May 3, 2001

Final Section 409A Regulations Require Prompt Action on Non-Qualified Deferred Compensation Arrangements


As described in Goodwin Procter’s October 2004, December 2004 and October 2005 Client Alerts, the American Jobs Creation Act of 2004 added Section 409A to the Internal Revenue Code. Section 409A substantially changed the federal income tax treatment of non-qualified deferred compensation (“NQDC”) arrangements maintained by employers and other entities that receive services from employees, partners, directors, and other individuals. Failure to comply with the new requirements will result in early taxation of NQDC, as well as a 20% penalty tax and additional interest payable to the IRS. These new rules generally became effective January 1, 2005, but the statute grants the IRS authority to issue transition rules and to provide guidance regarding a number of significant issues concerning the new rules.

Since the passage of Section 409A, the IRS issued interpretative guidance, including six notices and a set of lengthy proposed regulations, and extended the good faith compliance period and the deadline for documentation compliance two times from December 31, 2005 to December 31, 2006 and finally to December 31, 2007. On April 10, 2007, the IRS published comprehensive final regulations (the “Final Regulations”) that provide detailed guidance on Section 409A requirements. With the issuance of the Final Regulations, sponsors of NQDC arrangements must now act, no later than December 31, 2007, to bring their NQDC arrangements into written compliance.

The Final Regulations are lengthy and the guidance complex. Consequently this Client Alert provides only a brief overview of the requirements of Section 409A and summarizes some of the major aspects of the IRS guidance included in the Final Regulations. It also identifies action steps that must be taken for Section 409A compliance before year-end by an employer or any other entity that receives services from employees, partners, directors or other individuals (a “Company”) and that maintains an NQDC arrangement. However, this Client Alert does not cover all facets of Section 409A or the Final Regulations, and the impact of these tax law requirements can vary substantially based on the specific facts and circumstances. Consequently, Companies are strongly encouraged to review with their advisors the administration and documentation of their compensation arrangements to ensure timely compliance with Section 409A.

Specific Action Items for 2007

  • Review all compensatory arrangements, including all employment agreements, bonus programs and severance policies, to determine whether they are NQDC arrangements subject to Section 409A.
  • Amend arrangements subject to Section 409A to become compliant with the written plan requirements of Section 409A, or amend such arrangements in a manner so that they are clearly not subject to Section 409A.
  • Review administrative procedures of NQDC arrangements to make sure they comply in operation with the requirements of the Final Regulations.
  • Permit participants in NQDC arrangements to change their timing and payment elections prior to year-end without running afoul of the Section 409A restrictions. However, no election may be made to accelerate payment to 2007 or delay a payment otherwise payable in 2007.
  • Review all stock options and take appropriate action to eliminate any discount by repricing the options to the original fair market value at the time of grant.

Brief Overview of Section 409A Requirements

Section 409A imposes numerous requirements on NQDC arrangements, including the following:

  • NQDC may be distributed only after separation from service, disability or death, at a time (or in accordance with a schedule) specified in the arrangement, or upon an unforeseeable emergency or a change in control.
  • In the case of a key employee of a public company, a distribution on account of a separation from service generally cannot be made until six months after the separation.
  • An election to defer compensation earned during a calendar year generally must be made before the beginning of that year, although there are special rules in the case of the first year of eligibility and for “performance-based” compensation. Such election must also specify the time and form of payment.
  • Once an amount has been deferred, there are significant restrictions on the ability to change the timing and form of payment (with transition relief available through the end of 2007).
  • An NQDC arrangement generally may not permit acceleration of the time or schedule for payment.

Notably, Section 409A applies to many arrangements that a Company might not typically think of as “deferred compensation” – e.g., some stock options or other equity-based arrangements, certain bonus arrangements and severance pay, whether or not provided by employment or change of control agreements. However, Section 409A does not apply to arrangements that have special status under federal tax law – e.g., tax-qualified plans (Section 401(a) plans), Section 403(b) tax-deferred annuities, and eligible Section 457(b) plans of tax-exempt organizations. Also, welfare benefit arrangements such as vacation, sick leave and death benefit plans generally are not covered by Section 409A. Continued health coverage for a former employee under an insured health plan is also not subject to Section 409A. The Final Regulations also exclude from Section 409A indemnification payments and payment of legal fees related to bona fide disputes.

The Final Regulations also generally adopt the short-term deferral exception to Section 409A that was contained in the proposed regulations. A compensation arrangement can qualify under the short-term deferral exception if payment is required to be made, and is actually made, no later than the 15th day of the third month after the later of the end of the calendar year or the Company’s taxable year in which the legal right to the payment arises and there is no further substantial risk of forfeiture. Many bonus plans can be structured to meet this exception, but it is advisable for these plans to be set forth in writing with a payment date that falls within the short-term deferral period.

Time and Form of Payment

Separation from Service

The Final Regulations provide additional guidance on how to comply with the time and form of payment requirements of Section 409A.

Employees. An employee separates from service if the employee dies, retires or otherwise terminates employment. A termination of employment will occur if it is reasonably anticipated that no further services will be performed after a certain date or that the level of bona fide services that the employee will perform after such date (either as an employee or as an independent contractor) is reasonably anticipated to be no more than 20% of the average level of services performed over the immediately preceding 36-month period. The Final Regulations provide that an employee will be presumed to incur a separation from service if the level of services performed decreases to a level of 20% or less of the prior 36-month average. Conversely, if an employee performs services at a level of 50% or more of the prior 36-month average, there is a presumption that there has not been a separation from service.

Leaves of Absence. Individuals who are on military leave, sick leave or other bona fide leave of absence will not be considered to have a separation from service if the leave does not exceed six months (or longer if the individual has a legal or contractual right to reemployment). An individual who is on a disability leave that qualifies under the regulatory definition for disability leave may be considered to be on a bona fide leave of absence for up to 29 months.

Directors. If an individual provides services both as a director and an employee, the continuation of the individual as a director is not taken into account in determining whether the individual has a separation from service as an employee.

Sale of Assets. A sale of assets results in a separation from service for employees who transfer to the employ of the buyer. The Final Regulations include a special rule that permits the buyer and seller to specify whether such employees will incur a separation from service for purposes of NQDC arrangements maintained by the seller. All employees must be treated consistently and the use of this special rule must be specified no later than the closing of the transaction.  

Specified Time or Fixed Schedule

An NQDC arrangement may provide for payments to begin at a specified time or pursuant to a fixed schedule. The Final Regulations provide that amounts are payable at a specified time or pursuant to a fixed schedule if amounts are payable at a date or dates that are nondiscretionary and objectively determinable at the time the amount is deferred. For instance, it is possible to designate that the NQDC be payable in a particular calendar year. It is also permissible to specify that payment be made in the calendar year when the participant attains a specific age. However, it is not permissible to designate payment be made upon the occurrence of an event, such as an IPO or when a child begins college. The Final Regulations adopt the rule that a payment will be considered made on a fixed date if made by the end of the calendar year containing the fixed date or, if later, the 15th day of the third month following such fixed date.

The Final Regulations permit an NQDC arrangement to provide a different time and form of payment, depending on whether the triggering event occurs before or after a specified date. For instance, it is permissible for an NQDC arrangement to provide that payments made on account of separation from service prior to age 65 will be paid in a lump sum, but that payments made in connection with an individual’s separation from service at or after age 65 will be in installments.

Reimbursements, In-Kind Benefits. The Final Regulations provide that the reimbursement of expenses (or payment of in-kind benefits) can meet the requirement of a fixed time and form of payment if the reimbursements or in-kind benefits are to be provided for a fixed time period, and the amount available or paid to an individual in one calendar year may not affect the amount available in another calendar year (with a limited exception for lifetime caps on medical benefits). For example, a right to reimbursement of club membership dues of up to $10,000 in each of three calendar years is permissible; the right to receive up to $30,000 in a three-year period for reimbursement of membership dues is not permissible. Reimbursements and in-kind benefits cannot be exchanged for another form of benefit and may not be liquidated for cash. Payment of the reimbursement amount must be made by the end of the calendar year following the year in which the expenses are incurred.

Payment Schedule with Fixed or Formulaic Payment Limitations. A payment schedule with fixed or formulaic payment limitations are generally permissible. For example, an NQDC arrangement may provide that all payments to participants in any given year are limited to $1 million so long as there is an objective method of allocating the $1 million among participants if amounts otherwise payable exceed this cap. The arrangement must also specify how the reduced amounts are payable in a subsequent year.

Tax Gross-up Payments. Tax gross-up payments are permissible as long as the NQDC arrangement provides that the payments are to be made by the end of the calendar year following the year in which the taxes are due.

Mandatory Delay of Payment for Certain Employees of a Publicly Traded Corporation

Six-Month Delay. In the case of a Company that is a publicly traded corporation (or has a parent that is a publicly traded corporation), distributions of NQDC which are payable on account of a separation from service may not be made to a “specified employee” until six months after separation from service. Specified employees generally include up to 50 officers having annual compensation greater than $145,000 (adjusted for inflation) and certain large shareholders. There is an exception to the six-month delay for distributions made on account of the death of the individual.

Mergers and Acquisitions. The Final Regulations contain specific guidance on the methodology that may be used to determine a Company’s “specified employees,” including in the context of corporate transactions. Most notably, the Final Regulations include a welcome simplification of the determination of specified employees following mergers and acquisitions. If two public companies merge, the resulting company can consider the top 50 paid officers of the combined companies as specified employees until the next annual specified employee determination date. In the case of a merger of a public and a private company, the officers of the private company will not be considered specified employees of the public company during a transition period following the close of the merger. Accordingly, officers of the private company who terminate employment shortly after the merger will not be subject to the six-month payment delay imposed on specified employees.

Initial Elections

Under Section 409A, an initial election to defer compensation to be earned in a particular year must be made in the prior calendar year. Such election must also specify a time and form of payment of NQDC if not otherwise specified in the plan document.

The Final Regulations clarify a number of exceptions to the general rule that an initial election must be made before the beginning of the year in which the compensation is to be earned. In general these exceptions include the following:

  • Where the Company’s fiscal year is not the calendar year, an NQDC arrangement may provide that compensation that is earned for services performed during the Company’s fiscal year period and that is payable only after the end of the Company’s fiscal year (i.e., an annual bonus but not regular salary or quarterly bonuses) may be deferred under an election that is made before the beginning of such fiscal year (rather than before the calendar year in which the services are performed).
  • An individual who first becomes eligible to participate in an NQDC arrangement may make an initial deferral election any time during his first 30 days of participation in the arrangement, provided that the initial deferral election may apply only to compensation for services performed after the date of the election. In applying this rule to compensation paid based upon a specified period (for example, an annual bonus), the initial election may apply only to a pro rata portion of such compensation, based on the number of days remaining in the year after the election is made.

Performance-Based Compensation. Under a separate exception included in the Final Regulations, an NQDC arrangement may provide that an election to defer “performance-based” compensation earned over a period of at least 12 months may be made at any time up to six months before the end of the performance period, provided that the pre-established performance criteria have not been met at the time of the election. For example, for a performance-based incentive bonus that is based on services performed during the 2007 calendar year, a deferral election must be made no later than June 30, 2007, provided that the election to defer is made before such compensation has become readily ascertainable, i.e., both calculable and substantially certain to be paid. The Final Regulations also require an individual to be employed at the time the performance criteria are established. This requirement will affect the ability of a newly hired individual to defer any performance-based bonus.

Performance-based compensation is compensation that is contingent on the individual’s or the Company’s satisfaction of pre-established performance criteria over a service period of at least 12 months, where satisfaction of the criteria is substantially uncertain when established. The performance criteria must be stated in writing within 90 days after the service period begins, and generally must be objective. The performance criteria do not have to be approved by the compensation committee of the Company’s board of directors or by the Company’s stockholders.

Commissions. Commissions are subject to the general rule that the initial deferral election be made before the beginning of the calendar year in which the services giving rise to the commissions are performed. For bona fide sales commissions, the Final Regulations provide that services are deemed to be performed in the calendar year in which the customer remits payment to the Company. For investment commissions, the Final Regulations provide that services are deemed to be performed over the 12 months preceding the date the investment commission is determined.

NQDC Arrangement Linked to a Qualified Retirement Plan. Where the amount deferred under an NQDC arrangement is equal to the benefit that could not be provided under an employer’s qualified retirement plan due to Code restrictions, or is equal to an amount offset by the benefit under the employer’s qualified retirement plan, the Final Regulations provide that any change in the amount deferred under the NQDC arrangement due solely to a change in Code requirements applicable to the qualified retirement plan is not a deferral election under the NQDC arrangement. The Final Regulations also specify additional actions under the qualified retirement plan that will not result in a change in amount deferred under the NQDC arrangement. For instance, changes in deferral elections under the qualified retirement plan that affect matching contributions in an NQDC arrangement are permissible if, under the NQDC arrangement, the matching contribution would not exceed the amount that would have been provided under the qualified retirement plan but for Code limitations. However, the timing and form of distribution between a qualified retirement plan and an NQDC arrangement may no longer be linked after December 31, 2007. Therefore, companies that maintain such linked arrangements should now require separate elections for the qualified plan and the NQDC arrangement.

Changes in Elections

The Final Regulations confirm that under Section 409A, changes in the time and form of a distribution may be made only if all three of the following conditions are met:

  • The new election cannot be effective for at least 12 months after the date it is made.
  • Any additional deferral under the change must be for a period of at least five years from the date the payment would otherwise be made.
  • An election related to a distribution to be made upon a specified time (or fixed schedule) must be made at least 12 months prior to the date of the first scheduled payment.

The Final Regulations also provide special rules for applying the conditions for changing elections in the context of installment payments, annuity distributions and multiple payment events. Notably, the Final Regulations provide that a switch from one annuity form to a different, actuarially equivalent annuity form is not by itself a change in the form of payment.

The Final Regulations also clarify that the change-in-elections rules apply to changes made by beneficiaries, but do not apply to alternate payees under a domestic relations order or to changes made pursuant to USERRA.

Anti-Acceleration Rule

In general, under Section 409A an NQDC arrangement may not permit the acceleration of the time or schedule of any payment. For example, if a benefit is otherwise scheduled to be paid in installments, an NQDC arrangement generally cannot permit either the individual or the Company to choose to have the benefit paid as a lump sum. However, the Final Regulations provide that the rule against acceleration does not prohibit any of the following:

  • payment in accordance with plan provisions or an initial election (otherwise consistent with the Section 409A requirements) that call for distributions to be made on a relatively faster schedule on account of one event as opposed to another – e.g., it is permissible to provide that benefits will be paid in installments following separation from service but as a lump sum upon death before termination;
  • waiver of a vesting requirement that results in an earlier payment – e.g., a plan that provides for vesting after 10 years of service and payment upon separation from service may be modified to waive the vesting requirement if the individual separates after five years and receives payment at that time; however, if the plan provides for vesting after 10 years of service and payment three years following the vesting date, any acceleration in vesting will result in a violation of the anti-acceleration rule;
  • payments made earlier than otherwise scheduled in order to satisfy a divorce decree or other domestic relations order; or
  • certain early payments made to satisfy tax obligations – e.g., to pay employment taxes related to the NQDC, or where federal income tax is due as a result of the NQDC arrangement’s non-compliance with Section 409A, or because of the special NQDC rules applicable to tax-exempt employers.

In addition, under the Final Regulations the anti-acceleration rule generally does not prevent an NQDC arrangement from requiring payment of a participant’s benefit in a lump sum distribution if it is less than an amount stated in the arrangement. However, such a mandatory “cash-out” provision that is added by a plan amendment may apply to amounts deferred before the amendment is adopted only if certain requirements are satisfied – i.e., the mandatory cash-out amount cannot exceed the applicable dollar limit on elective contributions to a 401(k) plan (currently $15,500) and the participant’s interest in the NQDC arrangement must be fully paid out.

The anti-acceleration rule has a significant impact on the ability to pay out benefits on account of termination of an NQDC arrangement. Under the Final Regulations, such plan termination payments may be made only in limited circumstances, such as a change in control, a corporate dissolution or bankruptcy, or where the Company terminates all similar NQDC arrangements it maintains and does not establish any such new arrangements for three years. In any case where an arrangement is terminated and none of the available exceptions applies, no new amounts will be deferred under the arrangement, but payment of amounts previously deferred must be made at the time and in the form otherwise provided for by the arrangement’s terms (consistent with the Section 409A rules).

Stock Options and Other Equity-Based Compensation Arrangements

The Final Regulations generally follow the guidance promulgated by the proposed regulations regarding the application of Section 409A requirements to equity-based compensation arrangements, but there are changes in three areas that are particularly helpful.

  • Extension of Stock Option Exercise Period. The Final Regulations provide that an extension of the option exercise period will not be considered a modification that can cause the option to be subject to Section 409A if the extension does not exceed the balance of the original option term (not to exceed 10 years) or the option is underwater. This is welcome relief as it is not uncommon to extend the option exercise period in connection with termination of employment or cessation of services as a director.
  • Service Recipient Stock. Options and SARs granted with respect to service recipient stock will not be subject to Section 409A if they are granted at fair market value and do not contain any deferral feature. The proposed regulations contained a narrow definition of service recipient stock. The Final Regulations expand the definition of service recipient stock and provide that any common stock issued by any corporation in the parent-subsidiary chain of corporations between the ultimate parent corporation and the entity that employs the individual may be used as long as the common stock does not include any preferences (other than liquidation preferences), including preferential dividend rights. Therefore, an employee of a subsidiary may receive an option to acquire parent common stock or common stock of that subsidiary. However, an employee of parent may not receive an option to acquire subsidiary common stock unless that employee also provides services to the subsidiary. Parent and subsidiary status is generally determined using a 50% ownership test, but this test may be reduced to as low as 20% ownership in legitimate business circumstances.

The Final Regulations confirm that options or SARs granted with respect to preferred stock are always subject to Section 409A.

  • Valuation of Private Company Stock. The Final Regulations generally follow the proposed regulations regarding valuation of private company stock. Accordingly, a valuation of stock based upon a reasonable application of a reasonable valuation method is treated as reflecting the fair market value of the stock. The Final Regulations provide the same three quasi-safe harbors as before, namely independent appraisal, section 83 “non-lapse” restriction formula and valuation by a qualified person for a start-up company. The Final Regulations modify the start‑up company quasi‑safe harbor to exclude any company that reasonably anticipates a change in control to occur within 90 days or reasonably anticipates an IPO to occur within 180 days. This is a significant reduction from the one-year period required by the proposed regulations. A qualified person is defined as someone with at least five years of relevant experience in business valuation, financial accounting, investment banking, private equity, secured lending or other comparable experience.

For more information with regard to the application of Section 409A to equity-based compensation, please see our Client Alert: Final Section 409A Regulations and Equity Compensation Arrangements.

Separation Pay and Other Severance Arrangements

Plans or other arrangements that provide for the payment of severance upon termination of employment may be subject to the requirements of Section 409A. The Final Regulations made a number of helpful modifications in this area.

  • Any severance pay payable only in the event of involuntary termination (which may in some cases include termination for good reason), or pursuant to a window period, is not subject to Section 409A to the extent it does not exceed the lesser of (i) two times the individual’s prior year’s compensation or (ii) two times the IRS limit for qualified plans (currently $225,000), and if paid by no later than December 31 of the second calendar year following the calendar year in which the termination occurs. If severance pay exceeds this limit, only the excess will be considered deferred compensation subject to Section 409A.
  • Severance pay that is payable in a lump sum in the event of either an involuntary termination without cause or for good reason can be structured to meet the short-term deferral exception to the definition of NQDC.
  • Whether a termination is considered to be for good reason is determined based on the facts and circumstances of the particular situation. In this regard, the Final Regulations do provide a safe harbor definition which includes a material diminution in responsibilities, material reduction in compensation, relocation, etc. as well as a mandatory cure period.
  • Also excluded from Section 409A are agreements providing for the reimbursement of expenses of a terminated individual to the extent the reimbursements are excludable from the individual’s income, are for reasonable outplacement or moving expenses or relate to deductible business expenses – but only if such expenses or in-kind benefits are incurred no later than December 31 of the second calendar year following the year in which the termination occurs. While the expenses must be incurred by the end of the second year, the Final Regulations allow an extra year for the Company to actually make reimbursement payments.
  • Reimbursement of medical benefits or premiums that are taxable to the terminated individual, such as those provided by a self-insured health plan that does not meet the IRS non-discrimination rules, are excluded from Section 409A only to the extent such reimbursements are made within the COBRA period (generally 18 months following termination of employment or eligibility for another employer’s group health plan coverage, if earlier). Any reimbursements beyond the COBRA period must comply with the Section 409A rules.
  • Reimbursements or any other payments provided in connection with severance are not subject to Section 409A in any event if they do not exceed the dollar limit on elective contributions to a 401(k) plan (currently $15,500).

For more information regarding the application of Section 409A to severance payments, please see our Client Alert: Final Section 409A Regulations and Severance Pay.

Effective Date and Transitional Rules

Effective Date. Section 409A generally applies to amounts deferred after December 31, 2004 as well as any amount deferred before January 1, 2005 if the plan under which the deferral was made is “materially modified” after October 3, 2004. For this purpose, an amount is considered deferred before January 1, 2005 if the individual is vested in the amount at that time – i.e., there is no requirement for the performance of future services or any other substantial risk of forfeiture. Earnings on pre-2005 deferrals are also exempt from Section 409A. The Final Regulations are effective January 1, 2008. Prior to that date, taxpayers may choose to comply with the Final Regulations or in accordance with the prior IRS guidance.

Documentation Compliance. All NQDC arrangements that are subject to Section 409A must be amended no later than December 31, 2007 to include certain mandatory provisions required by the Final Regulations. General plan provisions purporting to nullify noncompliant plan terms or to supply any required specific terms will be disregarded in determining whether such arrangements comply with Section 409A. Plans and arrangements that wish to fall within an exception to Section 409A should also be amended accordingly no later than December 31, 2007. Most outstanding discounted stock options may still be cured and be excluded from Section 409A provided they are re-priced to the original fair market value before the end of 2007.