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On Oct. 7, 2004, Congress passed the American Jobs Creation Act of 2004, adding �409A to the Internal Revenue Code. Section 409A generally provides that if a nonqualified deferred compensation plan (NQDCP) fails to satisfy certain requirements, amounts deferred under the plan are currently includible in gross income — and subject to a 20 percent excise tax — to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. The law generally became effective with respect to amounts deferred after Dec. 31, 2004. The IRS issued Notice 2005-1, providing transitional relief and interim guidance on the application of �409A. On Sept. 29, 2005, the Internal Revenue Service issued proposed regulations under �409A, further clarifying the scope and application of the statute, providing additional guidance and extending certain transitional relief through Dec. 31, 2006. SCOPE OF �409A With certain exceptions for qualified employer retirement plans, eligible deferred compensation plans under �457(b) and certain welfare benefits plans, �409A applies to amounts deferred under a NQDCP. Section 409A and the proposed regulations cover a wide array of compensation arrangements not previously considered deferred compensation; including stock options, bonus plans and severance arrangements. All employers and other service recipients will need to perform a comprehensive review of their compensation plans and arrangements and make the necessary plan document and operational changes. Under the proposed regulations, a NQDCP generally is deemed to provide for deferral of compensation if the service provider has a legally binding right during a taxable year to compensation that has not been actually or constructively received and included in gross income, and that, pursuant to the terms of the plan, is payable to the service provider in a later year. A legally binding right to compensation may exist even in circumstances where the right is subject to a condition that constitutes a substantial risk of forfeiture, such as where the payment is subject to continued employment over a specified term. Thus, an agreement to pay an employee a lump sum in five years provided she continues in employment for the next 12 months would constitute a legally binding right, even though unvested. Compensation deferred under a NQDCP that does not satisfy the requirements of �409A is currently includible in income to the extent that it is not subject to a substantial risk of forfeiture. The proposed regulations provide that compensation is subject to a substantial risk of forfeiture if entitlement to the amount is conditioned on the performance of substantial future services by the service provider or the occurrence of a condition related to the purpose of the compensation, and the possibility of forfeiture is substantial. To satisfy the requirements of �409A, a NQDCP must be established and maintained in accordance with �409A both in form and operation. The term “plan” for purposes of �409A is defined quite broadly to include any plan, agreement or arrangement whether covering one individual or a class of individuals. However, the proposed regulations provide a number of notable exceptions to what constitutes deferred compensation. SHORT-TERM DEFERRALS The proposed regulations exempt certain short-term deferral arrangements from the scope of �409A. There is no deferral of compensation where, absent an election by the service provider to otherwise defer the payment to a later period, an amount of compensation is actually or constructively received by the service provider by the later of the 15th day of the third month following either the service provider’s or the service recipient’s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture. There are provisions in the proposed regulations that allow for payment later than the specified payment date, such as where timely payment was administratively impracticable and the circumstances causing the delay were unforeseeable as of the date upon which the legally binding right to the compensation arose. In a departure from the requirements of Notice 2005-1, the proposed regulations do not require that the arrangement provide in writing that the payment must be made by the relevant deadline, so when an amount is actually paid out by the appropriate deadline, it will qualify as a short-term deferral. However, where an arrangement does not provide in writing that payment must be paid by a specific date on or before the relevant deadline, failure to make payment by the deadline will result in an automatic violation of �409A. Thus, where possible, a compensation arrangement intended to take advantage of the short-term deferral exception should include a specified payment date. STOCK RIGHTS The proposed regulations exclude from coverage of �409A certain stock rights, including stock options and stock appreciation rights (SARs). An option to purchase the service recipient’s stock does not provide for deferral of compensation if the exercise price can never be less than the fair market value of the underlying stock on the date the option is granted, the number of shares subject to the option is fixed on the original date of grant, the transfer or exercise of the option is subject to taxation under �83, and the option does not include any feature for deferral of compensation. Similarly, a SAR in the service recipient’s stock does not provide for deferral of compensation if the compensation payable cannot be greater than the difference between the fair market value of the stock on the date of grant and the fair market value on the date of exercise, with respect to a number of shares fixed on or before the date of grant of the right. While Notice 2005-1 exempted only those SARs settled in stock of a publicly traded company, the proposed regulations extend the exception to SARs settled in cash and those issued by private companies. The proposed regulations include a number of provisions that define service recipient stock for this purpose (which, among other things, excludes preferred stock), provide guidance on stock valuation and address the effect of modifications of outstanding stock rights and the substitution of stock rights in connection with corporate transactions. Most significant are the rules addressing modifications that would be deemed the granting of a new stock right, which would then need to be re-examined under �409A as of the date of the modification. RESTRICTED PROPERTY In general, neither the transfer nor vesting of property taxable under �83 is treated as deferred compensation under �409A. On the other hand, a plan under which a service provider obtains a legally binding right to receive property in the future may constitute a deferral of compensation. INDEPENDENT CONTRACTORS Section 409A generally does not apply to amounts deferred pursuant to arrangements between independent contractors and service recipients where the independent contractor provides significant services to two or more service recipients during the taxable year in which the amount is deferred. The proposed regulations provide detailed rules to determine when services are “significant,” including a safe harbor where 70 percent or less of the service provider’s revenue is derived from any single service recipient. This exception for independent contractors does not apply to services performed as a director of a corporation. SECTION 409A COMPLIANCE Once an arrangement is determined to provide deferred compensation, �409A provides a detailed framework of rules within which the arrangement must operate to avoid the income inclusion and penalty provisions of �409A. The rules address the timing of initial and subsequent deferral elections, permissible payment events and a general prohibition on acceleration of deferred compensation. Each of these is discussed below. INITIAL DEFERRAL ELECTIONS Under �409A, a plan generally may only permit initial deferral elections for compensation related to services performed during the participant’s taxable year if the election to defer such compensation is made no later than the close of the previous year or at other such time as provided in the proposed regulations. The proposed regulations permit “evergreen” deferral elections that remain in place until the service provider changes the election. However, such elections satisfy the initial deferral election requirements only if the election becomes irrevocable with respect to future compensation no later than the last permissible date an affirmative initial deferral election could have been made. With respect to any performance-based compensation for services performed over a period of at least 12 months, an initial deferral election may be made no later than six months before the end of the period. Performance-based compensation is defined as compensation that is contingent on satisfaction of pre-established organizational or individual performance criteria, which may include payments based on subjective performance criteria. The proposed regulations clarify that performance criteria may be established up to 90 days after the commencement of the performance period, but the service provider may not make any election to defer after such compensation has become both substantially certain to be paid and readily ascertainable. Under �409A and the proposed regulations, during the first year in which a service provider becomes eligible to participate in the plan, the service provider may make an initial deferral election within 30 days after the date she becomes eligible to participate, but only with respect to compensation paid for services to be performed subsequent to the election. Deferral elections include elections both as to the time and form of payment. Thus, in a plan in which participation is not elective but which allows participants to elect the time and form of payment, elections will have to satisfy the initial and subsequent deferral election rules. PAYMENT Deferred compensation subject to �409A may be paid only on account of one of the following: separation from service, death, disability, a change in ownership or effective control of a corporation or a substantial portion of its assets, a specified time or pursuant to a fixed schedule, or an unforeseeable emergency. It would not be permissible to pay deferred compensation upon the occurrence of any other event, e.g., upon a child’s commencement of college. The proposed regulations provide detailed guidance on each permitted payment event. With respect to certain key employees of public companies, the proposed regulations provide that payments upon a separation of service may not be made earlier than six months after the separation from service. When payment is based on the occurrence of a permitted event, the plan must designate an objectively determinable date or year following the event upon which payment will be made, such as within 90 days after death or in the calendar year following separation from service. The proposed regulations do not require actual payment on the specified date; a payment will be treated as made upon the designated date if the payment is made by the later of the first day the payment is administratively feasible on or after the designated date, or the end of the calendar year containing the designated date. The proposed regulations permit a plan to provide for payment upon the earlier or the later of multiple payment events, and a different form of payment may be elected for each potential event, such as installment payments upon separation of service or, if earlier, a lump-sum payment upon death. LATER DEFERRAL ELECTIONS Section 409A and the proposed regulations provide that if a plan permits a service provider to make a subsequent election to delay a payment or change the form of payment, several requirements must be met. The plan must require that such elections will not take effect until at least 12 months from the date of the election. Except for payments made on account of death, disability or an unforeseeable emergency, the plan must require that the first payment with respect to which such election is made be deferred for a period of at least five years from the date the payment otherwise would have been made. ACCELERATION Under �409A, a payment of deferred compensation may not be accelerated except as provided in the proposed regulations. The proposed regulations incorporate payment accelerations that were permitted under Notice 2005-1, including payments necessary to comply with a domestic relations order or certain conflict of interest rules, payments intended to pay employment taxes, and certain de minimis payments related to termination of participation in a plan. The proposed regulations also permit the acceleration of the time or schedule of a payment to pay the amount that the service provider includes in income as a result of the plan failing to meet the requirements of �409A and in limited circumstances, upon a plan termination. Although beyond the scope of this article, �409A and the proposed regulations include provisions addressing plan aggregation issues, NQDCPs that are linked to qualified retirement plans, foreign arrangements, separation pay arrangements and the funding of deferred compensation through offshore trusts and upon a change in the employer’s financial health. DATES AND GUIDANCE The regulations are proposed to be generally applicable for taxable years beginning on or after Jan. 1, 2007, though taxpayers may rely on the proposed regulations until the effective date of the final regulations. Generally, �409A is effective with respect to amounts deferred in taxable years beginning after Dec. 31, 2004 and amounts deferred before that date under a plan that is materially modified after Oct. 3, 2004. The proposed regulations contain extensive transition and grandfathering provisions. Following are some of the more significant of them. The proposed regulations provide that amounts are considered deferred before Jan. 1, 2005, and thus not subject to �409A, if the service provider had a legally binding right to be paid the amount and it was earned and vested as of Dec. 31, 2004. A right to an amount is earned and vested only if it is not subject to either a substantial risk of forfeiture or a requirement to perform further services. The proposed regulations extend certain aspects of the transitional relief provisions contained within Notice 2005-1 though Dec. 31, 2006. Plans adopted on or before Dec. 31, 2006 will not be treated as violating �409A if the plan is operated in good faith compliance with the provisions of �409A and Notice 2005-1 through 2006 and the plan is amended on or before Dec. 31, 2006 to conform to the provisions of �409A and the proposed regulations. Compliance with the proposed or final regulations will be deemed good faith compliance with the statute. Also, payment elections (other than those providing for payments in 2006) generally may be changed prior to Dec. 31, 2006 without violating �409A. However, the ability of participants to terminate participation in a plan or cancel an outstanding deferral election, or of a service recipient to terminate a plan without violating �409A, was not extended and must be done on or before Dec. 31, 2005. Donald P. Carleen is a partner and chairs the executive compensation and employee benefits group at Fried, Frank, Harris, Shriver & Jacobson. Jason R. Nelms, a law clerk with the firm, assisted in the preparation of this article.

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