Guest Article

(From the September 19, 2005 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Section 409A Deferred Compensation Guidance Delayed... What Employers Should Do Now

With the demands of responding to Hurricane Katrina at the forefront, the Internal Revenue Service (IRS) and Treasury may delay guidance under section 409A until late September or early October. The much anticipated guidance is expected to provide an extension of the transition period currently scheduled to expire at the end of 2005. However, it is expected this extension will apply only to plan amendments that bring plan documents into compliance with section 409A and distribution election changes related to the new guidance. Further relief for the timing of initial deferral elections or election revocations is not expected. Therefore, despite the expected transition period extension, there are still some actions that employers should be preparing to take before December 31, 2005 to comply with section 409A.

Deferral elections: Under section 409A, an election to defer compensation for services performed in 2006 must be made by December 31, 2005, unless the compensation qualifies as performance-based compensation. The performance-based compensation exception under section 409A permits deferral elections to be made as late as six months before the end of the service period if the performance period is at least 12 months long and payment is contingent on the satisfaction of performance goals. Depending on the goals under the plan, the election may have to be made more than 6 months before the end of the service period to satisfy the requirement that the performance criteria must not be substantially certain to be met at the time the deferral election is made. Bonus compensation is not considered performance-based if it is based solely on the value of, or appreciation in the value of, the service recipient stock.

Given the timing requirements for deferral elections, employers should provide for a deferral election process this fall for salary and other non-performance based compensation to be earned next year. Because we do not yet have full guidance on implementation of distribution alternatives, employers should consider how to communicate with eligible employees.

Election revocations: A key part of transition relief available in 2005 is the ability for an employee to cancel all or part of a deferral election otherwise subject to section 409A. The transition relief for election revocations is not expected to be extended. Therefore, it is only during 2005 that plans can be amended to give participants the right to revoke a deferral election without jeopardizing the plan's section 409A compliance or implicating the doctrine of constructive receipt. The election revocation rules require that all revocation amounts be included in the employee's gross income in 2005 or, if later, the year in which the amounts become earned and vested.

As noted above, some continued opportunity to revise distribution elections is expected. Service providers who make deferral elections for 2006 or do not choose to cancel a deferral outstanding in 2005 should be prepared to leave those amounts deferred for some period, at least beyond 2006. As an example, stock options that were issued in the money have been compliant with the section 409A transition rules this year, as the exercise of the option is the equivalent of an election to cancel the deferral. If the option remains outstanding in 2006, however, it will need to comply with section 409A, including the restrictions on permissible distributions.

Plan terminations: Notice 2005-1 provides that an amendment adopted by December 31, 2005 terminating a plan grandfathered under section 409A will not be treated as a material modification.

It is not expected that this element of the transition relief will be extended. Employers should consider whether to amend their plans to include this provision and, if so, adopt the amendment by the end of the 2005.

Severance payments: Severance plans that cover collectively bargained employees or only non-key employees are not required to comply with section 409A during 2005, but only if the plan being is amended by the end of 2005 to comply with section 409A.

Although it is likely that the amendment requirement will be postponed, all severance plans will need to operate in compliance with section 409A. The issue of severance plans has generated significant comment, and Treasury and IRS officials have indicated that they are considering an extended exception. Until the guidance is issued, however, employers will need to consider what action might be required to enable their severance plans to operate in compliance with section 409A.

Overall, despite the lack of guidance, now is the time for employers to begin actively planning for the end of 2005 and the expiration of significant elements of transition relief provided by Notice 2005-1. These steps include:

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2005, Deloitte.