In the last few weeks of the year, employers may wish to review their compensation arrangements (including traditional nonqualified deferred compensation plans, discounted stock options and other covered arrangements) that are subject to Section 409A of the Internal Revenue Code to determine whether any last-minute compliance is required. As described in our previous Cooley Alerts, certain "transition relief" provided to employers by IRS and Treasury Department guidance is available only until December 31, 2005. This Alert reiterates the actions employers may wish to consider prior to December 31, 2005, and describes recent guidance on 2005 tax reporting under Section 409A. Click on the following links for Cooley Alerts describing the background and enactment of Section 409A and current guidance from the IRS and Treasury.
- Enactment of Section 409A
- Initial guidance under Section 409A  and 
2006 Deferral Elections. For nonqualified deferred compensation arrangements subject to 409A, any elective deferrals related to compensation to be deferred for the 2006 tax year generally need to be made by participants on or before December 31, 2005. Employers should review such arrangements to determine whether any such elections are required by year-end and may wish to notify any affected participants.
Termination of Participation and Cancellation of Deferral Elections. On or before December 31, 2005, plans may be terminated or amended to allow participants to terminate participation or cancel a deferral election. Such terminations and cancellations may be done without adverse Section 409A tax consequences, if certain conditions (described in our prior Cooley Alerts ) are satisfied. (Of course, non-Section 409A tax consequences would continue to apply.) Certain specific actions falling within this rule (that must be taken during the remainder of 2005) are described immediately below:
- Exercise of Discounted Stock Options . Discounted stock options are subject to the adverse tax consequences of Section 409A unless they are amended before January 1, 2007, or grandfathered. However, discounted stock options may be exercised by the participant on or prior to December 31, 2005, and such exercise should constitute a permissible termination of the participant’s participation.
- Compensation for Increased Stock Option Price. If the parties wish to increase the exercise price of a discounted stock option to comply with Section 409A, the employer may wish to make a cash (or other) payment to the participant to compensate for the lost discount. Such cash (or other) payments generally must be paid (or a binding, 409A-compliant deferred compensation arrangement entered into) on or before December 31, 2005. However, the corresponding increase in the option exercise price need not be documented until December 31, 2006.
- Replacement of Discounted Stock Options with Cash or Stock. If the parties wish to replace a discounted stock option with a cash or stock grant (or a binding, 409A-compliant deferred compensation arrangement), such replacement must occur on or prior to December 31, 2005.
Change in Payment Elections Related to 2006 Deferrals and Payments. Prior to January 1, 2007, plans may be amended to provide for (or participants may make) new payment elections for 2005 deferrals without regard to certain limitations in Section 409A on changes to existing payment elections.1 However, a participant may not, in 2006, (a) change a payment election for payments the participant would otherwise receive in 2006, or (b) cause payments to be made in 2006. Thus, elections should be made on or before December 31, 2005, to change the time or form of payments that will otherwise be received in 2006, or to cause payments from other years to be received in 2006. This likely includes an amendment to a discounted stock option to specify that the option may be exercisable only at a specified time (or times) within 2006.2
Suspension of 2005 tax reporting and withholding on deferred compensation
Section 409A imposes new reporting and withholding requirements for amounts (i) deferred after December 31, 2004 (and earnings thereon) pursuant to nonqualified deferred compensation arrangements or (ii) includible in income because of the application of Section 409A. Such amounts must be reported on Form W-2 (for employees) or Form 1099-MISC (for non-employees). Amounts includible in the income of an employee are also considered "wages" for withholding purposes and must be reported on Form 941.
Notice 2005-94, issued by the IRS on December 8, 2005, suspends the reporting and withholding requirements under Section 409A for calendar year 2005 until further guidance is issued. The IRS indicates that it expects to issue further guidance in the first half of 2006 and that such guidance will include the method for calculating the amounts deferred and the amounts includible in gross income because of the application of Section 409A. The Notice also states that a plan sponsor may be required to file a corrected Form 941 and to provide corrected Forms W-2 and 1099-MISC to its service providers to report previously unreported amounts. Participants will not be subject to penalties for any late tax payments with respect to such amounts as long as they report and pay any taxes due in accordance with such guidance.3
Circular 230 disclosure
The following disclosure is provided in accordance with the Internal Revenue Service’s Circular 230 (21 CFR Part 10). This Alert is not intended to constitute tax advice to any specific taxpayer or for any specific situation. Any tax advice contained in this Alert is intended to be preliminary, for discussion purposes only, and not final. Any such advice is not intended to be used for marketing, promoting or recommending any transaction or for the use of any person in connection with the preparation of any tax return. Accordingly, this advice is not intended or written to be used, and it cannot be used, by any person for the purpose of avoiding tax penalties that may be imposed on such person.
1 While payment elections for pre-2005 deferrals may also be changed under this rule, a tax advisor should be consulted before any such change, due to the potential loss of "grandfather" status for such pre-2005 deferrals.
2 However, it may be possible to amend such an option in 2006 to provide for exercise only in 2006, if the revised exercise window satisfies the "short-term deferral" exception to Section 409A.
3 Note, however, that a participant may be subject to interest for underpayment of such amounts.
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.