On September 29, the IRS issued long-awaited proposed regulations interpreting the deferred compensation rules under Section 409A of the Internal Revenue Code (the "Code").  Section 409A imposes a number of requirements that deferred compensation arrangements must satisfy in order to avoid current taxation of participants (and a possible 20% "additional tax" and interest charge).  The first guidance on Code section 409A was Notice 2005-1, which was issued last December.  The proposed regulations retain a number of the rules set forth in Notice 2005-1, modify several others, and address a number of new issues. 

We summarize below some of the key issues addressed in the proposed regulations, specifically (1) transition relief and the effective date of the new rules, (2) stock options/stock appreciation rights and "ad hoc" award grants, and (3) severance/separation pay.   Of particular interest to employers, the proposed regulations extend to December 31, 2006 the deadline for amending arrangements to comply with the new rules.  We are continuing to study the proposed regulations and expect to prepare additional client mailings that address key issues.

Transition Relief and Effective Date

Extended Transition Relief from Notice 2005-1

Effective Date/Good Faith Reliance.  Section 409A applies to amounts deferred on or after January 1, 2005.  Previous deferrals generally are "grandfathered" unless the arrangement is materially modified.  For these purposes, deferred compensation amounts that were not earned and vested as of December 31, 2004 are not protected by the grandfathering rules.

The regulations are proposed to be effective for taxable years beginning on or after January 1, 2007.  Notice 2005-1 generally provided that "good faith" compliance with Code section 409A was sufficient through December 31, 2005.  The proposed regulations extend that rule for an additional year, providing that a plan adopted on or before December 31, 2006 will be treated as complying with Code section 409A if the plan is operated through December 31, 2006 in good faith compliance with the provisions of Code section 409A and Notice 2005-1.  If any other guidance of general applicability under section 409A is published by the IRS with an effective date prior to January 1, 2007, the plan must also comply with that published guidance as of its effective date.  To the extent an issue is not addressed in Notice 2005-1 or other published guidance, the plan must follow a good faith, reasonable interpretation of Code section 409A, and, to the extent not inconsistent with section 409A, the plan’s terms.  In addition, compliance with the proposed regulations is automatically deemed to be good faith compliance with Code section 409A.

Plan Amendments.  Notice 2005-1 generally provided that plans had to be amended no later than December 31, 2005 to reflect Code section 409A.  The proposed regulations extend this deadline to December 31, 2006.  Thus, employers have an additional one-year "remedial amendment period" to bring their documents into compliance with the new rules.

Changes in Payment Elections.  Notice 2005-1 generally permitted plan amendments to change the form and timing of distributions to be made through December 31, 2005 without violating the rules under Code section 409A that generally prohibit acceleration of benefits and impose significant restrictions on additional deferral of benefit payments.  The proposed regulations extend this relief through December 31, 2006, subject to the restriction that election changes cannot be made in 2006 to defer payments that otherwise would be made in 2006 or to accelerate payments into 2006.

Mirror Elections under Qualified Plans.  Elections as to the timing and form of payment under a nonqualified plan or arrangement may be controlled by payment elections made under a corresponding qualified plan through December 31, 2006 (e.g., a Code section 415 excess benefit plan), provided that the payment is in compliance with the terms of the plan or arrangement as of October 3, 2004.  Thus, the regulations extend for one-year this transition relief from Notice 2005-1.

No Extension of Transition Relief

Deferral Elections.  Subject to certain exceptions, Code section 409A generally requires deferral elections to be made no later than December 31 of the year preceding the year in which the compensation is to be paid.  Notice 2005-1 extended that deadline to March 15, 2005 for compensation earned in 2005 with respect to services performed after that date.  The proposed regulations do not extend this special rule.

Cancellation of Deferrals/Termination of Plan Participation.  Notice 2005-1 permitted participants to terminate participation in a nonqualified plan or to cancel a deferral election for previously deferred amounts no later than December 31, 2005.  This relief is not extended.

Termination of Grandfathered Plans.  Notice 2005-1 permitted termination of grandfathered plans by December 31, 2005 as long as various requirements were satisfied, including distribution of all amounts in 2005.  The proposed regulations do not modify this transition relief.  One key item emphasized in the preamble to the proposed regulations is that a plan amendment that provides a participant a right to elect whether to terminate participation in the plan or to continue to defer amounts under the plan would be a material modification of the plan, and thus would lose "grandfathered" status for pre-2005 amounts.

Stock Options, Stock Appreciation Rights and "Ad Hoc" Awards

The proposed regulations include some welcome liberalization of the rules set forth in Notice 2005-1 regarding the application of Code section 409A to nonqualified stock options and stock appreciation rights ("SARs").  (Incentive stock options ("ISOs") are not subject to Code section 409A unless they are modified so as to lose ISO status.)  Notice 2005-1 generally provided that a discounted stock option would be subject to section 409A (and, in most cases, would fail to meet the applicable requirements, in particular the rules regarding distributions, since optionees generally have the right to elect when to exercise the option).  In addition, Notice 2005-1 provided that SARs were exempt from Code section 409A only if various requirements were met, including that (i) they were issued by a publicly-traded company, and (ii) they were settled only in stock, and not in cash.

Key provisions of the proposed regulations include the following:

• SARs generally are treated the same as options, can be issued by either a public or a private company, and can be settled in cash or stock.
  
  
• Discounted stock options and SARs that were not vested and exercisable as of December 31, 2004 generally are subject to Code section 409A.  The proposed regulations extend to December 31, 2006 the ability to cancel a discounted stock option or SAR and substitute a non-discounted option or SAR not subject to Code section 409A.  (The revised exercise price is based on the fair market value of the stock on the original grant date, not the date of cancellation/regrant.)  In addition, a cash payment may be provided by December 31, 2005 to make up for the lost discount, but any later payment for the lost discount may be subject to Code section 409A.
  
  
• The proposed regulations include various rules for valuing the stock underlying options and SARs.  Of particular note, for a public company, there is substantial flexibility in valuing the stock (e.g., the strike price of an option/SAR does not have to be based on the opening or closing price on the date of grant, but can be based on an average price as long as certain requirements are satisfied).  For a private company, the proposed regulations provide that stock value must be determined by a "reasonable application of a reasonable valuation method" and list a number of factors to be considered in the valuation process.  The regulations further provide that a valuation is not reasonable if the valuation date is more than 12 months earlier than the date for which the valuation is being used (e.g., the stock option grant date) or if the valuation fails to reflect a material change that affects the value of the company (e.g., a material litigation settlement or the issuance of a patent).
  
  
• A "modification" of an option or a SAR generally will be treated as a new grant (and must satisfy the various rules as of the date of new grant).  The proposed regulations provide that a modification generally means a change in the terms of the option or SAR that directly or indirectly reduces the exercise price, creates an additional deferral feature, or extends or renews the option or SAR.  An acceleration of the exercisability of a stock option or SAR is not a modification.  In addition, the regulations also allow short-term extensions of option/SAR exercise periods following termination of employment or when exercise of the option/SAR would otherwise violate applicable securities laws.

• Severance arrangements (including early retirement windows) generally are exempt from Code section 409A if the amount of the payment does not exceed two times the lesser of the employee's annual compensation or the limitation in effect under Code section 401(a)(17) (currently $210,000) as long as payments are completed no later than the end of the second calendar year following the year in which the employee terminates employment.  Thus, (i) payments to "specified employees" (generally top-50 officers) of publicly-traded companies that fall within these guidelines generally will not be subject to the requirement for a six-month delay in payments, but (ii) severance payments to specified employees in excess of $420,000 (based on 2005 dollar limitations) will always be subject to section 409A and the six-month rule.
  
  
• Where severance pay due to an involuntary termination by the employer has been the subject of bona fide, arm's-length negotiations, the election as to the time and form of payment of any severance that does not fall under the exception noted above may be made on or before the date the employee obtains a legally binding right to the payment.  This rule is significantly more flexible than many practitioners expected.  (However, it does not apply to terminations initiated by the employee, including "good reason" resignations, although the IRS has requested comments as to how severance payable upon a good reason resignation should be treated under section 409A.)
  
  
• Severance plans are treated as a separate type of plan and are not required to be aggregated with other nonqualified plans.  Thus, a violation of Code section 409A with respect to a severance arrangement generally will not "taint" other arrangements (e.g., supplemental retirement plans) that cover the individual.

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues.  For more information on this subject, please contact the Gibson Dunn attorney with whom you work or David West in Los Angeles (213-229-7654), Peter H. Turza or Michael J.Collins in Washington, D.C. (202-955-8500), Charles F. Feldman in New York (212-351-3908), Stephen W. Fackler in Palo Alto (650-849-5385), or David I. Schiller in Dallas (214-698-3205).

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