Current developments.

• Author: Walker, Deborah
• Position: Part 1 - Application of Sec. 409A

EXECUTIVE SUMMARY

* The Service issued much-anticipated proposed regulations on the application of Sec. 409A to NDC, and other guidance on Sec. 409A and offshore trusts.

* A ruling provides insight on the commission-based exception to the Sec. 162(m) compensation limit as a possible alternative to the performance-based exception.

* Rev. Proc. 2006-31 explains when the IRS will grant a request to revoke a Sec. 83(b) election due to a mistake of fact.

**********

This two-part article summarizes the major developments in compensation and employee benefits over the past year (August 2005-August 2006). Part I, below, deals with developments in executive compensation. Part II, in the February 2007 issue, will focus on fringe benefits and qualified retirement plans. The most significant development, the enactment of the Pension Protection Act of 2006, was the subject of an article in the November 2006 issue. (1)

Deferred Compensation

Proposed Regulations

In early October 2006, the IRS issued much-anticipated proposed regulations on the application of Sec. 409A to nonqualified deferred compensation (NDC) plans. (2) These rules implemented provisions enacted by the American Jobs Creation Act of 2004 (AJCA) and incorporated, changed and expanded initial guidance offered in Notice 2005-1. (3) Pursuant to Notice 2006-79, (4) the proposed regulations will not become effective before 2008, but can be relied on until then; compliance constitutes good-faith compliance with the statute. In addition, Notice 2005-1 remains outstanding until the regulations are finalized.

A complete discussion of the proposed regulations is beyond this article's scope; however, unless further extended, the deadline for formal compliance with Sec. 409A is Jan. 1, 2008. (Good-faith operational compliance has been required since Jan. 1, 2005.) In addition, under the proposed regulations' transition relief and Notice 2006-79, amounts cannot be paid in 2006 or 2007 that otherwise would have been payable in a later year.

Other Guidance

Sec. 409A technical correction on offshore trusts: The Gulf Opportunity Zone Act of 2005 (GO ZoneAct), approved by unanimous consent on Dec. 16, 2005 and signed by President Bush on Dec. 21, 2005, included a technical correction that significantly affects employers using trusts to fund deferred compensation. The correction provides that the Sec. 409A provisions on offshore trusts apply beginning in 2005, regardless of whether the NDC to which the trust relates was subject to Sec. 409A when the assets were contributed to the trust.

Sec. 409A(b)(1) provides that assets set aside in a trust for purposes of paying NDC are treated as Sec. 83 property when they are located outside of the U.S. There is an exception if the assets are held in the jurisdiction in which substantially all of the services to which the NDC relates are performed. Sec. 409A(b)(4) imposes an additional 20% tax on amounts required to be included in gross income under Sec. 409A(b)(1) and, under certain circumstances, an additional tax based on interest at the underpayment rate plus one percentage point.

AJCA Section 885(d) provides that Sec. 409A applies to amounts deferred after 2004. For this purpose, an amount is deferred after Dec. 31, 2004, unless it is fully earned and vested by that date and the plan under which it is deferred is not materially modified after Oct. 3, 2004. Thus, under the AJCA, only assets set aside as to amounts earned or vested after 2004 would be subject to Sec. 409A(b); amounts attributable to deferred compensation earned and vested before then would not be subject to Sec. 409A(b), even if they continued to be held in an offshore trust.

The technical correction provides that, notwithstanding AJCA Section 885(d)(1), Sec. 409A(b) took effect on Jan. 1, 2005. Thus, regardless of whether the related deferred compensation is subject to Sec. 409A, the trust is subject to Sec. 409A(b) and the penalties thereunder.

Example: A U.S. citizen worked for a Japanese corporation throughout Asia from 2000-2004 and earned vested deferred compensation during that time for which assets are held in a rabbi trust outside the U.S. Although the deferred compensation is not subject to Sec. 409A, under the technical correction, amounts not attributable to any services the employee performed in the same jurisdiction as the location of the trust are subject to Sec. 409A(b).

The new effective date also applies to assets held in a trust with financial-health trigger provisions subject to Sec. 409A(b).

Interim guidance on outstanding stock rights under Sec. 409A: Under Sec. 409A, amounts deferred under an NDC plan are included in income when deferred, or, if later, when no longer subject to a substantial risk of forfeiture, unless the plan complies with requirements for timing of elections and distributions, and funding arrangements. The definition of NDC is fairly broad, but the statute, Notice 2005-1 and the proposed regulations provide exceptions for certain arrangements. One such exception is for stock options, stock appreciation rights (SARs) and other stock-based compensation (collectively, stock rights).

To be exempted from Sec. 409A, a stock right must be issued with respect to service-recipient stock, have an exercise price that cannot be less than fair market value (FMV) on the grant date and include no deferral feature. For stock options, the exercise or disposition must be subject to tax under Sec. 83. For SARs to be exempted from Sec. 409A, the amount payable cannot be greater than the difference between the stock's FMV on the grant date and on the exercise date.

FMV determination: To meet...