Guest Article

(From the October 25, 2005 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Continued Discussion of Section 409A Regulations

The IRS and Department of Treasury have issued the much-anticipated proposed regulations regarding the application of IRC section 409A to nonqualified deferred compensation plans. 70 Fed. Reg. 57930 (10/3/2005). The proposed regulations incorporate, change and expand upon the initial guidance the IRS provided under Notice 2005-1, 2005-2 I.R.B. 274.

Section 409A has been effective since January 1, 2005; however, the proposed regulations will not become effective prior to January 1, 2007. The regulations can be relied upon, and compliance with the proposed regulations constitutes good faith compliance with the statute. In addition, the guidance in Notice 2005-1 can continue to be relied upon until the regulations are finalized.

The following represents one of a series of articles providing an in-depth analysis of the regulations. This article focuses on the permissible distribution events and subsequent deferral elections for deferred compensation arrangements to comply with section 409A. Subsequent articles will examine other specific topics covered by the regulations, including how to identify specified employees and redeferral requirements, as well as identify unanswered questions.

Introduction

Section 409A permits the distribution of deferred compensation only upon the occurrence of certain events, requires that distribution events be specified in advance, and restricts acceleration of distributions. The timing of distributions must be specified at the time when a legally binding right to deferred compensation arises or as part of a deferral election. Notice 2005-1 (the "Notice") addresses a few aspects of the distribution rules; the proposed regulations are more comprehensive.

Permissible Distribution Events

There are six permitted section 409A distribution events (described in more detail below):

The distribution does not have to be made immediately on a distribution event: Timing of a distribution may be fixed by reference to the event (e.g., six months after separation from service, or three years after death). The proposed regulations also do not require that distributions be made precisely on a scheduled day. Rather, a payment is treated as timely if is made in the same calendar year as the scheduled date or, if later, by the 15th day of the third calendar month following the scheduled date. For example, if a distribution is to be made on separation from service, a service provider who leaves on January 2, 2006, could be paid as late as December 31, 2006, and a November 2, 2006, terminee could be paid as late as February 15, 2007.

Separation from Service

The proposed regulations contain rules concerning what can or must be regarded as a separation from service. An employee whose annual rate of performance of services falls to less than 20 percent of the employee's average rate over the last three full years of employment is treated as having separated from service. On the other hand, someone whose compensation and rate of performing services have not fallen to less than 50 percent of the average level over the last three years is not considered to have separated from service. In other situations, the issue is resolved through consideration of the relevant facts and circumstances. For these determinations, service as both an employee and an independent contractor is taken into account. The preamble to the proposed regulations notes that the separation from service rules do not incorporate the "same desk rule" that previously applied to section 401(k) plans.

"Specified employees" may not receive distributions on account of separation from service until at least six months after the separation occurs (or upon death, if earlier). A plan can comply with this requirement by delaying all distributions for six months, or by providing for a catch-up distribution of the first six months of payments at the beginning of the seventh month. Future Washington Bulletin articles will discuss the methodology required for determining specified employees.

Fixed Time (or Pursuant to a Fixed Schedule) Specified Under the Plan

To be a permissible distribution date, the fixed time or schedule must be currently ascertainable and not contingent on an event if the time of occurrence is not already known. The plan could not, for instance, specify "the date (or year) on which profits reach X" or "the date of the employer's IPO."

The proposed regulations introduce one important exception, not contained in the Notice, to the rule that the time of distribution may not be based on the occurrence of an event: It is permissible to provide for distribution at a specified time or pursuant to a fixed schedule following the lapse of a substantial risk of forfeiture (vesting), disregarding any acceleration of the vesting for other than death or disability.

Disability

A service provider is disabled for purposes of a distribution if he or she is unable to engage in any substantial gainful activity or receives benefits for at least three months under the employer's disability plan as the result of a medically determinable physical or mental impairment that is expected to result in death or continue for at least 12 months. The service provider need not receive a Social Security disability determination, though that is acceptable proof of disability.

Change in Control

The proposed regulations retain the definition of change in control provided in the Notice. The Notice and the proposed regulations deal only with changes in control of a corporation. The preamble to the proposed regulations states that future guidance will permit distributions upon a change in control of a partnership. Taxpayers may apply the rules for corporations to partnership transactions by analogy pending further guidance.

The Notice and proposed regulations adopt a modified version of the basic structure of the definition of change in ownership or control under section 280G.

A change in ownership or control occurs with respect to a service provider only if the change relates to the entity to which the service provider provides services, that is liable for payment of the compensation, or that is further up in the chain of ownership. There are three types of change in control, each based on distinct criteria:

It is possible for more than one corporation involved in a transaction to have a change in control for purposes of section 409A (another departure from section 280G).

A plan may provide for distribution on some change in control events, but not all. In addition, the plan sponsor can retain discretion to terminate an arrangement in the event of a change in control, provided that the discretion is exercised within 30 days before and 12 months after the change in control and all substantially similar arrangements are also terminated. Unforeseeable Emergency

The statute's definition of "unforeseeable emergency" is based on the regulations under section 457: severe financial hardship arising from illness or accident of the service provider, spouse or dependents, casualty loss or other similar extraordinary and unforeseeable circumstances arising as a result of events beyond the control of the participant. In addition, the financial need must not be one that can be relieved through reimbursement or compensation from insurance or otherwise, by liquidation of the service provider's assets, to the extent the liquidation of such assets would not cause severe financial hardship, or by cessation of deferrals under the arrangement. An example of an event that does not meet this standard is enrollment of a child in college. Finally, the amount distributed may not be more than is reasonably necessary to meet the emergency and pay any anticipated tax on the distribution.

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.