I. Code Section 409A: There is Still an Opportunity to Correct Noncompliant Nonqualified Deferred Compensation Plans

Overview

Section 409A of the Internal Revenue Code of 1986, as amended (the "Code"), imposes certain requirements on nonqualified deferred compensation ("NQDC") plans. Participants in NQDC plans that do not comply with these requirements are subject to accelerated income inclusion of amounts "deferred," a 20% penalty tax and interest. Based on proposed regulations issued by the Treasury Department, plan sponsors may still have an opportunity to amend nonqualified deferred compensation plans to comply with Code Section 409A.

Transition Period

Compliance with Code Section 409A is required both in form and in operation. NQDC plans were required to operate in "good faith" compliance with published guidance during a transition period that ended on December 31, 2008. In addition, NQDC plan documents were required to be amended to comply with Code Section 409A no later than December 31, 2008. Participants in noncompliant arrangements are subject to accelerated income inclusion, penalties and interest at the time and to the extent that compensation provided pursuant to the plan is no longer subject to a substantial risk of forfeiture (i.e., when the compensation becomes vested).

Correcting Noncompliant Plans

The Treasury Department has issued guidance that provides correction methods for plans that do not comply with Code Section 409A in operation. While guidance on the correction of documentary failures has not yet been issued, Treasury Department officials have indicated that such guidance may be forthcoming. Until then, however, plan sponsors may consider relying on guidance provided in proposed regulations (the "Proposed Regulations)" issued by the Treasury Department on December 8, 2008, to correct documentary failures.

The Proposed Regulations provide that, in determining whether compensation under a NQDC plan is subject to accelerated income inclusion, penalties and interest, each tax year of an employee will be analyzed independently of the employee's prior or subsequent tax years. Therefore, noncompliance with Code Section 409A in a prior year will be disregarded if the NQDC plan is compliant when an employee's entitlements under the NQDC plan become vested in a later year. This gives plan sponsors an opportunity to amend noncompliant arrangements to the extent that the right to compensation under the arrangement has not yet vested, provided that the amendment is completed in a year before the year in which vesting occurs. The Proposed Regulations include an anti-abuse rule to prevent companies from consistently using this provision to avoid the general requirements of Code Section 409A.

Accordingly, to the extent that plan sponsors have not performed an analysis of the impact of Code Section 409A with respect to their NQDC arrangements (including employment agreements that provide for severance payments), an opportunity to take any necessary corrective action may remain. Such corrective action should be taken prior to year-end if compensation amounts under the NQDC arrangements will or may become vested during 2010 or later.

II. Code Section 162(m): Performance-Based Compensation Arrangements May Need to Be Amended By Year-End

Overview of Revenue Ruling 2008-13

On February 25, 2008, Fried Frank issued a client memorandum describing Revenue Ruling 2008-13 (the "Revenue Ruling"), in which the IRS addressed the effect that certain termination of employment provisions have on payments that are intended to qualify as "performance-based compensation" under Code Section 162(m).

The Revenue Ruling held that provisions in contracts, plans, award agreements or other arrangements that accelerate the vesting of "performance-based" awards upon a termination without cause, for good reason or upon voluntary retirement (regardless of actual performance) will cause compensation attributable to the award to be subject to the $1 million deduction limit under Code Section 162(m) (even if none of those events actually occurs, the performance targets are satisfied and the awards would have otherwise qualified as "performance-based compensation").

Transition Rules

The IRS provided that the holdings in the Revenue Ruling would not be applied to disallow a deduction for any compensation that otherwise satisfies the requirements for performance-based compensation and that is paid under a plan, agreement or contract if either:

  • the performance period for such compensation begins on or before January 1, 2009, or
  • the compensation is paid pursuant to the terms of an employment contract as in effect on February 21, 2008, without regard to any renewal or extension (including those that occur automatically under the terms of the contract).

Many performance-based compensation arrangements payable with respect to 2009 were exempt from the holdings of the Revenue Ruling under this transition relief. For most executive compensation arrangements with performance periods commencing in or after 2010, however, this transition relief will not apply. Accordingly, companies should review and, to the extent necessary, amend their executive compensation arrangements regarding the treatment of awards upon a participant's termination of employment - including provisions in employment agreements, equity arrangements, cash-based long-term incentive arrangements and arrangements pursuant to which annual bonuses are payable - to ensure that amounts intended to qualify as performance-based compensation do not become subject to the $1 million limit.

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