Notice 2005-1: A Glidepath to Compliance with Section 409A

Originally published on December 20, 2004

Treasury and IRS released on December 20, 2004 Notice 2005-1, their initial guidance on new Code section 409A ("409A"), a statutory provision that makes sweeping changes in the rules for nonqualified deferred compensation plans. Given the scope of these changes and the very brief lead time between the enactment of 409A and its January 1, 2005 effective date, the abrupt transition from current law to 409A could be an experience akin to falling off a cliff. Instead, Notice 2005-1 provides a smooth glidepath to compliance with 409A. Altogether, it fulfills and exceeds Congress’ requirement to provide transitional guidance within 60 days of the enactment of 409A. In addition to providing thoughtful transition rules, it includes certain basic definitions and rules that are necessary to determine what arrangements are covered by 409A, as well as a definition of change in control. Written in question and answer format, it also provides preliminary Q&A guidance on information reporting and withholding. At the same time, Notice 2001-5 does not cover the operational aspects of 409A, e.g., the rules for distributions, the definition of a key employee, plan document requirements, and amounts to be withheld when 409A is violated. These will be covered by additional guidance, which Treasury predicts will be released by mid-2005.

Reliance, Good Faith Compliance and Delayed Plan Amendments: Taxpayers may rely on Notice 2005-1 and if any later guidance is less favorable, Treasury and IRS will apply the new rule prospectively with adequate transition relief to permit plans to be modified. Pending additional guidance on 409A, for topics that are not covered by Notice 2005-1, good faith compliance is authorized. This should take into account the statute, its purpose and its legislative history. Plan amendments to comply with 409A may be made as late as December 31, 2005. In the meantime, operational compliance with 409A, using Notice 2005-1 and good faith, is sufficient. Q&A-19.

SARs Relief for Publicly Traded Companies: Notice 2005-1 provides a safe harbor that excludes from coverage by 409A non-discount stock appreciation rights that relate to employer stock that is traded on an established securities market, that are settled in such employer stock and that do not include any feature for the deferral of compensation other than the participant’s exercise right. Q&A-4(d)(iv).

Temporary SARs Relief for Pre-10/4/2004 Programs: Pending further guidance, payment of stock or cash pursuant to the exercise or cancellation of a non-discount stock appreciation right is excluded from coverage by 409A if the SAR does not include any feature for the deferral of compensation other than the participant’s exercise right. Q&A-4(d)(iv).

Fixed Payment Date SARs Valid: In addition to the SARs relief noted above, Notice 2005-1 makes clear that it is also possible to construct SARs that comply with 409A, e.g., by providing for a payout of the SAR at the expiration of its term, with the participant having the right to exercise the SAR (after vesting and before expiration of the term) by redirecting the SAR’s investment out of stock appreciation and into another investment. Q&A-4(d). (However, variable accounting likely applies to such a SAR unless the redirection may only be into phantom stock.)

ISO Valuation Rules Permitted: To assist companies that grant options but that do not have publicly traded stock, Notice 2005-1 permits use of the same relatively flexible rules for stock valuation that are permitted for incentive stock options. Q&A-4(d)(ii).

Transition Relief to Fix Discount Options: Discount options may be replaced with nondiscount options by December 31, 2005. This is not treated as a material modification. Also within this time, SARs that would involve the deferral of compensation may be replaced with SARs that are not subject to 409A. Q&A-18(d).

Restricted Property. Receipt of restricted stock or other restricted property is not a deferral of compensation, even though taxation will be delayed by the arrangement’s substantial risk of forfeiture. However, a service recipient’s legally binding promise to transfer property in the future is subject to 409A. Q&A-4(e).

Multi-year Compensation Arrangements: Multi-year compensation arrangements that have delayed vesting are not considered to be 409A deferred compensation if the compensation is paid reasonably promptly after vesting, i.e., within 2½ months after the tax year in which vesting occurs – using the later of the service recipient’s tax year or the service provider’s tax year. However, the service provider may not have an election to delay payment to a later year. Q&A-4(c).

Fiscal Year Bonuses: Similarly, bonuses paid based on the service recipient’s fiscal year will not become subject to 409A, if they are paid within 2½ months after the service recipient’s fiscal year. In addition, they may be paid within 2½ months after the service provider’s tax year (generally, the calendar year) if this is later. Again, no election to delay payment to a later year is permitted. Q&A-4(c).

Medical Reimbursement Arrangements: Q&A-3(b) clarifies that HRAs, HSAs and other medical reimbursement arrangements are exempt from 409A.

Routine Business Payments: 409A does not apply to payments between taxpayers that all use the accrual method of accounting for tax purposes. In addition, payments to a service provider that provides substantial services (other than as an employee or director) to two or more unrelated recipients are not covered. Thus, for example, a company’s payments to an outside law firm are not covered by 409A. For this purpose, a 20% interest in another entity is sufficient for it to be "related." Q&A-8.

Certain Severance Plans Excepted for 2005: Severance plans that are collectively bargained or cover no key employees do not need to comply with 409A in 2005, provided they are amended by December 31, 2005. Q&A-19(d).

Right to Cancel Deferrals: A plan adopted before December 31, 2005 may be amended (but need not be) to allow a participant during 2005 to terminate participation or cancel a deferral election (in whole or in part) with respect to amounts subject to 409A. The plan must be amended by December 31, 2005 and related amounts must be timely included in income. The amendment need not apply equally to all participants. In addition, the plan aggregation rules do not apply, so separate plans of the same type may be treated differently. Q&A-20.

Late Deferral Elections Permitted: For plans in existence by December 31, 2004, deferral elections can be made by March 15, 2005 and be treated as valid under 409A. The election can cover any amounts that have not yet been paid (or become payable) when the election is made. Q&A-21.

Form of Payment May Be Linked to Qualified Plan in 2005: Through December 31, 2005, determining the form of payment under a nonqualified plan based upon the participant’s election under a qualified plan will meet 409A, provided that this linkage operates in accordance with the nonqualified plan’s terms as of October 3, 2004. Q&A-23.

Plan Termination Permitted Until 12/31/2005: In general, a plan sponsor may not have or exercise discretion to terminate a plan that is subject to 409A and then make distributions. However, a plan sponsor may terminate and make distributions from a pre-October 4, 2004 arrangement on or before December 31, 2005, without it being a material modification that could trigger penalties under 409A. Q&A-18(c).

Discretionary Plan Termination Permitted After Change in Control: In addition to termination during the transition period, a plan may give the sponsor discretion to terminate the plan and make distributions within 12 months of a change in control event, as defined in Notice 2005-1. By allowing discretionary plan terminations following changes in control, Notice 2005-1 avoids requiring employers to anticipate perfectly what will eventually be the appropriate course with respect to a deferred compensation plan following a change in control event. Q&A-11.

Discretion Under Grandfathered Plans: If the terms of a plan on October 3, 2004 permitted the service recipient to exercise discretion over the time and manner of payment, it is not a material modification for the service recipient to exercise this discretion after 2004. Similarly, it is not a material modification for a participant to exercise a right permitted under the plan on October 3, 2004. Q&A-18(a).

Acceleration of Vesting Not Always a 409A Prohibited Acceleration: Code section 409A(a)(3) prohibits the acceleration of the time of schedule of any payment. Q&A-15 clarifies that accelerated vesting that does not itself trigger a distribution (and that otherwise meets 409A) is permissible, even though it makes possible a distribution that otherwise would not occur.

Stock Option Gain Deferral at Risk: To be excluded from 409A’s coverage, a nonstatutory tax option must "not include any feature for the deferral of compensation other than the deferral of recognition of income until the . . . exercise or disposition of the option . . . ." This suggests that if an option grant includes a right to engage in a transaction that will defer option gains beyond exercise or disposition, the option will be subject to 409A from its inception. Under 409A, the exercise feature of an option will run afoul of 409A’s distribution rules. This suggests that basic option design would have to be changed in order to allow deferral of gains. Q&A-4(d)(ii).

Tandem Options/SARs at Risk: Q&A-4(d)(ii) puts forth as an example of a feature that allows for deferral of compensation "tandem arrangements involving options and stock appreciation rights." Because inclusion of such a feature in an option or a SAR makes them subject to 409A, this example casts a shadow over tandem options/SARs.

No Exception for Nonqualified ESPPs: Notice 2005-1 reflects the statutory exception for employee stock purchase plans (ESPPs) that qualify under section 423, but it does not include – as had been requested – an exception from 409A’s coverage for nonqualified ESPP’s, e.g., an ESPP that generally follows section 423’s rules but not the requirement to cover all employees of the corporation.

Noncompete not a Substantial Risk of Forfeiture: As noted, a substantial risk of forfeiture can delay taxation without the arrangement being subject to 409A (if amounts are paid out reasonably promptly after the risk of forfeiture terminates). Notice 2005-1 provides, however, that refraining from substantial services, e.g., a non-compete agreement, is never considered a 409A substantial risk of forfeiture, even though it can be in some cases under sections 83 and 457. It appears Treasury is concerned that it could be too easy to delay the taxation of compensation outside the strictures of 409A if a noncompete were considered a substantial risk of forfeiture. Q&A-10(a).

Elective Risks of Forfeiture Disregarded: Elective extensions or additions of substantial risks of forfeiture are disregarded for purposes of section 409A. For example, an employee’s election to extend a risk of forfeiture by two years is ignored under 409A. Presumably this is because it could permit a redeferral for less than the minimum five-year period required under 409A. Elective additions of a risk of forfeiture are also generally disregarded. Thus the taxation of salary generally cannot be deferred by the employee electing to put his or her salary under a substantial risk of forfeiture. However, the notice does allow arrangements where a participant electively trades salary or bonus for a "materially greater" amount of compensation that is subject to a substantial risk of forfeiture. Q&A-10(a).

Section 457’s Broader Definition of Deferred Compensation Not Affected: Q&A-6 cautions that 409A’s rules that treat certain options as not deferring compensation under 409A do not alter the principle that options are treated as deferred compensation arrangements under section 457 (see Reg. § 1.457-11(d)). Similarly, amounts paid shortly after vesting remain deferred compensation under section 457, even though not deferred compensation under 409A.

409A Adds to Pre-existing Requirements: 409A applies in addition to pre-existing rules of taxation, including constructive receipt, economic benefit, cash equivalency and (in the case of tax exempt and governmental organizations) section 457(f). Compensation is taxed at the earlier of the time that applies under any of these principles and the time that applies under 409A. Part I of Notice 2005-1.

Basic definition of a Deferral of Compensation: A deferral of compensation occurs where there is a legally binding right in one year to compensation that has not been actually or constructively received and that pursuant to the terms of a plan is paid in a later year. If the service recipient (e.g., the employer) has a discretionary right either not to make payment or to reduce the amount of payment, then no deferral is deemed to occur. However, to avoid abuse of this rule, Notice 2005-1 provides that discretion not to pay (or to pay less) is disregarded if unlikely to be exercised. At the same time, the ability to avoid treatment as a deferral arrangement when there is a bona fide right to pay less also seems capable of abuse, but Notice 2005-1 does not include any special rules directed at that possibility. Q&A-4(a).

"Plan" Definition and Aggregation of Plans by Category: Under 409A, a plan is defined broadly as any agreement, method or arrangement whether negotiated or provided unilaterally by the service recipient. In addition, the requirements of 409A are applied as if – (a) a separate plan (or plans) is maintained for each service provider, and (b) all account balance plans covering an individual service provider are aggregated into a single plan, all nonaccount balance plans covering a provider are aggregated, and all other plans (such as discounted stock options) covering a provider are aggregated. The disaggregation rule in (a) appears to insulate other participants from 409A errors related to a specific participant. On the other hand, the aggregation rule in (b) blocks attempts to minimize the participant’s potential penalties under 404A by establishing many separate plans, e.g., a separate plan for each pay period’s deferral of base pay. However, this general aggregation rule in (b) above has a number of exceptions in Notice 2005-1 (several are note below). Q&A-9.

Definition of a Substantial Risk of Forfeiture: Compensation is subject to a substantial risk of forfeiture if – (a) it is conditioned on substantial services or on the occurrence of a condition related to the compensation, and (b) the possibility of forfeiture is substantial. Notice 2005-1 indicates that close scrutiny will be applied in cases where the participant owns a significant share of the total voting power or value of a company’s stock. As an example, the notice notes that a president’s ownership of 4% of an otherwise widely held company is sufficient for there not to be a substantial risk of forfeiture (because the possibility of the forfeiture condition being enforced is not substantial). Q&A-10.

Exceptions from the Prohibition on Accelerations: Q&A-15 sets forth the following exceptions to the general prohibition on accelerating the time or schedule of any payment – (i) payments to someone other than the participant that are needed to fulfill a domestic relations order, (ii) payments necessary to comply with federal rules against conflicts of interest, (iii) the minimum amount needed to pay withholding taxes upon a vesting event under a section 457(f) plan, and (iv) the minimum amount necessary to pay FICA taxes required by section 3121(v)(2) (and the related income tax withholding triggered by the distribution). In addition, a plan may be amended at any time to add a provision permitting automatic lump sum payment of not more than $10,000 upon the termination of a participant’s entire interest in a plan, provided the distribution is made reasonably promptly, i.e., within 2½ months of the participant’s separation from service or, if later, by the end of the calendar year containing the separation from service date. In determining whether a participant’s entire interest exceeds $10,000, Q&A-15 provides that the general rule aggregating plans of the same type does not apply.

General Effective Date: 409A applies to amounts deferred after December 31, 2004 and to amounts deferred earlier if the plan under which the deferral occurred is materially modified after October 3, 2004. Q&A-16.

Date of Deferral: In applying the effective date, an amount is considered deferred as of the date – (i) the service provider has a legally binding right to be paid the amount, and (ii) the right to the amount is earned and vested. The right to an amount is not earned and vested if it is subject to a substantial risk of forfeiture, as defined under section 83, or a requirement to perform additional services. Thus, benefits under a 457(f) plan that relies upon a noncompete agreement can be unvested for effective date purposes, even though a noncompete does not constitute a substantial risk of forfeiture under 409A generally. Further, a requirement to perform services beyond December 31, 2004 will cause an amount not to be vested for effective date purposes, even though the remaining service period at December 31, 2004 is not long enough to constitute a substantial risk of forfeiture (provided that it extends beyond the payroll period that includes December 31, 2004). Q&A-16.

Determining the Grandfathered Benefit: The pre-2005 grandfathered benefit is determined under Q&A-17 as follows.

• Account Balance Plan: The earned and vested account balance as of December 31, 2004. Subsequent earnings on this amount are also grandfathered, apparently including above market earnings, provided the right to these subsequent earnings is earned and vested as of December 31, 2004, based on the plan’s terms as in effect on October 3, 2004.
• Nonaccount Balance Plan: The present value as of December 31, 2004 of the earned and vested benefit that would be paid at the earliest possible date if the participant voluntarily separated from service "without cause" as of December 31, 2004. This means early retirement subsidies that are not yet payable are not grandfathered, even the portion that relates to benefits that are accrued as of December 31, 2004. In addition, the "without cause" language appears to disregard enhanced benefits that would be paid if the participant terminated with good reason. However, increases in the present value of the December 31, 2004 benefit that result solely from the passage of time are grandfathered. To calculate present value, the plan’s assumptions are used if reasonable (otherwise reasonable assumptions must be used). However, the rule that aggregates all nonaccount balance plans does not apply for purposes of identifying a plan’s assumptions.
• Equity-Based Plans: The earned and vested amount that would be paid to the participant net of any exercise price on December 31, 2004, along with related portion of future appreciation in the underlying equity.

Material Modifications: In general, a material modification occurs if a benefit or right as of October 3, 2004 is enhanced or a new benefit or right is added. Accelerating vesting, to increase the vested December 31, 2004 benefit, is a material modification. In addition, while amending a plan to comply with 409A is not generally a material modification, adding a new benefit for pre-2005 deferrals is a material modification even if it is benefit that is permitted under 409A, such as adding distributions for an unforeseeable emergency. An amendment to stop future deferrals is not a material modification. The special rule aggregating plans does not apply in determining material modifications, which should help contain the impact of a material modification. Q&A-18.

Temporary Definition of Performance-Based Compensation: 409A permits initial deferral elections to be made for performance-based compensation as late as six months from the end of the performance period. Pending additional guidance, performance-based compensation requires – (i) a performance period of at least 12 months, and (ii) a performance contingency based on individual or organizational criteria that are not substantially certain at the time of the deferral election. Subjective criteria are permitted if they relate to the participant or a work group or organization to which the participant belongs. Q&A-22.

Information Reporting: Notice 2001-5 provides guidance on the mechanics of reporting nonqualified deferred compensation on either a Form W-2 or Form 1099-MISC. However, the determination of amounts that are includible in income and subject to withholding as a result of 409A is left to future guidance. In the case of a nonaccount balance plan, year-by-year reporting of deferrals can be delayed until the amounts are considered reasonably ascertainable based on the regulations under section 3121(v)(2). A deferred amount to which the service recipient had a legally binding right before 2005 is not subject to reporting, even if the amount was not earned and vested by December 31, 2004.

Withholding: Amounts that are includible in income solely because of 409A need not be treated as wages subject to withholding until December 31, 2005. Q&A-32.