On Monday, Sept. 10, 2007, the Internal Revenue Service issued Notice 2007-78 giving employers a limited extension to Dec. 31, 2008 to adopt documents and modify existing agreements to comply with the requirements of Section 409A of the Internal Revenue Code. Section 409A was passed by Congress in late 2004 to regulate nonqualified deferred compensation, and its rules cover many arrangements generally not considered deferred compensation. Further, 409A provides severe penalties to participants for any failure to comply with its rules.
In April 2007, the IRS issued final regulations that employers and employees must follow in order to comply with 409A. These rules require that all plans and arrangements providing deferred compensation be in a writing that complies with 409A. Many employers encountered difficulty both in identifying deferred compensation arrangements and amending arrangements to comply. In addition, shareholder approval is required to modify some agreements, and the final regulations were issued too late for most companies to include proposed changes on the agenda for the 2007 stockholders meeting.
On Aug. 21, 2007, a consortium of 92 law firms, including Waller Lansden, sent a letter to the IRS commissioner requesting an extension of the compliance deadline. The IRS responded by giving a limited extension to Dec. 31, 2008 in order to allow employers more time to amend plan documents. Under the extension, the plans and arrangements must be operated in accordance with the final regulations for the entire 2008 year. Good faith compliance under all prior guidance is no longer satisfactory.
In addition, there are several important exceptions to the new extension. First, the transitional relief for 2007 that permits an arrangement to change the form and time of payment still ends on Dec. 31, 2007. Second, plans must include a compliant time and form of payment for any undistributed deferrals made or benefits accrued before Jan. 1, 2008. An employer may amend each plan individually or adopt a single amendment covering all of its plans to provide a compliant time and form of payment. Even a single amendment will require the identification of all such arrangements prior to Jan. 1, 2008. A noncompliant time or form, e.g., an acceleration of payment with a haircut (the right to take a distribution at the election of the participant if there is a reduction, e.g., 10%, in the amount due under the plan), will not cause the plan to violate 409A so long as the plan includes a compliant time and form and the noncompliant provision is not used. More importantly, however, any arrangements that have not been put to writing will have to be documented before the end of 2007.
Third, the final regulations provide that severance payments payable upon an involuntary termination or resignation by the employee for "good reason" are not subject to 409A if certain conditions are met. The final regulations provide a list of safe harbor good reasons and many arrangements will need to be modified to limit good reason to the safe harbor reasons to avoid making the payments subject to 409A and its penalties. Unfortunately, any change to the definition of good reason generally is a violation of 409A because it constitutes an impermissible extension of a substantial risk of forfeiture. Under the Notice, however, modifications to the definition of good reason can be made through Dec. 31, 2007 without violating 409A.
Under the IRS extension any permissible payment event, such as separation from service, changes in control, unforeseeable emergencies and disability, may be retroactively adopted on or before Dec. 31, 2008, if the plan operationally complies with the definition during 2008.
In another piece of welcome news, the Notice states that the IRS expects to establish a limited voluntary compliance program for correction of certain unintentional 409A operational failures. Although such failures will have to be corrected in the same tax year in which they occur, this procedure, once effective, should give employers and employees some assurance of compliance with 409A. The IRS also anticipates implementing a program whereby taxes and penalties may be limited for certain corrections. The Notice does not indicate that there will be any relief for plan documents that do not comply with 409A, however.
While the Notice gives employers some much needed relief, it is not a wholesale extension of the deadline. Therefore, employers must still identify and review all arrangements that provide for deferred compensation and make necessary changes by Dec. 31, 2008 or by Dec. 31, 2007, where applicable. It is extremely unlikely that the IRS will provide another extension.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
