Treasury and IRS Release Long-Awaited Guidance on Deferred Compensation Rules under Code Section 409A Certain Actions Necessary Before Year-End

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1 Treasury and IRS Release Long-Awaited Guidance on Deferred Compensation Rules under Code Section 409A Certain Actions Necessary Before Year-End October 5, 2005 On September 29, the Treasury Department and the IRS issued comprehensive proposed guidance for implementing and administering non-qualified deferred compensation plans, which are governed by section 409A of the Internal Revenue Code. Section 409A, added to the Code by the American Jobs Creation Act of 2004, resulted in sweeping changes to the taxation of non-qualified deferred compensation. Click here to read more. Section 409A imposes restrictions on deferral elections, distribution elections, distribution events and acceleration of payments. Failure to comply with section 409A will result in immediate taxation of the deferred amounts, an additional penalty of 20%, and the assessment of additional interest. The newly released proposed regulations incorporate and expand upon the guidance provided under IRS Notice and extend certain key transition deadlines set forth in Notice Specifically, the guidance extends until December 31, 2006 the period for plan sponsors to amend plan documents to conform to the section 409A requirements and for employees to amend their payment distributions (for payments not otherwise payable in 2006). Plan sponsors must continue to operate their plans in good faith compliance with the proposed regulations and Notice until the regulations are finalized. However, the proposed regulations do not extend the Notice period for a participant to terminate participation in a section 409A plan or to cancel 2005 deferral elections in such a plan. Therefore, plan sponsors and participants need to take any such actions on or before December 31, Actions to be taken by December 31, 2005 Participant deferral elections with respect to compensation for services performed during 2006 generally must be made on or prior to December 31, However, deferral elections for section 409A performance-based compensation may have a later election deadline.

2 Participant elections to terminate participation in a deferred compensation plan or to cancel outstanding deferral elections with regard to amounts subject to 409A must be made on or before December 31, The deferred compensation subject to these elections must be included in the participants income in Any amendment to the plan or arrangement necessary to permit such an election or termination must be made prior to December 31, Termination of any grandfathered plan (i.e., a plan or arrangement in place on December 31, 2004 with respect to vested amounts as of that date, plus earnings) must be completed on or before December 31, 2005, and all amounts paid under the plan must be included in the participants income in Any amendment to a grandfathered plan that gives a participant the right to elect to terminate participation in the plan or to continue to defer amounts will constitute a material modification of the plan that will cause the grandfathered plan to be covered under section 409A effective retroactively to January 1, Make-whole payments to a participant in connection with cancellation of a discounted option or a stock appreciation right (SAR) must generally be included in the participant s income in Highlights of the Proposed Regulations Guidance with Respect to Equity Compensation: A separate LawFlash will detail the guidance under the proposed regulations on equity compensation. Notably, the proposed regulations provide that non-discounted SARs are exempt from coverage under section 409A regardless of whether the SARs is settled in cash or in stock, permit limited extensions of an option exercise period and provide guidance for the substitution of stock rights in connection with a corporate transaction or event. Severance: A separate LawFlash will detail the proposed regulations regarding separation pay. The proposed regulations expand the scope of the exclusion provided in Notice by exempting certain severance plans and arrangements that provide for payment in the event of involuntary termination and certain window programs from the ambit of section 409A. The proposed regulations also provide guidance as to how an individually negotiated severance agreement can comply with section 409A timing rules for deferral elections. The Treasury Department and the IRS have requested additional comments with respect to severance payable upon a termination of employment for good reason. Short-term Deferrals: As under Notice , the proposed regulations exclude payments made within 2½ months of the close of the year in which they vest. Although the proposed regulations clarify that a written document is not required for the short-term deferral exclusion to apply, including payment deadlines in writing is a good idea because certain rules permitting a delay in payment are only available in cases where payment deadlines were specifically set forth in a plan. Deferral Elections and Distribution Requirements: A plan may provide each participant the opportunity to elect distribution events from a predetermined list of

3 events and designate and earlier of or later of date. Accordingly, participants under one plan may elect to have distributions triggered upon different events. Deferral elections and distribution requirements will be discussed more fully in a subsequent LawFlash. Split-Dollar Arrangements: The proposed regulations provide additional guidance regarding the application of 409A to split-dollar arrangements. Specifically, they exclude arrangements that provide only death benefits and arrangements that are treated as loans. Policies structured as endorsement policies are covered by 409A. The Treasury Department and the IRS have requested additional comments as to the scope of changes to split-dollar arrangements that may be necessary to comply with, or avoid the application of, 409A and under what conditions those changes should not be treated as a material modification for purposes of the grandfather rules applicable to split-dollar arrangements. Foreign Arrangements: The proposed regulations provide additional guidance relating to the application of 409A to nonresident aliens and foreign deferred compensation plans. Partnerships: The proposed regulations state that until further guidance is provided, partnerships and partners may continue to rely on Notice Moreover, the proposed regulations state that the change in control provisions can be applied by analogy to partnerships. Issues That Remain Open The Treasury Department and the IRS have not issued guidance regarding the calculation of the amount of a deferral (for purposes of meeting reporting requirements) or of the amounts included in income upon a violation of section 409A. The Treasury Department and the IRS requested additional comments regarding this topic. The Treasury Department and the IRS intend to address the consequences of funding deferred compensation plans in offshore trusts in subsequent guidance. The IRS and Treasury have requested comments regarding the application of section 409A to partnerships and other non-corporate entities. The Treasury Department and the IRS will provide additional guidance regarding circumstances which may require a delay in payment of a deferred amount and have requested additional comments regarding circumstances that may be appropriate for such guidance. All comments to Treasury and the IRS must be received by January 3, A public hearing is scheduled for January 26, Please contact any of the following Morgan Lewis attorneys for more information about the issues discussed in this Morgan Lewis LawFlash:

4 Chicago Brian D. Hector Dallas Riva T. Johnson Erin Turley New York Craig A. Bitman Gary S. Rothstein Palo Alto Zaitun Poonja S. James DiBernardo Philadelphia Robert L. Abramowitz Brian J. Dougherty I. Lee Falk Robert J. Lichtenstein Vivian S. McCardell Joseph E. Ronan Steven D. Spencer Mims Maynard Zabriskie Pittsburgh John G. Ferreira R. Randall Tracht San Francisco Mark H. Boxer Eva P. McComas Washington, D.C. Althea R. Day Gregory L. Needles About Morgan, Lewis & Bockius LLP Morgan Lewis is a global law firm with more than 1,200 lawyers in 19 offices located in Philadelphia, Washington, D.C., New York, Los Angeles, San Francisco, Miami, Pittsburgh, Princeton, Chicago, Palo Alto, Dallas, Harrisburg, Irvine, Boston, London, Paris, Brussels, Frankfurt and Tokyo. For more information about Morgan Lewis or its practices, please visit us online at

5 This LawFlash is provided as a general informational service to clients and friends of Morgan, Lewis & Bockius LLP. It should not be construed as imparting legal advice on any specific matter Morgan, Lewis & Bockius LLP. All Rights Reserved.