United States: Code Section 409a Transition Relief Extended Through 2007

The Treasury Department and the IRS have issued Notice 2006-79, which extends through December 31, 2007 existing transition relief for nonqualified deferred compensation plans that are subject to the requirements of Section 409A of the Internal Revenue Code (Code) with certain exceptions. The extension of transition relief gives plan sponsors an additional year to bring their plans into compliance with the final regulations under Code § 409A, which the Treasury Department and the IRS still expect to issue before the end of 2006, but will now become effective on January 1, 2008 instead of January 1, 2007, as initially contemplated.

Transition relief provided under the proposed Code § 409A regulations issued last year was due to expire at the end of 2006; but that deadline was set with the expectation that final regulations, which would have been effective as of January 1, 2007, would have already been issued some time ago. Recognizing that plan sponsors would not have sufficient time to analyze the final regulations and bring their plans into compliance before the end of 2006, even if the final regulations were issued today, the Notice delays the effective date of the yet to be issued final regulations until January 1, 2008 and extends most of the transition relief provided in the preamble of the proposed regulations through the end of 2007.

Even though plan sponsors need not comply with the upcoming final regulations until January 1, 2008, reasonable, good-faith compliance with Code § 409A and the applicable provisions of Notice 2005-1 (and any other applicable guidance with an effective date prior to January 1, 2008) is still required until that time. As discussed below, compliance with either the proposed regulations or final regulations, when issued, will constitute reasonable, good faith compliance with Code § 409A for the period prior to January 1, 2008.

Notice 2006-79 extends the following Code § 409A transitional relief through December 31, 2007.

A plan adopted on or before December 31, 2007 will not be treated as violating Code § 409A on or before December 31, 2007 if the plan is operated through that date in reasonable, good faith compliance with Code § 409A, Notice 2005-1 (and any other applicable guidance with an effective date prior to January 1, 2008) and the plan is amended on or before December 31, 2007 to conform to Code § 409A and the final regulations. Compliance with the proposed or the final regulations prior to their effective date is not required. Good-faith compliance with the proposed or final regulations will, however, constitute good faith compliance with the statute. A plan will not be operating in good faith compliance if discretion provided under the plan is exercised in a manner that causes the plan to violate Code § 409A. On the other hand, the exercising of a right under the plan by a participant, solely with respect to that participant’s benefits, that causes a violation of Code § 409A will not cause the plan to fail to be in good faith compliance with respect to other participants.

A plan may either provide or be amended to provide for new payment elections on or before December 31, 2007 without the provision being treated as a change in the time or form of payment or an acceleration of payment under Code § 409A, so long as the amendments and elections are made prior to December 31, 2007. As under the prior transition rule, an election or amendment to change the time and form of payment that is made in 2006 may not apply to amounts not otherwise payable in 2006 and may not cause an amount to be paid in 2006 that was otherwise payable in another year. Likewise, under the extended relief, an election or amendment to change the time and form of payment that is made in 2007 may not apply to amounts not otherwise payable in 2006 and may not cause an amount to be paid in 2007 that was otherwise payable in a year other than 2007.

The ability to link a payment election under a nonqualified deferred compensation plan to an election under a qualified plan is also extended through December 31, 2007. Unlike the transition relief provided under the proposed regulations, this extended transition relief also applies to payment elections under nonqualified deferred compensation plans that are linked to certain additional employer plans, including section 403(b) annuities, section 457(b) eligible plans, and certain foreign broad-based plans.

Note: Like the transition relief under the proposed regulations, this extended transition relief appears to provide an exception to the six-month delay requirement for payments of deferred compensation to key executives upon separation from service.

With the exception of certain discounted stock rights (discussed below), it will not be a material modification for purposes of Code § 409A to replace, on or before December 31, 2007, a stock option or SAR that provides for a deferral of compensation with a stock option or SAR that would not have constituted a deferral of compensation under Code § 409A if it had been granted on the original grant date of the replaced option or SAR. This relief, however, is not available where the replacement of a stock option or SAR results in the cancellation of a deferral in exchange for cash or vested property in 2007, such as in the cash-out or exercise of a discounted option.

Notice 2006-79 provides new transition relief for certain collectively bargained arrangements. A nonqualified deferred compensation arrangement made pursuant to one or more collective bargaining agreements in effect on October 3, 2004 is not required to comply with the provisions of Code § 409A on or before the earlier of the date on which the last of such collective bargaining agreements terminates (determined without regard to any extensions after October 3, 2004) and December 31, 2009.

Under Q&A 21 of Notice 2005-1, plan sponsors were permitted to allow service providers to make initial deferral elections with respect to 2005 compensation on or before March 15, 2005, provided that the plan was amended prior to December 31, 2005 to provide for such elections. Although the preamble to the proposed regulations did not specifically extend this amendment deadline, many plan sponsors interpreted the general extension of the amendment deadline in the proposed regulations to also apply to this amendment, which, technically, it did not. To avoid unintentional noncompliance, Notice 2006-76 extends from December 31, 2005 until December 31, 2007 the deadline for adopting amendments that memorialize the addition of the right to make initial deferral elections on or before March 31, 2005 with respect to 2005 compensation.

Notice 2006-79 does not extend transition relief for certain discounted stock rights. Relief is not available for a stock option or stock appreciation right if –

• the right was granted with respect to stock of a publicly traded corporation whose stock is registered under Section 12 of the Securities Exchange Act of 1934;
• the grantee was a reporting person under Section 16(a) of the Securities Exchange Act of 1934 at the time of grant; and
• the corporation either has reported or expects to report a financial expense in connection with the grant because the stock right was issued with an exercise price less than the fair market value of the underlying stock on the date of the grant and was not timely reported on the financial statements or reports under generally accepted accounting principles.

We recommend that plan sponsors take full advantage of the extensions provided under Notice 2006-79 and not amend their nonqualified deferred compensation plans and arrangements until they have had sufficient opportunity to fully review and analyze the final regulations when they are issued. Of course, in cases where a new plan is being established, or an employment or severance agreement that raises Code § 409A issues is being negotiated, waiting for the final regulations to be issued might not be an option. Whether you need Code § 409A advice now or in the future, our experienced attorneys are fully prepared to provide expert assistance in this area.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.