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On April 10, the Internal Revenue Service issued final regulations under Section 409A of the Internal Revenue Code. The final regulations are effective Jan. 1, 2008, and will replace initial guidance contained in Notice 2005-1 and in proposed regulations published in October 2005. Section 409A was added to the code by the American Jobs Creation Act of 2004 in response to a variety of corporate abuses, such as those surrounding the implosion of WorldCom and Enron, where executive employees were able to retain their generous deferred compensation benefits while the retirement benefits of rank-and-file employees were decimated. Section 409A provides, generally, that unless certain requirements are met, amounts deferred under a nonqualified deferred compensation plan will be currently includable in gross income and subject to a 20 percent penalty. Qualified retirement plans, such as profit-sharing, pension and 401(k) plans governed by Code Section 401, are not subject to the requirements of Section 409A. The final regulations were intended to be responsive to numerous comments received by the IRS in response to the publication of the proposed regulations. In general, the changes incorporated in the final regulations can be viewed as favorable to taxpayers. The following is a summary of some of the most significant aspects of the final regulations. Equity Compensation Nondiscounted stock options and nondiscounted stock appreciation rights issued with respect to employer stock are excluded from coverage under Section 409A. Under the proposed regulations, this exemption from 409A only applied to options that were granted with respect to the employer’s common stock that had the highest aggregate value of any class of common stock outstanding. The final regulations generally provide that any class of the employer’s common stock may be used in connection with options and stock appreciation rights, regardless of whether another class of common stock outstanding has a higher aggregate value. Moreover, under the proposed regulations, eligible employer stock could not have any preferences with respect to liquidation rights or dividends. Under the final regulations, eligible employer stock may have a preference with respect to liquidation rights only. The proposed regulations provided that any extension of the exercise period for a stock option extending beyond Dec. 31 of the year in which the option would have otherwise expired or, if longer, two and a half months, would constitute the deferral of income subject to Section 409A. The final regulations provide that the extension of an option exercise period will not be treated as an additional deferral subject to Section 409A if the exercise period is not extended beyond the earlier of the original maximum term of the option or 10 years from the original date of grant. Moreover, the final regulations provide that the extension of an option exercise period for an “underwater” option will not constitute an additional deferral feature and such an option would continue to be excluded from coverage under Section 409A. Because only nondiscounted stock options and nondiscounted stock appreciation rights are excluded from coverage under Section 409A, it is extremely important that the stock underlying such a right be properly valued. The proposed regulations contained a presumption that the valuation of the ill-liquid stock of a start-up corporation would be deemed to represent fair market value, rebuttable only by a showing that the valuation was grossly unreasonable. As set forth in the proposed regulations, this presumption would not apply if either the employer or the employee who received the stock right could have reasonably anticipated, as of the time the valuation is applied, that the employer would undergo a change in control or initiate a public offering of securities within the following 12-month period. Commentators suggested that a 12-month period was too long in a rapidly changing business world. In response to these concerns, the final regulations liberalize the availability of this presumption by reducing the 12-month look-back period to 90 days in the case of a change in control and to 180 days in the case of an initial public offering. Initial Eligibility Elections Section 409A generally requires that any election to defer compensation must be made prior to the start of the taxable year in which the services for which the compensation is to be earned are rendered. An exception to this rule is contained in Section 409A(a)(4)(B)(ii) which provides that the year in which an employee first becomes eligible to participate in a plan, an initial deferral election may be made within 30 days after the date the employee becomes eligible to participate in the plan. There was some ambiguity as to the application of this rule in the case of an employee who was previously a participant in a plan and who, subsequent to a termination or change to an ineligible job classification, is rehired or transferred back to an eligible classification. The final regulations provide that the initial year deferral election rules are applicable to such an employee if the rehired or newly eligible employee has not been an active participant in the plan for at least 24 months. Severance Payments The proposed regulations state that severance payments, payable upon a separation from service, could be characterized as deferred compensation subject to Section 409A. However, the proposed regulations also provided an exemption from coverage under Section 409A for severance payments that are: payable only upon an involuntary separation from service or pursuant to a “window program;” paid no later than the end of the employee’s second taxable year following the year of the separation from service; and limited to the lesser of 200 percent of the employee’s annualized compensation or 200 percent of the compensation limitation for qualified retirement plan contributions contained in Code Section 401(a)(17) ($225,000 in 2007). Significantly, the final regulations provide that certain voluntary employee resignations made for “good reason” can be treated as involuntary separations from service, thereby allowing payments made in connection with such a separation to be eligible for the exemption from Section 409A. The final regulations provide that to be treated as an involuntary separation for purposes of the severance payment exemption under Section 409A, the good reason must arise from actions by the employer resulting in a material negative change in the employment relationship, such as a material negative change in the duties to be performed, the conditions under which such duties are to be performed, or the compensation to be received. The final regulations also provide a safe harbor under which a payment upon a voluntary separation from service for good reason will be treated as a payment upon an involuntary separation from service. These conditions include that the amount be payable only if the employee separates from service within a limited period of time not to exceed one year following the initial existence of the good reason, and that the amount, time and form of payment upon a voluntary separation from service for a good reason be identical to the amount, time and form of payment upon an involuntary separation from service. In addition, the employee must be required to provide notice of the existence of the good reason condition within a period not to exceed 90 days of its initial existence, and the employer must be provided a period of at least 30 days during which it may remedy the good reason condition. Time of Benefit Payments Under Section 409A, distributions from a non-qualified deferred compensation plan are allowed only upon a separation from service, death, a specified time, pursuant to a fixed schedule, the occurrence of an unforeseeable emergency, or if the participant becomes disabled. In the case of a “key employee” employed by a publicly traded corporation, distributions payable upon separation from service may not be made earlier than six months after the date of the separation from service. Section 409A generally prohibits both delays and accelerations in the timing of these payments. The final regulations contain a number of clarifications with respect to these rules. The final regulations clarify that a payment will be treated as made on a fixed date or on a fixed schedule or on account of a specified payment event, if the payment or payments are made by the end of the calendar year in which the specified payment date or payment event occurs or, if later, the 15th day of the third month following such date or event. So, for example, where a payment is scheduled to be made upon the death of an employee, the payment is timely if made on or before the later of Dec. 31 of the calendar year in which the death occurs, or the 15th day of the third month following the date of death. The final regulations also provide that a payment will be deemed made at the scheduled time of payment and will not constitute an impermissible acceleration if the payment is made up to 30 days before the scheduled date, provided that the employee is not permitted, directly or indirectly, to designate the taxable year of the payment. With respect to the six-month waiting period for the payment of benefits to key employees, the final regulations provide that where a payment is made to such a key employee on account of disability, a change in control event, or an unforeseeable emergency, the payment need not be delayed merely because the key employee separates from service after incurring the disability or unforeseeable emergency, or after the change in control event. The final regulations also contain a safe harbor mechanism for designating an “over-inclusive” list of key employees as an alternative to identifying individual employees by name or position as key employees subject to the six-month waiting period. Written Plan Requirement The final regulations continue the requirement contained in the proposed regulations that a plan be in writing. To satisfy this requirement, the document or documents constituting the plan must specify, at the time an amount is deferred, the amount to which an employee has a right to be paid and the payment schedule or payment triggering events that will result in a payment. Significantly, the final regulations provide that a “savings clause” intended to conform plan language not otherwise in compliance with Section 409A will be deemed null and void. Accordingly, if a plan contains terms that do not meet the requirements of Section 409A or fails to contain a plan term necessary to meet the requirements of Section 409A, the plan will violate the requirements of Section 409A regardless of whether the plan contains such a savings clause. This article only contains a summary of some of the more significant provisions of the final regulations. Section 409A and the final regulations constitute a comprehensive set of rules relating to a wide variety of plans and arrangements. These final regulations should be consulted and read thoroughly as we approach the Dec. 31 deadline for plan compliance. MARK L. SILOW is the administrative partner and chief operating officer of Fox Rothschild. Silow formerly was chairman of the firm’s tax and estates department. Silow’s work involves a broad range of commercial and tax matters including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planning and employee benefits.

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