In September 2005, the IRS issued proposed regulations under Section 409A of the Internal Revenue Code, which expand upon existing guidance and, in some ways, interpret Section 409A more favorably for taxpayers than previous guidance. Companies must comply in good faith with Section 409A during 2005 and 2006. Employers may rely on the proposed regulations to demonstrate good faith compliance for 2005 and 2006. The proposed regulations generally extend the deadline for amending arrangements to comply with Section 409A until December 31, 2006. Certain actions, however, must be completed before the end of 2005.
Section 409A contains complex new rules for nonqualified deferred compensation arrangements, and imposes severe tax penalties for noncompliance. Prior to the proposed regulations, the IRS provided partial guidance at the end of 2004. The scope of Section 409A is broad, and includes stock options, phantom stock, restricted stock units, stock appreciation rights, employment agreements, severance plans, bonus plans, incentive plans, separation agreements, and layoff plans. Companies should review their deferred compensation arrangements to identify those subject to Section 409A.
Actions to be Completed by December 31, 2005
One month remains until the December 31, 2005 deadline to:
- Terminate grandfathered arrangements and distribute all benefits to participants.
- Cancel or revoke an outstanding deferral election, or terminate participation in an arrangement, and amend the arrangement. The amount must be included in the participant’s income in the later of 2005 or the year in which they vest.
- Elect to defer compensation earned in 2006.
- Change payment elections for amounts scheduled to be paid in 2006, or accelerate payments to 2006.
- Amend arrangements to reflect provision for participant elections to defer 2005 compensation that were made between December 31, 2004 and March 15, 2005 (or until June 30, 2005 for performance-based compensation), as permitted under earlier guidance.
Employers should be careful not to materially modify grandfathered plans, since this may eliminate their grandfathered status.
Actions Steps for 2006
For 2006, companies must:
- Report and withhold amounts subject to Section 409A, beginning with 2005 deferrals.
- Amend deferred compensation arrangements to comply with Section 409A by December 31, 2006 (arrangements must be operated in good faith compliance in 2005 and 2006).
- Replace outstanding stock rights to avoid Section 409A by December 31, 2006, such as replacing discounted stock options with undiscounted options.
- Change participant payment elections for amounts payable in 2007 or later without having to comply with Section 409A until December 31, 2006 (but payments cannot be accelerated to 2006).
Because of possible limits on amending arrangements, companies should amend arrangements and replace outstanding stock rights as soon as possible and in any event by the end of the second quarter of 2006. In addition, publicly-traded companies generally may need to report material amendments to deferred compensation plans.
The proposed regulations, though extensive, do not address all of the issues that arise under Section 409A, some of which are specifically left for future guidance.
For further information on Section 409A, please contact David J. Paik at (213) 620-1780.