Treasury Extends Transition Relief Under Section 409A

Employee Benefits Alert
10.05.06

Yesterday, the Treasury Department and IRS issued Notice 2006-79, which provides welcome transition relief for nonqualified deferred compensation plans under section 409A. In general, the Notice extends the deadline for plan sponsors to fully comply with the operational and documentary requirements of section 409A from January 1, 2007 until January 1, 2008. The extension generally applies to all arrangements covered by section 409A, except certain discounted stock options with backdating issues.

Effective Date of Final 409A Regulations

The proposed regulations issued under section 409A in October 2005 indicated that final regulations would become effective January 1, 2007. While it is still anticipated that final regulations will be issued before the end of 2006, the effective date is now delayed until at least January 1, 2008 in order to give plan sponsors adequate time for compliance. Accordingly, the Notice 2006-79 provides the additional transition relief described below.

Amendment and Operation of Plans

The Notice extends the deadline for amending a nonqualified deferred compensation plan to comply with the requirements of section 409A until December 31, 2007. Plans must be operated in good faith compliance with the requirements of section 409A until that time. Compliance with the proposed regulations or final regulations is not absolutely required before January 1, 2008, but will constitute good faith compliance with the statute.

Transition Rule for Payment Elections

Under the proposed regulations, plans generally may permit participants to make new payment elections through December 31, 2006, without regard to section 409A’s subsequent election or anti-acceleration rules. The Notice extends the period for making new payment elections through December 31, 2007. But just as the proposed regulations provided, a new payment election or amendment made in 2006 cannot apply to amounts otherwise payable in 2006 or cause amounts otherwise payable in another year to be paid in 2006. Similarly, a payment election or amendment made in 2007 cannot apply to amounts otherwise payable in 2007 or cause amounts otherwise payable in another year to be paid in 2007.

The Notice clarifies that this transition relief and the accompanying special conditions with regard to 2006 and 2007 apply both to payment elections by service providers and to plan amendments made by service recipients. Further, the Notice permits more than one change or amendment, as long as each change or amendment is made in accordance with the applicable deadlines and conditions. For example, a service provider that made a payment election in 2005 to have deferred compensation paid in a lump sum in 2010 can make a new election in 2006 or 2007 to change the time and form of payment. If, however, a service provider elected in 2005 to be paid in 2006, that election cannot be changed in 2006 to defer payment to a later year.

Discounted Stock Rights

Similar to the transition relief afforded payment elections, the Notice provides that stock rights subject to section 409A (for example, discounted stock options and SARs) can be amended to provide for fixed payment terms consistent with section 409A, or to permit service providers to elect fixed payment terms, without regard to section 409A’s subsequent election or anti-acceleration rules, as long as the rights are amended and any elections are made by December 31, 2007.

The Notice also generally extends the period during which discounted stock options and SARs may be cancelled and replaced with fair market value stock options and SARs (so as to avoid application of section 409A) to December 31, 2007.

These extensions, however, do not apply to discounted stock options and SARs issued by a public company to a Section 16 officer, if the company has reported or now expects to report an expense due to the discount that was not timely reported on the company’s financial statements, i.e., backdated stock options. Thus, the deadline for amending these rights to provide a fair market value exercise price or to comply with section 409A remains December 31, 2006. Companies that potentially may have backdating issues must identify any problematic awards and fix them for section 409A purposes before the end of this year.

Payments Linked to Qualified Plans

Under the proposed regulations, a payment election under a qualified plan can continue to control distributions from a nonqualified plan through December 31, 2006, provided that the distribution is made in accordance with the terms of the nonqualified plan as of October 3, 2004. The Notice extends this transition relief through December 31, 2007, and also applies the relief to nonqualified plans that are linked to certain other types of employer plans, such as section 403(a) and 403(b) annuities, eligible deferred compensation plans under section 457(b), and certain foreign broad-based plans.

2005 Transition Relief for Initial Deferral Elections

Notice 2005-1, the first piece of guidance issued under section 409A, provided transition relief for initial deferral elections for 2005, generally allowing such elections to be made until March 15, 2005. Sponsors wishing to use this transition relief were required to amend their plans to reflect use of the rule by December 31, 2005. The Treasury Department and IRS have realized, however, that many sponsors did not understand this amendment deadline and therefore unintentionally failed to comply. Accordingly, Notice 2006-79 extends this amendment deadline to December 31, 2007.

Collectively Bargained Arrangements

A nonqualified plan maintained pursuant to a collective bargaining agreement in effect on October 3, 2004 is not required to comply with section 409A until December 31, 2009 or, if earlier, the date on which the collective bargaining agreement terminates (without regard to any extensions made after October 3, 2004).

A copy of Notice 2006-79 can be found here.

For additional information, please contact any of the following lawyers:

Jeanette Dayan, jdayan@milchev.com, 202-626-6037

Elizabeth F. Drake, edrake@milchev.com, 202-626-5838

Marianna G. Dyson, mdyson@milchev.com, 202-626-5867

Michael M. Lloyd, mlloyd@milchev.com, 202-626-1589 

C. Frederick Oliphant, foliphant@milchev.com, 202-626-5834

Anthony G. Provenzano, aprovenzano@milchev.com, 202-626-1463

Gary G. Quintiere, gquintiere@milchev.com, 202-626-1491

Lee H. Spence, lspence@milchev.com, 202-626-5965

Adrian L. Morchower

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