Employee Benefits Alert
On November 30, 2006, the Treasury Department and IRS issued two important pieces of guidance. Notice 2006-100 provides guidance under Code section 409A on the reporting and withholding requirements for 2005 and 2006 with respect to deferrals and amounts includible in income under that provision. Notice 2006-107 provides transitional guidance on the new diversification requirements under the Pension Protection Act of 2006 (PPA) for employer securities held by defined contribution plans. That Notice also includes a model notice that can be provided to affected participants to advise them of their new diversification rights, as required by the PPA.
Notice 2006-100 (section 409A reporting and withholding)
As explained below, Notice 2006-100 provides relief to employers and payers for 2006 with regard to reporting deferred compensation amounts that comply with section 409A, but requires employers to report and withhold on deferred compensation amounts that are includible in income pursuant to section 409A (referred to below as “section 409A noncompliant deferrals”). Notice 2006-100 also requires employers to report section 409A noncompliant deferrals that were includible in income in 2005 and provides guidance to employees and other service providers on their income tax reporting and tax payment requirements for section 409A noncompliant deferrals for 2005 and 2006.
Background - Section 409A Reporting and Withholding
In connection with the enactment of Code section 409A, the American Jobs Creation Act of 2004 (Jobs Act), amended Code sections 6041 and 6051 to require employers and payers to report deferrals under nonqualified deferred compensation plans on a Form W-2 or a Form 1099-MISC without regard to whether such deferrals were includible in income. In addition, the Jobs Act modified the income tax withholding rules of Code section 3401(a) to treat deferred compensation amounts includible in income under section 409A as “wages” for such purposes, and also required payers to report amounts includible in income under section 409A for non-employees.
In Notice 2005-1, the IRS provided the following general rules for reporting and withholding with respect to deferred compensation subject to Code section 409A:
- Employers should report the total amount of deferrals under a nonqualified deferred compensation plan in box 12 of Form W-2 using Code Y.
- Employers should report section 409A noncompliant deferrals as wages in box 1 of Form W-2, and also report such amounts in box 12 using Code Z.
- Payers should report the total amount of deferrals under a nonqualified deferred compensation plan for a non-employee in box 15a of Form 1099-MISC.
- Payers should report section 409A noncompliant deferrals for a non-employee in box 7 and box 15b of Form 1099-MISC.
Notice 2005-94 waived the reporting requirements for 2005 with respect to annual deferrals of compensation. With regard to section 409A noncompliant deferrals, Notice 2005-94 suspended the reporting and withholding requirements, but the Notice provided that future guidance could require the filing of a corrected information return and payee statement for 2005. The Notice also indicated that employees and other service providers would not be assessed penalties with respect to 2005 section 409A noncompliant deferrals if they reported and paid any taxes due in accordance with future guidance.
New Reporting and Withholding Guidance
Notice 2006-100 modifies Notice 2005-1 and supersedes Notice 2005-94 as follows:
- For 2005 and 2006, employers and payers are excused from reporting amounts deferred under a nonqualified deferred compensation plan in box 12 of Form W-2 using Code Y, and in box 15a of Form 1099-MISC, as the case may be. Thus, deferrals that comply with Code section 409A will not have to be reported for either 2005 or 2006.
- For 2006, employers must treat section 409A noncompliant deferrals as wages for income tax withholding purposes and must report such amounts as wages paid on line 2 of Form 941, in box 1 of Form W-2, and in box 12 of Form W-2 using Code Z. Note that the amount required to be withheld is not increased by the additional taxes imposed by section 409A(a)(1)(B) (the additional interest and 20% penalty amounts).
- For 2006, for non-employees, payers must report section 409A noncompliant deferrals on the Form 1099-MISC as non-employee compensation in box 7 and also in box 15b.
- For 2005, employers and payers are now required to file corrected (or original, if applicable) information returns and furnish corrected (or original, if applicable) payee statements (either Form W-2 or 1099-MISC, as the case may be), reporting any previously unreported section 409A noncompliant deferrals. Such information return and payee statement must be filed and furnished by the applicable deadlines for reporting section 409A noncompliant deferrals for 2006.
The Notice prescribes interim rules (which are generally based on the Code section 3121(v)(2) rules) for calculating the amount of section 409A noncompliant deferrals for these purposes and specifies that section 409A noncompliant deferrals that are neither actually nor constructively received during 2006 are treated as paid on December 31, 2006 for purposes of withholding, depositing, and reporting the income tax at the source on wages under Code section 3401(a). The Notice provides options for an employer if the employer fails to withhold the full amount of taxes required to be withheld under the foregoing provision.
The Notice also provides guidance with regard to reporting and withholding on transfers to certain offshore and other funded arrangements that are subject to tax under Code section 409A. For employees and other service providers with section 409A noncompliant deferrals in either 2005 or 2006, the Notice requires them to report and pay taxes due on amounts includible for 2006 and, with respect to amounts includible in 2005, to file an amended return and pay the appropriate taxes by the due date for their 2006 income tax return, including extensions. Employees and service providers are to use the same rules for calculating the amount of section 409A noncompliant deferrals as employers and payers.
Notice 2006-107 (employer securities diversification rights)
The PPA added section 401(a)(35) to the Code, providing new diversification rights for participants in defined contribution plans that hold publicly traded employer securities (other than certain ESOPs). These requirements are generally effective for plan years beginning on or after January 1, 2007. Notice 2006-107 provides transitional guidance on Code section 401(a)(35) that will apply until regulations under the provision are issued.
Scope of Code section 401(a)(35)
Code section 401(a)(35) generally applies to defined contribution plans that hold publicly traded employer securities. Notice 2006-107 clarifies that a plan will not be treated as holding employer securities for this purpose by virtue of investments in diversified mutual funds and similar pooled investment vehicles that meet certain requirements (e.g., a mutual fund that happens to hold employer securities). The Notice also exempts an ESOP from the diversification requirements of Code section 401(a)(35) if (1) the ESOP does not hold contributions or earnings to which Code section 401(k) or 401(m) applies and (2) the ESOP is a separate plan under Code section 414(l), e.g., the ESOP is not a portion of a plan that holds any non-ESOP amounts.
Code section 401(a)(35) requires that participants must be allowed to divest investments in employer securities that are attributable to employer contributions after the participant completes at least three years of service. These rights also apply to alternate payees of participants who have completed at least three years of service and to beneficiaries of deceased participants. (Participants, alternate payees, and beneficiaries must be allowed to divest employer stock investments attributable to elective deferrals, after-tax contributions and rollover contributions at any time.)
Notice 2006-107 provides that a participant completes three years of service for this purpose immediately after the end of the third vesting computation period under the plan that constitutes the completion of a third year of service under Code section 411(a)(5). If, however, a plan uses the elapsed time method of crediting service for vesting purposes, or provides for immediate vesting, a participant completes three years of service on the third anniversary of his or her date of hire.
Under Code section 401(a)(35), a plan must offer at least three diversified investment options to which participants may direct the proceeds of divestitures of employer securities. Notice 2006-107 provides that investment options that meet the requirements of the Department of Labor’s regulations under ERISA section 404(c) will be treated as diversified for this purpose.
Restrictions on Diversification Rights
Code section 401(a)(35) allows a plan to limit the time for divestitures of employer securities to periodic, reasonable opportunities that occur at least quarterly. A plan may not, however, impose restrictions with respect to investments in employer securities that are not imposed on other investments. Notice 2006-107 generally prohibits restrictions such as: (1) restrictions on a participant’s right to divest employer securities that are not imposed on other investments or (2) benefits that are conditioned on an investment in employer securities. Thus, for example, a plan generally may not:
- allow participants to divest employer securities on a periodic basis (such as quarterly), but allow divestiture of another investment on a more frequent basis (such as daily);
- provide that a participant who divests his or her account of employer securities will receive less favorable treatment (such as a lower rate of matching contributions) than a participant whose account remains invested in employer securities; or
- provide that a participant who divests his or her account of employer securities cannot reinvest in employer securities for a period of time.
In contrast, a plan may limit the extent to which a participant’s account can be invested in employer securities (e.g., 10 percent of a participant’s account balance), or close an employer stock fund to future investments, provided that the limitations apply without regard to a prior divestiture of employer securities.
The Notice provides two transition rules that apply during 2007. The first of these allows a plan to continue, through March 30, 2007, a restriction on divestiture rights that is in effect on December 18, 2006. The second allows a plan to continue, through December 31, 2007, to (1) impose a restriction on investments in employer securities that does not apply to a stable value fund and (2) permit more frequent divestitures of an investment that is not a generally available investment (e.g., an investment that is limited to a fixed class of participants).
Restrictions to Comply with Securities Laws
Notice 2006-107 provides that a plan may impose restrictions on diversification rights that are reasonably designed to comply with applicable securities laws, and gives the following examples of permitted restrictions:
- limits on the rights of Section 16 officers to divest employer securities to a certain period following the publication of the employer’s quarterly earnings statements;
- limits on divestitures of employer securities for up to 90 days following the employer’s IPO; and
- fees imposed on other investment options under the plan that do not apply to investments in employer securities.
Plan administrators must notify affected participants of their diversification rights under Code section 401(a)(35) at least 30 days before the participants are entitled to exercise these rights. This notice requirement is generally effective for plan years beginning after December 31, 2006. Notice 2006-107 provides a model notice for this purpose and also clarifies that no plans (including those with plan years beginning in January, 2007) are required to furnish notices before January 1, 2007.
For additional information, please contact any of the following lawyers:
Jeanette Dayan, firstname.lastname@example.org, 202-626-6037
Elizabeth F. Drake, email@example.com, 202-626-5838
Marianna G. Dyson, firstname.lastname@example.org, 202-626-5867
Michael M. Lloyd, email@example.com, 202-626-1589
C. Frederick Oliphant, firstname.lastname@example.org, 202-626-5834
Anthony G. Provenzano, email@example.com, 202-626-1463
Gary G. Quintiere, firstname.lastname@example.org, 202-626-1491
Lee H. Spence, email@example.com, 202-626-5965
Adrian L. Morchower