Compensation

July 2007

Analyzing Deferred Compensation Arrangements Under the Section 409A Final Regulations: A Six-Step Analytic ProcessBy Stewart Reier

This is the rst installment of Stewart Reier's Six-Step Analysis. We will present Parts III and IV in the August issue, and conclude with Parts V and VI in the September issue.n April 10, 2007, the United States Treasury Department (Treasury) issued nal regulations (the Final Regs) under Internal Revenue Code Section 409A (Code Sec. 409A).1 Congress enacted Code Sec. 409A in October 2004 to strictly regulate the use of deferred compensation arrangements. Under Code Sec. 409A, deferred compensation includes not only employee-elective deerre c ed compensation, but also includes supplemental ferred com ex cuti re emen plan (SER xec ive executive retirement plans (SERPs), severance-related ar ngeme , rran em c in ca arrangements, and certain cash-based and equityba ed i ce ase incentive compensation arrangements. mpensation based inc nt e com h F dress d es with The Final Regs addressed many issues w respect rre compensation tax law. The major a o w h to the new deferred compensation ta law The majo issues addressed or claried were the following: various denitions, including: deferral of compensation nonqualied deferred compensation plan service provider service recipient specied employee service recipient stock change in control event; plans and arrangements that are exempt from Code Sec. 409A;Stewart Reier is a Shareholder with the law rm of Vedder, Price, Kaufman & Kammholz, P.C. in New York City and heads its New York executive compensation practice group.

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permissible distribution/payment events; subsequent deferral elections; equity-based compensation; and separation from service, including a good reason termination. The Final Regs failed to address the following items: partnerships; offshore trusts; split-dollar life insurance arrangements (however, Notice 2007-34,2 which was released along with the Final Regs, addressed split-dollar life insurance arrangements to some extent); e reporting, withholding and calculation of deferred amo m ferred amounts; and penalties. Generally, the Final Regs bring to a close a process begun in December 2004 when the Treasury and the Internal Revenue Service (the IRS) rst began to address the many substantive and technical issues created by the enactment of Code Sec. 409A. Although more Code Sec. 409A regulations are still to come, the Final Regs now provide the means to fully analyze compensatory arrangements to determine if such arrangements are subject to Code Sec. 409A, and if so, whether such arrangements comply with the requirements of Code Sec. 409A. This article presents a concise analytic framework based on the Final Regs to determine whether compensation is subject toand compliant withCode Sec. 409A.

2007 S. Reier

CORPORATE BUSINESS TAXATION MONTHLY

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Analyzing Deferred Compensation Arrangementsunderpayment interest rate. In addition, the interest is measured from the point in time when the On October 11, 2004, Congress passed the American deferred compensation was rst deferred or not Jobs Creation Act of 2004 (the Jobs Act),3 which subject to a substantial risk of forfeiture. President Bush signed into law on October 22, 2004. Finally, and most importantly, the recipient of Section 885 of the Jobs Act amended the Internal the deferred compensation will be subject to Revenue Code of 1986 (the Code) by adding a new an additional 20-percent penalty tax on the Code Sec. 409A, Inclusion in Gross Income of Dedeferred compensation. ferred Compensation Under Nonqualied Deferred It is important to note that Section 132 of the RevCompensation Plans. Generally, Code Sec. 409A sets enue Act of 19784 was not repealed. Act Sec. 132 a very high bar for compensation to qualify for tax provided that the IRS could no longer regulate or isdeferral. Code Sec. 409A also generally proscribes sue rulings (other than private letter rulings (LTRs)) the use of offshore rabbi trusts as permissible regarding the constructive receipt of deferred comfunding arrangements for deferred compensation pensation after February 1, 1978.5 Act Sec. 132 thus arrangements (although this is a separate analysis effectively froze deferred compensation law as of and not the subject of this February 1, 1978. Since article). If the deferred 1978, the IRS generally The Final Regs only apply to compensation arrangehas adhered to the proment violates Code Sec. scription under Act Sec. compensatory relationships 409As strict requirements, 132 other than issuing between one that provides the then the compensation two revenue procedures services (a service provider) and in 1992: will be treated as constructively received in the year Rev. Proc. 92-646 created one that receives such services (a of deferral. a model rabbi trust that service recipient). The heading to Code needed to be followed in Sec. 409A(a) is Rules Reorder for a taxpayers to lating to Constructive Receipt. That section provides receive a favorable LTR; and that [I]f at any time during a taxable year a nonRev. Proc. 92-657 amplified Rev. Proc. 71qualied deferred compensation plan fails to meet the 19,8 the original revenue procedure that guided requirements of [Code Sec. 409A] or is not operated taxpayers when requesting a LTR on a deferred n acco ord in accordance with [the Code Sec. 409A requirecompensation arrangement, generally by addmen ] m nts], all mpensation deferred under the plan for ments], all compensation defe ing rules with respect to the new plan and new th tax he taxable a d reced the t able year and all preceding taxable years shall participants. e includible n gross income ncl n dib be includ ble in gross income for the taxable year to Since the Jobs Act did not repeal Act Sec. 132, u o v the extent not subject to a substantial risk of forfeiture individual taxpayers and employers must realize that usl ncluded gross ncome. u ed o e defer ed compensation is now subject to two tax e m and not previously included in gros income. deferred comp Deferred compensation that fails to comply with regimes superimposed over one another: Code Sec. 409A produces onerous results: The principles underlying constructive receipt, genThe noncompliant deferred compensation will be erally still frozen as of February 1, 1978; and treated as taxable income with respect to the year The explicit requirements under Code Sec. 409A. in which the Code Sec. 409A violation occurs. On December 20, 2004, the IRS issued Notice Ordinary income tax applies to this compensa2005-1,9 which set forth initial guidance with respect tion. This tax becomes due even if the recipient to the new tax law. On September 29, 2005, the IRS of the deferred compensation has yet to receive released proposed regulations (Proposed Regs) such compensation. under Code Sec. 409A, which were published in the Since Code Sec. 409A applies to compensation Federal Register on October 4, 2005.10 constructively paid but never taxed in the same tax Following the issuance of the Proposed Regs, the year, the taxpayer not only owes ordinary income IRS issued ve more notices in 2006: tax on this compensation but also interest on the Notice 2006-4,11 which provided guidance with underpayment of taxes. That interest rate for this respect to stock options and stock appreciation purpose is set at one percent above the standard rights granted before January 1, 2005, and is

Overview

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July 2007obsoleted for taxable years after January 1, 2008 except for the Q&A sections with respect to: application to arrangements covered by Code Sec. 457, application to partners and partnerships, and information reporting and withholding guidance. Notice 2006-33, 12 which related to Code Sec. 409A compliance of offshore trusts due to technical corrections made to Code Sec. 409A(b) under the Gulf Opportunity Zone Act of 2005,13 and which is not affected by the Final Regs. Notice 2006-64, 14 which provided relief for the acceleration of deferred compensation due to federal conflict-of-interest rules, and which is superseded by the Final Regs for any service providers tax year beginning on or after January 1, 2008. Notice 2006-79, 15 which extended Code Sec. 409A compliance for all written plans from December 31, 2006 to December 31, 2007 and provided additional transition relief, and which is not affected by the Final Regs. Notice 2006-100, 16 which provided interim reporting rules, and which is not affected by the Final Regs. Announcement 2007-18, 17 which provided relief to rank-and-file employees who may have inadvertently been subject to Code Sec. 40 4 9A due to backdated stock options. 409A Along w ng Along with the release of the Final Regs, the release IR iss ed Notice 2 7-34 entitled Application RS sue IRS issued o 2007-34 of Sect n 4 9A to Sp t-Do f Sect tio Section 409A to Split-Dollar Life Insurance in erre C atio o Nonqualified Deferred Compensation Plan Are e rangements. Thi Notice general provides that This generally provides split-dollar life insurance arrangements are arrangements that will be tested like other deferred compensation arrangements, and thus may be subject to Code Sec. 409A. However, a modication to an existing grandfathered split-dollar life insurance arrangement in order to bring the arrangement into Code Sec. 409A compliance will not be treated as a material modication under the split-dollar life insurance Treasury Regs, and thus will preserve grandfathering for purposes of applying the splitdollar life insurance grandfathering regulations under Reg. 1.61-22 and 1.7872-15. Finally, taxes pursuant to the Federal Insurance Contributions Act (FICA) (i.e.,Social Security and Medicare tax) on deferred compensation imposed under Code Sec. 3121(v) are, for the most part, not impacted by Code Sec. 409A. Accordingly, taxpayers are obligated to pay FICA taxes under the existing taxing regime established by Reg. 31.3121(v)(2)-1 and 31.3121(v)(2)-2. These FICA taxes are generally relevant when there is no longer a substantial risk of forfeiture,18 regardless of whether the compensation is paid or continues to be deferred.

Important and Immediate Action to be Taken by CompaniesCompanies (referred to under the Final Regs as service recipients) have struggled with Code Sec. 409A ever since its enactment in October 2004. The requirement that all existing nongrandfathered deferred compensation arrangements fully comply with Code Sec. 409A rst had a deadline at the end of 2005. Then the IRS pushed this back to the end of 2006, and then further pushed the deadline back to the end of 2007 in Notice 2006-10. The Final Regs have retained the December 31, 2007 full compliance date. Thus, companies need to undertake the following procedures: immediately inventory: all deferred compensation plans, programs, agreements and arrangements; all compensatory plans, programs, agreem e n t s a n d a r ra n g e m e n t s ( i n c l u d i n g cash-based and equity-based incentive compensation plans); and all written and unwritten employment arrangements (including employment agreements, individual severance agreem e n t s ( b o t h ch a n g e - i n - c o n t r o l a n d nonchange-in-control), severance plans (both change-in-control and nonchangein-control); then review all such plans, programs, agreements and arrangements to determine if they are subject to Code Sec. 409A; and then amend all such plans, programs, agreements and arrangements (other than grandfathered arrangements) to bring such arrangements into Code Sec. 409A compliance on or prior to December 31, 2007. Companies need to be very careful to ensure that all arrangements are reviewed and amended (if necessary), as deferred compensation arrange-


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Analyzing Deferred Compensation Arrangementsments subject to Code Sec. 409A can be found in a wide array of documents (e.g., a simple employment offer letter or a retention agreement). reported under Form W-2 or under Form 1099. This reporting obligation not only includes compliant deferred compensation, which has passed Steps 3 and 4 above, but also noncompliant deferred compensation.

Analytic StepsCode Sec. 409A and the Final Regs generally create an analytic framework involving six basic steps to determine whether compensation is deferred and subject to Code Sec. 409A. Step 1: Determine whether the compensation is under a grandfathered arrangement. Generally this grandfathering situation means that the arrangement was in effect prior to October 4, 2004 and the arrangement has never been materially modied. Step 2: Determine whether the compensation is actually deferred compensation under Code Sec. 409A. This requires an analysis of whether the compensation meets the regulatory definition of deferral of compensation, and then whether the compensation can be characterized as either: short-term deferred compensation, which generally is exempt from Code Sec. 409A, or Code Sec. 83 property, which involves a careful analysis of whether the transferred property satisfies the strict requirements for the Code Sec. 409A exemption. Step 3: If the compensation meets the regulatory definition of deferral of compensation, the the t en t next step is to determine whether the then compe ation is deferred under a nonqualified c mp p compensation s deferred def d ferre compensation plan (NQDCP). Code on p deferred co e Sec 409 would not apply if the compensaSec 4 A would n ot ap c c. Sec. 409A i Q p d tion is not a NQDCP, perhaps based on certain s, uch as tax-qualified pension a ed o exemptions, such a s ta x-qua ifie d p ensio n plans, certain welfare plans, certain separation pay plans and certain foreign plans. Step 4: If the deferred compensation is deferred under a NQDCP, then the next step is to determine whether the NQDCPs provisions relating to initial deferral elections and subsequent deferral elections with respect to the deferred compensation comply with Code Sec. 409A. Step 5: The next step is to determine whether the NQDCPs provisions relating to the distribution/payment of the deferred compensation comply with Code Sec. 409A. Step 6: The final step is to determine whether the deferred compensation has been properly

DefinitionsThe Final Regs and the Six-Step Analysis below use specific terms with specific definitions. Below is a list of these terms and the location of their definitions in the Six-Step Analysis (CCH Note: Some of these definitions are located in the second or third installment of this three-part article): account balance plansee I.B. anti-acceleration rulesee V.B. broad-based retirement plansee III.B.2.c. change in control event (CIC)see V.A.7. commission compensationsee IV.A.10. controlling interestsee II.E.3.b. date of grant of an optionsee II.E.2.a.v. domestic relation ordersee IV.B.2.d established securities marketsee II.E.2. exercise datesee II.E.2.a.vii. exercise pricesee II.E.2.a.vi. fiscal year compensationsee IV.A.4. gross fair market valuesee V.A.7.c. groupsee V.A.7. initial deferral electionsee IV.A.1. life annuitysee IV.B.2.a. management servicessee II.A.1. material modificationsee I.G. modified foreign earned incomeIII.B.2.c. mutual company unitsee II.E.3.a. nonaccount balance plansee I.C. n nonqualified deferred compensation plan n onqua if (NQDCP)see III.A.1. nonresident aliensee III.B.2.a option or stock optionsee II.E.2.a.ii. performance-based compensationsee II.2.1.b. permissible distribution/payment eventsee V.A.1. plansee III.A.1 related to another personsee II.A.2. separation paysee II.D.2. separation pay arrangementssee II.D.2. service providersee II.A.1. service recipientsee II.A.2. service recipient stocksee II.E.3. 70-percent Safe Harbor rulesee II.A.1.

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July 2007

Analytic FrameworkBased on the Final Regs and the above Six-Step Approach, the following analysis can be used to determine whether compensation is subject to Section 409A, and if so, then whether such compensation complies with the Section 409A Final Regs: Non-Application Due to Grandfathering October 4, 2004 cut-off date Calculation of grandfathered account balance plan amounts Calculation of grandfathered nonaccount balance plan amounts Calculation of grandfathered equity-based compensation Calculation of grandfathered earnings on grandfathered deferred compensation Denition of plan for grandfathering purposes Material modication of a grandfathered plan Denition of deferred compensation subject to Section 409A Establishment of the service provider/service recipient relationship Denition of service provider Denition of service recipient Denition of deferral of compensation Earnings on deferred compensation When deferred compensation is not subject to Section 409A Short-term deferrals (the short-term or 2-1/2 month rule) Certain delayed payments Substantial risk of forfeiture Performance-based compensation Separation pay plans Collectively bargained arrangements Window programs Foreign separation pay plans Involuntary separation from service Good Reason separation from service Reimbursements and certain other separation payments Certain indemnication and liability insurance plans Legal settlements Certain educational benets Customary timing arrangements Certain foreign plans, arrangements and situations Arrangements with respect to compensation covered by treaty or other international agreement Arrangements with respect to certain other compensation Tax equalization agreements Certain limited deferrals of a nonresident alien Foreign plan earnings Additional foreign plans as designated by the IRS Commissioner When equity-based compensation is subject to Section 409A Exemption for compensation that is Section 83 property Stock rights on service recipient stock


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Analyzing Deferred Compensation Arrangements

Certain denitions and concepts Denition of stock right Denition of option Denition of stock appreciation right or SAR Denitions of stock, established securities market, and readily tradable Determination of the date of grant of an option or SAR Denition of exercise price When an exercise of an option occurs Denition of transfer Basic rules ISOs and ESPPs Dividends and dividend equivalents Stock right modications Extensions and renewals Substitutions or assumptions of stock rights by reason of a corporate transaction Acceleration of date when exercisable Discretionary-added benets Change in underlying stock increasing value Change in the number of shares purchasable Rescission of changes Successive modications and extensions Service recipient stock Basic rule Eligible issuer of service recipient stock Fair market valuation of service recipient stock if publicly traded Fair market valuation of service recipient stock if not publicly traded Nonqualied Deferred Compensation Plans (NQDCPs) Denition of NQDCP Denition and establishment of plan Exempt plans Qualied employer plans Certain foreign plans Denition of nonresident alien Participation by nonresident aliens, certain resident aliens, and bona de residents of possessions Participation by U.S. citizens and lawful permanent residents Broad-based foreign retirement plans Plans subject to a totalization agreement and similar plans Certain welfare-benet plans IRC Section 457 plans Aggregation rules Deferral Provisions Permissible initial deferral elections Basic rule Initial deferral election with respect to short-term deferrals Initial deferral election with respect to certain forfeitable rights

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July 2007

Initial deferral election with respect to scal year compensation Initial deferral election with respect to rst year of eligibility Initial deferral election with respect to performance-based compensation Initial deferral elections with respect to certain separation pay Initial deferral elections with respect to certain commissions Initial deferral elections with respect to compensation paid for nal payroll period Elections to annualize recurring part-year compensation NQDCPs linkage to qualied employer plans and certain other arrangements Changes in elections under a cafeteria plan USERRA rights Subsequent changes in time and form of payment Basic rule Denition of payments for purposes of subsequent changes in time and form of payment Life annuities Installment payments Beneciaries Domestic relations orders Coordination with anti-acceleration rule Application to multiple payment events Delay of payment under certain circumstances Payments subject to IRC Section 162(m) Payments that would violate Federal securities laws or other applicable law Other events or conditions USERRA rights Special rules for certain resident aliens Distribution/Payment Provisions Permissible distributions/payment events Basic rules Designation of alternative specied dates or payment schedules based upon date of permissible distribution/payment event When a payment is treated as made upon the designated payment date Disputed payments and refusals to pay Designation of time and form of payment with respect to earnings Substitutions Special rules for certain resident aliens Specied time or xed schedule Reimbursement or in-kind benets plans Tax gross-up payments Death Disability Unforeseeable emergency Separation from service Independent contractors Employees Specied employees Mandatory 6-month delay of payment Denition of specied employee Denition of compensation for specied employee identication


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Analyzing Deferred Compensation Arrangements

Specied employee identication date Specied employee effective date Alternative method for satisfying the six-month delay rule Corporate transactions (1) Mergers and acquisitions of public service recipients (2) Mergers and acquisitions of non public service recipients (3) Spinoffs (4) Public offerings and other corporate transactions (5) Alternative method of compliance Nonresident alien employees Elections affecting the identication of specied employees Asset purchase transactions Dual status Collectively bargained plans covering multiple employers Change in control events (CIC) Type 1 CIC: Change in the ownership of a corporation Type 2 CIC: Change in the effective control of a corporation Type 3 CIC: Change in the ownership of a substantial portion of a corporations assets Certain back-to-back arrangements Special rules for certain delayed payments pursuant to a CIC Certain transaction-based compensation Certain nonvested compensation Anti-acceleration rule Basic rule Exceptions to the anti-acceleration rule Domestic relations order Conicts of interest IRC Section 457(f) Limited cashouts Payment of employment taxes Payments upon income inclusion under Section 409A Cancellation of deferrals following an unforeseeable emergency or hardship distribution Termination and liquidation of a NQDCP Certain distributions to avoid a nonallocation year under IRC Section 409(p) Linkage to qualied employer plans and certain other arrangements Payment of state, local or foreign taxes Cancellation of deferral elections due to disability Certain offset Bona de disputes as to a right to a payment Changes in elections under a cafeteria plan Reporting, Withholding and Calculation of Section 409A Deferred Compensation Service recipients Reporting and withholding Calculation of amounts Service provider Amounts required to be included in income by a service provider Calculation of additional tax

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July 2007ture (as dened under the Code Sec. 83 regulations)19 or a requirement to perform further services, on an amount deferred that is not subject to a substantial risk of forfeiture or a requirement to perform further services, is not treated as earnings on the amount deferred, but a separate right to compensation. The amount is considered deferred before January 1, 2005 if, before January 1, 2005, the service provider had a legally binding right (as described in more detail at II.B. below) to be paid the amount, and the right to the amount was earned and vested. A right to an amount was earned and vested only if the amount was not subject to a substantial risk of forfeiture or a requirement to perform further services.20 Amounts to which the service provider did not have a legally binding right before January 1, 2005 (e.g., Six-Step Analysis because the service recipient retained discretion to I. Nonapplication Due to reduce the amount), will not be considered deferred before January 1, 2005. Grandfathering In addition, amounts A plan that otherwise provides to which the service proA. October 4, 2004 vider (e.g., the employee) for a deferral of compensation Cut-Off Date had a legally binding right does not fail to provide a deferral before January 1, 2005 Final Reg. 1.409A-6(a) of compensation merely because but the right to which provides that Code Sec. the right to payment of the was subject to a substan409A applies with respect to: compensation is conditioned upon tial risk of forfeiture or a requirement to perform amounts deferred in a separation from service. further services after Detax years beginning cember 31, 2004 are not after December 31, considered deferred before January 1, 2005 for pur200 , 2 04, 2004, and poses of the effective date. However, an amount to am un deferred amou amounts deferred in tax y years beginning before which the service provider had a legally binding right Jan ary 2005 i the plan under which the deferJ nua January 1, 2 if before January 1, 2005 but for which the service proral m e materially modied after October ma m ral is made is mater ally m vider was required to continue performing services r 3, 2004. retain right e g to retain the rig only through the completion of the For amounts de erred in tax yea beginning bedeferred years payroll period,21 is not treated as subject to a requirefore January 1, 2005 under a plan that is materially modied after October 3, 2004, whether the plan ment to perform further services (or a substantial risk complies with the requirements of Code Sec. 409A of forfeiture) for purposes of the effective date. and the Final Regs is determined by reference to the A stock option, stock appreciation right or similar terms of the plan in effect as of, and any actions taken compensation that on or before December 31, 2004, under the plan on or after, the date of the material was immediately exercisable for cash or substantially modication. vested property22 is treated as earned and vested, Code Sec. 409A is applicable with respect to earnregardless of whether the right would terminate if ings on amounts deferred only to the extent that Code the service provider ceased providing services for Sec. 409A is applicable with respect to the amounts the service recipient. deferred. Accordingly, Code Sec. 409A does not Finally, Code Sec. 409A does not apply with respect apply with respect to earnings on amounts deferred to amounts deferred under a plan maintained pursubefore January 1, 2005 unless Code Sec. 409A apant to one or more bona de collective bargaining plies with respect to the amounts deferred. A right to agreements in effect on October 3, 2004, for the peearnings that is subject to a substantial risk of forfeiriod ending on the earlier of the date on which the last short-term (or 2-1/2 month) deferral rule II.D.1. six-month delay rulesee V.A.6.c.i. specified employeesee V.A.6.c.i. stock appreciation right or SARsee II.E.2.a.iii. stock rightII.E.2.a.i. stock right modificationsee II.E.2.c. subsequent deferral election (or change in the time or form of payment)see IV.B.1. substantial risk of forfeituresee II.D.1.b. transaction-based compensationV.A.7.e.i. two-times rulesee II.D.2.b. window programsee II.D.2.b.


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Analyzing Deferred Compensation Arrangementsof such collective bargaining agreements terminates (determined without regard to any extension thereof after October 3, 2004) or December 31, 2009. plan to receive a payment of benets following the termination of services, and receive the benets in the form with the maximum value. Note that for any subsequent tax year of the service provider, the grandfathered amount may increase to equal the present value of the benet the service provider actually becomes entitled to, in the form and at the time actually paid, determined under the terms of the plan (including applicable limits under the Code), as in effect on October 3, 2004, without regard to any further services rendered by the service provider after December 31, 2004, or any other events affecting the amount of or the entitlement to benets (other than a participant election with respect to the time or form of an available benet). For purposes of calculating the present value of a benet, reasonable actuarial assumptions and methods must be used, which will be determined as of each date the benet is valued for purposes of determining the grandfathered benet, provided that any reasonable actuarial assumptions and methods that were used by the service recipient with respect to such benet as of December 31, 2004, will continue to be treated as reasonable assumptions and methods for purposes of calculating the grandfathered benet. Actuarial assumptions and methods will be presumed reasonable if they are the same as those used to value benets under a qualied plan sponsored by the service recipient the benets under which are part of the benet formula under, or otherwise impact the amount of benets under, the nonaccount balance plan.

B. Calculation of Grandfathered Account Balance Plan AmountsFinal Reg. 1.409A-1(c)((2)(i)(A) provides that the term account balance plan means: an agreement, method, program, or other arrangement that is an account balance plan as defined in Reg. 31.3121(v)(2)-1(c)(1)(ii)(A), including mandatorily bifurcating the agreement, method, program, or other arrangement in accordance with the rules provided in Reg. 31.3121(v)-1(c)(1)(iii)(B); or an agreement, method, program, or other arrangement that would be described in the bullet above if the service provider were an employee. The amount of compensation deferred before January 1, 2005, under a NQDCP that is an account balance plan equals the portion of the service providers account balance as of December 31, 2004, the right to which is earned and vested23 as of December 31, 2004, plus any future contributions to the account, the right to which was earned and vested as of December 31, 2004, to the extent such contributions are actually made.

C. Calculation of Grandfathered Nonaccount Balance Plan Amountsina R g al Reg. Final Reg 1.409A-1(c)((2)(i)(C) provides that the term n na ount balance pl e m non term nonaccount balance plan means: An agreement, method, program, or other arA ag m gr hod, ran ran em t tha is a nona ngeme nge rangement that nonaccount balance plan g 3 )( 2) as defined in Reg. 31.3121(v)(2)-1(c)(2)(i), o g including ma datorily bifurca ng the agreemandatorily bifurcating e agreement, method, program or other arrangement in accordance with the rules provided in Reg. 31.3121(v)-1(c)(1)(iii)(B); or An agreement, method, program, or other arrangement that would be described in the bullet above if the service provider were an employee. The amount of compensation deferred before January 1, 2005, under a NQDCP that is a nonaccount balance plan equals the present value of the amount to which the service provider would have been entitled under the plan if the service provider voluntarily terminated services without cause on December 31, 2004, and received a payment of the benets with the maximum value available from the plan on the earliest possible date allowed under the

D. Calculation of Grandfathered Equity-Based CompensationThe a amount of compensation deferred before January 1, 2005 under an equity-based compensation plan n 2005 under is determined similar to a grandfathered account balance plan, except that the account balance is deemed to be the amount of the payment available to the service provider on December 31, 2004 (or that would be available to the service provider if the right were immediately exercisable) the right to which is earned and vested24 as of December 31, 2004. Note that the payment available to the service provider excludes any exercise price or other amount that must be paid by the service provider.

E. Calculation of Grandfathered Earnings on Grandfathered Deferred CompensationFinal Reg. 1.409A-6(a)(1)(i) provides that Code Sec. 409A:

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July 2007

F. Denition of Plan for is applicable with respect to earnings on amounts Purposes of Grandfathering deferred only to the extent that Code Sec. 409A is applicable with respect to the amounts deferred, and The term plan generally has the same meaning is not applicable with respect to earnings on provided in the Final Regs with respect to deferred amounts deferred before January 1, 2005, uncompensation that is not grandfathered (see III.A. beless Code Sec. 409A applies with respect to the low), except that the plan aggregation rules (see III.C. amounts deferred. below) treating all nonaccount balance plans under Final Reg. 1.409A-6(a)(3)(iv) provides that earnwhich compensation is deferred as a single plan do ings on amounts deferred under a plan before January not apply for purposes of the actuarial assumptions 1, 2005, include only income (whether actual or and methods used to determine the grandfathered notional) attributable to the amounts deferred under amounts. Accordingly, different reasonable actuarial a plan as of December 31, 2004, or to such income. assumptions and methods may be used to calculate Thus, notional interest earned under the plan on the amounts deferred by a service provider in two amounts deferred in an account balance plan as of different agreements, methods, programs or other arDecember 31, 2004, generally will be treated as earnrangements each of which constitutes a nonaccount ings on amounts deferred balance plan. under the plan before When the right to earnings is G. Material January 1, 2005. Similarly, an increase Modication specied under the terms of the in the amount of payof a Grandfathered plan, the legally binding right to ment available pursuant Plan earnings arises at the time of the to a stock option, stock appreciation right or other Final Reg. 1.409A-6(a)(4) deferral of the compensation to equity-based compensaprovides that a modicawhich the earnings relate. tion above the amount of tion of a grandfathered payment available as of plan is a material modiDecember 31, 2004 due to appreciation in the cation if a benet or right existing as of October 3, underlying stock after December 31, 2004, or ac2004, is materially enhanced or a new material bencrual of other earnings such as dividends, is treated et or right is added, and such material enhancement as earnings on the amount deferred. In the case of or addition affects amounts earned and vested before no acc ona a nonaccount balance plan, earnings include the January 1, 2005. Such material benet enhancein eas , due solely ncre se, increase, d sole y to the p passage of time, in the ment or addition is a material modication whether pr ent va res val o the future p ure payments to which the present v value of he it occurs pursuant to an amendment or the service se ice pr erv e ro ervice prov er has obtained service provider has obtained a legally binding right, recipients exercise of discretion under the terms of f which d the the present value of wh h constituted th amounts the p plan. Note that a reduction of an existing benet efore January 1, is not a materia modication. o a deferred under th plan be the before Janu ry 1 2005. not material Thus, for each year, there will be an increase For purposes of analyzing a material modication, (determined using the same interest rate used to dethe term plan has the same meaning as discussed termine the amounts deferred under the plan before immediately above at I.F. except that the aggregation January 1, 2005) resulting from the shortening of rules discussed in III.C. below treating all account the discount period before the future payments are balance plans under which compensation is deferred made, plus, if applicable, an increase in the present as a single plan, all nonaccount balance plans under value resulting from the service providers survivorwhich compensation is deferred as a separate single ship during the year. However, an increase in the plan, all separation pay arrangements due to an actual potential benets under a nonaccount balance plan involuntary separation from service or participation in a due to, for example, an application of an increase in window program as a separate single plan, and all other compensation after December 31, 2004, to a nal NQDCPs as a separate single plan, do not apply. average pay plan or to subsequent eligibility for an Thus, a material modication would occur under early retirement subsidy, does not constitute earnany of the following: ings on the amounts deferred under the plan before The amendment of a plan to add a provision January 1, 2005. that payments of deferred amounts earned andCORPORATE BUSINESS TAXATION MONTHLY

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Analyzing Deferred Compensation Arrangementsvested before January 1, 2005, may be allowed upon request if service providers are required to forfeit 20 percent of the amount of the payment (typically referred to as a haircut). Allowing a service recipient to exercise discretion so as to accelerate vesting of a benefit under the plan to a date on or before December 31, 2004. The addition of a right to a payment upon an unforeseeable emergency of an amount earned and vested before January 1, 2005. The amendment of a plan or the exercise of discretion under the terms of the plan that materially enhances an existing benet or right or adds a new material benet or right (even if the enhanced or added benet would be permitted under Code Sec. 409A). On the other hand, a material modication would not occur under any of the following: Allowing a service recipient to exercise discretion over the time and manner of payment of a benefit to the extent such discretion is provided under the terms of the plan as of October 3, 2004. Allowing a service provider to exercise a right permitted under the plan as in effect on October 3, 2004. The amendment of a plan to bring the plan into compliance with the provisions of Code Sec. 409A. T e re The removal of a haircut provision. T e est shm nt The establishment of or co contributions to a trust or oth o her arrangement om which benets under the other a ng e from wh pla pla are o an plan a to be paid provi paid, provided that the contribui e t tion to the trust or other arrangement would not au e mou e includible otherwise cause an am unt to be includible in amount the service providers gross income. The establishment of or contributions to a trust or other arrangement from which benets under the plan are to be paid, provided that the contribution to the trust or other arrangement would not otherwise cause an amount to be includible in the service providers gross income. The modication of a provision requiring the immediate cancellation of a current deferral election, to require the cancellation of deferrals for the same length of time beginning with the rst date at which the application of such cancellation would not violate Code Sec. 409A (e.g., the rst date of the service providers rst tax year following the cancellation). Compliance with a domestic relations order25 with respect to payments to an individual other than the service provider, or an amendment to a plan to require compliance with a domestic relations order with respect to payments to an individual other than the service provider. The modication of a plan providing a life annuity form of payment to permit an election between the existing life annuity form of payment and other forms of annuity payments that would be treated as a single form of payment with the existing life annuity form of payment (as described in IV.B.2.a. below). The modication of a grandfathered plan to add a limited cashout feature that qualied as an exception to the anti-acceleration rule under the Final Regs (see V.B. below). The Final Regs presume that the adoption of a new plan or the grant of an additional benet under an existing plan after October 3, 2004 and before January 1, 2005 constitutes a material modication of a plan. However, the presumption may be rebutted by demonstrating that the adoption of the plan or grant of the additional benet was consistent with the service recipients historical compensation practices. For example, the presumption that the grant of a discounted stock option on November 1, 2004 is a material modication of a plan may be rebutted by demonstrating that the grant was consistent with the historic practice of granting substantially similar discounted stock options (both as to terms and amounts) each November for a signicant number of years. The grant of an additional benet under an existing plan that consists of a deferral of additional compensation not otherwise provided under the plan as of on October 2004 October 3, 200 will be treated as a material modio cation of the plan only as to the additional deferral of compensation, if the plan explicitly identies the additional deferral of compensation and provides that the additional deferral of compensation is subject to Code Sec. 409A. Accordingly, amendments to conform a plan to the requirements of Code Sec. 409A with respect to deferrals under a plan occurring after December 31, 2004, will not constitute a material modication of the plan with respect to amounts deferred that are earned and vested on or before December 31, 2004, provided that there is no concurrent material modication with respect to the amount of, or rights to, amounts deferred that were earned and vested on or before December 31, 2004. Similarly, a grant

20

July 2007of an additional benet under a new plan adopted March 1 to allow an individual employee to elect a after October 3, 2004 and before January 1, 2005 new change in the time or form of payment without will not be treated as a material modication of an realizing that such a change constituted a material existing plan to the extent that the new plan explicitly modication that would subject the plan to the reidenties additional deferrals of compensation and quirements of Code Sec. 409A, and the modication provides that the additional deferrals of compensation is rescinded on November 1, then the plan is not are subject to Code Sec. 409A. considered materially modied if no change in the A cessation of deferrals under, or termination of, a time or form of payment has been made pursuant to plan, pursuant to the provisions of such plan, is not the modication before November 1. a material modication. Amending a plan to provide II. Definition of Deferred participants an election whether to terminate parCompensation Subject to ticipation in a plan generally constitutes a material modication of the plan. Code Sec. 409A With respect to an account balance plan, it is not A. Establishment of the Service Provider/ a material modication to change a notional investment measure, or to add to an existing investment Service Recipient Relationship measure, to an investment measure that qualies as a predetermined actual investment26 or, for any given Th e Fi n a l R e g s o n l y a p p l y t o c o m p e n s a 27 tory relationships between one that provides tax year, reects a reasonable rate of interest For this the services (a service purpose, if with respect to provider) and one that an amount deferred for a Even though deferred receives such services period, a plan provides for compensation may fall within (a service recipient). a xed rate of interest to be the denition of a deferral of Typically, this relationcredited, and the rate is to be reset under the plan at compensation, there are instances ship will be either a standard employee/ema specied future date that where the deferred compensation ployer relationship or an is not later than the end may be recharacterized and independent contractor of the fth tax year that providing services to an begins after the beginning become completely exempt from individual, a company or of the period, the rate is Code Sec. 409A. easo ab on other entity. reasonable at the beginni g of the period, and ing th eriod and d, ning o t 1. Denition of Service Provider th r e is n c he ge efore the rate s not changed before the reset date, then the ra will be t ated as reasonab in all future periods ate rate will b treated reasonable Final Reg. 1.409A-1(f) provides that the term sere before the reset date. vice p provider includes: tio extension e o a an individual, n The modication, extension or re ewal of a stock renewal f stock an individu corporation, subchapter S corporaright (as dened in II.E.2 below) will not constitute a tion or partnership; material modication of the stock right, if the modia personal service corporation (as dened in cation, extension or renewal would not be treated as Code Sec. 269A(b)(1)), or a noncorporate entity the grant of a new stock right under the Final Regs and that would be a personal service corporation if would not result in the stock right being treated as havit were a corporation; or ing had a deferral feature from the date of grant. a qualied personal service corporation (as deAny modication to the terms of a plan that would ned in Code Sec. 448(d)(2)), or a noncorporate inadvertently result in treatment as a material modientity that would be a qualied personal service cation is not considered a material modication of corporation if it were a corporation; the plan to the extent the modication in the terms for any taxable year in which such individual, of the plan is rescinded by the earlier of a date before corporation, subchapter S corporation, partnerthe right is exercised (if the change grants a discretionship, or other entity accounts for gross income ary right) or the last day of the tax year of the service from the performance of services under the cash provider during which such change occurred. Thus, receipts and disbursements method of accountif a service recipient modies the terms of a plan on ing. The term service provider also includes a


21

Analyzing Deferred Compensation Arrangementsperson who has separated from service (a former service provider). Code Sec. 409A generally does not apply to an amount deferred under a plan between a service provider and a service recipient with respect to a particular trade or business in which the service provider participates, including earnings credited to such deferred amount, if during the service providers taxable year in which the service provider obtains a legally binding right to the payment of the amount deferred all of the following applies: The service provider is actively engaged in the trade or business of providing services, other than as an employee or as a member of the board of directors of a corporation (or similar position with respect to an entity that is not a corporation). The service provider provides signicant services (see below) to two or more service recipients to which the service provider is not related and that are not related to one another person (see below). The service provider is not related to the service recipient, subject to the modication that the language 20 percent is not used instead of 50 percent each place 50 percent appears in Code Secs. 267(b) and 707(b)(1). Whether a service provider is providing signicant services depends on the facts and circumstances of each case. However, the Final Regs do provide for a 70-Percent Safe Harbor under two sets of facts: A service provider who provides services to two or more service recipients to which the service o mo provider is not related, and that are not related to pro de p ovid s elated, one another, is deemed to be providing signicant o e ano e de ed b services to two or more of such service recipients more services s vic ce for a given tax year if the revenues generated from f e g n the services p vided to any ser ce recipient or provided to service group of related service recipients during such tax year do not exceed 70 percent of the total revenue generated by the service provider from the trade or business of providing such services. In the case of a service provider who has been providing services in a trade or business for a period of not less than three consecutive years, a service provider who provides services to two or more service recipients to which the service provider is not related and that are not related to one another is deemed to be providing signicant services to two or more of such service recipients for a given tax year if, in each of the prior three tax years, the revenues generated from the services provided to any service recipient or group of related service recipients during such prior tax years did not exceed 70 percent of the total revenue generated by the service provider from the trade or business of providing such services, and at the time an amount is deferred, the service provider does not know or have reason to anticipate that the revenues generated from the services provided to any service recipient or group of related service recipients during the current year will exceed 70 percent of the total revenue generated by the service provider from the trade or business of providing such services. A person is related to another person if the persons bear a relationship to each other that is specied in the related taxpayer rules under Code Sec. 267(b) or Code Sec. 707(b)(1), subject to the modications that: The language 20 percent is used instead of 50 percent each place it appears in Code Secs. 267(b) and 707(b)(1), Code Sec. 267(c)(4) is applied as if the family of an individual includes the spouse of any member of the family; or the persons are engaged in trades or businesses under common control.28 In addition, an individual is related to an entity if the individual is an ofcer of an entity that is a corporation, or holds a position substantially similar to an ofcer of a corporation with an entity that is not a corporation. With respect to services provided to related persons, Code Sec. 409A does not apply to an amount deferred under a plan that is a bona de agreement, h method, program or other arrangement between a serv ce provider o service prov de and a related service recipient arising in the ordinary course of a particular trade or business in which the service provider is engaged to the extent that: The service provider provides services to the service recipient as an independent contractor. During the service providers tax year in which the amount is deferred, the service provider qualies for the 70-percent Safe Harbor with respect to such trade or business. Such agreement, method, program or other arrangement and the practices thereunder (including billing and collection practices), are substantially similar to the agreements, methods, programs or other arrangements and practices applicable to one or more unrelated service re-

22

July 2007cipients to whom the service provider provides substantial services and that produce a majority of the total revenue that the service provider earns from the trade or business of providing such services during the tax year. Code Sec. 409A applies to a service provider providing management services to a service recipient. The term management services means services that involve the actual or de facto direction or control of the nancial or operational aspects of a trade or business of the service recipient, or investment management or advisory services provided to a service recipient whose primary trade or business includes the investment of nancial assets (including investments in real estate), such as a hedge fund or a real estate investment trust. Code Sec. 414(c), at least 50 percent is used instead of at least 80 percent each place it appears in Reg. 1.414(c)-2. A plan may provide with respect to a deferral of compensation under the plan that in applying: Code Secs. 1563(a)(1), (2) and (3) for purposes of determining a controlled group of corporations under Code Sec. 414(b), another dened percentage greater than 50 percent, but not greater than 80 percent, is used instead of at least 80 percent at each place it appears in Code Secs. 1563(a)(1), (2) and (3); and Reg. 1.414(c)-2 for purposes of determining trades or businesses (whether or not incorporated) that are under common control for purposes of Code Sec. 414(c), another dened percentage greater than 50 percent, but not greater than 80 percent, is used instead of at least 80 percent at each place it appears in Reg. 1.414(c)-2. In addition, where the use of such denition of service recipient for purposes of determining a separation from service is based upon legitimate business criteria, the plan may provide that for purposes of a deferral of compensation under the plan that in applying: Code Secs. 1563(a)(1), (2) and (3) for purposes of determining a controlled group of corporations under Code Sec. 414(b), the language at least 20 percent or another dened percentage not less than 20 percent but not greater than 50 percent is used instead of at least 80 percent at each place it appears in Code Secs. 1563(a)(1), (2) and (3); and Reg. 1.414(c)-2 for purposes of determining trades or businesses (whether or not incorporated) that are under common control for purposes h of Code Se 414(c), the language at least 20 Sec. o percent or another dened percentage not less than 20 percent but not greater than 50 percent is used instead of at least 80 percent at each place it appears in Reg. 1.414(c)-2. Where a plan denes service recipient or employer other than the denition under the 50 percent standard, the plan must designate in writing the alternate denition no later than the last date at which the time and form of payment of the applicable amount deferred must be elected in accordance with the initial deferral rules under the Final Regs. Any such change in the denition for such amounts deferred will constitute a change in the time and form of payment subject to the rules governing subsequent deferral elections and the acceleration of payments.

2. Denition of Service RecipientThe term service recipient means the person for whom the services are performed and with respect to whom the legally binding right to compensation arises. A service recipient includes all persons with whom such person would be considered a single employer under: Code Sec. 414(b) Employees of Controlled Group of Corporations, or Code Sec. 414(c) Employees of Partnerships, Proprietorships, etc., under Common Control. Thus, if the service provider is an employee, the service recipient generally is the employer (including all pe persons treated as a single employer under ng a p g Code S c. 414(b) or (c)) It is important to note that Sec. 4(b) or (c)). Code Sec Code S c. 409A applies to a plan that provides for Sec. 9 pp Code Sec the def ra of com th d fer al f compensation, even if the payment he deferral mpensation of the compensation is not made by the person for h on t whom services ar perform d. are performed. med There are additional special rules associated with the denition of service recipient (and employer) with respect to a service providers separation from service. The term service recipient or employer means the service recipient as dened above, provided that and applying: Code Secs. 1563(a)(1), (2) and (3) for purposes of determining a controlled group of corporations under Code Sec. 414(b), the language at least 50 percent is used instead of at least 80 percent each place it appears in Code Secs. 1563(a)(1), (2) and (3); and Reg. 1.414(c)-2 for purposes of determining trades or businesses (whether or not incorporated) that are under common control for purposes of


23

Analyzing Deferred Compensation Arrangementstion to reduce or eliminate the compensation, or has Final Reg. 1.409A-1(b)(1) generally provides that effective control over any portion of the compensathere is a deferral of compensation (and thus, tion of the person retaining the discretion to reduce deferred compensation) if, under the terms of or eliminate the compensation, or is a member of the compensation plan or arrangement and the the family30 of the person retaining the discretion to relevant facts and circumstances, the service reduce or eliminate the compensation. provider has a legally binding right during a tax Compensation is not considered subject to unilateryear to compensation that, pursuant to the terms al reduction or elimination merely because it may be of the plan, is or may be payable to (or on behalf reduced or eliminated by operation of the objective of) the service provider terms of the plan, such as in a later tax year. A the application of a nonlegally binding right to discretionary, objective The general rule is that property an amount that will be provision creating a subtransferred in connection with the excluded from income stantial risk of forfeiture. performance of services and which Similarly, a service prowhen and if received is taxed under Code Sec. 83 is does not constitute a vider does not fail to have deferral of compensaa legally binding right exempt from Code Sec. 409A. tion, unless the service to compensation merely provider has received the because the amount of right in exchange for, or has the right to exchange compensation is determined under a formula that the right for, an amount that will be includible in provides for benets to be offset by benets provided income (other than due to participation in a cafunder another plan (including a plan that is qualied eteria plan described in Code Sec. 125). under Code Sec. 401(a)), or because benets are The Final Regs do not precisely dene what is a reduced due to actual or notional investment losses, legally binding right. The preamble to the Final Regs or in a nal average pay plan, subsequent decreases states that [a] legally binding right includes a conin compensation. tractual right that is enforceable under the applicable C. Earnings on Deferred Compensation law or laws governing the contract. A legally binding right also includes an enforceable right created under Final Reg. 1.409A-1(b)(2) provides that references other applicable law, such as a statute.29 to the deferral of compensation or deferred comTh Fin he The Final Regs state that a service provider does pensation include references to earnings. When no ha ot ave gally binding r not have a legally binding right to compensation the right to earnings is specied under the terms of o th ex he xte t c pensa to the extent that compensation may be reduced the plan, the legally binding right to earnings arises un ate lly or eliminated nila eral y ate unilaterally o elim nated by t service recipient or the at the time of the deferral of the compensation to v g c other person after the services creating the right to which the earnings relate. A plan may provide that on ave been performed. Practitioners en c o e the time and fo of payment of earnings is treated n the compensation have been perform d. Practitioners time and form commonly refer to power as negative discretion. separately from the time and form of payment of It should be noted, however, that a service provider the underlying compensation, so that, provided will be considered to have a legally binding right that the rules of Code Sec. 409A are otherwise to the compensation if the facts and circumstances met, a plan may provide that earnings will be paid indicate that the discretion to reduce or eliminate the at a separate time or in a separate form from the compensation is available or exercisable only upon payment of the underlying compensation. For the a condition, or the discretion to reduce or eliminate application of the deferral election rules to current the compensation lacks substantive signicance. payments of earnings and dividend equivalents, Whether the negative discretion lacks substantive see V.A.1.d. below. signicance depends on all of the relevant facts and Whether a deferred amount constitutes earnings circumstances. However, the discretion to reduce on an amount deferred, or actual or notional income or eliminate the compensation will not be treated attributable to an amount deferred, is determined as having substantive signicance where the service under the principles defining income attributprovider to whom the compensation may be paid has able to the amount taken into account under Reg. effective control of the person retaining the discre1.3121(v)(2)-1(d)(2). Accordingly, with respect to

B. Denition of Deferral of Compensation

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July 2007an account balance plan, earnings on an amount deferred generally include an amount credited on behalf of a service provider under the terms of the plan that reects a rate of return that does not exceed either the rate of return on a predetermined actual investment or, if the income does not reect the rate of return on a predetermined actual investment, a reasonable rate of interest. With respect to nonaccount balance plans, earnings on an amount deferred generally include an increase, due solely to the passage of time, in the present value of the future payments to which the service provider has obtained a legally binding right, the present value of which constituted the amount deferred (determined as of the date such amount was deferred), but only if the amount deferred was determined using reasonable actuarial assumptions and methods. A right to earnings on an amount deferred generally is treated as a right to a deferral of compensation. However, the use of an unreasonable rate of return, or unreasonable actuarial assumptions and methods, generally will result in the treatment of some or all of such a right to deferred compensation as a right only to deferred compensation, and not a right to earnings on deferred compensation, so that the provision will not be applicable. With respect to plans that are neither account balance plans nor nonaccount balance plans, these rules apply by analogy. the last day of the applicable 2-1/2 month period described below. The following rules apply for purposes of the 2-1/2 month rule: The applicable 2-1/2 month period is the period ending on the later of the 15th day of the third month following the end of the service providers rst taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture or the 15th day of the third month following the end of the service recipients rst taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture. A payment is treated as actually or constructively received if the payment is includible in income, including if the payment is includible in income under Code Sec. 83, the economic benet doctrine, Code Sec. 402(b), or Code Sec. 457(f). A right to a payment that is never subject to a substantial risk of forfeiture is considered to be no longer subject to a substantial risk of forfeiture on the rst date the service provider has a legally binding right to the payment. A plan provides for a deferred payment if the plan provides that any payment will be made or completed on or after any date, or upon or after the occurrence of any event, that will or may occur later than the end of the applicable 2-1/2 month period, such as a separation from service, death, disability, CIC (as dened in V.A.7 below), specied time or schedule of payment, or unforeseeable emergency, regardless of whether an amount is actually paid as a result of the occurrence of such a payment date or event during h the applicable 2-1/2 month period. A plan mig provide that the service provider or might service recipient may make an election under the plan (including an initial deferral election with respect to short-term deferrals) of a different payment date, schedule or event. Such right is disregarded for this purpose. In such cases, whether a plan provides for a deferred payment is determined based on the payment date, schedule or event that would apply if no such election were made, except that if the plan would not provide for a deferred payment absent such an election, and the service provider or service recipient makes such an election, whether the plan provides for a deferred payment is determined based upon the payment date, schedule, or event that the service provider or service recipient in fact elected.

D. When Deferred Compensation Is Not Subj ct to Code Sec. 409A bjec j SubjectEv n though deferred compen ven houg Even th ug deferred compensation may fall within th d ni he ni iti o d ral the denition of a deferral of compensation, there ar inst nces where the deferr compensation may re instances where tan are inst deferred h c plet be recharacterized and become completely exempt from Code Sec. 4 9A. 409A.

1. Short-Term Deferrals (The Short-Term or 2-1/2 Month Rule)The basic rule is that even if compensation satises the denition of a deferral of compensation, if the deferred compensation is paid within a short or 2-1/2 month period of time after certain events (e.g., the lapse of a substantial risk of forfeiture, the satisfaction of a performance goal), the compensation is exempt from Code Sec. 409A. Final Reg. 1.409A-1(b)(4) provides that a deferral of compensation does not occur if the plan under which a payment is made does not provide for a deferred payment and the service provider actually or constructively receives such payment on or before


25

Analyzing Deferred Compensation ArrangementsA stock right provides for a deferred payment if such right includes any provision pursuant to which the holder of the stock right will or may have the right to exercise the stock right after the applicable 2-1/2 month period. The 2-1/2 month rule is applied separately to each payment required to be made under a plan. If a plan provides for a deferred payment with respect to part of a payment (for example a life annuity or a series of installment amounts treated as a single payment), the plan provides for a deferred payment with respect to the entire payment. a. Certain Delayed Payments A payment that otherwise qualies as a short-term deferral but is made after the applicable 2-1/2 month period may continue to qualify as a short-term deferral if the taxpayer establishes that: it was administratively impracticable to make the payment by the end of the applicable 2-1/2 month period and, as of the date upon which the legally binding right to the compensation arose, such impracticability was unforeseeable, or the taxpayer establishes that making the payment by the end of the applicable 2-1/2 month period would have jeopardized the ability of the service recipient to continue as a going concern. In addition, payment must be made as soon as administratively practicable or as soon as the payment would no longer have such effect. An action or failure to act of the service provider or a person under the service providers control, such as a failure nde t er to pr vide necessary info provide o prov e cessa y information or documentation, ormat is no a un re a not an unforeseeable event event. ot Finally, a payment t hat ot Fin lly, na lly aym ent that otherwise qualifies as a short-term deferral but is made after the aph t t plicable 2-1/2 month period may continue to p e riod m y c ontinue qualify as a short-term deferral if the taxpayer establishes that the service recipient reasonably anticipated that the service recipients deduction with respect to such payment otherwise would not be permitted by application of Code Sec. 162(m), and provided that: as of the date the legally binding right to the payment arose, a reasonable person would not have anticipated the application of Code Sec. 162(m) at the time of the payment, and the payment is made as soon as reasonably practicable following the rst date on which the service recipient anticipates or reasonably should anticipate that, if the payment were made on such date, the service recipients deduction with respect to such payment would no longer be restricted due to the application of Code Sec. 162(m). b. Substantial Risk of Forfeiture Deferred compensation that is subject to a substantial risk of forfeiture may take advantage of the short-term deferral rule, and thus, if it is paid within the 2-1/2 month short-term deferral period following vesting, the compensation is exempt from Code Sec. 409A. It can also take advantage of special initial deferral election rules as described in IV.A.3. below. It is important to note that the substantial-risk-offorfeiture standard used for purposes of Code Sec. 409A is quite different from the substantial-risk-offorfeiture standard used for purposes of Code Secs. 83, 402(b) and 457(f). Final Reg. 1.409A-1(d) provides 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 any person or the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. A condition related to a purpose of the compensation must relate to the service providers performance for the service recipient or the service recipients business activities or organizational goals (e.g., the attainment of a prescribed level of earnings or equity value or completion of an initial public offering). Moreover, if a service providers entitlement to the amount is conditioned on the occurrence of the service providers involuntary separation from service without cause, the right is subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial. An amount is not subject to a substantial risk of forfeiture merely because the right to the amount is i conditioned, di cond tioned, directly or indirectly, upon the refraining o d from the performance of services. Other than certain transaction-based compensation (see V.A.7.e.i. below), the addition of any risk of forfeiture after the legally binding right to the compensation arises, or any extension of a period during which compensation is subject to a risk of forfeiture, is disregarded for purposes of determining whether such compensation is subject to a substantial risk of forfeiture. An amount will not be considered subject to a substantial risk of forfeiture beyond the date or time at which the recipient otherwise could have elected to receive the amount of compensation, unless the present value of the amount subject to a substantial risk of forfeiture (disregarding, in determining the present value, the risk of forfeiture) is materially greater than the present value of

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July 2007the amount the recipient otherwise could have elected to receive absent such risk of forfeiture. This means that compensation that the service provider would receive for continuing to perform services regardless of whether the service provider elected to receive the amount that is subject to a substantial risk of forfeiture is not taken into account in determining whether the present value of the right to the amount subject to a substantial risk of forfeiture is materially greater than the amount the recipient otherwise could have elected to receive absent such risk of forfeiture. Thus, a salary deferral generally may not be made subject to a substantial risk of forfeiture. However, where a bonus plan provides an election between a cash payment or restricted stock units with a present value that is materially greater (disregarding the risk of forfeiture) than the present value of such cash payment and that will be forfeited absent continued services for a period of years, the right to the restricted stock units generally will be treated as subject to a substantial risk of forfeiture. With respect to stock rights, a stock right is not subject to a substantial risk of forfeiture at the earlier of the rst date the holder may exercise the stock right and receive cash or property that is substantially vested or the rst date that the stock right is not subject to a forfeiture condition that would constitute a substantial risk of forfeiture. Accordingly, a stock option that the service provider may exercise immediately and receive substantially vested stock is not subject to a substantial risk of forfeiture, even if he s the stock option automatically terminates upon the stock service pr e e providers separation from service. service pro ers separation f Th fol he llo in it ons a The following situations apply in determining w ethe he whe er th possibility fo whether the possibility of forfeiture is substantial h hts o on in the case of rights to compensation granted by en ervice provider e a service recipient to a se service pro ider that owns owns a signicant amount of the total combined voting power or value of all classes of equity of the service recipient. The substantial possibility of forfeiture occurs where the service providers ownership is determined with application of the attribution rules under Code Sec. 318 if the service recipient is a corporation, or if the service recipient is an entity that is not a corporation, with application by analogy of the attribution rules under Code Sec. 318). All such relevant facts and circumstances are to be taken into account in determining whether the probability of the service recipient enforcing such condition is substantial, including: The service providers relationship to other equity holders and the extent of their control, potential control and possible loss of control of the service recipient; The position of the service provider in the service recipient and the extent to which the service provider is subordinate to other service providers; The service providers relationship to the ofcers and directors of the service recipient (or similar positions with respect to a noncorporate service recipient); The person or persons who must approve the service providers discharge; and Past actions of the service recipient in enforcing the restrictions. c. Performance-Based Compensation Performance-based compensation, where the compensation does not vest or become payable until certain performance goals are met, is a variant of compensation subject to a substantial risk of forfeiture. It can also take advantage of special initial deferral election rules as described in IV.A.6. below. Code Sec. 409A performance-based compensation is similar tobut not the same asCode Sec. 162(m) performance-based compensation. The term performance-based compensation means compensation the amount of which, or the entitlement to which, is contingent on the satisfaction of pre-established organizational or individual performance criteria relating to a performance period of at least 12 consecutive months. Organizational or individual performance criteria are considered pre-established if established in writing by not later than 90 days after the commencement of the period of service to which the criteria relates, provided that the outcome is substantially uncertain at the time the criteria are established. r Performance-based compensation may include Per ormance a payments based on performance criteria that are not approved by a compensation committee of the board of directors (or similar entity in the case of a noncorporate service recipient) or by the stockholders or members of the service recipient. Performancebased compensation does not include any amount or portion of any amount that will be paid either regardless of performance, or based upon a level of performance that is substantially certain to be met at the time the criteria is established. In addition, compensation generally is not performance-based compensation merely because the amount of such compensation is determined by reference to the value of the service recipient or the stock of the service recipient. Where a portion of an


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Analyzing Deferred Compensation Arrangementsamount of compensation would qualify as performance-based compensation if the portion were the sole amount available under the plan, that portion of the award will not fail to qualify as performancebased compensation if that portion is designated separately or otherwise separately identiable under the terms of the plan, and the amount of each portion is determined independently of the other. Compensation may be performance-based compensation where the amount will be paid regardless of satisfaction of the performance criteria due to the service providers death, disability or a CIC, provided that a payment made under such circumstances without regard to the satisfaction of the performance criteria will not constitute performance-based compensation. Generally, a disability refers to any medically determinable physical or mental impairment resulting in the service providers inability to perform the duties of his or her position or any substantially similar position, where such impairment can be expected to result in death or can be expected to last for a continuous period of not less than six months. In addition, the term performance-based compensation may include payments based upon subjective performance criteria, provided that: the subjective performance criteria are bona de and relate to the performance of the participant service provider, a group of service providers that includes the participant service provider, or b a bus business unit for which the participant service pro de p ovid provides services des provider provid service (which may include t e entire o ni nt organization), a on), and the en the d e determination that any subjective perforthe dete mina ion that a e mance criteria have been met is not m made by the am y member mi m participant se ice provider or a family member service provider of the participant service provider,31 or a person under the effective control of the participant service provider or such a family member, and no amount of the compensation of the person making such determination is effectively controlled in whole or in part by the service provider or such a family member. With respect to equity-based compensation, compensation is performance-based compensation if it is based solely on an increase in the value of the service recipient, or a share of stock in the service recipient, after the date of a grant or award. However, compensation payable for a service period that is equal to the value of a pre-determined number of shares of stock, and is variable only to the extent that the value of such shares appreciates or depreciates, generally will not be performancebased compensation. The attainment of a prescribed value for the service recipient (or a portion thereof), or a share of stock in the service recipient, may be used as a pre-established organizational criterion for purposes of providing performance-based compensation, provided that the other requirements stated above are satised. In addition, an award of equity-based compensation may constitute performance-based compensation if entitlement to the compensation is subject to a condition that would cause the award to otherwise qualify as performance-based compensation, such as a performance-based vesting condition. A provision that allows a service provider to defer compensation that would be realized upon the exercise of a stock right generally constitutes an additional deferral feature for purposes of the denition of a deferral of compensation under the Final Regs.

2. Separation Pay PlansA plan that otherwise provides for a deferral of compensation does not fail to provide a deferral of compensation merely because the right to payment of the compensation is conditioned upon a separation from service. However, the following are exceptions where the severance pay will not constitute deferred compensation: collectively bargained separation pay plans; certain involuntary separation from service plans; window programs; foreign separation pay plans; and certain reimbursements. These exceptions may be used in combination, so that c compensation under a plan that would be excepted under one d cepted under o exception may be treated as being excepted under another. However, any payment or benet, or entitlement to a payment or benet, that acts as a substitute for, or replacement of, amounts deferred by the service recipient under a separate NQDCP constitutes a payment or a deferral of compensation under the separate NQDCP, and does not constitute a payment or deferral of compensation under a separation pay plan. If a service provider receives a payment at separation from service and also has a legally binding right to an amount of deferred compensation that would be forfeited upon the separation from service, whether the payment acts as an acceleration of vesting and substitute payment for the amount of deferred compensation forfeited, or whether the

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July 2007deferred compensation is treated as forfeited and the amount paid is treated as a separate payment of current compensation, is determined based on the facts and circumstances, provided that, where the separation from service is voluntary, it is presumed that the payment results from an acceleration of vesting followed by a payment of the deferred compensation that is subject to Code Sec. 409A. Accordingly, any change in the payment schedule to accelerate or defer the payments would be subject to the rules of Code Sec. 409A. The presumption that a right to a payment is not a new right, but is instead a right substituted for a pre-existing forfeited right, may be rebutted by demonstrating that the service provider would have obtained the right to the payment regardless of the forfeiture of the nonvested right. A factor indicating that the service provider would have obtained a right to a payment regardless of the forfeiture of the nonvested right is that the amount to which the service provider obtains a right is materially less than an amount equal to the present value of the forfeited amount, multiplied by a fraction. The numerator of the fraction is the period of service the service provider actually completed. The denominator of the fraction is the full period of service the service provider would have been required to complete to receive the full amount of the payment. Thus, a service provider might be entitled to a future payment only if the service provider completes three years of service and at the time of termination the servic provider has completed one year of serservice he s vice. n that vent, he service vi . In th event, the service provider can rebut the ice ha presumption f payment pr um tio if the pa ent to the service provider is res mpt materially present m e ally less materia y le than the presen value of one-third of eria the nonvested amount. A o unt. Another such factor is that the acto payment to the se ice provider is o a type customservice provider s of type customov yp m arily made to service providers who separate from service with the service recipient and do not forfeit nonvested rights to deferred compensation (e.g., a payment of accrued but unused leave or a payment for a release of actual or potential claims). The term separation pay plan means any plan that provides separation pay or, where a plan provides both amounts that are separation pay and that are not separation pay, that portion of the plan that provides separation pay. The term separation pay means any deferral of compensation that will not be paid under any circumstances unless the service provider has had a separation from service, whether voluntary or involuntary, including payments in the form of reimbursements of expenses incurred, and the provision of in-kind benets. A deferral of compensation that the service provider may receive without a separation from service does not become separation pay merely because the service provider elects to receive or receives the payment after or upon a separation from service. A deferral of compensation does not fail to be separation pay merely because the payment is conditioned upon the execution of a release of claims, noncompetition or nondisclosure provisions, or other similar requirements. Again, it should be noted that any amount, or entitlement to any amount, that acts as a substitute for, or replacement of, amounts deferred by the service recipient under a NQDCP constitutes a payment of compensation or deferral of compensation under such NQDCP. a. Collectively Bargained Arrangements A separation pay plan does not provide for a deferral of compensation to the extent the plan is a collectively bargained separation pay plan that provides for separation pay only upon an involuntary separation from service or pursuant to a window program. Only the portion of the separation pay plan attributable to employees covered by a bona de collective bargaining agreement is considered to be provided under a collectively bargained separation pay plan. A collectively bargained separation pay plan is a separation pay plan that meets the following three conditions: The separation pay plan is contained within an agreement that the Secretary of Labor determines to be a collective bargaining agreement. The separation pay provided by the collective bargaining agreement was the subject of arms-length negotiations between employee representatives and one or more employers, and e the agreem between employee representatives the agreement and one or more employers satises Code Sec. 7701(a)(46). The circumstances surrounding the agreement evidence good faith bargaining between adverse parties over the separation pay to be provided under the agreement. To the extent a plan is subject to a bona de collective bargaining agreement covering services performed for multiple employers under which an employee must separate from service with all such employers in order to receive a payment, such plan may use any reasonable denition of involuntary separation from service, provided that: such denition is consistent with any denition of a separation from service adopted for purposes


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Analyzing Deferred Compensation Arrangementsof collectively bargained plan covering multiple employers (see V.A.6.f . below), and the denition of an involuntary separation from service provided by the collective bargaining agreement was the subject of arms length negotiations between employee representatives and two or more employers, the agreement between employee representatives and such employers satises Code Sec. 7701(a)(46), and the circumstances surrounding the agreement evidence good faith bargaining between adverse parties over such denition. b. Window Programs The term window program refers to a program established by a service recipient in connection with an impending separation from service to provide separation pay, where such program is made available by the service recipient for a limited period of time (no longer than 12 months) to service providers who separate from service during that period or to service providers who separate from service during that period under specied circumstances. A program will not be considered a window program if a service recipient establishes a pattern of repeatedly providing for similar separation pay in similar situations for substantially consecutive, limited periods of time. Whether the recurrence of these programs constitutes a pattern is determined based on the facts and circumstances. Although no one factor is determinative, relevant factors include: whether the benets are on account of a specic wh wheth business vent condition, bus b sines event or conditio the degree to which pay lates the separation pa relates to the event or condit e se at ep tion; tion and tion a n; whether the event or c condition is temporary or h e discrete or is a permanent aspec of the employs permanent aspect the employm t h p ers business. A separation pay plan that is not a collectively bargained separation pay plan and that provides for separation pay only pursuant to a window program does not provide for a deferral of compensation to the extent that the separation pay, or portion of the separation pay, provided under the plan meets the following requirements (referred to as the twotimes rule): The separation pay does not exceed two times the lesser of: the sum of the service providers annualized compensation based upon the annual rate of pay for services provided to the service recipient for the tax year of the service provider preceding the tax year of the service provider in which the service provider has a separation from service with such service recipient. This amount is adjusted for any increase during that year that was expected to continue indenitely if the service provider had not separated from service; or the maximum amount that may be taken into account under a qualied plan pursuant to Code Sec. 401(a)(17) (which was increased from $220,000 to $225,000 in 2007) for the year in which the service provider has a separation from service. The plan provides that the separation pay described above must be paid no later than the last day of the second tax year of the service provider following the tax year of the service provider in which occurs the separation from servic

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