AUGUST 20, 2008

DEADLINE NEARS TO COMPLY
WITH SECTION 409A FINAL REGS

Time is running out. The deadline to document or amend compensation arrangements to comply with the final regulations under section 409A of the Internal Revenue Code (Section 409A) is December 31, 2008. After that date, any arrangement that violates Section 409A could result in burdensome consequences described below.

December 31, 2008 also marks the end of the transitional relief period, during which one is permitted to rely on a good-faith reading of the statute, ignore certain noncompliant contract provisions and amend certain existing payment elections—all of which are greatly restricted after December 31, 2008.

We urge you to act NOW to identify and review all of your compensation arrangements, written or not, and document or amend them to comply with Section 409A while the more flexible transition rules are still available.

Section 409A Affects Everyone

Section 409A is more than a minor inconvenience. It affects employees and employers in the following significant ways:

  • Immediate income recognition and an additional 20 percent federal excise tax (a separate 20 percent state excise tax applies in California) are the tax consequences to the employee for nonqualified deferred compensation that violates Section 409A.

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  • Withholding obligations of the employer are increased by the immediate income recognition of deferred compensation.

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  • Complaints from executives and key employees, who more likely have compensation subject to Section 409A, may involve demand for recompense arising from the additional tax burden. Although less likely, rank-and-file employee compensation may be affected.

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  • Representations and warranties made by employers in acquisition and financing agreements often include Section 409A.

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  • Coordinating your human resources and payroll departments to comply with Section 409A will require time and effort (and possibly the participation of inside and outside counsel). This becomes more difficult as the end of the year approaches.

Arrangements Subject to Section 409A

In reviewing your compensation arrangements, please note that the following usually implicate Section 409A:

  • employment and consulting agreements, including offer letters.

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  • severance agreements and policies.

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  • change-in-control agreements, parachute plans, and stay bonuses.

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  • expense reimbursement, including medical benefits, club dues, car allowance, relocation policies, financial assistance programs, outplacement services.

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  • tax gross-ups.

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  • bonus, commission and long-term incentive plans.

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  • restricted stock units (RSUs), phantom stock, performance awards and other equity awards besides restricted stock.

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  • top-hat plans, supplemental executive retirement plans (SERPs), excess plans, salary or director fee deferral arrangements.

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  • discount stock options and stock appreciation rights (SARs).

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  • split-dollar life insurance.

Common Problems Associated with Section 409A

Look out for the following common situations associated with
Section 409A:

  • Failing to document an arrangement involving deferred compensation.

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  • Failing to specify in writing the manner in which a payment is to be delayed for six months with respect to severance-triggered deferred compensation of a “specified employee” of a public company.

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  • Failing to specify the deadline by which the following payments are to be made: annual bonuses, expense reimbursement, medical benefits, tax gross-ups, and outplacement services.

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  • Providing different forms of severance based either (1) on the circumstances surrounding a separation from service, like making lump sum payments upon termination by reason of disability but payment in installments upon termination without cause; or (2) upon the occurrence of a change in control, like paying in installments before a change in control, lump sums after.

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  • Paying severance to an employee who continues to perform services in a non-employee capacity, like an executive transitioning to a non-employee director or consultant.

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  • Conditioning commencement of severance upon receipt of a general release.

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  • Using noncompliant definitions of “change in control,” “disability,” “good reason,” “separation from service” or “termination of employment.”

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  • Paying deferred compensation to non-US-based individuals, such as expatriates and nonresident aliens subject to US tax or establishing tax equalization or totalization arrangements, that is, grossing up an employee from one country for the economic consequences of working elsewhere.

Section 409A contains many rules and exceptions so there may be several workarounds to a given problem, especially during the transitional relief period.

Transitional Relief Period Ends December 31

Since 2004, we have been in a transitional relief period that ends December 31, 2008. Within this period, you may do certain things that will not be permitted after December 31, 2008:

  • You may choose to comply with either (1) the final regulations or (2) any other generally applicable guidance published with an effective date before January 1, 2008. To the extent that an issue is not addressed by the pre-2008 guidance, you are allowed to rely on a good-faith reading of the statute—even if this reading is inconsistent with the final regulations. After 2008, compliance with the final regulations is mandatory.

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  • You may ignore certain noncompliant discretionary provisions of an agreement, so long as you administer the agreement in compliance with Section 409A. For example, if a plan gives an employer discretion to delay or extend a payment in a manner that would violate Section 409A, no violation occurs unless the employer exercises that discretion. After 2008, a noncompliant provision, though discretionary, causes a per se violation of Section 409A.

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  • During 2008, you may elect to defer or accelerate receipt of compensation (or amend an existing election), so long as the election or amendment (1) applies to an amount that would not otherwise be payable in 2008 and (2) does not cause an amount to be paid in 2008 that would not otherwise be payable in 2008. For example, during 2008, you may defer a payment due in 2009 to 2010. After 2008, a subsequent deferral election is greatly restricted. Under the final regulations, an election to defer a scheduled payment must be made no later than one year before the scheduled payment date and the payment must be deferred to no fewer than five years after the original payment date.

Transitional relief is available only until December 31, 2008, so any amendment made thereafter must comply with the final regulations. That is why it is important to make any amendments during the transitional relief period, if possible.

Action Items for 2008

Now is the time to bring your compensation arrangements into compliance with Section 409A.

Please consider the following action items:

  • Identify all arrangements involving deferred compensation.

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  • Review each compensation arrangement for compliance with
    Section 409A. Arrangements should be viewed from both a per-plan and a per-participant basis.

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  • Prepare your human resources and payroll departments for compliance with Section 409A. This may involve coordination with your outside service providers. Under Section 409A, certain payment deadlines require strict compliance, while others do not. Ensure that your staff knows the difference.

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  • Consider the alternative elections available under Section 409A. Section 409A allows you to make certain elections relating to, among other things, the definition of “compensation” and the identification of “specified employees.” Alternative elections for 2009 generally require board action by no later than December 31, 2008.