This article is reprinted with permission
New York Law Journal.
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Transitional Relief Under §409A Extended Through 2008
This column discusses the recent extension by the Internal Revenue Service (IRS) of transition relief under §409A of the Internal Revenue Code (code) through Dec. 31, 2008. On Sept. 10, 2007, the IRS extended through Dec. 31, 2008 the transition period relief for compliance with plan documentation requirements. IRS Notice 2007-78, 2007-41 I.R.B. 780 (Notice or IRS Notice).
On Oct. 22, in response to many complaints over the limitation of the extension just to plan documentation, the IRS expanded the scope of the extension to include operational compliance requirements as well. Notice 2007-86.
Final Regulations, issued on April 10, 2007, to take effect Jan. 1, 2008, were published on April 17, 2007 in the Federal Register (Final Regulations). 72 Fed. Reg. 19234. The transition relief had been scheduled to expire Dec. 31, 2007. Notice 2007-86 is lengthy and detailed in its statement of transition rules that it extends to Dec. 31, 2008. It should be examined carefully as specific questions arise as to what constitutes compliance with it.
Code §409A, enacted in 2004, applies special taxation rules to certain nonqualified deferred compensation plans. For this purpose, such plans may include not only plans that on their face constitute deferred compensation but also a variety of compensation arrangements that might not ordinarily be thought of as deferred compensation such as certain severance arrangements, certain stock option and stock-based awards and certain perquisite and benefit programs. Failure to comply with code §409A results in the following adverse tax consequences to the service provider:
(i) the nonqualified deferred compensation amounts are subject to current income tax in the year first deferred or, if later, in the year in which the amounts become vested, i.e., are no longer subject to a substantial risk of forfeiture;
(ii) a 20 percent additional tax is imposed on the deferred amounts, on top of the applicable ordinary income tax; and
(iii) an additional one percent interest rate on top of the interest rate that normally would apply is imposed on the tax deficiency resulting from failure to report the deferred amounts in income in the year first deferred or in the year in which the amounts became vested.
Initial guidance for the transition period commencing in 2005 was provided by Notice 2005-1, 2005-1 C.B. 274. Numerous notices and other guidance have been issued since. In addition to Notice 2005-1 and other transition period guidance, the IRS published Proposed Regulations at 70 Fed. Reg. 57930 (Oct. 4, 2005) and, as noted above, Final Regulations at 72 Fed. Reg. 19234 (April 17, 2007). On Oct. 23, 2006, the IRS published Notice 2006-79, 2006-43 I.R.B. 763 which, among other things, extended the transition period for compliance through Dec. 31, 2007. On Sept. 10, 2007, as noted, the IRS issued Notice 2007-78 which extended until Dec. 31, 2008 relief for the purposes of making certain plan documents compliant with code §409A and the Final Regulations. And on Oct. 22, as noted, the IRS issued Notice 2007-86 which expanded the relief to include, as well, the operational compliance of plans and other covered arrangements.
There are specific exceptions to these extensions, which reflect previous transition rules and other guidance. For example, certain offshore trusts and other asset arrangements will cease to enjoy "grace period" relief Dec. 31, 2007. (See Notice 2007-78, §VI.) Also, certain discounted options and other discounted stock rights of certain executives subject to the disclosure rules of the U.S. Securities and Exchange Commission are not eligible for transition relief. (See Notice 2006-79, §3.07.)
Good Faith Reliance
As in the past, during 2008, compliance can be based on good faith reliance on guidelines previously provided by the IRS, even if there are conflicting guidance provisions. The second paragraph of §3.01(B)(1).01 provides as follows:
Compliance with the proposed regulations is not required and compliance with the final regulations before Jan. 1, 2009 is not required. However, for periods before Jan. 1, 2008, compliance with the proposed regulations or the final regulations will constitute reasonable, good faith compliance with the statute. For periods after Dec. 31, 2007 and before Jan. 1, 2009, compliance with the final regulations (but not the proposed regulations) will constitute reasonable, good faith compliance with the statute.
Section 3.01(A) of Notice 2007-86 provides:
To the extent an issue is not addressed in Notice 2005-1 or other applicable guidance, taxpayers must apply a reasonable, good faith interpretation of the statute. Reliance upon the final regulations is treated as applying a reasonable, good faith interpretation of the statute.
Section 3.01 of Notice 2007-86 should be read carefully in terms of what taxpayers can rely on if guidance or regulations contain conflicting provisions. For example, §3.01(A) states (with respect to periods prior to Jan. 1, 2009), "Where a provision of Notice 2005-1 is inconsistent with the final regulations, taxpayers may rely upon either Notice 2005-1 or the final regulations." Section 3.01 (B)(1).01 contains other provisions regarding what constitutes good faith compliance notwithstanding conflicts between or among Notice 2005-1, the Proposed Regulations and the Final Regulations.
Section 3.01(B)(1).02 provides rules regarding new payment elections that may be made on or before Dec. 31, 2008 with respect to time and form of payment without the election or amendment being treated as a change in the time or form of payment under code §409A(a)(4) or an acceleration of a payment under code §409A(a)(3).
An important caveat: Notice 2007-86 continues as to 2008 the previous position reflected in Notice 2006-79 that any new payment election made during the transition period cannot accelerate payments into, or defer them out of, the year in which the election is made. Clause .02 contains the following statement:
With respect to an election or amendment to change a time and form of payment made on or after Jan. 1, 2008 and on or before Dec. 31, 2008, the election or amendment may apply only to amounts that would not otherwise be payable in 2008 and may not cause an amount to be paid in 2008 that would not otherwise be payable in 2008.
The next to last paragraph of Clause .02 provides that an election previously made to defer a payment into 2008 cannot be further deferred from 2008 unless the election is made prior to 2008. Thus, for those taxpayers with previously deferred amounts that are scheduled to be paid in 2008, the election to further defer must be made in the limited period remaining in 2007. (Clause .02 also provides that changes in elections or amendments may be made more than once, provided, of course, that each such election or amendment change is made in accordance with the applicable transition guidance, including being made in a timely manner.)
• Transitioning Nonqualified Plans Out of Election 'Links' to Qualified Plans. Provisions in nonqualified deferred compensation plans that link the time and form of payment of amounts deferred under those plans to distribution elections made by the service provider under a related qualified plan generally do not comply with the election rules applicable to payments pursuant to nonqualified plans under code §409A. Transition relief previously issued by the IRS allowed such elections made by a participant in a qualified plan (or under certain other types of employer plans) to continue to govern the time and form of payments to be made to the participant under the nonqualified plan, provided that the nonqualified plan provided for such "linked" payments as of Oct. 3, 2004. However, Notice 2006-79 allowed "linked" payments to continue to be made only through Dec. 31, 2007. Section 3.03 of Notice 2007-86 extends, through Dec. 31, 2008, the ability of nonqualified plans to make payments pursuant to payment elections made under qualified and other specified employer plans. Accordingly, in order to comply with code §409A's payment election rules, nonqualified plans with linked payment provisions will have to be amended before Jan. 1, 2009.
Discounted Stock Options
• And Other Stock Rights. The last paragraph of Clause .02 provides that any modification of a discounted stock option (or other discounted stock right) to provide for a fixed payment term consistent with code §409A may be made prior to the end of 2008 for the purpose of bringing the applicable stock option or other stock right into compliance with code §409A. Clause .04 of §3.01(B)(1) provides that substitutions of nondiscounted stock options and stock appreciation rights for discounted stock options and stock appreciation rights may be made during 2008, to the extent that the optionee does not also receive cash or vested property in exchange for giving up the discount. (As previously noted, certain executive officers of publicly traded companies are excluded from the benefit of the transition relief as to previously discounted stock options or other discounted stock rights. See Notice 2006-79, §3.07) Assuming the nondiscounted stock options or stock appreciation rights otherwise meet the requirements of code §409A, the substituted stock options or stock appreciation rights will be treated as granted as of the original grant date of the stock option or stock appreciation right.
• IRS Notice 2007-89: Reporting and Wage Withholding Under Code §409A. On Oct. 23, 2007, the IRS issued Notice 2007-89 providing guidance to employers and taxpayers that amounts deferred during 2007 under a nonqualified deferred compensation plan will not be required to be reported in Forms W-2 or 1099 if the plan meets the requirements of code §409A. Deferred amounts that do not meet the requirements of code §409A remain subject to the reporting and withholding required to be reported in Forms W-2 or 1099. Previous guidance on this matter, Notice 2006-100, 2006-51 I.R.B. 1109, was issued on Nov. 30, 2006 and provided similar guidance on withholding and reporting requirements for amounts deferred during 2005 and 2006. (Notice 2007-89 generally continues the guidance applicable to 2005 and 2006 under Notice 2006-100 to 2007.)
1. By letter to the IRS dated Sept. 21, 2007, the Section of Taxation of the American Bar Association requested that the 2008 transition period extension be expanded to include full operational compliance, stressing the difficulty in understanding and implementing the complex requirements of the Final Regulations. Another letter to the IRS, to similar effect and also dated Sept. 21, 2007, was signed by 96 law firms.
2. Notice 2007-86, in expanding the relief to include operational compliance (that is, not just plan documentation) modifies and supersedes the transition relief provided by §3 of Notice 2006-79. Notice 2007-86 also revokes and supersedes the transition relief provided by §III, and modifies §IVA of Notice 2007-78.