This two-part article provides an overview of current developments in employee benefits, including executive compensation, welfare benefits, and qualified plans. Part 1 focuses primarily on executive compensation and welfare benefits.

• Author: Walker, Deborah
• Position: Current Developments in Employee Benefits and Pensions, part 1

EXECUTIVE SUMMARY

* Final regulations trader Sec. 409A were released that will become effective as of January 1, 2008. In the interim, taxpayers must operate in "good faith compliance" with the statute, Notice 2005-1, and the six other Sec. 409A notices released by the Service.

* The Service provided guidance on the reporting and wage withholding requirements applicable to nonqualified deferred compensation arrangements for 2005 and 2006 and granted reporting relief for deferrals made in 2006 but not includible in income under Sec. 409A.

* The IRS updated the definition of covered employee under Sec.162(m)(3) to reflect the changes made by the SEC to the list of officers covered by the Exchange Act disclosure requirements.

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This two-part article covers significant developments in late 2006 and 2007 in employee benefits, including executive compensation, welfare benefits, and qualified plans. Part I, below, focuses on new guidance regarding executive compensation and welfare benefits. Part II, in the December 2007 issue, will focus on updates and changes to the rules for qualified retirement plans.

Executive Compensation

Sec. 409A Guidance

One of the most important pieces of executive compensation guidance released this year involved Sec. 409A, originally enacted as part of the American Jobs Creation Act of 2004 (AJCA). (1)

Final regs.: The IRS released final regulations under Sec. 409A on April 10, 2007 (TD 9321); they will become effective as of January 1, 2008. In the interim, taxpayers must operate in "good faith compliance" with the statute, Notice 2005-1, and the six other Sec. 409A notices released by the Service. (2) (See suggestions for complying with the regulations in the box at the end of this article.) Compliance with either the proposed or final regulations is not required but constitutes good-faith compliance. There are several important differences between the existing guidance and final regulations:

* The definition of "service recipient stock" has been expanded, giving service recipients additional flexibility to determine the stock on which they grant equity rights.

* Extending the exercise period of equity rights will not be treated as the addition of an impermissible deferral feature, as long as the extended expiration date does not go beyond the earlier of 10 years from the date of grant or the end of the original maximum term of the option. As before, there are no restrictions on the extension of underwater equity rights.

* The regulations clarify when a reimbursement arrangement or an arrangement for in-kind benefits does not provide for a deferral of compensation (and thus is not subject to Sec. 409A), and how such arrangements that do defer compensation can comply with Sec. 409A payment timing roles.

* The regulations revise rules on what constitutes a payment, a change in payment, or permissible delays in payment. The changes provide additional flexibility and reduce the likelihood that an unanticipated or inadvertent delay will result in income inclusion and additional tax under Sec. 409A.

* The short-term deferral exception to Sec. 409A coverage exempts compensation paid no later than 2 1/2 months after the end of the year in which the service provider's rights become vested. The final regulations clarify that this exception applies only to arrangements that do not provide for payment outside the short-term deferral period under any circumstances. The preamble notes that if a short-term deferral plan is in writing and specifies that payment will be made during the first 2 1/2 months of the year following vesting, the rules on timely payment will allow it to be paid at any time during that year. Related guidance provides that payments to be made only on involuntary termination or on voluntary termination under a window program or for "good reason" are not vested. As a result of the changes, the short-term deferral exception becomes applicable in more situations. For example, payments that become available only on an involuntary severance may be made without the six-month delay applicable to specified employees, even if other payments to the same individual are subject to the delay.

* The final regulations permit service recipients to devise alternative methods of identifying employees for whom distributions must be delayed for six months, provided the chosen method is reasonably likely to identify everyone who falls within the statutory definition of "specified employee" (which looks to the definition of "key employee" under Sec. 416) and not more than 200 employees are identified. Many employers were concerned that the classification of an employee as a specified employee could later be determined to be erroneous, resulting in inadvertent violations of Sec. 409A distribution rules (either through failure to observe the six-month delay for specified employees or improper postponement of distributions to specified employees). The final regulations make greater certainty possible.

* Certain "involuntary separation" payments are excepted from the rules of Sec. 409A. The final regulations provide that termination under a "good reason" provision can be an involuntary separation from service, possibly exempting related payments, if the "good reason" provision is not intended to avoid Sec. 409A. They also include a safe-harbor definition of "good reason" Payments on account of involuntary separation may be exempt from Sec. 409A if limitations on the amount and distribution period are met. This exemption makes it possible to make some payments to specified employees during the six-month period after severance from employment.

* Previous guidance under Sec. 409A required that payments from all similar plans be aggregated if a plan failed to meet distribution, acceleration, election, or funding rules. The final regulations retain this general rule but increase the aggregation categories from four to nine. (3) The increase in the number of these groups will limit the additional Sec. 409A tax to lesser amounts of compensation in the event payments do not conform to the rules.

Withholding guidance: The IRS issued Notice 2006-100 (4) to provide guidance on the reporting and wage withholding requirements applicable to nonqualified deferred compensation (NQDC) for 2005 and 2006. The notice granted reporting relief in 2006 for deferrals not includible in income under Sec. 409A. As a result, service recipients did not need to use Code Y in box 12 of Form W-2, Wage and Tax Statement, or box 15a of Form 1099-MISC, Miscellaneous Income, to report amounts deferred under NQDC plans in 2006. This relief did not extend to amounts includible in income as a result of Sec. 409A violations in 2005 or 2036. Therefore, service recipients were required to report this income on Form W-2 (using Code Z in box 12) or Form 1099-MISC (using box 15b) for 2005 or 2006. (5)

Notice 2006-100 confirmed that withholding is not required for the 20% additional tax on income attributable to Sec. 409A violations and that, if interest is required to be added to the amount due, it is calculated from the latest of January 1, 2005, the year amounts were deferred, or the year in which they are no longer subject to a substantial risk of forfeiture.

The final regulations did not contain reporting or withholding guidance; the preamble noted that the IRS would address those topics in the future.

Option granting practices: In late 2006, congressional hearings were held on option backdating. Options are considered backdated when the exercise price is established based on the stock's fair market value (FMV) at a date earlier than the grant date rather than the stock's FMV on the grant date. Government regulators viewed the practice as providing employees with advantages not available to other investors. In addition, options often had to be expensed for accounting purposes after it was determined that they were backdated. This changed the tax deduction associated with the options grant and created specific tax issues under the incentive stock option and NQDC provisions of the Code.

The issue of backdating (or misdating) options has increased focus on what constitutes the "grant date" The determination of the grant date is a facts-and-circumstances test, and...