Guest Article

(From the October 31, 2005 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Section 409A Regulations: Last in a Series

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 the last in a series of articles providing an in-depth analysis of the regulations. This article focuses on the methodology for identifying specified employees and the requirements to make changes in the time and form of distribution for section 409A compliant deferred compensation arrangements.

Changes in Time and Form of Distribution

In General

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. In addition, section 409A prohibits a participant's ability to delay a scheduled distribution (i.e., to redefer amounts under the plan) unless the following conditions are met:

The proposed regulations provide that an election to delay distributions applies to each payment under the plan. What constitutes a "payment" is determined under the terms of the plan. If the distribution calls for a series of installment payments, the plan may provide that each installment is a separate payment. This approach allows the service provider to postpone the receipt of particular installments without having to delay the entire series. Alternatively, a plan can provide that installment payments are one payment. If the installments are one payment, then a participant can elect to change to a lump sum distribution, provided the lump sum is paid no sooner than five years after the date the installment payments would have commenced. Where a distribution is in annuity form, the individual payments cannot be treated as separate payments.

The redeferral requirements are based on the date payment would otherwise be made. With respect to a specified time or fixed schedule of payments, if only the year of distribution is provided, then January 1 of that year is the relevant date for redeferral purposes.

Short-Term Redeferrals

The redeferral rules also apply to short-term deferrals, even though these amounts are not considered deferred compensation for purposes of section 409A. If there is a legally binding right over a period of at least 12 months before vesting, a redeferral election can be made using the vesting date as the payment date. Thus, the election to delay distribution of a short term deferral must be made at least 12 months before payment would otherwise be made and must provide for a deferral of at least five years beyond vesting.

Identifying Specified Employees

In General

Section 409A requires that distributions to "specified employees" on account of a separation from service be subject to a six month delay. A plan can comply with this requirement by delaying all distributions for six months, or by providing for a catch-up distribution at the beginning of the seventh month equal to the payments that otherwise would be made during the first six months after separation from service.

Who is a Specified Employee?

A "specified employee" is an employee of a corporation with stock that is publicly traded on an established market or otherwise who (1) owns more than five percent of the stock of the corporation; (2) owns more than one percent of the stock of the corporation and has compensation from the corporation in excess of $150,000 per year (not indexed); or (3) is an officer with compensation in excess of $130,000 per year (indexed). Officer status is based on the nature of one's duties, not on title, and no more than 50 employees can be considered officers.¹ Whether the stock of the corporation is publicly traded is determined as of the date of separation from service.

To determine the specified employees, the employer must select an identification date. The facts concerning stockholdings, compensation and officer status as of that date identify the specified employees, but the identifications do not become effective until the beginning of the fourth calendar month after the identification date. They then remain in effect for 12 months. A change in the method of determining specified employees cannot be effective until 12 months after the change is adopted. The proposed regulations also provide guidance on identifying specific employees in connection with spinoffs and mergers.

Example

If the employer selects an identification date of December 31, the persons identified as specified employees on December 31, 2005, are subject to the special distribution restrictions beginning on April 1, 2006, and continuing through March 31, 2007, when the newly identified group of specified employees begins to apply.

Treatment of Nonresident Aliens

The basic rule for calculating specified employees would take into account nonresident alien employees. The proposed regulations would allow the plan to require a six month delay for distribution upon separation from service for all employees that are nonresident aliens.

Note that an employer is permitted to define its own class of employees subject to a delay. For example, a plan sponsored by an employer with only officers as key employees could provide for a six-month delay in distributions on separation from service with respect to any individual who is an officer as of January 1 of the year in which the individual separates from service, as well as for any distribution to a nonresident alien covered by the plan. By doing so, the employer is effectively insuring compliance with the specified employee rules by implementing delayed distributions for a group that will include any individual who is a specified employee, as well as other employees.

¹ The limit on the number of officers is 10 percent of all employees if the corporation has 30 to 500 employees and 3 if it has fewer than 30. These and the other elements of the definition are borrowed from the definition of "key employee" in IRC section 416(i).

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.