Section 409A - IRS Extends Transition Relief for Nonqualified Deferred Compensation Plans

The IRS has extended its transition relief under Section 409A of the Code for nonqualified deferred compensation plans. The relief extends through December 31, 2007, the deadline for amending nonqualified plans to comply with Section 409A of the Internal Revenue Code of 1986, as amended ("Section 409A"). Notably, however, the IRS has not extended transition relief for discounted stock options issued by publicly traded corporations that back-dated the option grants.

Overview of Transition Rules

Under IRS Notice 2006-79 (the "Notice"), the IRS has extended a variety of transition rules that were intended to afford employers sufficient time to comply with Section 409A. The transition period was scheduled to expire December 31, 2006, but in light of the IRS's delay in issuing the final regulations under Section 409A the IRS has extended various transition rules, including:

Amendment and Operation of Plan

In order to provide employers more time to implement the provisions of Section 409A, the IRS has extended through December 31, 2007 the deadline by which plan documents must be amended to conform with Section 409A. During the extended transition period, a plan will be treated as complying with Section 409A only if the plan is operated in reasonable, good faith compliance with Section 409A, Notice 2005-1 and other interim guidance.

Changes in Payment Elections

The Notice extends through December 31, 2007 the provisions that permit a plan to be amended to provide for new payment elections with respect to amounts subject to Section 409A. This provision applies to elections or amendments by a service provider, a service recipient, or both a service provider and a service recipient.

Substitution of Non-discounted Stock Options and SARs for Discounted Options and SARs

The Notice also generally extends the transition relief that permits employers to replace discounted options and/or SARs with an option or SAR that complies with Section 409A (or an exception thereto). The period during which the cancellation and reissuance may occur is extended through December 31, 2007, but only to the extent such cancellation and reissuance in 2007 does not result in the cancellation of a deferral in exchange for cash/property in 2007.

The IRS, however, has not extended the transition relief for any stock option or stock appreciation right (a "Stock Right") that: (i) was granted with respect to publicly traded stock; (ii) was granted to a person subject to the disclosure requirements of Section 16(a) of the Securities Exchange Act of 1934; and (iii) the sponsor either has reported or reasonably expects to report a financial expense due to the issuance of a Stock Right with an exercise price lower than the fair market value of the underlying stock at the date of grant that was not timely reported on financial statements of the sponsor. Accordingly, the extended transition period does not apply to back-dated options or SARs granted by publicly traded companies.

Payments Linked to Qualified Plans

The Notice also extends through December 31, 2007 the ability to link a payment election under a nonqualified deferred compensation plan (as in effect on October 3, 2004) to the election under a qualified plan, including 403(b) annuities, Section 457(b) plans and broad-based foreign plans.

Collectively Bargained Arrangements

With respect to deferred compensation arrangements maintained pursuant to one or more collective bargaining agreements (in effect on October 3, 2004), the Notice provides that these plans are not required to comply with Section 409A before the earlier of the date on which the last of such collective bargaining agreements terminates (determined without regard to any extension thereof after October 3, 2004) or December 31, 2009.

What Employers Should Do Now

In light of the extension of the transitions rules, employers must continue to focus on establishing procedures for ensuring reasonable, good faith compliance with Section 409A. Particular emphasis should be on plans that contain both grandfathered benefits and benefits subject to Section 409A, and making sure that: (i) the plan's distribution provisions for non-grandfathered benefits comply with Section 409A; and (ii) timely elections are in place to govern benefit distributions. All new plans, programs, employment agreements, performance awards and other arrangements potentially subject to Section 409A should be designed to ensure operational compliance with Section 409A.

Additionally, employers contemplating offering new payment elections and/or modifying distribution options during the transition period should consider whether it is advisable to make such changes in 2006 (as opposed to 2007). For example, under the transition rules, an election made during 2006 to change the time and form of payment may apply only to amounts that would not otherwise be payable in 2006 (and may not cause an amount to be paid in 2006 that would not otherwise be payable in 2006). A substantially similar approach applies to elections made in 2007. Accordingly, if distributions are to begin in 2007, employers will need to consider implementing new elections in 2006.