered by Code Section 409A?
• When can distributions of deferred compensation be accelerated or be made upon a change in control?
• For those arrangements that are covered by Code Section 409A, what transition rules will govern such arrangements through 2005? and
• What are the withholding and reporting requirements under Code Section 409A?

Arrangements Covered Under New Section 409A

General Rule

In general, Code Section 409A provides that all amounts deferred under a "non-qualified deferred compensation plan" with respect to any individual will be includable in the income of the service provider (e.g.,. an employee) as soon as such amounts are no longer subject to a "substantial risk of forfeiture", unless the requirements of Code Section 409A are met. In addition, the employee is subject to an additional tax equal to 20% of the amount of deferred compensation includible in gross income, plus interest accruing from the later of the date the compensation was deferred or became vested until the year in which it is included in the employee's income.

What is a "Deferral of Compensation"?

With some very important exceptions noted below, a "deferral of compensation" has occurred if the service provider has a "legally binding right" during any taxable year to receive compensation that has not already been actually or constructively received and that is payable to (or on behalf of) the service provider in a later taxable year. Section 409A governs not only arrangements between an employer and an employee, but also to arrangements with independent contractors, or between a partnership and its partners.

A "legally binding right" to compensation exists if the service recipient cannot unilaterally reduce or eliminate the compensation after the service provider has performed the services creating the right to the compensation. The Notice elaborates on the definition of "legally binding right" by saying that if facts and circumstances indicate that the compensation can be reduced only upon a condition that is unlikely to occur, or that is unlikely to be exercised by the service recipient, the service provider will still be considered to have a "legally binding right" to such compensation. Likewise, a legally binding right to compensation will still exist even if the amount of compensation is unvested, is measured by actual or hypothetical investment performance, is determined under a formula that provides for benefits to be offset by benefits under a qualified plan, or other similar criteria. For example, an employee with a deferred compensation account (under an arrangement in which the employer does not have the right to unilaterally reduce or eliminate such amount) would be considered to have a legally binding right to such amounts, even if the employee were unvested in such amounts, and so had to complete additional service in order to obtain a right to a distribution. In all cases under the Notice, actual or hypothetical earnings attributable to deferred compensation are treated the same as the deferred compensation to which such earning are attributable.

Exceptions to What is Considered a "Deferral of Compensation" under Section 409A

Following are some of the important exceptions to what is considered a "deferral of compensation" and thus, to what is subject to Code Section 409A:

(a) Certain Benefits and Employment Policies. Nonqualified deferred compensation plans do not include qualified pension, profit-sharing or 401(k) plans or 457(b) plans, any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan, nor do they include any Archer Medical Savings Account, Health Savings Account, or any other medical or health expense reimbursement arrangement that meets the requirements of the Code for exclusion from income.

(b) Normal Payroll Payments and Short-Term Deferrals. Compensation paid after the end of the taxable year under normal payroll rules is not considered a "deferral of compensation" subject to Code Section 409A. Nor are short-term deferrals of no more than 2 ½ months after the employer's or employee's taxable year in which the compensation (including multi-year compensation arrangements) is no longer subject to a "substantial risk of forfeiture", unless the service provider is given the opportunity to, and does, elect to receive the compensation in a year later than the year in which he or she obtained a legally binding right to payment.

(c) Stock Appreciation Rights (SARs). SARs are not considered deferred compensation if (i) the amount of payment upon exercise does not exceed the fair market value of the underlying stock at the date of exercise minus the fair market value of such stock at the date of grant, (ii) the underlying stock is traded on an established securities market, (iii) only such traded stock can be delivered in settlement of the SAR upon its exercise, and (iv) the SAR does not include any arrangement to defer the receipt of income beyond the taxable year in which it is exercised. For SARs granted under plans in effect on October 3, 2004, only requirements (i) and (iv) above need to be met, until further guidance is issued. The right to receive unvested or restricted stock upon the exercise of a SAR does not cause it to be considered deferred compensation. In addition, SARs with fixed payment dates are not considered deferred compensation.

(d) Nonstatutory Stock Options. In general, a non-qualified stock option is not considered to involve the deferral of compensation if (i) the exercise price is no less than the fair market value of the stock on the date the option was granted, and (ii) the option does not include any arrangement to defer the receipt of compensation beyond the date of exercise of the option. The right to receive unvested or restricted stock upon exercise of an option does not cause it to constitute a deferral of compensation.

Note: Any amendment to an option that could be viewed as advantageous to the option holder, such as the extension of the exercise period or the acceleration of vesting, could be treated under Section 409A as a material modification and also as the grant of a new option. If the option is treated as newly granted on the date of the option amendment, and the original exercise price of the option is less than the current fair market value of the stock, the option would most probably be treated as a discount option subject to the provisions of Code Section 409A. Furthermore, unless the option had a fixed exercise date, the new option would also immediately violate the distribution rules of Code Section 409A and subject the option holder to a 20% tax to the extent the option is vested.

For purposes of determining the value of stock on the date of grant of the option, the Notice provides that "any reasonable valuation method may be used". The Notice gives little guidance on what methods the IRS would consider reasonable in this regard, other than providing that a valuation under Section 20.2031-2 of the Estate Tax Regulations would be reasonable (a willing buyer and a willing seller, each with knowledge of all relevant facts). In the mergers and acquisition context, the Notice also provides that the substitution of options pursuant to the requirements that govern the number and exercise price of substituted incentive stock options would comply with the requirements of Code Section 409A.

(e) Statutory Stock Options (ISOs) and Employee Stock Purchase Plans (ESPPs). As stated in the Conference Committee Report that accompanied the AJCA, the grant of options pursuant to the ISO or ESPP rules of the Code will not be considered the deferral of compensation. See the Note under (d) above regarding the possible effects of an amendment to an option, which could also apply to incentive stock options.

(f) Restricted Property. A deferral of income will not be considered to exist merely because a service provider receives property that is not currently includable in income because it is non-transferable and subject to a substantial risk of forfeiture under Code Section 83.

(g) Arrangements Between Independent Businesses. Section 409A does not apply to arrangements between two taxpayers if both of them use the accrual method of accounting. In addition, Code Section 409A does not apply if the service provider is actively engaged in the trade or business of providing substantial services, other than as an employee or a director of a corporation, and provides such services to two or more service recipients that are not related to the service provider and not related to each other.

Distributions Permitted Upon a Change in Control

Under Code Section 409A, distributions of deferred compensation may be made upon a change in the ownership or effective control of a corporation, or a change in the ownership of a substantial portion of the assets of a corporation. The Notice expands on the statutory language, providing that a distribution of deferred compensation may be made upon a change in control of a corporation if either the right to payment is objectively determinable under the terms of the plan, or is payable as a result of the corporation's discretion to terminate the plan within 12 months following a change in control. A "change in control" under the Notice can occur upon (i) a change in the ownership of the corporation (new owners acquire at least 50% of the corporation's stock), (ii) a change in the effective control of the corporation (new owners either replace a majority of the corporation's board or acquire at least 35% of the corporation's stock, either within a 12-month period), or (iii) a change in ownership of a substantial portion of assets of the corporation (unrelated persons acquire at least 40% of the assets of the corporation).

Acceleration of Payments

Code Section 409A prohibits the acceleration of the time of any payment under a deferred compensation plan, except as provided otherwise in Treasury Regulations. The Notice provides for some exceptions to the general rule, and permits acceleration of a distribution for (i) domestic relations orders issued, for example, in the event of a service provider's divorce; (ii) distributions required to comply with certain conflict of interest requirements; (iii) the payment of the minimum amount of withholding taxes under Code Section 457(f) plans; (iv) cash-outs of $10,000 or less made upon the termination of the service provider's interest in a plan that are made before the end of the calendar year in which the service provider separates from service, or, if later, within 2 ½ months after the service provider's separation from service.

Effective Dates and Transition Relief

General Effective Date

The provisions of new Code Section 409A become effective with respect to compensation that is deferred after December 31, 2004, or with respect compensation deferred before January 1, 2005, if the plan under which such amounts were deferred is "materially modified" after October 3, 2004.

What is a Material Modification?

In general, amounts deferred, earned and vested before 2005 are not subject to Code Section 409A unless there is a material modification after October 3, 2004 with respect to such amounts. In general, a material modification is a change to a plan that either enhances an existing benefit or adds a new benefit or right. A material modification can arise as a result of an amendment to a plan, or through the exercise of the service provider's or the service recipient's discretion under the terms of the plan, except with respect to the exercise of discretion by a service recipient (but not a service provider) in accordance with plan terms that were in place on October 3, 2004. Changing the investment measure of a benefit will not be considered a material modification. Nor will any modification made to bring plan into compliance with Code Section 409A be considered material, unless such modification enhances or adds to the participant's benefits. Therefore, the modification of a plan after October 3, 2004 to permit distribution on account of unforeseeable emergency would be considered a material modification, even though such a distribution event is permitted under Code Section 409A. Taking away a "haircut" distribution option, on the other hand, because it does not enhance the service provider's benefit, is not considered a material modification.

Starting, Stopping and Replacing as a Material Modification.

Creating a new plan or benefit, or amending, freezing or terminating an existing arrangement can result in material modifications that cause such amounts to become subject to Code Section 409A:

(a) Creating New Plans or Benefits. The adoption of a new arrangement, or the grant of a new benefit under an existing arrangement after October 3, 2004 is considered a material modification, unless the service recipient can show that the grant of the new benefit (such as the grant of SARs) is consistent with past practice. As mentioned above, an amendment to an option, such as the extension of the exercise period or the acceleration of vesting, could be treated under Section 409A as the grant of a new option that could make the option subject to Code Section 409A, and further, could subject the option holder to the 20% tax under Code Section 409A.

(b) Freezing or Terminating Plans. Amending an arrangement to stop future deferrals is not a material modification, nor is an amendment to terminate a plan on or before December 31, 2005 and distribute all amounts under the plan; provided that all amounts distributed are includible in the income of the service providers in the year in which such termination occurs. Note: This exception does not change the general rule under Code Section 409A that a service recipient may not terminate a plan and pay benefits out at its discretion (although, see discussion above "Distributions Permitted Upon a Change in Control"). This exception merely permits a plan in effect on October 3, 2004 to be terminated in 2005 without becoming subject to Code Section 409A, as the result of a material modification.

(c) Substitution of Stock Options or SARs. Replacing a stock option or SAR before December 31, 2005 will not be considered to be a material modification if the replacement stock option or SAR would not have constituted a deferral of compensation under Code Section 409A if it had been granted on the original date of the replaced stock option or SAR, and the exercise price and number of shares to which the stock option or SAR relate meet the requirements of Code Section 409A and the rules for determining the amount and exercise price of incentive stock options in a corporate transaction.

Transition Rules for Plans Adopted Before 2006

The following transition rules apply specifically to plans adopted before 2006:

(a) Modifications of Plans or Distribution Elections to Comply with Section 409A â€" Good Faith Compliance. A plan adopted on or before December 31, 2005 will not be treated as violating the distribution and deferral provisions of Code Section 409A if it is operated in good faith compliance with Code Section 409A and is amended by December 31, 2005 to comply with the provisions of Code Section 409A. In addition, distribution elections with respect to amounts subject to Code Section 409A may be changed prior to December 31, 2005 to comply with Code Section 409A, without running afoul of the restrictions under Code Section 409A that relate to changing distribution options.

(b) Modification of Plan to Permit Participant to Cancel Deferral Election in 2005. A plan may be amended on or before December 31, 2005 to permit a participant during 2005 to terminate his or her participation in the plan or cancel any deferral election with regard to amounts subject to Code Section 409A. Any such amendment need not apply to all participants, and separate plans may be treated differently. Any amounts subject to a participant's election to terminate participation or cancel his or her deferral election must be distributed and subject to taxation during 2005, or if later, the year in which the participant earns and becomes vested in such amounts.

(c) Certain Severance Plan Payments During 2005. Severance plans that are amended on or before December 31, 2005 to comply with Code Section 409A are not required to meet the requirements of Code Section 409A during 2005 if (i) the severance plan is collectively bargained, or (ii) no key employees are covered under the severance plan. Very generally, a "key employee" is one of the 50 most highly compensated officers of a corporation.

Deferral Elections Permitted Until March 15, 2005 for Plans in Existence on December 31, 2004

A plan that was in existence on December 31, 2004 and that is amended by December 31, 2005 to comply with the requirements of Code Section 409A, can permit deferral elections to be made until the earlier of (i) March 15, 2005 or (ii) the date the compensation would otherwise be received in the absence of the deferral election; provided that the compensation relates to services performed on or before December 31, 2005.

Deferrals of Bonuses

Until further guidance is issued, a deferral election made with respect to certain bonus compensation based on services performed over a period of at least 12 months will be treated as meeting the performance-based criteria of Code Section 409A if the election to defer such bonus is made at least 6 months prior to the end of the service period. The Notice contains additional rules as to what kinds of bonuses will be included within this rule.

Distribution Elections Based on Qualified Plan Distributions

The Notice provides that with respect to deferred compensation plans in existence on October 3, 2004, payment elections controlled by a participant's payment election under a plan qualified under Code Section 401(a) (e.g. 401(k) and tax-qualified pension plans) will not violate Code Section 409A through December 31, 2005.

Withholding and Reporting Deferred Compensation

Reporting Amounts Deferred

In accordance with the AJCA, the Notice generally requires reporting on an IRS Form W-2 or Form 1099 of amounts of compensation deferred or includable in income during a year. The reporting rules are effective for amounts deferred in 2005 and later. Such amounts are reportable in box 1 as part of total wages to the extent includable in income and in box 12 of Form W-2, using code Y for amounts deferred during the year and code Z for deferred amounts (whether deferred in the current or a prior year) that are includable in income during such year under Code Section 409A. For non-employees, deferred compensation is reported in box 7 of IRS Form 1099-MISC, and in box 15a for current year deferrals and in box 15b for deferred amounts includable in income for such year.

No reporting is required with respect to individuals for whom the service recipient is not required to file a Form W-2 or Form 1099. Amounts deferred under a non-account balance plan do not need to be reported to the extent the amount deferred is not reasonably ascertainable. Furthermore, until further guidance is issued, deferrals for any individual during a year that total less than $600 do not have to be reported.

Withholding and Payment of Tax on Amounts Deferred

Withholding is required with respect to deferred amounts included in an employee's income under Code Section 409A. Amounts not actually or constructively received by an employee that are includible in the employee's income during calendar year 2005 may be treated for withholding purposes as having been received at any time during 2005. This transition relief does not override any other tax rules that would require any such amounts to be included in income sooner than December 31, 2005. SECA taxes apply to amounts includable in the income of a self-employed individual under Code Section 409A, and FICA taxes apply to the amount of income recognized by employees under Code Section 409A.

Actions to Take Now

• List all arrangements that potentially involve the deferral of compensation (e.g. stock option or other equity compensation arrangements, deferred compensation plans, SERPs, bonus programs, employment agreements and severance programs), and operate those arrangements in good faith in accordance with Section 409A.
• Make sure the March 15, 2005 deadline is met for all deferrals of amounts earned in 2005 (other than bonus amounts for which the Notice provides a later deferral deadline).
• Before making any changes to any deferred compensation arrangements (e.g. establishing, amending or terminating a deferred compensation arrangement or accelerating the vesting of a stock option), make sure that Section 409A is not implicated. Remember, even a change that complies with Section 409A can cause an employee or other service provider to incur the 20% penalty tax.