[Federal Register Volume 70, Number 191 (Tuesday, October 4, 2005)]
[Proposed Rules]
[Pages 57930-57984]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-19379]
[[Page 57929]]
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Part II
Department of the Treasury
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Internal Revenue Service
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26 CFR Part 1
Application of Section 409A to Nonqualified Deferred Compensation
Plans; Proposed Rule
Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 /
Proposed Rules
[[Page 57930]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-158080-04]
RIN 1545-BE79
Application of Section 409A to Nonqualified Deferred Compensation
Plans
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations regarding the
application of section 409A to nonqualified deferred compensation
plans. The regulations affect service providers receiving amounts of
deferred compensation, and the service recipients for whom the service
providers provide services. This document also provides a notice of
public hearing on these proposed regulations.
DATES: Written or electronic comments must be received by January 3,
2006. Outlines of topics to be discussed at the public hearing
scheduled for January 25, 2006, must be received by January 4, 2006.
ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-158080-04), room
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand-delivered Monday through
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
158080-04), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue, NW., Washington, DC or sent electronically, via the IRS
Internet site at www.irs.gov/regs or via the Federal eRulemaking Portal
at www.regulations.gov (IRS REG-158080-04). The public hearing will be
held in the Auditorium, Internal Revenue Building, 1111 Constitution
Avenue, NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Stephen Tackney, at (202) 927-9639; concerning submissions of comments,
the hearing, and/or to be placed on the building access list to attend
the hearing, Richard A. Hurst at (202) 622-7116 (not toll-free
numbers).
SUPPLEMENTARY INFORMATION:
Background
Section 409A was added to the Internal Revenue Code (Code) by
section 885 of the American Jobs Creation Act of 2004, Public Law 108-
357 (118 Stat. 1418). Section 409A generally provides that unless
certain requirements are met, amounts deferred under a nonqualified
deferred compensation plan for all taxable years are currently
includible in gross income to the extent not subject to a substantial
risk of forfeiture and not previously included in gross income. Section
409A also includes rules applicable to certain trusts or similar
arrangements associated with nonqualified deferred compensation, where
such arrangements are located outside of the United States or are
restricted to the provision of benefits in connection with a decline in
the financial health of the sponsor.
On December 20, 2004, the IRS issued Notice 2005-1 (2005-2 I.R.B.
274 (published as modified on January 6, 2005)), setting forth initial
guidance with respect to the application of section 409A, and supplying
transition guidance in accordance with the terms of the statute. Notice
2005-1 requested comments on all aspects of the application of Section
409A, including certain specified topics. Numerous comments were
submitted and all were considered by the Treasury Department and the
IRS in formulating these regulations. In general, these regulations
incorporate the guidance provided in Notice 2005-1 and provide
substantial additional guidance. For a discussion of the continued
applicability of Notice 2005-1, see the Effect on Other Documents
section of this preamble.
Explanation of Provisions
I. Definition of Nonqualified Deferred Compensation Plan
A. In General
Section 409A applies to amounts deferred under a nonqualified
deferred compensation plan. For this purpose a nonqualified deferred
compensation plan means any plan that provides for the deferral of
compensation, with specified exceptions such as qualified retirement
plans, tax-deferred annuities, simplified employee pensions, SIMPLEs
and section 501(c)(18) trusts. In addition, section 409A does not apply
to certain welfare benefit plans, including bona fide vacation leave,
sick leave, compensatory time, disability pay, and death benefit plans.
In certain instances, these regulations cross reference the
regulations under section 3121(v)(2), which provide a special timing
rule under the Federal Insurance Contributions Act (FICA) for
nonqualified deferred compensation, as defined in section 3121(v)(2)
and the regulations thereunder. However, unless explicitly cross-
referenced in these regulations, the regulations under section
3121(v)(2) do not apply for purposes of section 409A and under no
circumstances do these proposed regulations affect the application of
section 3121(v)(2).
B. Section 457 Plans
Section 409A does not apply to eligible deferred compensation plans
under section 457(b). However, section 409A applies to nonqualified
deferred compensation plans to which section 457(f) applies, separately
and in addition to the requirements applicable to such plans under
section 457(f). Section 409A(c) provides that nothing in section 409A
prevents the inclusion of amounts in gross income under any other
provision of the Code. Section 409A(c) further provides that any amount
included in gross income under section 409A will not be required to be
included in gross income under any other Code provision later than the
time provided in section 409A. Accordingly, if in a taxable year an
amount subject to section 409A (but not required to be included in
income under section 409A) is required to be included in gross income
under section 457(f), that amount must be included in gross income
under section 457(f) for that taxable year. Correspondingly, if in a
taxable year an amount that would otherwise be required to be included
in gross income under section 457(f) has been included previously in
gross income under section 409A, that amount will not be required to be
included in gross income under section 457(f) for that taxable year.
These proposed regulations are intended solely as guidance with
respect to the application of section 409A to such arrangements, and
should not be relied upon with respect to the application of section
457(f). Thus, State and local government and tax exempt entities may
not rely upon the definition of a deferral of compensation under Sec.
1.409A-1(b) of these proposed regulations in applying section 457(f).
For example, for purposes of section 457(f), a deferral of compensation
includes a stock option and an arrangement in which an employee or
independent contractor of a state or local government or tax-exempt
entity earns the right to future payments for services, even if those
amounts are paid immediately upon vesting and would qualify for the
exclusion from the definition of deferred compensation under Sec.
1.409A-1(b)(5) of these proposed regulations. However, until further
guidance is issued, State and
[[Page 57931]]
local government and tax exempt entities may rely on the definitions of
bona fide vacation leave, sick leave, compensatory time, disability
pay, and death benefit plans for purposes of section 457(f) as
applicable for purposes of applying section 409A and Sec. 1.409A-
1(a)(4) of these proposed regulations to nonqualified deferred
compensation plans under section 457(f).
C. Arrangements With Independent Contractors
Consistent with Notice 2005-1, Q&A-8, these regulations exclude
from coverage under section 409A certain arrangements between service
providers and service recipients. Under these regulations, amounts
deferred in a taxable year with respect to a service provider using an
accrual method of accounting for that year are not subject to section
409A. In addition, section 409A generally does not apply to amounts
deferred pursuant to an arrangement between a service recipient and an
unrelated independent contractor (other than a director of a
corporation), if during the independent contractor's taxable year in
which the amount is deferred, the independent contractor is providing
significant services to each of two or more service recipients that are
unrelated, both to each other and to the independent contractor. In
response to comments, these regulations clarify that the determination
is made based upon the independent contractor's taxable year in which
the amount is deferred.
Commentators also requested clarification of the circumstances in
which services to each service recipient will be deemed to be
significant, as required for the exclusion. Determining whether
services provided to a service recipient are significant generally will
involve an examination of all relevant facts and circumstances.
However, two clarifications have been provided. First, the analysis
applies separately to each trade or business in which the service
provider is engaged. For example, a taxpayer providing computer
programming services for one service recipient will not meet the
exception if, as a separate trade or business, the taxpayer paints
houses for another unrelated service recipient. To provide certainty to
many independent contractors engaged in an active trade or business
with multiple service recipients, a safe harbor has been provided under
which an independent contractor with multiple unrelated service
recipients, to whom the independent contractor also is not related,
will be treated as providing significant services to more than one of
those service recipients, if not more than 70 percent of the total
revenue generated by the trade or business in the particular taxable
year is derived from any particular service recipient (or group of
related service recipients).
Commentators also requested clarification with respect to the
application of section 409A to directors. As provided in these
regulations, an individual will not be excluded from coverage under
section 409A merely because the individual provides services as a
director to two or more unrelated service recipients. However, the
provisions of section 409A apply separately to arrangements between the
service provider director and each service recipient. Accordingly, the
inclusion of income due to a failure to meet the requirements of
section 409A with respect to an arrangement to serve as a director of
one service recipient will not cause an inclusion of income with
respect to arrangements to serve as a director of an unrelated service
recipient. In addition, the continuation of services as a director with
one service recipient will not cause the termination of services as a
director with an unrelated service recipient to fail to constitute a
separation from service for purposes of section 409A, if the
termination would otherwise qualify as a separation from service.
Commentators also requested clarification with respect to the
application of the rule to directors who are also employees of the
service recipient. In general, the provisions of section 409A will
apply separately to the arrangements between the service recipient and
the service provider for services as a director and the arrangements
between the service recipient and the service provider for services as
an employee. However, the distinction is not intended to permit
employee directors to limit the aggregation of arrangements in which
the individual participates as an employee by labeling such
arrangements as arrangements for services as a director. Accordingly,
an arrangement with an employee director will be treated as an
arrangement for services as a director only to the extent that another
non-employee director defers compensation under the same, or a
substantially similar, arrangement on similar terms. Moreover, the
separate application of section 409A to arrangements for services as a
director and arrangements for services as an employee does not extend
to a service provider's services for the service recipient as an
independent contractor in addition to the service provider's services
as a director of the service recipient. Under those circumstances, both
arrangements are treated as services provided as an independent
contractor.
Commentators also requested clarification of the application of the
exclusion to independent contractors who provide services to only one
service recipient, when that service recipient itself has multiple
clients. Specifically a commentator requested that the rule be applied
on a look through basis, so that the independent contractor will be
deemed to be providing services for multiple service recipients. The
Treasury Department and the IRS do not believe that such a rule is
appropriate. Where multiple persons have come together and formed an
entity that is itself a service recipient of the independent
contractor, the independent contractor is performing services for the
single entity service recipient.
The Treasury Department and the IRS believe that where the service
recipient is purchasing an independent contractor's management
services, amounts deferred with respect to the independent contractor's
performance of services should not be excluded from coverage under
section 409A. Among the many objectives underlying the enactment of
section 409A is to limit the ability of a service provider to retain
the benefits of the deferral of compensation while having excessive
control over the timing of the ultimate payment. Where the independent
contractor is managing the service recipient, there is a significant
potential for the independent contractor to have such influence or
control over compensation matters so that categorical exclusion from
coverage under section 409A is not appropriate. Accordingly, the
regulations provide that compensation arrangements between an
independent contractor and a service recipient that involve the
provision of management services are not excluded from coverage under
section 409A, and in such cases, the service recipient is not treated
as unrelated for purposes of determining whether arrangements with
other service recipients are excluded from coverage under section 409A
under the general rule addressing independent contractors providing
services to multiple unrelated service recipients. For this purpose,
management services include services involving actual or de facto
direction or control of the financial or operational aspects of the
client's trade or business, or investment advisory services that are
integral to the trade or business of a service recipient whose primary
trade or business involves the management of
[[Page 57932]]
investments in entities other than the entities comprising the service
recipient, such as a hedge fund or real estate investment trust.
II. Definition of Nonqualified Deferred Compensation
A. In General
Consistent with Notice 2005-1, Q&A-4, these regulations provide
that a plan provides for the deferral of compensation only if, under
the terms of the plan and the relevant facts and circumstances, the
service provider has a legally binding right during a taxable year to
compensation that has not been actually or constructively received and
included in gross income, and that, pursuant to the terms of the plan,
is payable to (or on behalf of) the service provider in a later year. A
legally binding right to compensation may exist even where the right is
subject to conditions, including conditions that constitute a
substantial risk of forfeiture. For example, an employee that in Year 1
is promised a bonus equal to a set percentage of employer profits, to
be paid out in Year 3 if the employee has remained in employment
through Year 3, has a legally binding right to the payment of the
compensation, subject to the conditions being met. The right thus may
be subject to a substantial risk of forfeiture, and accordingly be
nonvested; however, the promise constitutes a legally binding right
subject to a condition.
In contrast, a service provider does not have a legally binding
right to compensation if that compensation may be unilaterally reduced
or eliminated by the service recipient or other person after the
services creating the right to the compensation have been performed.
Notice 2005-1, Q&A-4 provides that, if the facts and circumstances
indicate that the discretion to reduce or eliminate the compensation is
available or exercisable only upon a condition that is unlikely to
occur, or the discretion to reduce or eliminate the compensation is
unlikely to be exercised, a service provider will be considered to have
a legally binding right to the compensation. Commentators criticized
the provision as being difficult to apply, because the standard is too
vague, requiring a subjective judgment as to whether the discretion is
likely to be exercised. The intent of this provision was to eliminate
the possibility of taxpayers avoiding the application of section 409A
through the use of plan provisions providing negative discretion, where
such provisions are not meaningful. In response to the comments, these
regulations adopt a standard under which the negative discretion will
be recognized unless it lacks substantive significance, or is available
or exercisable only upon a condition. Thus, where a promise of
compensation may be reduced or eliminated at the unfettered discretion
of the service recipient, that promise generally will not result in a
legally binding right to compensation. However, where the negative
discretion lacks substantive significance, or the discretion is
available or exercisable only upon a condition, the discretion will be
ignored and the service provider will be treated as having a legally
binding right. In addition, where the service provider has control
over, or is related to, the person granted the discretion to reduce or
eliminate the compensation, or has control over all or any portion of
such person's compensation or benefits, the discretion also will be
ignored and the service provider will be treated as having a legally
binding right to the compensation.
B. Short-Term Deferrals
Notice 2005-1, Q&A-4(c), set forth an exception from coverage under
section 409A under which certain arrangements, referred to as short-
term deferrals, would not be treated as resulting in the deferral of
compensation. Specifically, Notice 2005-1, Q&A-4 provided that until
further guidance a deferral of compensation would not occur if, absent
an election to otherwise defer the payment to a later period, at all
times the terms of the plan require payment by, and an amount is
actually or constructively received by the service provider by, the
later of (i) the date that is 2\1/2\ months from the end of the service
provider's first taxable year in which the amount is no longer subject
to a substantial risk of forfeiture, or (ii) the date that is 2\1/2\
months from the end of the service recipient's year in which the amount
is no longer subject to a substantial risk of forfeiture. For these
purposes, an amount that is never subject to a substantial risk of
forfeiture is considered to be no longer subject to a substantial risk
of forfeiture on the date the service provider first has a legally
binding right to the amount. Under this rule, many multi-year bonus
arrangements that require payments promptly after the amount vests
would not be subject to section 409A.
The exception from coverage under section 409A for short-term
deferrals set forth in Notice 2005-1, Q&A-4, has been incorporated into
these proposed regulations. Commentators questioned whether a written
provision in the arrangement requiring the payment to be made by the
relevant deadline is necessary, or whether the customary practice of
the service recipient is sufficient. These regulations do not require
that the arrangement provide in writing that the payment must be made
by the relevant deadline. Accordingly, where an arrangement does not
otherwise defer compensation, an amount will qualify as a short-term
deferral, and not be subject to section 409A, if the amount is actually
paid out by the appropriate deadline. However, where an arrangement
does not provide in writing that a payment must be paid by a specified
date on or before the relevant deadline, and the payment is not made by
the appropriate deadline (except due to unforeseeable administrative or
solvency issues, as discussed below), the payment will result in
automatic violation of section 409A due to the failure to specify the
payment date or a permissible payment event. In addition, the rules
permitting the service recipient limited discretion to delay payments
of amounts subject to section 409A (for example, where the service
recipient reasonably anticipates that payment of the amount would not
be deductible due to application of section 162(m), or where the
service recipient reasonably anticipates that payment of the amount
would violate a loan covenant or similar contractual provision) would
not be available, because the arrangement would not have specified a
payment date subject to the delay. In contrast, where an arrangement
provides in writing that a payment must be made by a specified date on
or before the relevant deadline, and the payment is not made by the
appropriate deadline so that section 409A becomes applicable, the rules
contained in these regulations generally permitting the payment to be
made in the same calendar year as the fixed payment date become
applicable. In addition, the rules permitting a plan to provide for a
delay in the payment in certain circumstances and the relief applicable
to disputed payments and refusals to pay would also be available.
Accordingly, it will often be appropriate to include a date or year for
payment even when it is intended that the payment will be made within
the short-term deferral period.
The short-term deferral rule does not provide a method to avoid
application of section 409A if the legally binding right creates a
right to deferred compensation from the outset. For example, if a
legally binding right to payment in Year 10 arises in Year 1, but the
right is subject to a substantial risk
[[Page 57933]]
of forfeiture through Year 3, paying the amount at the end of Year 3
would not result in the payment failing to be subject to section 409A,
but rather generally would be an impermissible acceleration of the
payment from the originally established right to payment in year 10.
Commentators also questioned whether the 2\1/2\ month deadline for
payment could be extended where the payment was not administratively
practicable, or where the payment was made late due to error. These
regulations provide that a payment made after the 2\1/2\ month deadline
may continue to be treated as meeting the requirements of the exception
from the definition of a deferral of compensation if the taxpayer
establishes that it was impracticable, either administratively or
economically, to avoid the deferral of the receipt by a service
provider of the payment beyond the applicable 2\1/2\ month period and
that, as of the time the legally binding right to the amount arose,
such impracticability was unforeseeable, and the payment is made as
soon as practicable. Some commentators had asked for a rule permitting
delays due to unintentional error to satisfy the standard for the
exclusion. However, the exception is based upon the longstanding
position set forth in Sec. 1.404(b)-1T, Q&A-2(b) regarding the timing
of the deduction with respect to a payment under a nonqualified
deferred compensation plan. Similar to the deduction rule, the
exclusion from coverage under section 409A treats a payment made within
the appropriate 2\1/2\ month period as made within such a short period
following the date the substantial risk of forfeiture lapses that it
may be treated as paid when earned (and not deferred to a subsequent
period). Also similar to the rule governing the timing of deductions,
the exclusion from coverage under section 409A permits only limited
exceptions to the requirement that the amount actually be paid by the
relevant deadline. Pending further study, the Treasury Department and
the IRS believe that providing further flexibility with respect to
meeting the deadline would create the potential for abuse and
enforcement difficulty.
C. Stock Options and Stock Appreciation Rights
In General
The legislative history states that section 409A does not cover
grants of stock options where the exercise price can never be less than
the fair market value of the underlying stock at the date of grant (a
non-discounted option). See H.R. Conf. Rept. No. 108-755, at 735
(2004). Thus an option with an exercise price that is or may be below
the fair market value of the underlying stock at the date of grant (a
discounted option) is subject to the requirements of section 409A.
Consistent with the legislative history and with Notice 2005-1, Q&A-4,
these regulations provide that a non-discounted stock option, that has
no other feature for the deferral of compensation, generally is not
covered by section 409A. However, a stock option granted with an
exercise price below the fair market value of the underlying shares of
stock on the date of grant generally would be subject to section 409A
except to the extent the terms of the option only permit exercise of
the option during the short-term deferral period.
Commentators stressed that in many respects, a stock appreciation
right can be the economic equivalent of a stock option, especially a
stock option that allows the holder to exercise in a manner other than
by the payment of cash (a cashless exercise feature). Accordingly,
Notice 2005-1, Q&A-4 exempted from coverage certain non-discounted
stock appreciation rights that most closely resembled stock options--
stock appreciation rights settled in stock. The Treasury Department and
the IRS were concerned that the manipulation of the purported stock
valuation for purposes of determining whether the stock appreciation
right was issued at a discount or settled at a premium could lead to a
stock appreciation right being used to circumvent section 409A.
Accordingly, the exception was limited to stock appreciation rights
issued with respect to stock traded on an established securities
market.
Commentators criticized the distinction between public corporations
and non-public corporations, asserting that this distinction is not
meaningful and unfairly discriminated against the latter corporations
and placed such corporations at a severe competitive disadvantage. In
addition, commentators questioned whether the distinction between
stock-settled and cash-settled stock appreciation rights was relevant,
where the amount of income generated would be identical.
In response to the comments, these regulations treat stock
appreciation rights similarly to stock options, regardless of whether
the stock appreciation right is settled in cash and regardless of
whether the stock appreciation right is based upon service recipient
stock that is not readily tradable on an established securities market.
The Treasury Department and the IRS remain concerned that manipulation
of stock valuations, and manipulation of the characteristics of the
underlying stock, may lead to abuses with respect to stock options and
stock appreciation rights (collectively referred to as stock rights).
To that end, these regulations contain more detailed provisions with
respect to the identification of service recipient stock that may be
subject to, or used to determine the amount payable under, stock rights
excluded from the application of section 409A, and the valuation of
such service recipient stock, discussed below.
2. Definition of Service Recipient Stock
The legislative history of section 409A states that the exception
from coverage under section 409A for certain nonstatutory stock options
was intended to cover options granted on service recipient stock. H.R.
Conf. Rept. No. 108-755, at 735 (2004). Section 409A(d)(6) provides
that, for purposes of determining the identity of the service recipient
under section 409A, aggregation rules similar to the rules in section
414(b) and (c) apply. Taxpayers requested that the definition of
service recipient be expanded for purposes of the exception for stock
rights to cover entities that would not otherwise be treated as part of
the service recipient applying the rules under section 414(b) and (c).
The Treasury Department and the IRS agree that the exclusion for
nonstatutory stock rights was not meant to apply so narrowly.
Accordingly, for purposes of the provisions excluding certain stock
rights on service recipient stock, the stock right, or the plan or
arrangement under which the stock right is granted, may provide that
section 414(b) and (c) be applied by modifying the language and using
``50 percent'' instead of ``80 percent'' where appropriate, such that
stock rights granted to employees of entities in which the issuing
corporation owns a 50 percent interest generally will not be subject to
section 409A.
Commentators also requested that the threshold be dropped below 50
percent to cover joint ventures and other similar arrangements, where
the participating corporation does not have a majority interest. These
regulations provide for such a lower threshold, allowing for the stock
right, or the plan or arrangement under which the stock right is
granted, to provide for the modification of the language and use of
``20 percent'' instead of ``80 percent'' in applying section 414(b) and
(c), where the use of such stock with respect to stock rights is due to
legitimate business criteria. For example, the use of such stock with
[[Page 57934]]
respect to stock rights issued to employees of a joint venture that
were former employees of a corporation with at least a 20 percent
interest in the joint venture generally would be due to legitimate
business criteria, and accordingly would be treated as service
recipient stock for purposes of determining whether the stock right was
subject to section 409A. A designation by a service recipient to use
either the 50 percent or the 20 percent threshold must be applied
consistently to all compensatory stock rights, and any designation of a
different permissible ownership threshold percentage may not be made
effective until 12 months after the adoption of such change.
The increased ability to issue stock rights with respect to a
related corporation for whom the service provider does not directly
perform services could increase the potential for service recipients to
exploit the exclusion for certain stock rights by establishing a
corporation within the group of related corporations, the purpose of
which is to serve as an investment vehicle for nonqualified deferred
compensation. Accordingly, these regulations provide that other than
with respect to service providers who are primarily engaged in
providing services directly to such corporation, the term service
recipient for purposes of the definition of service recipient stock
does not include a corporation whose primary purpose is to serve as an
investment vehicle with respect to the corporation's interest in
entities other than the service recipient (including entities
aggregated with the corporation under the definition of service
recipient incorporating section 414(b) and (c)).
Commentators also questioned whether the exception for certain
stock rights could apply where a service recipient provides a stock
right with respect to preferred stock or a separate class of common
stock. The Treasury Department and the IRS believe this exception was
intended to cover stock rights with respect to service recipient stock
the fair market value of which meaningfully relates to the potential
future appreciation in the enterprise value of the corporation. The use
of a separate class of common stock created for the purpose of
compensating service providers, or the use of preferred stock with
substantial characteristics of debt, could create an arrangement that
more closely resembles traditional nonqualified deferred compensation
arrangements rather than an interest in appreciation of the value of
the service recipient. An exception that excluded these arrangements
from coverage under section 409A would undermine the effectiveness of
the statute to govern nonqualified deferred compensation arrangements,
contrary to the legislative intent. Accordingly, these regulations
clarify that service recipient stock includes only common stock, and
only the class of common stock that as of the date of grant has the
highest aggregate value of any class of common stock of the corporation
outstanding, or a class of common stock substantially similar to such
class of stock (ignoring differences in voting rights). In addition,
service recipient stock does not include any stock that provides a
preference as to dividends or liquidation rights.
With respect to the foreign aspects of such arrangements,
commentators requested clarification that service provider stock may
include American Depositary Receipts (ADRs). These regulations clarify
that stock of the service recipient may include ADRs, provided that the
stock to which the ADRs relate would otherwise qualify as service
recipient stock.
Commentators also requested that certain equity appreciation rights
issued by mutual companies, intended to mimic stock appreciation
rights, be excluded from coverage under section 409A. These regulations
expand the exclusion for stock appreciation rights to include equity
appreciation rights with respect to mutual company units. A mutual
company unit is defined as a specified percentage of the fair market
value of the mutual company. For this purpose, a mutual company may
value itself under the same provisions applicable to the valuation of
stock of a corporation that is not readily tradable on an established
securities market. The Treasury Department and the IRS request comments
as to the practicability of this provision, and whether such a
provision should be expanded to cover equity appreciation rights issued
by other entities that do not have outstanding shares of stock.
3. Valuation
Notice 2005-1, Q&A-4(d)(ii) provides that for purposes of
determining whether the requirements for exclusion of a nonstatutory
stock option have been met, any reasonable valuation method may be
used. Commentators expressed concern that the standard was too vague,
given the potential consequences of a failure to comply with the
requirements of section 409A.
These regulations provide that with respect to service recipient
stock that is readily tradable on an established securities market, a
valuation of such stock may be based on the last sale before or the
first sale after the grant, or the closing price on the trading day
before or the trading day of the grant, or any other reasonable basis
using actual transactions in such stock as reported by such market and
consistently applied. Commentators pointed out that certain service
recipients, generally corporations in certain foreign jurisdictions,
would not be able to meet this requirement because the service
recipient is subject to foreign laws requiring pricing based on an
average over a period of time. To allow compliance with these
requirements, these regulations further provide that service recipients
(including U.S. service recipients) may set the exercise price based on
an average of the price of the stock over a specified period provided
such period occurs within the 30 days before and 30 days after the
grant date, and provided further that the terms of the grant are
irrevocably established before the beginning of the measurement period
used to determine the exercise price.
Commentators asked for clarification of the definition of stock
that is readily tradable on an established securities market.
Specifically, commentators requested clarification of the scope of an
established securities market, and whether that term includes over-the-
counter markets and foreign markets. The regulations adopt the
definition of an established securities market set forth in Sec.
1.897-1(m). Under that definition, over-the-counter markets generally
are treated as established securities markets, as well as many foreign
markets. However, the stock must also be readily tradable within such
markets to qualify as stock readily tradable on an established
securities market.
With respect to corporations whose stock is not readily tradable on
an established securities market, these regulations provide that fair
market value may be determined through the reasonable application of a
reasonable valuation method. The regulations contain a description of
the factors that will be taken into account in determining whether a
given valuation method is reasonable. In addition, in an effort to
provide more certainty, certain presumptions with respect to the
reasonableness of a valuation method have been set forth. Provided one
such method is applied reasonably and used consistently, the valuation
determined by applying such method will be presumed to equal the fair
market value of the stock, and such presumption will be rebuttable only
by a showing that the valuation is grossly unreasonable. A method will
be treated as used consistently where the same method is used for all
equity-based compensation
[[Page 57935]]
granted to service providers by the service recipient, including for
purposes of determining the amount due upon exercise or repurchase
where the stock acquired is subject to an obligation of the service
recipient to repurchase, or a put or call right providing for the
potential repurchase by the service recipient, as applicable.
Commentators specifically requested clarification as to whether a
valuation method based upon an appraisal will be treated as reasonable,
and if so with respect to what period. These regulations provide that
the use of an appraisal will be presumed reasonable if the appraisal
satisfies the requirements of the Code with respect to the valuation of
stock held in an employee stock ownership plan. If those requirements
are satisfied, the valuation will be presumed reasonable for a one-year
period commencing on the date as of which the appraisal values the
stock.
Commentators also specifically requested clarification of whether a
valuation method based on a nonlapse restriction addressed in Sec.
1.83-5(a) will be treated as reasonable. Under Sec. 1.83-5(a), in the
case of property subject to a nonlapse restriction (as defined in Sec.
1.83-3(h)), the price determined under the formula price is considered
to be the fair market value of the property unless established to the
contrary by the Commissioner, and the burden of proof is on the
Commissioner with respect to such value. If stock in a corporation is
subject to a nonlapse restriction that requires the transferee to sell
such stock only at a formula price based on book value, a reasonable
multiple of earnings or a reasonable combination thereof, the price so
determined ordinarily is regarded as determinative of the fair market
value of such property for purposes of section 83.
The Treasury Department and the IRS do not believe that this
standard, in and of itself, is appropriate with respect to the
application of section 409A. The Treasury Department and the IRS are
not confident that a formula price determined pursuant to a nonlapse
restriction will, in every case, adequately approximate the value of
the underlying stock. The Treasury Department and the IRS are also
concerned that such formula valuations, in the absence of other
criteria, may be subject to manipulation or to the provision of
predictable results that are inconsistent with a true equity
appreciation right. Further, the Treasury Department and the IRS do not
believe that the burden of proof with respect to valuation should be
shifted to the Commissioner in all cases where such formulas have been
utilized. Accordingly, the use of a valuation method based on a
nonlapse restriction that meets the requirements of Sec. 1.83-5(a)
does not by itself result in a presumption of reasonableness. However,
where the method is used consistently for both compensatory and
noncompensatory purposes in all transactions in which the service
recipient is either the purchaser or seller of such stock, such that
the nonlapse restriction formula acts as a substitute for the value of
the underlying stock, the formula will qualify for the presumption that
the valuation method is reasonable for purposes of section 409A. In
addition, depending on the facts and circumstances of the individual
case, the use of a nonlapse restriction to determine value may be
reasonable, taking into account other relevant valuation criteria.
Commentators also expressed concern about the valuation of illiquid
stock of certain start-up corporations. These commentators argued that
the value of such stock is often highly speculative, rendering
appraisals of limited value. Commentators also noted that such stock
often is not subject to put rights or call rights that could be viewed
as a nonlapse restriction. Given the illiquidity and speculative value,
commentators argued that the risk that taxpayers would use rights on
such shares as a device to pay deferred compensation is low. In
response, these regulations propose additional conditions under which
the valuation of illiquid stock in a start-up corporation will be
presumed to be reasonable. A valuation of an illiquid stock of a start-
up corporation will be presumed reasonable if the valuation is made
reasonably and in good faith and evidenced by a written report that
takes into account the relevant factors prescribed for valuations
generally under these regulations. For this purpose, illiquid stock of
a start-up corporation refers to service recipient stock of a service
recipient that is in the first 10 years of the active conduct of a
trade or business and has no class of equity securities that are traded
on an established securities market, where such stock is not subject to
any put or call right or obligation of the service recipient or other
person to purchase such stock (other than a right of first refusal upon
an offer to purchase by a third party that is unrelated to the service
recipient or service provider), provided that this rule does not apply
to the valuation of any stock if the service recipient or service
provider reasonably may anticipate, as of the time the valuation is
applied, that the service recipient will undergo a change in control
event or participate in a public offering of securities within the 12
months following the event to which the valuation is applied (for
example, the grant date of an award). A valuation will not be treated
as made reasonably and in good faith unless the valuation is performed
by a person or persons with significant knowledge and experience or
training in performing similar valuations.
As stated in the preamble to Notice 2005-1, the Treasury Department
and the IRS are concerned about the treatment of stock rights where the
service recipient is obligated to repurchase the stock acquired
pursuant to the stock right, or the service provider retains a put or
call right with respect to the stock. Where the service provider
retains such a right, the ability to receive a purchase price that
differs from the fair market value of the stock could be used to
circumvent the application of section 409A. Accordingly, these
regulations generally require that where someone is obligated to
purchase the stock received upon the exercise of a stock right, or the
stock is subject to a put or call right, the purchase price must also
be set at fair market value, the determination of which is also subject
to the consistency requirements for the methods used in determining
fair market value.
4. Modification
Commentators asked under what conditions a modification, extension,
or renewal of a stock right will be treated as a new grant. The
treatment as a new grant is relevant because although the original
grant may have been excluded from coverage under section 409A, if the
new grant has an exercise price that is less than the fair market value
of the underlying stock on the date of the new grant, the new grant
would not qualify for the exclusion from coverage under section 409A.
Accordingly, the regulations set forth rules governing the types of
modifications, extensions or renewals that will result in treatment as
a new grant. The regulations provide that the term modification means
any change in the terms of the stock right that may provide the holder
of the right with a direct or indirect reduction in the exercise price
of the stock right, or an additional deferral feature, or an extension
or renewal of the stock right, regardless of whether the holder in fact
benefits from the change in terms. Under this definition, neither the
addition of a provision permitting the transfer of the stock right nor
a provision permitting the service provider to exchange the stock right
for
[[Page 57936]]
a cash amount equal to the amount that would be available if the stock
right were exercised would be modifications of the stock right. In
addition, these regulations explicitly provide that both a change in
the terms of a stock right to allow for payment of the exercise price
through the use of pre-owned stock, and a change in the terms of a
stock right to facilitate the payment of employment taxes or required
withholding taxes resulting from the exercise of the right, are not
treated as modifications of the stock right for purposes of section
409A.
Generally, a change to the exercise price of the stock right (other
than in connection with certain assumptions or substitutions of a stock
right in connection with a corporate transaction or certain adjustments
resulting from a stock split, stock dividend or similar change in
capitalization) is treated as a modification, resulting in a new grant
that may be excluded from section 409A if it satisfies the requirements
in these regulations as of the new grant date. However, depending upon
the facts and circumstances, a series of repricings of the exercise
price may indicate that the original right had a floating or adjustable
exercise price and did not meet the requirements of the exclusion at
the time of the original grant.
Generally, an extension granting the holder an additional period
within which to exercise the stock right beyond the time originally
prescribed will be treated as evidencing an additional deferral feature
meaning that the stock right was subject to section 409A from the date
of grant. Commentators stated that it is not uncommon upon a
termination of employment to extend the exercise period for some brief
period of time to allow the terminated employee a chance to exercise
the stock right. In response, these regulations provide that it is not
an extension of a stock right if the exercise period is extended to a
date no later than the later of the fifteenth day of the third month
following the date, or December 31 of the calendar year in which, the
right would otherwise have expired if the stock right had not been
extended, based on the terms of the stock right at the original grant
date. The regulations further provide that it is not an extension of a
stock right if at the time the stock right would otherwise expire, the
stock right is subject to a restriction prohibiting the exercise of the
stock right because such exercise would violate applicable securities
laws and the expiration date of the stock right is extended to a date
no later than 30 days after the restrictions on exercise are no longer
required to avoid a violation of applicable securities laws.
These regulations also provide that if the requirements of Sec.
1.424-1 (providing rules under which an eligible corporation may, by
reason of a corporate transaction, substitute a new statutory option
for an outstanding statutory option or assume an old option without
such substitution or assumption being considered a modification of the
old option) would be met if the right were a statutory option, the
substitution of a new right pursuant to a corporate transaction for an
outstanding right or the assumption of an outstanding right will not be
treated as the grant of a new right or a change in the form of payment
for purposes of section 409A. Section 1.424-1 applies several
requirements. Among them is the requirement under Sec. 1.424-
1(a)(5)(ii) that the excess of the aggregate fair market value of the
shares subject to the new option over the exercise price immediately
after the substitution must not exceed the excess of the fair market
value of the shares subject to the old option over the exercise price
immediately before the substitution. In addition, Sec. 1.424-
1(a)(5)(iii) requires that on a share by share comparison, the ratio of
the exercise price to the fair market value of the shares subject to
the option immediately after the substitution not be more favorable
than the ratio of the exercise price to the fair market value of the
shares subject to the old option immediately before the substitution.
Commentators expressed concern that the use of the regulations
contained in Sec. 1.424-1, and specifically the ratio test prescribed
in Sec. 1.424-1(a)(5)(iii), would prove difficult to apply in
circumstances where, to reduce dilution, the acquiring corporation
wished to issue a smaller number of shares than the shares underlying
the old option, but also wished to retain the entire aggregate
difference between the fair market value of the shares and the exercise
price that had been available to the service provider before the
substitution. In response, Notice 2005-1, Q&A-4 and these regulations
provide that the requirement of Sec. 1.424-1(a)(5)(iii) will be deemed
to be satisfied if the ratio of the exercise price to the fair market
value of the shares subject to the right immediately after the
substitution or assumption is not greater than the ratio of the
exercise price to the fair market value of the shares subject to the
right immediately before the substitution or assumption. For example,
if an employee had an option to purchase 25 shares for $2 per share,
and immediately prior to a substitution by reason of a corporate
transaction the fair market value of a share was $5, then the aggregate
spread amount would be $75 (25 shares multiplied by ($5-$2) = $75). The
ratio of the exercise price to the fair market value would be $2/$5 =
.40. As a part of the transaction, new employer wishes to substitute
for the option an option to purchase 5 shares of new employer, when the
shares have a fair market value of $20 per share. To maintain the
aggregate spread of $75, the new grant has an exercise price of $5 (5
shares multiplied by ($20 - $5) = $75). The ratio of the exercise price
to the fair market value immediately after the substitution is $5/$20 =
.25, which is not greater than the ratio immediately before the
substitution. Provided that the other requirements of Sec. 1.424-1
were met, this substitution would not be considered a modification of
the original stock option for purposes of section 409A.
One commentator asked for more flexible rules concerning
adjustments to and substitutions of options following a spinoff or
similar transaction because short-term trading activity in the period
immediately following such a transaction frequently does not accurately
reflect the relative long-term fair market values of the stock of the
distributing and distributed corporations. To address this problem, the
regulations provide that such adjustments or substitutions may be made
based on market quotations as of a predetermined date not more than 60
days after the transaction, or based on an average of such market
prices over a period of not more than 30 days ending not later than 60
days after the transaction.
These provisions addressing substitutions and assumptions of rights
apply to stock appreciation rights, as well as stock options. However,
the guidance provided in these regulations with respect to the
assumption of stock appreciation right liabilities should not be
interpreted as guidance with respect to issues raised under any other
provision of the Code or common law tax doctrine.
D. Restricted Property
Consistent with Notice 2005-1, Q&A-4(e), these regulations provide
that if a service provider receives property from, or pursuant to, a
plan maintained by a service recipient, there is no deferral of
compensation merely because the value of the property is not includible
in income in the year of receipt by reason of the property being
nontransferable and subject to a substantial risk of forfeiture, or is
includible in income solely due to a valid election under section
83(b). However, a plan under which a service provider obtains a
[[Page 57937]]
legally binding right to receive property (whether or not the property
is restricted property) in a future year may provide for the deferral
of compensation and, accordingly, may constitute a nonqualified
deferred compensation plan.
Commentators asked for clarification with respect to how this
provision applies to a promise to transfer restricted property in a
subsequent tax year. Specifically, commentators questioned how section
409A would apply to a bonus program offering a choice between a payment
in cash and a payment in substantially nonvested property. Because the
promise grants the service recipient a legally binding right to receive
property in a future year, this promise generally could not constitute
property for section 83 purposes under Sec. 1.83-3(e), and could
constitute deferred compensation for purposes of section 409A. However,
the regulations provide that the vesting of substantially nonvested
property subject to section 83 may be treated as a payment for purposes
section 409A, including for purposes of applying the short-term
deferral rule. Accordingly, where the promise to transfer the
substantially nonvested property and the right to retain the
substantially nonvested property after the transfer are both subject to
a substantial risk of forfeiture (as defined for purposes of section
409A), the arrangement generally would constitute a short-term deferral
because the payment would occur simultaneously with the vesting of the
right to the property. For example, where an employee participates in a
two-year bonus program such that, if the employee continues in
employment for two years, the employee is entitled to either the
immediate payment of a $10,000 cash bonus or the grant of restricted
stock with a $15,000 fair market value subject to a vesting requirement
of three additional years of service, the arrangement generally would
constitute a short-term deferral because under either alternative the
payment would be received within the short-term deferral period.
E. Arrangements Between Partnerships and Partners
The statute and legislative history to section 409A do not
specifically address arrangements between partnerships and partners
providing services to a partnership, and do not explicitly exclude such
arrangements from the application of section 409A. The application of
section 409A to such arrangements raises a number of issues, relating
both to the scope of the arrangements subject to section 409A, and the
coordination of the provisions of subchapter K and section 409A with
respect to those arrangements that are subject to section 409A. The
Treasury Department and the IRS continue to analyze the issues raised
in this area, and accordingly these regulations do not address
arrangements between partnerships and partners. Notice 2005-1, Q&A-7
provides interim guidance regarding the application of section 409A to
arrangements between partnerships and partners. Until further guidance
is issued, taxpayers may continue to rely on Notice 2005-1, Q&A-7.
Commentators have asked whether section 409A applies to guaranteed
payments for services described in section 707(c). Until further
guidance is issued, section 409A will apply to guaranteed payments
described in section 707(c) (and rights to receive such guaranteed
payments in the future), only in cases where the guaranteed payment is
for services and the partner providing services does not include the
payment in income by the 15th day of the third month following the end
of the taxable year of the partner in which the partner obtained a
legally binding right to the guaranteed payment or, if later, the
taxable year in which the right to the guaranteed payment is first no
longer subject to a substantial risk of forfeiture.
The Treasury Department and the IRS continue to request comments
with respect to the application of section 409A to arrangements between
partnerships and partners.
F. Foreign Arrangements
The regulations provide guidance with respect to the application of
section 409A to various foreign arrangements. As an initial matter, the
regulations provide that an arrangement does not provide for a deferral
of compensation subject to section 409A where the compensation subject
to the arrangement would not have been includible in gross income for
Federal tax purposes if it had been paid to the service provider at the
time that the legally binding right to the compensation first arose or,
if later, the first time that the legally binding right was no longer
subject to a substantial risk of forfeiture, if the service provider
was a nonresident alien at such time. Accordingly, if, for example, a
foreign citizen works outside the United States and then retires to the
United States, the compensation deferred and vested while working in
the foreign country generally will not be subject to section 409A.
With respect to U.S. citizens or resident aliens working abroad,
the regulations provide that an arrangement does not provide for a
deferral of compensation subject to section 409A where the compensation
subject to the arrangement would have constituted foreign earned income
(within the meaning of section 911) paid to a qualified individual (as
defined in section 911(d)(1)) and the amount of the compensation is
less than or equal to the difference between the maximum section 911
exclusion amount and the amount actually excludible from gross income
under section 911 for the taxable year for the individual. This
hypothetical exclusion is applied at the time that the legally binding
right to the compensation first exists or, if later, the time that the
legally binding right is no longer subject to a substantial risk of
forfeiture. Under section 911, a U.S. citizen or resident alien who
resides in a foreign jurisdiction generally may exclude up to $80,000
of foreign earned income (to be adjusted for inflation after 2007). For
example, an individual with $70,000 of foreign earned income excluded
under section 911 in 2006 could also defer up to $10,000 of additional
compensation that would not be subject to section 409A, if the
additional compensation would qualify as foreign earned income if paid
to the individual in 2006. This exception to coverage under section
409A is intended to be applied on an annual basis, so that individuals
will not be entitled to carry over any unused portion of the exclusion
under section 911 to a future year. This exception also is not intended
to modify the rules under section 911 or the regulations thereunder.
Similarly, these regulations also address deferrals of compensation
income that would be excluded from gross income for Federal income tax
purposes under section 893 (generally covering compensation paid to
foreign workers of a foreign government or international organization
working in the United States), section 872 (generally covering certain
compensation earned by nonresident alien individuals), section 931
(generally covering certain compensation earned by bona fide residents
of Guam, American Samoa, or the Northern Mariana Islands) and section
933 (generally covering certain compensation earned by bona fide
residents of Puerto Rico). The regulations provide that an arrangement
does not provide for a deferral of compensation subject to section 409A
where the compensation subject to the
[[Page 57938]]
arrangement would have been excluded from gross income for Federal tax
purposes under any of these sections, if the compensation had been paid
to the service provider at the time that the legally binding right to
the compensation first arose or, if later, the time that the legally
binding right was no longer subject to a substantial risk of
forfeiture.
The Treasury Department and the IRS understand that nonresident
aliens may work for very limited periods in the United States. Many
deferrals of the compensation earned by nonresident aliens for services
rendered in the United States will not be covered by section 409A,
because under an applicable treaty the amount of compensation deferred
would not be includible in gross income for Federal tax purposes if
paid at the time the legally binding right to the compensation deferred
was no longer subject to a substantial risk of forfeiture. However,
certain compensation earned in the United States by a nonresident alien
might be includible in gross income under such circumstances, where
there is no applicable treaty or where the treaty does not provide an
exclusion. Where a nonresident alien defers such compensation earned in
the United States under a foreign nonqualified deferred compensation
plan--for example because the service in the United States is credited
under the plan--the application of section 409A to the deferrals of the
compensation subject to Federal income tax could be exceedingly
burdensome in light of the relatively small amounts attributable to the
service in the United States. Accordingly, these regulations adopt a de
minimis exception, under which section 409A will not apply to an amount
of compensation deferred under a foreign nonqualified deferred
compensation plan for a given calendar year where the individual
service provider is a nonresident alien for that calendar year and the
amount deferred does not exceed $10,000.
Commentators requested clarification of the application of section
409A to participation by U.S. citizens and resident aliens in foreign
plans. In this context, it should be noted that under these
regulations, transfers that are taxable under section 402(b) of the
Code generally are not subject to section 409A. See Sec. 1.409A-
1(b)(6) of these regulations and Notice 2005-1, Q&A-4. Such transfers
may consist of contributions to an employees' trust, where the trust
does not qualify under section 501(a). Many foreign plans that hold
contributions in a trust will constitute funded plans. To the extent
that a contribution to the trust is subject to inclusion in income for
Federal tax purposes under section 402(b), such a contribution will not
be subject to section 409A.
These regulations also provide that section 409A does not override
treaty provisions that govern the U.S. Federal taxation of
participation in particular foreign plans. Where a treaty provides that
amounts contributed to a foreign plan by or on behalf of a service
provider are not subject to U.S. Federal income tax, section 409A will
not cause such amounts to be subject to inclusion in gross income.
Some commentators requested that any participation in a foreign
plan be exempted from section 409A, or that only deferrals of U.S.
source compensation income be subject to section 409A. However, with
respect to U.S. citizens working abroad, and with respect to resident
aliens in the United States, compensation income generally is subject
to U.S. Federal income tax absent an applicable treaty provision.
Accordingly, the provisions of section 409A generally are applicable to
this type of deferred compensation. In addition, the Treasury
Department and the IRS are concerned that providing a broad exception
for foreign plans or foreign source income would create opportunities
for U.S. citizens and resident aliens to avoid application of section
409A through participation in a foreign plan, or through reallocations
of deferrals among U.S. source and foreign source income.
The regulations provide, however, that with respect to non-U.S.
citizens who are not lawful permanent residents of the United States,
amounts deferred under certain broad-based foreign retirement plans are
not subject to section 409A. This exception is intended to allow a
worker who is not a green card holder to continue to participate in a
broad-based foreign retirement plan that does not comply with section
409A without incurring adverse tax consequences due solely to the
worker earning some income in the United States that is in some manner
credited under the plan.
Commentators expressed concerns as to U.S. citizens and lawful
permanent residents working abroad, and their ability to participate in
broad-based plans of foreign employers. Generally, these workers'
incomes are subject to Federal income tax, including section 409A.
However, when U.S. citizens and lawful permanent residents work abroad
for employers who sponsor broad-based foreign retirement plans
providing relatively low levels of retirement benefits and such plans
are nonelective, the worker's ability to control the timing of the
income is limited. In such cases, the concerns with respect to the
potential manipulation of the timing of compensation income addressed
by section 409A are also limited, and do not outweigh the
administrative burdens that would arise if a foreign employer's failure
to amend these plans to be consistent with the provisions of section
409A would result in substantial adverse tax consequences to U.S.
citizens and lawful permanent residents working abroad who are covered
by such plans. Accordingly, an exception for foreign broad-based
retirement plans also applies with respect to U.S. citizens and lawful
permanent residents, but only with respect to nonelective deferrals of
foreign earned income and only to the extent that the amount deferred
in a given year does not exceed the amount of contributions or benefits
that may be provided by a qualified plan under section 415 (calculated
by treating the foreign source income as compensation for purposes of
section 415).
Commentators also requested that certain types of payments,
referred to as expatriate allowances, be exempted from coverage under
section 409A. These payments were defined broadly to include many types
of payments to U.S. citizens working abroad, intended to put the
service providers in substantially the same economic position as the
service providers would have been in had the services been provided in
the United States. One very common arrangement involves payments
intended to compensate the service provider for any differences in tax
rates, often referred to as tax equalization plans. With respect to
these plans, the Treasury Department and the IRS recognize that such
payments often must be delayed because of the need to calculate foreign
tax liabilities after the end of the year. In addition, where the
amounts are limited to the amounts necessary to make up for difference
in tax rates, the potential for abuse with respect to the timing of
compensation income is not great, since the compensation will directly
relate to taxes that the service provider has paid to a foreign
jurisdiction. Accordingly, these regulations exempt tax equalization
plans from coverage under section 409A provided that the payment is
made no later than the end of the second calendar year beginning after
the calendar year in which the individual's U.S. Federal income tax
return is required to be filed (including extensions) for the year to
which the tax equalization payment relates.
[[Page 57939]]
Other payments are not excluded from section 409A merely because
they are denominated as expatriate allowances. The Treasury Department
and the IRS believe that the rules provided in these regulations with
respect to setting and meeting payment dates under a nonqualified
deferred compensation plan will provide sufficient flexibility to
permit arrangements involving expatriate allowances to satisfy the
requirements of section 409A. For example, as discussed more fully
below, these regulations generally provide that to meet the requirement
that a payment be made upon a permissible payment event or a fixed
date, the service recipient may make the payment by the later of the
earliest date administratively practicable following, or December 31 of
the calendar year in which occurs, the permissible payment event or
fixed date. At the minimum, this should offer almost 12 months of
flexibility with respect to a payment scheduled for January 1 of a
calendar year. The Treasury Department and the IRS request comments,
however, as to circumstances in which this flexibility will not be
sufficient.
Commentators also requested a grace period during which
arrangements with persons who have become resident aliens during a
calendar year may be amended to comply with the requirements of section
409A. These regulations generally provide such relief. With respect to
the initial year in which the service provider becomes a resident
alien, the plan may be amended with respect to the service provider
through the end of that year to comply with (or be excluded from
coverage under) section 409A, including allowing the service provider
the right to change the time and form of a payment. Provided that the
election is made before the amount is paid or payable, initial deferral
elections may also be made with respect to compensation related to
services in that initial year, if the election is made by the end of
the year or, if later, the 15th day of the third month after the
service provider meets the requirements to be a resident alien. The
relief generally does not extend further because a service recipient
and service provider should reasonably anticipate the potential
application of section 409A after the initial year in which the service
provider attains the status of a resident alien. However, the Treasury
Department and the IRS also recognize that there may be significant
gaps between the years in which the service provider is treated as a
resident alien. Accordingly, the grace period is available in a
subsequent year, provided that the service provider has been a
nonresident alien for at least five consecutive calendar years
immediately preceding the year in which the service provider is again a
resident alien.
Commentators also requested that amounts contributed or benefits
paid under a foreign social security system that is the subject of a
totalization agreement be exempted from coverage under section 409A.
Totalization agreements refer to bilateral agreements between the
United States and foreign jurisdictions intended to coordinate coverage
under the Social Security system in the United States and similar
systems of the foreign jurisdictions. These agreements are intended to
minimize the potential for application of two different employment
taxes, and correspondingly to coordinate the benefits under the two
different social security systems. The Treasury Department and the IRS
believe that section 409A was not intended to apply to benefits to
which the service provider is entitled under the foreign jurisdiction
social security system. Accordingly, these types of plans have been
excluded from the definition of a nonqualified deferred compensation
plan for purposes of section 409A. Similarly, for jurisdictions not
covered by a totalization agreement, these regulations provide that
amounts deferred under a government mandated social security system are
not subject to section 409A.
G. Separation Pay Arrangements
1. In General
Many commentators requested clarification of the application of
section 409A to plans or arrangements providing payments upon a
termination of services, generally described as severance plans. Some
commentators requested that all such arrangements be excluded from
coverage under section 409A. However, section 409A(d)(1)(B) contains a
list of welfare benefits that are specifically excluded from coverage
under section 409A, including bona fide vacation leave, sick leave,
compensatory time, disability pay and death benefit plans. Noticeably
absent from this list is an exception for severance plans. This is
particularly noteworthy because section 457(e)(11) contains the
identical list of exclusions, with the one exception that the list of
excluded plans under section 457(e)(11) includes severance pay plans,
while the list of excluded plans under section 409A(d)(1)(B) does not.
Therefore, it appears that Congress intended that severance payments
could constitute deferred compensation under section 409A. To avoid
confusion with other Code provisions, such as the specific exclusion
from coverage under section 457(e)(11) for severance plans or the
treatment of such arrangements under section 3121(v)(2), these
regulations generally refer to such arrangements as separation pay
arrangements.
With respect to payments available upon a voluntary termination of
services, there is no substantive distinction between a plan labeled a
severance plan or separation pay plan and a nonqualified deferred
compensation plan that provides for payments upon a separation from
service. If, as is often the case, the service recipient reserves the
right to eliminate such arrangement at any time, the service provider
may not have a legally binding right to the payment until payment
actually occurs, or such other time as the service recipient's
discretion to eliminate the right to the payments lapses. However, as
provided in these regulations, where such negative discretion lacks
substantive significance, or the person granted the discretion is
controlled by, or related to, the service provider to whom the payment
will be made, the service provider will be considered to have a legally
binding right to the compensation.
Commentators requested that the exclusion from coverage under
section 409A contained in Notice 2005-1, Q&A-19(d) for payments during
the calendar year 2005 to non-key employees pursuant to severance plans
that are classified as welfare plans, rather than pension plans, in
accordance with the Department of Labor regulations, be made a
permanent exclusion. This approach generally would be consistent with
the regulations under section 3121(v)(2) of the Code. However, the
Department of Labor regulations reflect different concerns with respect
to separation pay arrangements from the concerns addressed in section
409A. The Department of Labor regulations focus on whether an
arrangement sufficiently resembles a retirement plan to require funding
of the obligations under such a plan, or rather is a welfare plan that
would not require funding. In contrast, section 409A focuses on the
manipulation of the timing of inclusion of compensation income.
Accordingly, these regulations do not categorically exclude these
arrangements from coverage under section 409A, although a modified
version of this exception has been provided, as discussed below.
Some commentators requested that the Treasury Department and the
IRS adopt an exclusion for all amounts
[[Page 57940]]
payable upon an involuntary separation. This request is based upon the
position under certain other Code provisions, and stated in certain
court cases, that payments to which an individual becomes entitled upon
an involuntary separation from service do not constitute nonqualified
deferred compensation. See Kraft Foods North America v. U.S., 58 Fed.
Cl. 507 (2003); Sec. 31.3121(v)(2)-1(b)(4)(iv). As discussed above,
the statutory language and structure of section 409A strongly suggest
that separation pay arrangements, including arrangements providing
separation pay upon an involuntary separation, were meant to be covered
by section 409A. Furthermore, the Treasury Department and the IRS
believe that section 409A was not intended to be applied so narrowly.
Section 409A addresses the manipulation of the timing of inclusion of
compensation. Payments due to a separation from service, regardless of
whether voluntary or involuntary, constitute a payment of compensation.
Accordingly, the ability to manipulate the timing of the inclusion of
income related to the receipt of those amounts is within the scope of
section 409A.
Much of the discussion above relates to predetermined arrangements,
where the right to the payment upon an involuntary termination of
services arises as part of an arrangement covering multiple service
providers, often covering a service provider from the time the service
provider begins performing services. Where the separation pay
arrangement involves an agreement negotiated with a specific service
provider at the time of the involuntary separation from service,
commentators asked how deferral elections could be provided that would
meet the requirement that the election be made in the year before the
year in which the services were performed. Commentators pointed out
that even if the service provider does not already participate in any
involuntary separation pay arrangement, the rule in section
409A(a)(4)(B) that allows an initial deferral election to be made
within 30 days of initial eligibility under a plan applies only with
respect to services performed after the election. To address these
concerns, these regulations provide that where separation pay due to an
involuntary termination has been the subject of bona fide, arm's length
negotiations, the election as to the time and form of payment may be
made on or before the date the service provider obtains a legally
binding right to the payment.
The Treasury Department and the IRS recognize that separation pay
arrangements providing for short-term payments upon an involuntary
separation from service are common arrangements, and that compliance
with the provisions of section 409A may be burdensome. In addition, the
Treasury Department and the IRS recognize that where both the amount of
the payments and the time over which such payments may be made are
limited, these arrangements create fewer concerns with respect to
manipulation of the timing of compensation income. Accordingly, these
regulations generally exempt such arrangements where the entire amount
of payments does not exceed two times the service provider's annual
compensation or, if less, two times the limit on annual compensation
that may be taken into account for qualified plan purposes under
section 401(a)(17) ($210,000 for calendar year 2005), each for the
calendar year before the year in which the service provider separates
from service, and provided further that the arrangement requires that
all payments be made by no later than the end of the second calendar
year following the year in which the service provider terminates
service. These limitations generally are consistent with the safe
harbor under which severance plans may be treated as welfare plans
under the applicable Department of Labor regulations, and should allow
most of these arrangements to avoid coverage under section 409A.
The Treasury Department and the IRS further recognize that
separation pay arrangements often occur in the context of a window
program, where certain groups of service providers are identified as
being subject to a separation from service, and the service recipient
provides the identified service providers an incentive to voluntarily
separate from service and obtain a benefit. Although technically these
programs involve a voluntary separation from service, these regulations
generally treat separations due to participation in a window
arrangement the same as arrangements with respect to involuntary
separations from service for purposes of the exceptions to coverage
from section 409A.
These exclusions for separation pay are not intended to allow for
rights to payments that would otherwise be deferred compensation
subject to section 409A to avoid application of section 409A by being
recharacterized as separation pay. Accordingly, the exclusions for
separation pay do not apply to the extent the separation pay acts as a
substitute for, or a replacement of, amounts that would otherwise be
subject to section 409A. For example, a right to separation pay
obtained in exchange for the relinquishment of a right to a payment of
deferred compensation subject to section 409A will not be excluded from
coverage under section 409A, but rather will be treated as a payment of
the original amount of deferred compensation.
2. Treatment as a Separate Plan
Commentators have stated that arrangements involving payments due
to an involuntary separation often operate separately from more
traditional types of nonqualified deferred compensation plans. In
addition, especially in the case of agreements covering an individual,
the involuntary separation pay agreement may involve many different
types of payments that are of a much smaller magnitude than amounts
deferred under other types of nonqualified deferred compensation plans.
Commentators expressed concerns that inadvertent violations of section
409A with respect to these unique arrangements could lead to much
larger amounts being included in income and subject to the additional
tax under section 409A due to the aggregation of such involuntary
separation pay arrangements with other arrangements under the
definition of a plan. The Treasury Department and the IRS have
concluded that a nonqualified deferred compensation plan providing
separation pay due to an involuntary separation from service, or
participation in a window program, should be treated as a separate type
of plan from account balance plans, nonaccount balance plans, and other
types of plans (generally equity-based compensation arrangements) in
which the service provider may participate that do not provide
separation pay due to an involuntary separation from service, or
participation in a window program.
3. Application of the Short-Term Deferral Rule to Separation Pay
Arrangements
Many commentators asked for a clarification with respect to the
application of the short-term deferral rule to separation pay
arrangements. The right to a payment that will only be paid upon an
involuntary termination of services generally would be viewed as a
nonvested right. Accordingly, an involuntary separation pay arrangement
may be structured to meet the requirements of the short-term deferral
exception.
Some commentators also requested that arrangements involving rights
to payments upon termination of services for good reason be treated as
a right subject to a substantial risk of forfeiture. These arrangements
are common,
[[Page 57941]]
especially following a transaction resulting in a change in control of
the service recipient. The Treasury Department and the IRS are not
confident that amounts payable upon a voluntary separation from
service, and amounts payable only upon a termination of services for
good reason, always may be adequately distinguished. Furthermore, even
if the types of good reasons sufficient to constitute a substantial
risk of forfeiture could be elucidated, the application of such a rule
would involve intensive factual determinations, leaving taxpayers
uncertain in their planning and creating a significant potential for
abuse. Accordingly, the regulations do not treat the right to a payment
upon a separation from service for good reason categorically as a right
subject to a substantial risk of forfeiture. However, the Treasury
Department and the IRS request comments as to what further guidance may
be useful with respect to arrangements containing these types of
provisions.
4. Reimbursement Arrangements
Many commentators requested clarification with respect to the
application of section 409A to reimbursement agreements, involving the
service recipient reimbursing expenses of the terminated service
provider. Because the promise to reimburse the former service provider
is not contingent on the provision of any substantial services for the
service provider, the right to the payment generally would not be
treated as subject to a substantial risk of forfeiture. Accordingly, if
the period in which expenses incurred will be reimbursed extends beyond
the year in which the legally binding right arises, the right to the
amount generally would constitute deferred compensation. The Treasury
Department and the IRS recognize that reimbursement arrangements
following a termination of services are common, and that requiring the
service recipient to designate an amount at the time of the termination
conflicts with the service recipient's desire to pay only amounts that
the former service provider has actually incurred as an expense.
However, a categorical exclusion for reimbursement arrangements is not
tenable, because such an exclusion would allow for a limitless amount
of deferred compensation to be paid without regard to the rules of
section 409A, where such compensation took the form of the
reimbursement of personal expenses (for example, reimbursements of home
mortgage payments). These regulations provide that certain
reimbursement arrangements related to a termination of services are not
covered by section 409A, to the extent that the reimbursement
arrangement covers only expenses incurred and reimbursed before the end
of the second calendar year following the calendar year in which the
termination occurs. The types of reimbursement arrangements excluded
include reimbursements that are otherwise excludible from gross income,
reimbursements for expenses that the service provider can deduct under
section 162 or section 167, as business expenses incurred in connection
with the performance of services (ignoring any applicable limitation
based on adjusted gross income), outplacement expenses, moving
expenses, medical expenses, as well as any other types of payments that
do not exceed $5,000 in the aggregate during any given taxable year.
For purposes of this provision, reimbursement arrangements include
the provision of in-kind benefits, or direct payments by the service
recipient to the person providing the goods or services to the
terminated service provider, if the provision of such in-kind benefits
or direct payments would be treated as reimbursement arrangements if
the service provider had paid for such in-kind benefits or such goods
or services and received reimbursement from the service recipient.
H. Split-Dollar Life Insurance Arrangements
Commentators suggested that split-dollar life insurance
arrangements should be excluded from the requirements of section 409A.
However, the Treasury Department and the IRS believe that in applying
the general definition of deferred compensation to split-dollar life
insurance arrangements, the requirements of section 409A may apply to
certain types of such arrangements (as described in Sec. 1.61-22).
Split-dollar life insurance arrangements that provide only death
benefits (as defined in these proposed regulations) to or for the
benefit of the service provider may be excluded from coverage under
section 409A under the exception from the definition of a nonqualified
deferred compensation plan provided in these proposed regulations for
death benefit plans. Also, split-dollar life insurance arrangements
treated as loan arrangements under Sec. 1.7872-15 generally will not
give rise to deferrals of compensation within the meaning of section
409A, provided that there is no agreement under which the service
recipient will forgive the related indebtedness and no obligation on
the part of the service recipient to continue to make premium payments
without charging the service provider a market interest rate on the
funds advanced. However, policies structured under the endorsement
method, where the service recipient is the owner of the policy but
where the service provider obtains a legally binding right to
compensation includible in income in a taxable year after the year in
which a substantial risk of forfeiture (if any) lapses, may provide for
a deferral of compensation. Just as a promise to transfer property in a
future year may provide for a deferral of compensation (even though the
transfer itself is subject to section 83), an endorsement method split-
dollar life insurance arrangement that grants the service provider a
legally binding right to a future transfer of interests in a policy
owned by the service recipient may provide for a deferral of
compensation subject to section 409A. For example, where a service
recipient enters into an endorsement method split-dollar life insurance
arrangement with respect to a service provider, and irrevocably
promises to pay premiums in future years, the arrangement may provide
for a deferral of compensation within the meaning of section 409A.
Commentators raised concerns about the impact of changes to a
split-dollar life insurance arrangement to comply with section 409A,
where the split-dollar life insurance arrangement was entered into on
or before September 17, 2003, and is not otherwise subject to the
regulations set forth in Sec. 1.61-22 (a grandfathered split-dollar
life insurance arrangement). Pursuant to Sec. 1.61-22(j)(2), if a
grandfathered split-dollar life insurance arrangement is materially
modified after September 17, 2003, the arrangement is treated as a new
arrangement entered into on the date of the modification. Commentators
expressed concern that modifications necessary to comply with section
409A may cause the split-dollar life insurance arrangement to be
treated as materially modified for purposes of Sec. 1.61-22(j)(2).
Comments are requested as to the scope of changes that may be necessary
to comply with, or avoid application of, section 409A, and under what
conditions those changes should not be treated as material
modifications for purposes of Sec. 1.61-22(j)(2).
III. Definition of Plan
A. Plan Aggregation Rules
These regulations generally retain the plan aggregation rules set
forth in Notice 2005-1, Q&A-9. Under the notice, all amounts deferred
under an account balance plan are treated as deferred
[[Page 57942]]
under a single plan, all amounts deferred under a nonaccount balance
are treated as deferred under a single plan, and all amounts deferred
under any other type of plan (generally equity-based compensation) are
treated as deferred under a single plan. As discussed above, these
regulations expand this rule so that all amounts deferred under certain
separation pay arrangements are treated as a single plan. The purposes
behind these aggregation rules are two-fold. First, because the
provisions of section 409A are applied on an individual participant
basis, rather than disqualifying the arrangement as to all
participants, plan aggregation rules are necessary to implement the
compliance incentives intended under the provision. Without such rules,
multitudes of separate arrangements could be established for a single
participant. Should the participant want access to an amount of cash,
the participant would amend one or more of these separate arrangements
and receive payments. The participant would argue that only those
separate arrangements under which the amounts were paid failed to meet
the requirements of section 409A and were subject to the income
inclusion and additional tax, although in fact amounts were also
available under the additional separate arrangements. Under that
analysis, section 409A essentially would act as a 20 percent penalty
required to receive a payment, similar to the haircut provisions that
were intended to be prohibited by section 409A. The Treasury Department
and the IRS do not believe that Congress intended that the consequences
of section 409A could be limited in such a manner. However, the
Treasury Department and the IRS also believe that complex plan
aggregation rules, especially rules reliant on the particular facts and
circumstances underlying each arrangement, would lead to unwarranted
complexities and burdens with respect to service recipient planning and
IRS enforcement. Accordingly, these regulations adopt rules intended to
be simple and relatively easy to administer that retain the integrity
of the compliance incentives inherent in the statute.
Commentators asked whether an isolated violation of a term of an
arrangement with respect to one participant will be treated as a
violation of the same arrangement term with respect to other
participants covered by the same arrangement. First, the terms of the
arrangement with respect to each participant must be determined, based
upon the rights the individual participant has under the plan.
Generally, these rights will be determined based upon the written
provisions applicable under a particular arrangement, as evidenced by a
plan document, agreement, or some combination of documents that specify
the terms of the contract under which the compensation is to be paid.
However, where the terms of a plan or arrangement comply with section
409A, but the service recipient does not follow such terms, an
individual participant's actual rights under the arrangement may be
unclear. Where a violation of a provision is not an isolated incident,
or involves a number of participants or an identifiable subgroup of
participants under the arrangement, the violation may result in a
finding that even with respect to a participant who did not directly
benefit from the violation, the actual terms of the arrangement differ
from the written terms of the arrangement. For example, if a plan
document provides for installment payments upon a separation from
service, but participants in the arrangement repeatedly are offered the
opportunity to receive a lump sum payment, the facts and circumstances
may indicate that the arrangement provides for an election of a lump
sum payment for all participants.
An analogous analytical framework applies where the service
recipient offers different benefits to separate participants in the
same plan or arrangement. Under the terms of the overall arrangement,
the service provider may grant many different types of rights,
including some rights that would not be subject to the requirements of
section 409A and some rights that would be subject to those
requirements. With respect to the application of section 409A, a plan
or arrangement is analyzed as consisting of the rights and benefits
that have actually been granted to a particular service provider. For
example, with respect to an equity-based omnibus plan that permits the
grant of discounted stock options that would be subject to the
requirements of section 409A, as well as other types of stock options
which would be excluded from coverage under section 409A, only those
service providers actually granted the discounted stock options will be
treated as having deferred an amount of compensation subject to section
409A, and then only with respect to the stock options subject to
section 409A.
B. Written Plan Requirement
Although the statute does not explicitly state that a plan or
arrangement must be in writing, the statute requires that a plan
contain certain provisions in order to comply with section 409A. For
example, section 409A(a)(2)(A) requires that a plan provide that
compensation deferred under the plan may not be distributed earlier
than certain specific events. Section 409A(a)(4)(B) requires that a
plan provide certain restrictions with respect to initial deferral
elections. Section 409A(a)(4)(C) requires that, if a plan permits under
a subsequent election a delay in a payment or a change in the form of
payment, the plan must require certain limits on the scope of such a
delay or change. The clear implication of these provisions of section
409A is that the plan or arrangement must be set forth in writing and
these regulations incorporate that requirement.
IV. Definition of Substantial Risk of Forfeiture
The scope of the definition of a substantial risk of forfeiture is
central to the application of section 409A. In addition to the timing
of the potential inclusion of income under section 409A, the existence
of a substantial risk of forfeiture may also determine whether an
amount is subject to section 409A or whether it qualifies for the
exclusion under the short-term deferral rule. These regulations
generally adopt the same definition as provided in Notice 2005-1, Q&A-
10. This definition reflects the concerns of the Treasury Department
and the IRS that the use of plan terms that purport to prescribe a
substantial risk of forfeiture but, in fact, do not put the right to
the payment at a substantial risk, may be used to circumvent the
application of section 409A in a manner inconsistent with the
legislative intent. The definition of a substantial risk of forfeiture
in these regulations contains certain restrictions. Certain amendments
of an arrangement to extend a substantial risk of forfeiture will not
be recognized. The ability to periodically extend, or roll, the risk of
forfeiture is sufficiently suspect to question whether the parties ever
intended that the right be subject to any true substantial risk, or
rather whether the period is being extended through periods in which
the service recipient can be reasonably assured that the forfeiture
condition will not occur. Similarly, the risk that a right will be
forfeited due to the violation of a noncompete agreement can be
illusory, such as where the service provider has no intent to compete
or to provide such services. In addition, a rational service provider
normally would not agree to subject amounts that have already been
earned, such as salary payments, to a condition that creates a real
possibility
[[Page 57943]]
of forfeiture, unless the service provider is offered a material
inducement to do so, such as an additional amount of compensation.
Accordingly, these provisions will not be treated as creating a
substantial risk of forfeiture for purposes of section 409A.
V. Initial Deferral Election Rules
A. In General
Section 409A(a)(4)(B)(i) provides that in general, a plan must
provide that compensation for services performed during a taxable year
may be deferred at the participant's election only if the election to
defer such compensation is made not later than the close of the
preceding taxable year or at such other time as provided in
regulations. The legislative history indicates that the taxable year to
which the statute refers is the service provider's taxable year, as it
indicates that the Secretary may issue guidance ``providing
coordination rules, as appropriate, regarding the timing of elections
in the case when the fiscal year of the employer and the taxable year
of the individual are different.'' H.R. Conf. Rep. No. 108-755, at 732
(2004). Accordingly, these regulations provide as a general rule that a
service provider must make a deferral election in his or her taxable
year before the year in which the services are performed. As discussed
below, certain coordination rules for fiscal year employers have been
provided.
An election to defer an amount includes an election both as to the
time and form of the payment. An election is treated as made as of the
date the election becomes irrevocable. Changes may be made to an
initial deferral election, provided that the election becomes
irrevocable (except to the extent the plan permits a subsequent
deferral election consistent with these regulations) no later than the
last date that such an election may be made. Commentators had
questioned whether an evergreen deferral election, or a deferral
election as to future compensation that remains in place unless the
service provider changes the election, would be effective for purposes
of section 409A. Such an election satisfies the initial deferral
election requirements only if the election becomes irrevocable with
respect to future compensation no later than the last permissible date
an affirmative initial deferral election could have been made with
respect to such compensation. For example, with respect to a salary
deferral program under which an employee makes an initial deferral
election to defer 10 percent of the salary earned during the subsequent
calendar year, a plan may provide that the deferral election remains
effective unless and until changed by the employee, provided that with
respect to salary earned during any future taxable year, the election
to defer 10 percent of such salary becomes irrevocable no later than
the December 31 of the preceding calendar year.
B. Nonelective Arrangements
Some commentators asked whether the initial deferral election rules
apply to nonelective arrangements. The requirement that the election be
made in the year before the services are performed is not applicable
where the participant is not provided any election with respect to the
amount deferred, or the time and form of the payment. However, as
stated in the legislative history, ``[t]he time and form of
distribution must be specified at the time of initial deferral.'' H.R.
Conf. Rep. No. 108-755, at 732 (2004). In addition, the application of
the subsequent deferral rules becomes problematic if the original time
and form of deferred payment established by the service recipient is
not viewed as an initial deferral election. Therefore, in order to
avoid application of the initial deferral rules, a plan may not provide
a service provider or service recipient with ongoing discretion as to
the time and form of payment, but rather must set the time and form of
payment no later than the time the service provider obtains a legally
binding right to the compensation.
C. Performance-Based Compensation
Section 409A(a)(4)(B)(iii) provides that in the case of any
performance-based compensation based on services performed over a
period of at least 12 months, a participant's initial deferral election
may be made no later than six months before the end of the period. The
legislative history indicates that the performance-based compensation
should be required to meet certain requirements similar to those under
section 162(m), but not all requirements under that section. H.R. Conf.
Rep. No. 108-755, at 732 (2004). An example in the legislative history,
adopted in these regulations, is that the requirement of a
determination by the compensation committee of the board of directors
is not required.
Notice 2005-1 did not provide a definition of performance-based
compensation. Rather, Notice 2005-1, Q&A-22 provided a definition of
bonus compensation that, until further guidance was issued, could be
used for purposes of applying the exception to the general rule
regarding initial deferral elections.
Under these regulations, performance-based compensation is defined
as compensation the payment of which or the amount of which is
contingent on the satisfaction of preestablished organizational or
individual performance criteria. Performance-based compensation does
not include any amount or portion of any amount that will be paid
either regardless of performance, or based upon a level of performance
that is substantially certain to be met at the time the criteria are
established.
Performance-based compensation generally may include payments based
upon subjective performance criteria, provided that the subjective
performance criteria relate to the performance of the participant
service provider, a group of service providers that includes the
participant service provider, or a business unit for which the
participant service provider provides services (which may include the
entire organization), and the determination that the subjective
performance criteria have been met is not made by the service provider
or a member of the service provider's family, or a person the service
provider supervises or over whose compensation the service provider has
any control.
Commentators requested that, similar to the provision contained in
Sec. 1.162-27(e)(2) governing the requirements for establishing
performance criteria for purposes of applying the deduction limitation
under section 162(m), service recipients be allowed to establish
performance criteria within 90 days of the commencement of a
performance period of 12 months or more, rather than having to
establish such criteria before the commencement of the period. These
regulations adopt a similar provision with respect to the establishment
of performance criteria for purposes of the exception under the
deferral election rules, permitting the criteria to be established up
to 90 days after the commencement of the period of service to which the
criteria relates, provided that the outcome is not substantially
certain at the time the criteria are established.
The legislative history indicates that to constitute performance-
based compensation, the amount must be (1) variable and contingent on
the satisfaction of preestablished organizational or individual
performance criteria and (2) not readily ascertainable at the time of
the election. H.R. Conf. Rep. No. 108-755, at 732 (2004). These
regulations clarify that where the right to receive a specified
[[Page 57944]]
amount is itself not substantially certain, the amount is not readily
ascertainable as the amount paid could either be the specified amount
or zero. Accordingly, these regulations provide that at the time of the
initial deferral election, either the amount must not be readily
ascertainable, or the right to the amount must not be substantially
certain. So, for example, the right to a $10,000 bonus that otherwise
qualifies as performance-based compensation could be deferred by an
employee up to six months before the end of the performance period,
provided that at the time of the deferral election the employee is not
substantially certain to meet the criteria and receive the $10,000
payment.
Under the definition of bonus compensation provided in Notice 2005-
1, Q&A-22, bonus compensation does not include any amount or portion of
any amount that is based solely on the value of, or appreciation in
value of, the service recipient or the stock of the service recipient.
Commentators criticized this limitation as inconsistent with the
provisions of Sec. 1.162-27 governing application of the deduction
limitation under section 162(m), and the legislative history to section
409A indicating that the definition of performance-based compensation
for purposes of section 409A would be similar to that provided under
section 162(m) and the regulations thereunder. These proposed
regulations eliminate this limitation, so that performance-based
compensation may be based solely upon an increase in the value of the
service recipient, or the stock of the service recipient, after the
date of grant or award. However, if an amount of compensation the
service provider will receive pursuant to a grant or award is not based
solely on an increase in the value of the stock after the grant or
award (for example, in the case of restricted stock units or a stock
right granted with an exercise price that is less than the fair market
value of the stock as of the date of grant), and that other amount
would not otherwise qualify as performance-based compensation, none of
the compensation attributable to the grant or award is performance-
based compensation. Nonetheless, an award of equity-based compensation
may constitute performance-based compensation if entitlement to the
compensation is subject to a condition that would cause a non-equity-
based award to qualify as performance-based compensation, such as a
performance-based vesting condition.
The Treasury Department and the IRS are concerned that the
inclusion of such amounts in the definition of performance-based
compensation could lead to a conclusion that an election to defer
amounts payable under a stock right will necessarily comply with
section 409A if the initial deferral election is made at least 6 months
before the date of exercise. However, under these proposed regulations,
a stock right with a deferral feature is subject to section 409A from
the date of grant. To comply with section 409A, the arrangement would
be required to specify a permissible payment time and a form of
payment. The requirement would not be met if, at some point during the
term of the stock right, the stock right becomes immediately
exercisable and the holder may decide whether and when to exercise the
stock right. In addition, where a deferral feature is added to an
existing stock right the stock right generally would violate section
409A because the stock right would have a deferral feature and would
not have specified a permissible payment time or event.
D. First Year of Eligibility
Section 409A and these proposed regulations contain an exception to
the general rule regarding initial deferral elections, under which a
service provider newly eligible for participation in a plan may make a
deferral election within the first 30 days of participation in the
plan, provided that the election may only apply to compensation with
respect to services performed after the election. These regulations
further provide that for compensation that is earned based upon a
specified performance period (for example, an annual bonus), where a
deferral election is made in the first year of eligibility but after
the beginning of the service period, the election is deemed to apply to
compensation paid for service performed subsequent to the election if
the election applies to the portion of the compensation that is no
greater than the total amount of compensation for the performance
period multiplied by the ratio of the number of days remaining in the
performance period after the election over the total number of days in
the performance period.
Commentators had requested that the plan aggregation rules not
apply in determining whether a service provider is newly eligible for
participation in a plan. The concern is that a mid-year promotion, or
management reorganization or other corporate event may make the service
provider eligible for an arrangement that is of the same type as an
arrangement in which the service provider already participates. For
example, an employee participating in a salary deferral account-balance
plan may become eligible for a bonus and a bonus deferral arrangement
that would also be an account-balance plan.
The Treasury Department and the IRS believe that the plan
aggregation rules are necessary in this context. Without such a rule,
service providers may attempt to take advantage of the new eligibility
exception by establishing serial arrangements. For example, an employer
may argue that a 2007 salary deferral program is a new program, and not
a continuation of the 2006 salary deferral program. Commentators argue
that standards should be provided comparing the terms of the two plans
to distinguish new arrangements from those that are merely
continuations of existing arrangements. However, such rules would by
necessity be complicated and burdensome, generally relying on the facts
and circumstances of the individual arrangements and resulting in
administrative burden and uncertainties. Accordingly, these regulations
retain the plan aggregation rules.
However, as discussed below, certain other initial deferral
election rules have been provided that address many of the situations
in which service recipients desire to grant service providers the
opportunity to make initial deferral elections due to eligibility in
new programs. For example, the rule governing initial deferral
elections with respect to certain forfeitable rights discussed below
allows initial deferral elections upon eligibility for many bonus
programs and ad hoc equity-based compensation grants. The Treasury
Department and the IRS request comments as to whether these rules
adequately address the concerns raised with respect to the definition
of plan for purposes of applying the initial eligibility exception.
E. Initial Deferral Election With Respect to Short-Term Deferrals
As discussed above, an amount that is paid by the 15th day of the
third month following the end of the first taxable year in which the
payment is no longer subject to a substantial risk of forfeiture
generally will not constitute a deferral of compensation. Commentators
asked how the deferral election rules apply to an election to defer
such an amount. Generally, once the service provider has begun
performing the services required to vest, no election to defer could be
made that would meet the timing requirements for initial deferral
elections. Commentators suggested that the rules governing subsequent
changes to the time and form of payment could be applied to elections
to defer these
[[Page 57945]]
amounts. The regulations provide that for purposes of an election to
defer amounts that would not otherwise be subject to section 409A due
to the short-term deferral rule, the date the substantial risk of
forfeiture lapses is treated as the original time of payment
established by an initial deferral election, and the form in which the
payment would be made absent a deferral election is treated as the
original form of payment established by an initial deferral election.
Accordingly, the service provider may elect to defer the payment beyond
the time at which the payment originally was scheduled to be made, in
accordance with the rules governing subsequent changes in the time and
form of payment. In general, this means that the service provider must
make the election at least 12 months before the right to the payment
vests, and must defer the payment for a period of not less than 5 years
from the date the right to the payment could vest. Thus, no payment
could be made within 5 years of the date the right to the payment vests
(including upon a separation from service), except for instances of a
change in control of the corporation, death, disability or an
unforeseeable emergency. This would also mean that if the right to the
payment actually vests within 12 months of the election, and the
election is given effect so that the payment is not made within the
short-term deferral period, the deferral of the payment would violate
the requirements of section 409A.
For example, an employee may be entitled to the immediate payment
of a bonus upon the occurrence of an initial public offering, where
such a condition qualifies as a substantial risk of forfeiture so that
the arrangement would constitute a short-term deferral. At some point
after obtaining the right to the payment but before the initial public
offering, the employee elects to defer any potential bonus payment to a
date 5 years from the date of the initial public offering. To comply
with the initial deferral election rules, that deferral election must
not be given effect for 12 months. Accordingly, if the initial public
offering occurred within 12 months of the deferral election, the
payment must be made at the time of the initial public offering in
accordance with the short-term deferral rules. If the payment is not
made at such time, but rather is made, for example, 5 years from the
date of the initial public offering, the payment would be deemed
deferred pursuant to an invalid initial deferral election effective
before the required lapse of 12 months and the arrangement would
violate section 409A.
F. Initial Deferral Election With Respect to Certain Forfeitable Rights
Commentators asked how the initial deferral election rules would
apply with respect to grants of nonqualified deferred compensation that
occur in the middle of a taxable year, especially where such grants
were unforeseeable by the service provider. Under these circumstances,
an initial deferral election could not be made by the service provider
during the taxable year before the year in which the award was granted,
unless the service recipient had the foresight to request such an
election in the prior year. The Treasury Department and the IRS do not
believe that a categorical exclusion from the initial deferral election
rules is appropriate, because such a rule would encourage the
characterization of all grants of nonqualified deferred compensation as
occurring in the middle of the year and in large part render
ineffective the initial deferral election rules set forth in section
409A. However, these regulations provide that where a grant of
nonqualified deferred compensation is subject to a forfeiture condition
requiring the continued performance of services for a period of at
least 12 months, the initial deferral election may be made no later
than 30 days after the date of grant, provided that the election is
made at least 12 months in advance of the end of the service period.
Under these circumstances, the election still must be made in all cases
at least 12 months before the service provider has fully earned the
amount of compensation, analogous to the general requirement that the
election be made no later than the end of the year before the services
are performed. The Treasury Department and the IRS believe that such a
rule will provide a reasonable accommodation to service recipients
granting certain ad hoc awards, such as restricted stock units, that
often are subject to a requirement that the service provider continue
to perform services for at least 12 months.
G. Initial Deferral Election With Respect to Fiscal Year Compensation
The legislative history to section 409A indicates that the Treasury
Department and the IRS are to provide guidance coordinating the initial
deferral election rules with respect to compensation paid by service
recipients with fiscal years other than the calendar year. H.R. Conf.
Rep. No. 108-755, at 732 (2004). These regulations provide such a rule,
generally permitting an initial election to defer fiscal year
compensation on or before the end of the fiscal year immediately
preceding the first fiscal year in which any services are performed for
which the compensation is paid. For these purposes, fiscal year
compensation does not encompass all compensation paid by a fiscal year
service recipient. Where the compensation is not specifically based
upon the service recipient's fiscal year as the measurement period, the
timing requirements applicable to an initial deferral election are
unchanged. Accordingly, the rule applies to compensation based on
service periods that are coextensive with one or more of the service
recipient's consecutive fiscal years, where no amount of such
compensation is payable during the service period. For example, a bonus
based upon a service period of two consecutive fiscal years payable
after the completion of the second fiscal year would be fiscal year
compensation. In contrast, periodic salary payments or bonuses based on
service periods other than the service recipient's fiscal year would
not be fiscal year compensation, and the deferral of such amounts would
be subject to the general rule.
H. Deferral Elections With Respect to Commissions
Commentators requested clarification with respect to the
application of section 409A to commissions. These regulations address
commissions earned by a service provider where a substantial portion of
the services provided by the service provider consists of the direct
sale of a product or service to a customer, each payment of
compensation by the service recipient to the service provider consists
of a portion of the purchase price for the product or service (for
example, 10 percent of the purchase price), or an amount calculated
solely by reference to the volume of sales (for example, $100 per item
sold), and each compensation payment is contingent upon the service
recipient receiving payment from an unrelated customer for the product
or services. In that case, the service provider is treated as having
performed the services to which the commission compensation relates
during the service provider's taxable year in which the unrelated
customer renders payment for such goods or services. Accordingly, under
the general initial deferral election rule an individual service
provider could make an initial deferral election with respect to such
compensation through December 31 of the calendar year preceding the
year in which the customer renders the
[[Page 57946]]
payment from which the commission is derived.
VI. Time and Form of Payment
A. In General
The regulations incorporate the statutory requirement that payments
be made at a fixed date or under a fixed schedule, or upon any of five
events: a separation from service, death, disability, change in the
ownership or effective control of a corporation (to the extent provided
by the Secretary), or unforeseeable emergency. As requested by
commentators, these regulations provide guidance on what it means for a
payment to be made upon one of these events. Where the time of payment
is based upon the occurrence of a specified event (such as one of the
five events listed above or upon the lapse of a substantial risk of
forfeiture as discussed below), the plan must designate an objectively
determinable date or year following the event upon which the payment is
to be made. For example, the plan may designate the payment date as 30
days following a separation from service, or the first calendar year
following a service provider's death. The Treasury Department and the
IRS recognize that it may not be administratively feasible to make a
payment upon the exact date or year designated. Furthermore, the
Treasury Department and the IRS recognize that certain minimal delays
that do not meaningfully affect the timing of the inclusion of income
should not result in a violation of the requirements of section 409A.
Accordingly, a payment will be treated as made upon the designated date
if the payment is made by the later of the first date it is
administratively feasible to make such payment on or after the
designated date, or the end of the calendar year containing the
designated date (or the end of the calendar year if only a year is
designated). This relaxation of the timing rules for administrative
necessity is not intended to provide a method for the service provider
to further defer the payment. Accordingly, any inability to make the
payment that is caused by an action or inaction of the service
provider, or any person related to, or under the control of, the
service provider, will not be treated as causing the making of the
payment to be administratively infeasible.
Once an event upon which a payment is to be made has occurred, the
designated date generally is treated as the fixed date on which, or the
fixed schedule under which, the payment is to be made (but not for
purposes of the application of section 409A(a)(2)(B) generally
requiring a six month delay in any payment upon a separation from
service to a key employee of a corporation whose stock is traded on an
established securities market). Accordingly, the recipient may change
the time and form of payment after the event has occurred, provided
that the change would otherwise be timely and permissible under these
regulations. For example, a plan provides for payment of a lump sum on
the third anniversary following a separation from service. A service
provider has a separation from service on July 1, 2010. The July 1,
2013, payment date is now treated as the fixed date upon which the
payment is to be made. Accordingly, the service provider generally
could elect to defer the time and form of payment provided that the
election were made on or before June 30, 2012, and deferred the payment
to at least July 1, 2018. For a discussion of the application of the
subsequent deferral rules when only a calendar year of payment is
specified, see section VI.B of this preamble.
B. Specified Time or Fixed Schedule of Payments
Generally a plan will be deemed to provide for a specified time or
fixed schedule of payments where, at the time of the deferral, the
specific date upon which the payment or payments will be made may be
objectively determined. As requested by commentators, these regulations
permit plans to specify simply the calendar year or years in which the
payments are scheduled to be made, without specifying the particular
date within such year on which the payment will be made. Although this
provision would be consistent with the flexibility allowed with respect
to meeting the specified time or fixed schedule of payments
requirement, the provision must be coordinated with the subsequent
deferral rules. Section 409A(a)(4)(C)(iii) requires that if a plan
permits under a subsequent election a delay in a payment or a change in
the form of payment with respect to a payment payable at a specified
time or a fixed schedule, the plan must require that the election be
made not less than 12 months prior to the date of the first scheduled
payment. Application of such a provision requires a specific date for
the first scheduled payment. For a plan that does not designate a
specific date, but rather only the year in which the payment is to be
made, the first scheduled payment is deemed to be scheduled to be paid
as of January 1 of such year for this purpose.
Commentators asked whether a specified time or fixed schedule of
payments could be determined based upon the date the service provider
vests in the amount of deferred compensation, where the vesting is
based upon the occurrence of an event. These regulations provide that a
plan provides for payment at a specified time or fixed schedule of
payments if the plan provides at the time of the deferral that the
payment will be made at a date or dates that are objectively
determinable based upon the date of the lapsing of a substantial risk
of forfeiture, disregarding any acceleration of the vesting other than
due to death or disability. So, for example, a plan that provides at
the time the service provider obtains a legally binding right to the
payment that the payment will be made in three installment payments,
payable each December 31 following an initial public offering, where
the condition that an initial public offering occur before the service
provider is entitled to a payment constitutes a substantial risk of
forfeiture, would satisfy the requirement that the plan provide for
payments at a specified time or pursuant to a fixed schedule.
C. Separation From Service
Section 409A(a)(2)(A)(i) provides that a plan may permit a payment
to be made upon a separation from service as determined by the
Secretary (except a payment to a specified employee, in which case the
payment must be made subject to a six-month delay, discussed more fully
below). These regulations provide guidance as to the circumstances
under which service providers, including employees and independent
contractors, will be treated as separating from service for purposes of
section 409A. These rules are intended solely as guidance with respect
to section 409A(a)(2)(A)(i), and should not be relied upon with respect
to any other Code provisions, such as provisions with respect to
distributions under qualified plans and provisions related to the
service recipients' employment tax and information reporting
obligations.
1. Employees
These regulations provide that an employee experiences a separation
from service if the employee dies, retires, or otherwise has a
termination of employment with the employer. However, the employment
relationship is treated as continuing intact while the individual is on
military leave, sick leave, or other bona fide leave of absence (such
as temporary employment by the Government) if the period of such leave
does not exceed six months, or if longer, so long as the individual's
right
[[Page 57947]]
to reemployment with the service recipient is provided either by
statute or by contract. If the period of leave exceeds six months and
the individual's right to reemployment is not provided either by
statute or by contract, the employment relationship is deemed to
terminate on the first date immediately following such six-month
period.
Whether the employee has experienced a termination of employment is
determined based on the facts and circumstances. The Treasury
Department and the IRS do not intend for this standard to allow for the
extension of deferrals through the use of consulting agreements or
other devices under which the service provider technically agrees to
perform services as demanded, but for which there is no intent that the
service provider perform any significant services. Accordingly, the
regulations provide an anti-abuse rule stating that where an employee
either actually or purportedly continues in the capacity as an
employee, such as through the execution of an employment agreement
under which the service provider agrees to be available to perform
services if requested, but the facts and circumstances indicate that
the employer and the service provider did not intend for the service
provider to provide more than insignificant services for the employer,
an employee will be treated as having a termination of employment and a
separation from service. For these purposes, an employer and employee
will be deemed to have intended for the employee to provide more than
insignificant services if the employee provides services at an annual
rate equal to at least 20 percent of the services rendered and the
annual remuneration for such services is equal to at least 20 percent
of the average remuneration earned during the immediately preceding
three full calendar years of employment (or, if the employee was
employed for less than three years, such lesser period).
In addition, the Treasury Department and the IRS do not intend for
this standard to be circumvented to create a separation from service
where the service provider continues to perform significant services
for the service recipient. For these purposes, the regulations provide
that where an employee continues to provide services to a previous
employer in a capacity other than as an employee, a separation from
service will be treated as not having occurred if the former employee
provides services at an annual rate that is 50 percent or more of the
services rendered, on average, during the final three full calendar
years of employment (or, if less, such lesser period) and the annual
remuneration for such services is 50 percent or more of the average
annual remuneration earned during the immediately preceding three full
calendar years of employment (or if less, such lesser period).
Commentators asked whether the previous positions of the Treasury
Department and the IRS with respect to a separation from service for
purposes of section 401(k), generally referred to as the same desk
rule, would apply in these circumstances. Under that rule, in certain
situations where the identity of the employee's employer changed, such
as with respect to a sale of substantially all of the assets of the
original employer to a new employer who hired the employee, the
employee would not be treated as having a separation from service where
the duties and responsibilities of the employee had not materially
changed. These regulations do not incorporate this standard.
Commentators had requested the ability to elect whether to apply
the same desk rule in the case of a corporate transaction, such as a
sale of substantially all of the assets of the original employer. The
Treasury Department and the IRS do not believe that such a rule would
be consistent with the provisions of section 409A, which generally
restrict such control over the time and form of payment.
2. Independent Contractors
The definition of a separation from service of an independent
contractor in these proposed regulations generally is derived from the
definition of severance from employment provided in Sec. 1.457-
6(b)(2). Comments are requested with respect to any changes that may be
necessary to address issues arising under section 409A.
3. Delay for Key Employees
Section 409A(a)(2)(B)(i) provides that payments upon a separation
from service to a key employee of a corporation whose stock is publicly
traded on an established securities market must be delayed at least six
months following the separation from service. For these purposes, a key
employee is defined in accordance with section 416(i), disregarding
section 416(i)(5). Commentators asked for guidance on when a
determination as to whether an individual is a key employee must be
made. Section 416 relies upon plan year concepts, which generally are
not relevant to the application of section 409A. In addition, the
Treasury Department and the IRS wish to establish rules that minimize
the administrative burden, while implementing the legislative intent.
Accordingly, the regulations provide that the identification of key
employees is based upon the 12-month period ending on an identification
date chosen by the service recipient. Persons who meet the requirements
of section 416(i)(1)(A)(i), (ii) or (iii) during that 12-month period
are considered key employees for the 12-month period commencing on the
first day of the 4th month following the end of the 12-month period.
For example, if an employer chose December 31 as an identification
date, any key employees identified during the calendar year ending
December 31 would be treated as specified employees for the 12-month
period commencing the following April 1. In this manner, service
recipients generally may know in advance whether the person to whom a
payment is scheduled to be made will be subject to the provision. In
addition, service recipients may choose an identification date other
than December 31, provided that the date must be used consistently and
provided that any change in the identification date may not be
effective for a period of at least 12 months.
Some commentators had requested that certain types of payments,
generally life annuities or longer-term installment payments, be
excepted from the six-month delay requirement. The statutory language
does not contemplate such an exception. Where an executive is aware
that the source of funds to pay for his nonqualified deferred
compensation are at significant risk, the executive may separate from
service to obtain initial annuity or installment payments while such
funds exist. Commentators argue that annuity payments or long-term
installment payments generally would be less significant in amount.
However, the Treasury Department and the IRS are not inclined to
establish arbitrary limits, where such amounts may actually be quite
significant due to the overall amount of the entire benefit, the number
of installment payments, or the age of the participant, especially
where the statutory language does not contemplate the creation of such
an exception. Rather, the Treasury Department and the IRS believe that
the provisions with respect to separation pay should provide service
recipients the ability to provide reasonably significant amounts of
benefits to terminating executives, that may respond to many of the
concerns underlying the request to relax the six-month delay
requirement.
To meet the six-month delay requirement, a plan may provide that
any payment pursuant to a separation of service due within the six-
month period is delayed until the end of the six-
[[Page 57948]]
month period, or that each scheduled payment that becomes payable
pursuant to a separation from service is delayed six months, or a
combination thereof. For example, a nonqualified deferred compensation
plan of a corporation whose stock is publicly traded on an established
securities market may provide that a participant is entitled to 60
monthly installment payments upon separation from service, payable
commencing the first day of the first month following the date of
separation from service. To comply with the requirement of a six-month
delay for payments to key employees, the plan may provide that in the
case of an affected participant, the aggregate amount of the first
seven months of installments is paid at the beginning of the seventh
month following the date of separation from service, or may provide
that the commencement date of the 60 months of installment payments is
the first day of the seventh month following the date of separation
from service, or may provide for a combination of these provisions. A
plan may be amended to specify or change the manner in which the delay
will be implemented, provided that the amendment may not be effective
for at least 12 months. Because the delay requirement applies only to
certain public corporations, a corporation or other entity not covered
by the requirement may have failed to include a provision in its plans
at the time the corporation is contemplating becoming a public
corporation. These regulations provide that where the stock of the
service recipient is not publicly traded on an established securities
market, a plan may be amended to specify or change the manner in which
the delay will be implemented, effective immediately upon adoption of
the amendment. A plan may provide a service provider an election as to
the manner in which the six-month delay is to be implemented, provided
that such election is subject to otherwise applicable deferral election
rules.
D. Death or Disability
As provided in section 409A(a)(2)(A)(ii) and (iii), these
regulations state that the death or disability of the service provider
are permissible payment events. The regulations incorporate the
definition of disability provided in section 409A(a)(2)(C). These
regulations clarify that a plan that provides for a payment upon a
disability need not provide for a payment upon all disabilities
identified in section 409A(a)(2)(C), as long as any disability upon
which a payment would be made is contained within the definition
provided in section 409A(a)(2)(C). In addition, these regulations
provide that a service recipient may rely upon a determination of the
Social Security Administration with respect to the existence of a
disability.
E. Change in Ownership or Effective Control of the Corporation
The provisions defining a change in ownership or effective control
of a corporation remain substantially unchanged from Notice 2005-1,
Q&As-11 through 14. These provisions are based largely upon the
discussion in the legislative history, indicating that the guidance
should provide a similar, but more restrictive, definition of a change
in the ownership or effective control of a corporation as compared to
the definition used for purposes of the golden parachute provisions of
section 280G. H.R. Conf. Rep. No. 108-755, at 730 (2004). Accordingly,
the provisions largely mirror the regulations under section 280G,
though the percentage changes in ownership necessary to qualify as
permissible payment events have increased. However, unlike the golden
parachute provisions, a change in control event may occur that does not
relate to the entire group of affiliated corporations. Rather, the
relevant analysis for purposes of section 409A generally is whether the
corporation for whom the service provider performed services at the
time of the event, the corporation or corporations liable for the
payment at the time of the event, or a corporate majority shareholder
of one of these corporations, experienced a change in control event.
Commentators asked whether the provisions relating to the change in
ownership or effective control of a corporation will be extended to
non-corporate entities. Specifically, some commentators asked whether
change in control provisions could be applied in the case of a
partnership or other pass-through entity. Neither the statute nor the
legislative history refers to a permissible distribution upon a change
in ownership or effective control of any type of entity other than a
corporation.
However, the Treasury Department and the IRS plan to issue
regulations under section 409A(a)(3) that will allow an acceleration of
payments upon a change in the ownership of a partnership or in the
ownership of a substantial portion of the assets of the partnership.
Until further guidance is issued, the section 409A rules regarding
permissible distributions upon a change in the ownership of a
corporation (as described in proposed Sec. 1.409A-3(g)(5)(iv)) or a
change in the ownership of a substantial portion of the assets of a
corporation (as described in proposed Sec. 1.409A-3(g)(5)(vi)) may be
applied by analogy to changes in the ownership of a partnership and
changes in the ownership of a substantial portion of the assets of a
partnership. For purposes of this paragraph, any references in proposed
Sec. 1.409A-3(g)(5) to corporations, shareholders, and stock shall be
treated as referring also to partnerships, partners, and partnership
interests, respectively, and any reference to ``majority shareholder''
as applied by analogy to the owner of a partnership shall be treated as
referring to a partner that (a) owns more than 50 percent of the
capital and profits interests of such partnership, and (b) alone or
together with others is vested with the continuing exclusive authority
to make the management decisions necessary to conduct the business for
which the partnership was formed. The Treasury Department and the IRS
request comments with respect to the application of a change in control
provision to partnerships and other non-corporate entities, as well as
suggestions with respect to the formulation of which types of events
should qualify and would be analogous to the corporate events described
in the regulations.
Commentators also raised questions regarding the application of
section 409A to earn-out provisions where an acquirer contracts to make
an immediate payment at the closing of the transaction with additional
amounts payable at a later date, subject to the satisfaction of
specified conditions. In such situations, the later payments could
create delays in payments of compensation calculated by reference to
the value of target corporation shares. These regulations address this
situation by providing that compensation payable pursuant to the
purchase by the service recipient of service recipient stock or a stock
right held by a service provider, or payment of amounts of deferred
compensation calculated by reference to the value of service recipient
stock, may be treated as paid at a specified time or pursuant to a
fixed schedule in conformity with the requirements of section 409A if
paid on the same schedule and under the same terms and conditions as
payments to shareholders generally pursuant to a change in the
ownership of a corporation that qualifies as a change in control event
or as payments to the service recipient pursuant to a change in the
ownership of a substantial portion of a corporation's assets that
qualifies as a change in control event, and any amounts paid pursuant
to such a schedule and such terms and conditions will not be treated as
violating the
[[Page 57949]]
initial or subsequent deferral election rules, to the extent that such
amounts are paid not later than five years after the change in control
event.
F. Unforeseeable Emergency
The regulations contain provisions defining the types of
circumstances that constitute an unforeseeable emergency, and the
amounts that may be paid due to the unforeseeable emergency. Generally
these provisions are derived directly from section 409A(a)(2)(B)(ii).
Commentators requested that in the case of an unforeseeable emergency,
a service provider be permitted to cancel future deferrals. This issue
is discussed in this preamble at paragraph VII.D.
G. Multiple Payment Events
The regulations permit a plan to provide that payments may be made
upon the earlier of, or the later of, two or more specified permissible
payment events or times. In addition, the regulations provide that a
different form of payment may be elected for each potential payment
event. For example, a plan may provide that a service provider will
receive an installment payment upon separation from service or, if
earlier, a lump sum payment upon death. The application of the rules
governing changes in time and form of payment and the anti-acceleration
rules to amounts subject to multiple payment events, is discussed
below.
H. Delay in Payment by the Service Recipient
Commentators noted that for certain compelling reasons, a service
recipient may be unwilling or unable to make a payment of an amount due
under a nonqualified deferred compensation plan. These regulations
generally provide that in the case of payments the deduction for which
would be limited or eliminated by the application of section 162(m),
payments that would violate securities laws, or payments that would
violate loan covenants or other contractual terms to which the service
recipient is a party, where such a violation would result in material
harm to the service recipient, the plan may provide that the payment
will be delayed. In addition, plans may be amended to add such
provisions, but such an amendment cannot be effective for a period of
at least 12 months. However, if a plan is amended to remove such a
provision with respect to amounts deferred previously, the amendment
will constitute an acceleration of the payment. In the case of amounts
for which the deduction would be limited or reduced by the application
of section 162(m), these regulations require that the payment be
deferred either to a date in the first year in which the service
recipient reasonably anticipates that a payment of such amount would
not result in a limitation of a deduction with respect to the payment
of such amount under section 162(m) or the year in which the service
provider separates from service. In the case of amounts that would
violate loan covenants or similar contracts, or would result in a
violation of Federal securities laws or other applicable laws, the
arrangement must provide that the payment will be made in the first
calendar year in which the service recipient reasonably anticipates
that the payment would not violate the loan contractual terms, the
violation would not result in material harm to the service recipient,
or the payment would not result in a violation of Federal securities
law or other applicable laws. These regulations also provide that the
Commissioner may prescribe through guidance published in the Internal
Revenue Bulletin other circumstances in which a plan may provide for
the delay of a payment of a deferred amount. The Treasury Department
and the IRS specifically request comments as to what other
circumstances may be appropriate to include in such guidance.
I. Disputed Payments and Refusals To Pay
In addition to situations in which a plan may delay payment due to
certain business circumstances, commentators expressed concern about
the possibility that a service recipient will refuse to pay deferred
compensation when the payment is due, and whether such refusal to pay
would result in taxation of the service provider under section 409A.
Generally these situations will arise where either the obligation to
make the payment, or the amount of the payment, is subject to dispute.
But this situation may also arise where the service recipient simply
refuses to pay. In either situation, these proposed regulations
generally provide that the payment will be deemed to be made upon the
date scheduled under the terms of the arrangement, provided that the
service provider is acting in good faith and makes reasonable, good
faith efforts to collect the amount. Factors relevant in determining
whether a service provider is acting in good faith and making
reasonable, good faith efforts to collect the amount include both the
amount of the payment, or portion of a payment, in dispute, as well as
the size of the disputed portion in relation to the entire payment.
Although a payment may be delayed under this provision without
violating section 409A because the service recipient refuses to make
the payment, the payment may not be made subject to a subsequent
deferral election because the payment was delayed. Rather, the payment
must be made by the later of the end of the calendar year in which, or
the 15th day of the third month following the date that, the service
recipient and the service provider enter into a legally binding
settlement of such dispute, the service recipient concedes that the
full amount is payable, or the service recipient is required to make
such payment pursuant to a final and nonappealable judgment or other
binding decision. This paragraph is not intended to serve as a means of
deferring payments without application of section 409A, by feigning a
dispute or surreptitiously requesting that the service recipient refuse
to pay the amount at the due date. Where the service provider is not
acting in good faith, for example creating a dispute with no or tenuous
basis, or where the service provider is not making reasonable, good
faith efforts to collect the amount, the failure to receive the payment
at the date originally scheduled may result in a violation of the
permissible payment requirements. Among the factors to be considered is
the practice of the service recipient with respect to payments of
nonqualified deferred compensation. In addition, these regulations
provide that the service provider is treated as having requested that a
payment not be made, rather than the service recipient having refused
to make such payment, where the decision that the service recipient
will not make the payment is made by the service provider, or any
person or group of persons under the supervision of the service
provider at the time the decision is made.
VII. Anti-Acceleration Provision
A. In General
Under section 409A(a)(3), a payment of deferred compensation may
not be accelerated except as provided in regulations by the Secretary.
Certain permissible payment accelerations were listed in Notice 2005-1,
Q&A-15, including payments necessary to comply with a domestic
relations order, payments necessary to comply with certain conflict of
interest rules, payments intended to pay employment taxes, and certain
de minimis payments related to the participant's termination of his or
her interest in the plan. All the permissible payment accelerations
contained in Notice 2005-1, Q&A-15, are included in these regulations.
[[Page 57950]]
B. Payments Upon Income Inclusion Under Section 409A
These regulations provide that a plan may permit the acceleration
of the time or schedule of a payment to a service provider to pay the
amount the service provider includes in income as a result of the plan
failing to meet the requirements of section 409A. For this purpose, a
service provider will be deemed to have included the amount in income
if the amount is timely reported on a Form W-2 ``Wage and Tax
Statement'' or Form 1099-MISC ``Miscellaneous Income'', as appropriate.
C. Plan Terminations
Some commentators requested that service recipients be allowed to
retain the right to accelerate payments upon a termination of the
arrangement, where the termination is at the discretion of the service
recipient. A general ability of a service recipient to make such
payments raises the potential for abuse, especially with respect to
arrangements with individual service providers. Where a service
provider retains sufficient influence to obtain a termination of the
arrangement, the service recipient's discretion to terminate the plan
in substance would mean that amounts deferred were available to the
service provider upon demand. Such a condition would be inconsistent
with the provisions of and legislative intent behind section 409A.
Some commentators requested that service recipients be permitted to
terminate arrangements where the arrangements are broad-based, covering
a significant number of service providers. Due to concerns about
administrability and equity, the regulations do not adopt the
suggestion.
Some commentators also suggested that service recipients be
permitted to terminate arrangements due to bona fide business reasons.
However, the Treasury Department and the IRS are not confident that
such a standard could be applied on a consistent and coherent basis,
leaving service recipients unable to plan with confidence and creating
the potential for abuse. The Treasury Department and the IRS are
considering further guidance establishing criteria or circumstances
under which a plan could be terminated. For that purpose, these
regulations provide authority to the Commissioner to establish such
criteria or circumstances in generally applicable guidance published in
the Internal Revenue Bulletin.
These proposed regulations provide three circumstances under which
a plan may be terminated at the discretion of the service recipient in
accordance with the terms of the plan. The first addresses a service
recipient that wants to cease providing a certain category of
nonqualified deferred compensation, such as account balance plans,
entirely. A plan may be terminated provided that all arrangements of
the same type (account balance plans, nonaccount balance plans,
separation pay plans or other arrangements) are terminated with respect
to all participants, no payments other than those otherwise payable
under the terms of the plan absent a termination of the plan are made
within 12 months of the termination of the arrangement, all payments
are made within 24 months of the termination of the arrangement, and
the service recipient does not adopt a new arrangement that would be
aggregated with any terminated arrangement under the plan aggregation
rules at any time for a period of five years following the date of
termination of the arrangement.
The remaining two exceptions relate to events that are both
objectively determinable to have occurred--and so may be determined
consistently--and are of such independent significance that they are
unlikely to be related to any attempt to accelerate payments under a
nonqualified deferred compensation plan in a manner inconsistent with
the intent of the statute. These regulations provide that during the 12
months following a change in control of a corporation, the service
recipient may elect to terminate a plan and make payments to the
participants. In addition, a plan may provide that the plan terminates
upon a corporate dissolution taxed under section 331, or with the
approval of a bankruptcy court pursuant to 11 U.S.C. Sec.
503(b)(1)(A), provided that the amounts deferred under the plan are
included in the participants' gross incomes by the latest of (i) the
calendar year in which the plan termination occurs, (ii) the calendar
year in which the amount is no longer subject to a substantial risk of
forfeiture, or (iii) the first calendar year in which the payment is
administratively practicable.
D. Terminations of Deferral Elections Following an Unforeseeable
Emergency or a Hardship Distribution
Commentators noted that although section 409A provides that a
service provider may receive a payment upon an unforeseeable emergency,
there is no provision explicitly permitting or requiring the service
provider to halt all elective deferrals to receive such a payment. In
addition, commentators noted that to receive a hardship distribution
under a qualified plan with a qualified cash or deferred arrangement
under section 401(k), a participant generally would be required
pursuant to the regulations under section 401(k) to halt any elective
deferrals of compensation into a nonqualified deferred compensation
plan. In response, these regulations provide that a plan may provide
that a deferral election terminates if a service provider obtains a
payment upon an unforeseeable emergency. Similarly, these regulations
provide that a plan may provide that a deferral election is terminated
if required for a service provider to obtain a hardship distribution
under a qualified plan with a qualified cash or deferred arrangement
under section 401(k). In each case, the deferral election must be
terminated, and not merely suspended. A deferral election under the
arrangement made after a termination of a deferral election due to a
hardship distribution or an unforeseeable emergency will be treated as
an initial deferral election.
E. Distributions To Avoid a Nonallocation Year Under Section 409(p)
Commentators noted that in the case of an S corporation sponsoring
an employee stock ownership plan, under certain conditions
distributions from a nonqualified deferred compensation plan may be
necessary to avoid a nonallocation year (within the meaning of section
409(p)(3)). These regulations provide rules under which such
distributions may be made to avoid such a nonallocation year.
VIII. Subsequent Changes in the Time and Form of Payment
A. In General
Section 409A(a)(4)(C) and these regulations provide that, in the
case of a plan that permits a service provider to make a subsequent
election to delay a payment or to change the form of a payment
(provided that any such payment is the subject of an initial deferral
election), the following conditions must be met:
(1) The plan must require that such election not take effect until
at least 12 months after the date on which the election is made,
(2) In the case of an election related to a payment other than a
payment on account of death, disability or the occurrence of an
unforeseeable emergency, the plan requires that the first payment with
respect to which such election is made be deferred for a period of not
less than 5 years from the date such payment would otherwise have been
made (the 5-year rule), and
[[Page 57951]]
(3) The plan requires that any election related to a payment at a
specified time or pursuant to a fixed schedule may not be made less
than 12 months prior to the date of the first scheduled payment.
B. Definition of Payment
Commentators requested clarification whether the individual amounts
paid in a defined stream of payments, such as installment payments, are
treated as separate payments or as one payment. This affects the
application of the rules governing subsequent deferral elections,
particularly the 5-year rule.
These proposed regulations provide generally that each separately
identified amount to which a service provider is entitled to payment
under a plan on a determinable date is a separate payment. Accordingly,
if an amount is separately identified as a payment, either because the
right arises under a separate arrangement or because the arrangement
identifies the amount as a separate payment, the amount will not be
aggregated with other amounts for purposes of the rules relating to
subsequent changes in the time and form of payment and the anti-
acceleration rule. For example, an arrangement may provide that 50
percent of the benefit is paid as a lump sum at separation from
service, and that the remainder of the benefit is paid as a lump sum at
age 60, which would identify each amount as a separate payment.
However, once a payment has been identified separately, the payment may
only be aggregated with another payment if the aggregation would
otherwise comply with the rules relating to subsequent changes in the
time and form of payment and the anti-acceleration rule.
The Treasury Department and the IRS recognize that most taxpayers
view the ability to elect installment payments as a choice of a single
form of payment. Accordingly, the entitlement to a series of
installment payments under a particular arrangement generally is
treated as a single payment for purposes of the subsequent deferral
rules. However, taxpayers could also view each individual payment in
the series of payments as a separate payment. Accordingly, these
regulations provide that an arrangement may specify that a series of
installment payments is to be treated as a series of separate payments.
An installment payment must be treated consistently both with
respect to the rules governing subsequent changes in the time and form
of payment, and with respect to the anti-acceleration rules. For
example, if a 5-year installment payment is treated as a single payment
and is scheduled to commence on July 1, 2010, then consistent with the
5-year rule a service provider generally could change the time and form
of the payment to a lump sum payment on July 1, 2015, provided the
other conditions related to a change in the time and form of payment
were met. In contrast, if a 5-year installment payment is designated as
five separate payments scheduled for the years 2010 through 2014, then
the service provider could not change the time and form of the payment
to a lump sum payment to be made on July 1, 2015 because the separate
payments scheduled for the years 2011 through 2014 would not have been
deferred at least 5 years. Rather, the service provider generally could
change the time and form of payment to a lump sum payment only if the
payment were scheduled to occur no earlier than 2019 (5 years after the
last of the originally scheduled payments).
One exception to this rule is a life annuity, the entitlement to
which is treated as a single payment. The Treasury Department and the
IRS believe that taxpayers generally view an entitlement to a life
annuity as a single form of payment, rather than a series of separate
payments. In addition, treating a life annuity as a series of payments
would lead to difficulty in applying the rules governing subsequent
changes in the time and form of payment, because the aggregate amount
of the payments and the duration of the payments are unknown, as their
continuation depends on the continued life of the service provider or
other individual. For example, if a single life annuity were treated as
a series of separate payments, an election to change a form of payment
to a lump sum payment could be made only if the lump sum payment were
deferred to a date no earlier than five years after the death of the
participant.
C. Application to Multiple Payment Events
As discussed above, a plan may provide that a payment will be made
upon the earlier of, or the later of, multiple specified permissible
payment events. In addition, a plan may provide for a different form of
payment depending upon the payment event. For example, a plan may
provide that a service provider is entitled to an annuity at age 65 or,
if earlier, a lump sum payment upon separation from service.
The question then arises as to how the provisions governing changes
in the time and form of payment and the anti-acceleration provision
apply where there are multiple potential payment events, and possibly
multiple forms of payment as well. The regulations provide that these
provisions are to apply to each payment event separately. In the
example above, these provisions would apply separately to the
entitlement to the installment payment at age 65, and the entitlement
to the lump sum payment at separation from service. Accordingly, the
service provider generally would be able to delay the annuity payment
date subject to the rules governing changes in the time and form of
payment, while retaining a separate right to receive a lump sum payment
at separation from service if that occurred at an earlier date. In
other words, the 5-year rule would apply to the annuity payment date
(delaying payment from age 65 to at least age 70) but not to the
unchanged lump sum payment available upon separation from service
before age 70.
Similarly, a plan may provide that an intervening event that is a
permissible payment event under section 409A may override an existing
payment schedule already in payment status. For example, a plan could
provide that a participant would receive six installment payments
commencing at separation from service, but also provide that if the
participant died after the payments commenced, all remaining benefits
would be paid in a lump sum.
An additional question arises where a new payment event, or a fixed
time or fixed schedule of payments, is added to the plan. Generally,
the addition of the payment event or date will be subject to the rules
governing changes in the time and form of payment and the anti-
acceleration rules. Accordingly, no fixed time of payment could be
added that did not defer the payment at least five years from the date
the fixed time was added. In addition, no payment due to any other
added permissible event could be made within five years of the addition
of the event. For example, a service provider entitled to a payment
only on January 1, 2050, could not make a subsequent deferral election
to be paid on the later of January 1, 2050, or separation from service,
but could make a subsequent deferral election to be paid at the later
of separation from service or January 1, 2055.
IX. Application of Rules to Nonqualified Deferred Compensation Plans
Linked to Qualified Plans
A. In General
Commentators raised many issues concerning the application of
section 409A to nonqualified deferred compensation plans linked to
qualified plans. These linked plans exist in a variety of formats, and
are referred to
[[Page 57952]]
under various labels such as excess plans, wrap plans, and supplemental
employee retirement plans (SERPs). Typically the purpose of such plans
is to replace the benefits that would have been provided under the
qualified plan absent the application of certain limits contained in
the Code (for example, section 415, section 401(a)(17) or section
402(g)). Often the amounts deferred under the nonqualified deferred
compensation plan are established through an offset formula, where the
amount deferred equals an amount determined under a formula, offset by
any benefits credited under the qualified plan. Because of the close
relationship between the qualified plan and the nonqualified deferred
compensation plan, sponsor and participant actions under the qualified
plan may affect the calculation or payment of the amounts deferred
under the nonqualified deferred compensation plan. Commentators asked
for guidance regarding the circumstances under which an action (or
failure to act) under the qualified plan may be treated as violating
section 409A, to the extent the action (or failure to act) also affects
the amounts deferred under the nonqualified deferred compensation plan.
These proposed regulations generally adopt rules under which
nonqualified deferred compensation plans linked to qualified plans may
continue to operate, though certain changes may be required. The intent
of these rules generally is to permit the qualified plan to be
established, amended and operated under the rules governing qualified
plans, without causing the linked nonqualified deferred compensation
plan to violate the rules of section 409A. However, the relief provided
under certain rules to accommodate the linked plan structure is not
intended to relax the rules generally with respect to all of the
amounts deferred under the nonqualified deferred compensation plan,
simply because a limited portion of the amounts deferred may be
affected by actions under the qualified plan. Accordingly, in certain
circumstances the relief provided relates solely to amounts deferred
under the nonqualified deferred compensation plan that do not exceed
the applicable limit on the qualified plan benefit for the taxable
year.
B. Actions That Do Not Constitute Deferral Elections or Accelerations
Where amounts deferred under a nonqualified deferred compensation
plan are linked to the benefits under a qualified plan, certain
participant actions taken with respect to the benefit accrued under the
qualified plan may affect the amounts deferred under the nonqualified
deferred compensation plan. Where the amounts deferred under the
nonqualified deferred compensation plan increase, the issue is whether
the action taken with respect to the benefit accrued under the
qualified plan constitutes a deferral election. Where the amounts
deferred under the nonqualified deferred compensation plan decrease,
the issue is whether the action taken with respect to the benefit
accrued under the qualified plan constitutes an impermissible
acceleration of a payment under the nonqualified deferred compensation
plan.
With respect to the benefits provided under the qualified plan,
these regulations provide generally that neither the amendment of the
qualified plan to increase or decrease such benefits under the
qualified plan nor the cessation of future accruals under the qualified
plan is treated as a deferral election or an acceleration of a payment
under the nonqualified deferred compensation plan. Similarly, the
addition, removal, increase or reduction of a subsidized benefit or
ancillary benefit under the qualified plan, or a participant election
with respect to a subsidized benefit or ancillary benefit under the
qualified plan, will not constitute either a deferral election or an
acceleration of a payment under the nonqualified deferred compensation,
even where such action results in an increase or decrease in amounts
deferred under the nonqualified deferred compensation plan.
Additional relief is provided with respect to nonqualified deferred
compensation plans linked to defined contribution plans that include a
401(k) or similar cash or deferred arrangement. Specifically, the
regulations provide that a service provider's action or inaction under
a qualified plan that is subject to section 402(g), including an
adjustment to a deferral election under such qualified plan, will not
be treated as either a deferral election or an acceleration of a
payment under the linked nonqualified deferred compensation plan,
provided that for any given calendar year, the service provider's
actions or inactions under the qualified plan do not result in an
increase in the amounts deferred under all nonqualified deferred
compensation plans in which the service provider participates in excess
of the limit with respect to elective deferrals under section 402(g) in
effect for the year in which such actions or inactions occur. The
Treasury Department and the IRS intend for this provision to address
common arrangements whereby the amounts deferred under the nonqualified
deferred compensation plan are linked to amounts deferred under a
401(k) arrangement (often referred to as 401(k) wrap plans), but only
to the extent the amount of affected deferrals under the nonqualified
deferred compensation plan does not exceed the maximum amount that ever
could have been electively deferred under the qualified plan.
Similar relief is provided with respect to plans involving matching
contributions. The regulations provide that a service provider's action
or inaction under a qualified plan with respect to elective deferrals
or after-tax contributions by the service provider to the qualified
plan that affects the amounts that are credited under a nonqualified
deferred compensation arrangement as matching amounts or other amounts
contingent on service provider elective deferrals or after-tax
contributions will not be treated as either a deferral election or an
acceleration of payment, provided that such matching or contingent
amounts, as applicable, are either forfeited or never credited under
the nonqualified deferred compensation arrangement in the absence of
such service provider's elective deferral or after-tax contribution,
and provided the service provider's actions or inactions under the
qualified plan do not result in an increase or decrease in the amounts
deferred under all nonqualified deferred compensation plans in which
the service provider participates in excess of the limit with respect
to elective deferrals under section 402(g) in effect for the year in
which such actions or inactions occur. Although the section 402(g)
limit applies to elective deferrals, rather than matching
contributions, the Treasury Department and the IRS believe that
matching contributions in excess of 100 percent of the elective
deferrals of pre-tax contributions or after-tax contributions will be
rare.
X. Statutory Effective Dates
A. Effective Dates--Earned and Vested Amounts
Consistent with Notice 2005-1, Q&A-16, these regulations provide
that an amount is considered deferred before January 1, 2005, and thus
is not subject to section 409A, if the service provider had a legally
binding right to be paid the amount and the right to the amount was
earned and vested as of December 31, 2004. For these purposes, a right
to an amount is earned and vested only if the amount is not subject to
either a substantial risk of forfeiture or a
[[Page 57953]]
requirement to perform further services. Some commentators questioned
the application of section 409A to contractual arrangements entered
into before the enactment of the statute. However, the statutory
effective date is tied to the date the amount is deferred and the
legislative history states that for these purposes, ``an amount is
considered deferred before January 1, 2005, if the amount is earned and
vested before such date.'' H.R. Conf. Rep. No. 108-755, at 737 (2004).
Accordingly, these regulations are consistent with the legislative
intent that deferred amounts that were not earned, or were not vested,
as of December 31, 2004, are subject to the provisions of section 409A.
Clarification has been provided with respect to when a stock right
or similar right to compensation will be treated as earned and vested.
The issue arises because often a stock right terminates upon a
separation from service. Taxpayers questioned whether this meant that
the right had not been earned and vested, because future services would
be required to retain the right. These regulations clarify that a stock
right or similar right will be treated as earned and vested by December
31, 2004, if on or before such date the right was either immediately
exercisable for a payment of cash or substantially vested property, or
was not forfeitable. Accordingly, stock options that on or before
December 31, 2004, were immediately exercisable for substantially
vested stock generally would not be subject to section 409A. In
contrast, a nonstatutory stock option that was immediately exercisable
on or before December 31, 2004, but only for substantially nonvested
stock, generally would be subject to section 409A.
B. Effective Dates--Calculation of Grandfathered Amount
For account balance plans and plans that are neither account
balance plans nor nonaccount balance plans (generally equity-based
compensation), these regulations generally retain the method of
calculating the grandfathered amount set forth in Notice 2005-1, Q&A
16. Accordingly, for account balance plans the grandfathered amount
generally will equal the vested account balance as of December 31,
2004, plus any earnings with respect to such amounts. For equity-based
compensation, the grandfathered amount generally will equal the payment
that would be available if the right were exercised on December 31,
2004, and any earnings with respect to such amount. For this purpose,
the earnings generally would include the increase in the payment
available due to appreciation in the underlying stock.
Commentators argued that the definition of the grandfathered amount
contained in Notice 2005-1, Q&A 16 with respect to nonaccount balance
plans was not sufficiently flexible to account for subsequent increases
in benefits unrelated to any further performance of services or
increases in compensation after December 31, 2004. For example, a
participant's benefit may increase if the participant becomes eligible
for a subsidized benefit at a specified age that the participant
reaches after December 31, 2004. In response, these proposed
regulations provide that for nonaccount balance plans, the
grandfathered amount specifically equals the present value as of
December 31, 2004, of the amount to which the service provider would be
entitled under the plan if the service provider voluntarily terminated
services without cause on December 31, 2004, and received a payment of
the benefits with the maximum value available from the plan on the
earliest possible date allowed under the plan to receive a payment of
benefits following the termination of services. Notwithstanding the
foregoing, for any subsequent calendar year, the grandfathered amount
may increase to equal the present value of the benefit the service
provider actually becomes entitled to, determined under the terms of
the plan (including applicable limits under the Code), as in effect on
October 3, 2004, without regard to any further services rendered by the
service provider after December 31, 2004, or any other events affecting
the amount of, or the entitlement to, benefits (other than the
participant's survival or a participant election under the terms of the
plan with respect to the time or form of an available benefit).
Because separation pay plans with respect to involuntary
terminations and window programs are now treated as separate plans,
these regulations provide a rule for calculating the grandfathered
amount under such plans. For these purposes, the principles used to
calculate the grandfathered amounts under a nonaccount balance plan and
an account balance plan are to be applied by analogy, depending upon
the structure of the separation pay plan.
C. Material Modifications
Commentators have pointed out that a grandfathered plan may become
subject to section 409A upon any material modification, even if such
modification occurs many years after 2004. Given the substantial
amounts of compensation that are deferred under grandfathered plans, as
well as the potential for these amounts to grow through accumulated
grandfathered earnings, the consequences of such a modification could
be significant. Commentators expressed concern that as long as these
plans exist, there will be the potential for a change to the plan to
mistakenly cause the plan to become subject to section 409A. In
response, these regulations include a provision stating that to the
extent a modification is rescinded before the earlier of the date any
additional right granted under the modification is exercised or the end
of the calendar year in which the modification was made, the
modification will not be treated as a material modification of the
plan. For example, if a subsequent deferral feature is added that would
allow participants to extend the time and form of payment of a
grandfathered deferred amount, and if the right is removed before the
earlier of the time the participant exercises the right or the end of
the calendar year, then the modification will not be treated as a
material modification of the plan. However, this provision is not
intended to cover material modifications that are made with the
knowledge that the modification will subject the amounts to section
409A, but are then rescinded.
Consistent with Notice 2005-1, Q&A-18(a), these regulations also
provide that it is not a material modification to change a notional
investment measure to, or to add, an investment measure that qualifies
as a predetermined actual investment within the meaning of Sec.
31.3121(v)(2)-1(d)(2) of this chapter. Commentators requested similar
flexibility with respect to investment measures reflecting reasonable
rates of interest. These regulations provide such flexibility,
generally adopting a modified version of the rules contained in Sec.
31.3121(v)(2)-1(d)(2) of this chapter. Under these regulations, it is
not a material modification to change a notional investment measure to,
or to add, an investment measure that qualifies as a predetermined
actual investment within the meaning of Sec. 31.3121(v)(2)-1(d)(2) of
this chapter or, for any given taxable year, reflects a reasonable rate
of interest. For this purpose, if with respect to an amount deferred
for a period, a plan provides for a fixed rate of interest to be
credited, and the rate is to be reset under the plan at a specified
future date that is not later than the end of the fifth calendar year
that begins after the beginning of the period, the rate is reasonable
at the beginning of the period, and the rate is not changed before the
reset date, then the rate will be treated as reasonable in
[[Page 57954]]
all future periods before the reset date. These proposed regulations
also contain other clarifications of the application of the material
modification rule.
XI. Transition Relief
A. In General
Until the effective date of these regulations, Notice 2005-1
generally remains in effect. Notice 2005-1, Q&As-18 through 23.
provided transition relief that was limited to the 2005 calendar year.
Commentators generally reacted favorably to the scope of the transition
rules. The Treasury Department and the IRS intended for the transition
rules to be generous during the calendar year 2005, both to enable
taxpayers to familiarize themselves with the new provisions, and also
to provide a period during which the Treasury Department and the IRS
could develop regulations and taxpayers generally could be confident
that either their plans were not in violation of section 409A, or could
be corrected to avoid additional tax under the statute.
Because final regulations are not yet in place, the IRS and the
Treasury Department are hereby extending through 2006 certain aspects
of the transition relief provided for 2005 by Notice 2005-1. In
addition, in response to questions, certain provisions of Notice 2005-1
are clarified below. However, because taxpayers will have had, by the
end of 2005, over a year to implement the statute, certain other
transition relief is not being extended through 2006.
B. Amendment and Operation of Plans Adopted on or Before December 31,
2006
Pursuant to Notice 2005-1, Q&A-19, a plan adopted on or before
December 31, 2005, will not be treated as violating section 409A(a)(2),
(3) or (4) only if the plan is operated in good faith compliance with
the provisions of section 409A and Notice 2005-1 during the calendar
year 2005, and the plan is amended on or before December 31, 2005, to
conform to the provisions of section 409A with respect to amounts
subject to section 409A. To allow time to finalize these regulations,
and for practitioners to implement the final regulations, the deadline
by which plan documents must be amended to comply with the provisions
of section 409A and the regulations is hereby extended to December 31,
2006. Accordingly, in order to be treated as complying with section
409A(a)(2), (3) or (4), a plan adopted before December 31, 2006, must
be amended on or before December 31, 2006, either to conform to the
provisions of section 409A with respect to amounts subject to section
409A, or to provide a compensation arrangement that does not provide
for a deferral of compensation for purposes of section 409A.
The good faith compliance period provided under Q&A-19 of Notice
2005-1 is also hereby extended through December 31, 2006. Accordingly,
a plan adopted on or before December 31, 2006, will be treated as
complying with section 409A(a)(2), (3) or (4) only if the plan is
operated through December 31, 2006, in good faith compliance with the
provisions of section 409A and Notice 2005-1. If any other guidance of
general applicability under section 409A is published in the Internal
Revenue Bulletin with an effective date prior to January 1, 2007, the
plan must also comply with such published guidance as of its effective
date. To the extent an issue is not addressed in Notice 2005-1 or such
other published guidance, the plan must follow a good faith, reasonable
interpretation of section 409A, and, to the extent not inconsistent
therewith, the plan's terms.
These regulations are not proposed to become effective prior to
January 1, 2007, and, accordingly, a plan is not required to comply
with either these proposed regulations or the final regulations prior
to January 1, 2007. However, compliance with either these proposed
regulations or the final regulations will be good faith compliance with
the statute. In general, these proposed regulations expand upon, and
should be read consistently with, the provisions of Notice 2005-1.
However, to the extent that a provision of either these proposed
regulations or the final regulations is inconsistent with a provision
of Notice 2005-1, the plan may comply with the provision of the
proposed or final regulations in lieu of the corresponding provision of
Notice 2005-1.
A plan will not be operating in good faith compliance if the plan
sponsor exercises discretion under the terms of the plan, or a service
provider exercises discretion with respect to that service provider's
benefits, in a manner that causes the plan to fail to meet the
requirements of section 409A. For example, if an employer retains the
discretion under the terms of the plan to delay or extend payments
under the plan and exercises such discretion, the plan will not be
considered to be operated in good faith compliance with section 409A
with regard to any plan participant. However, an exercise of a right
under the terms of the plan by a service provider solely with respect
to that service provider's benefits under the plan, in a manner that
causes the plan to fail to meet the requirements of section 409A, will
not be considered to result in the plan failing to be operated in good
faith compliance with respect to other participants. For example, the
request for and receipt of an immediate payment permitted under the
terms of the plan if the participant forfeits 20 percent of the
participant's benefits (a haircut) will be considered a failure of the
plan to meet the requirements of section 409A with respect to that
service provider, but not with respect to all other service providers
under the plan.
C. Change in Payment Elections or Conditions on or Before December 31,
2006
Notice 2005-1, Q&A-19(c) provided generally that with respect to
amounts subject to section 409A, a plan could be amended to provide for
new payment elections without violating the subsequent deferral and
anti-acceleration rules, provided that the plan was amended and the
participant made the election on or before December 31, 2005. The
period during which a plan may be amended and a service provider may be
permitted to change payment elections, without resulting in an
impermissible subsequent deferral or acceleration, is hereby extended
through December 31, 2006, except that a service provider cannot in
2006 change payment elections with respect to payments that the service
provider would otherwise receive in 2006, or to cause payments to be
made in 2006. Other provisions of the Internal Revenue Code and common
law doctrines continue to apply to any such election.
Accordingly, with respect to amounts subject to section 409A and
amounts that would be treated as a short-term deferral within the
meaning of Sec. 1.409A-1(b)(4), a plan may provide, or be amended to
provide, for new payment elections on or before December 31, 2006, with
respect to both the time and form of payment of such amounts and the
election will not be treated as a change in the form and timing of a
payment under section 409A(a)(4) or an acceleration of a payment under
section 409A(a)(3), provided that the plan is so amended and the
service provider makes any applicable election on or before December
31, 2006, and provided that the amendment and election applies only to
amounts that would not otherwise be payable in 2006 and does not cause
an amount to be paid in 2006 that would not otherwise be payable in
such year. Similarly, an outstanding stock right that provides for a
deferral of
[[Page 57955]]
compensation subject to section 409A may be amended to provide for
fixed payment terms consistent with section 409A, or to permit holders
of such rights to elect fixed payment terms consistent with section
409A, and such amendment or election will not be treated as a change in
the time and form of a payment under section 409A(a)(4) or an
acceleration of a payment under section 409A(a)(3), provided that the
option or right is so amended and any elections are made, on or before
December 31, 2006.
D. Payments Based Upon an Election Under a Qualified Plan for Periods
Ending on or Before December 31, 2006
For calendar year 2005, Notice 2005-1 Q&A-23 provides relief for
nonqualified deferred compensation plans where the time and form of
payment is controlled by the time and form of payment elected by the
service provider under a qualified plan. Commentators indicated that
this is a common arrangement with respect to nonqualified deferred
compensation plans providing benefits calculated in relation to
benefits accrued under a defined benefit qualified plan. Generally, the
provisions with respect to the election of a time and form of a payment
with respect to a qualified plan benefit would not comply with the
requirements of section 409A were the plan subject to section 409A.
Accordingly, election provisions under a nonqualified plan that
mirrored or depended upon an election under a qualified plan generally
would not comply with section 409A. The Treasury Department and the IRS
were concerned that service providers, service recipients and plan
administrators would not have sufficient time to solicit, retain and
process new elections from service providers to comply with section
409A in 2005. Accordingly, relief was provided in Notice 2005-1, Q&A-
23, under which an election under a nonqualified deferred compensation
plan that was controlled by an election under a qualified plan could
continue in effect during the calendar year 2005.
Commentators requested that this relief be a permanent provision in
the regulations. Although the Treasury Department and the IRS
understand that such a provision would make the coordination of
benefits under a qualified plan and benefits under a nonqualified
deferred compensation plan calculated by reference to the qualified
plan benefits easier to administer, the provisions of section 409A are
not as flexible with respect to the timing of such elections as the
qualified plan provisions. Given that the benefits under a nonqualified
deferred compensation plan often dwarf the benefits provided under a
qualified plan, the Treasury Department and the IRS do not believe that
the importation of the more flexible qualified plan rules would be
consistent with the legislative intent behind the enactment of section
409A. Accordingly, the transition relief has not been made permanent.
However, because other transition relief granting a participant the
ability to change a time and form of payment through the end of the
calendar year 2006 would, in many instances, allow a participant to
elect the same time and form of payment that had been elected under the
qualified plan, the relief is hereby extended through the calendar year
2006.
Accordingly, for periods ending on or before December 31, 2006, an
election as to the timing and form of a payment under a nonqualified
deferred compensation plan that is controlled by a payment election
made by the service provider or beneficiary of the service provider
under a qualified plan will not violate section 409A, provided that the
determination of the timing and form of the payment is made in
accordance with the terms of the nonqualified deferred compensation
plan as of October 3, 2004, that govern payments. For this purpose, a
qualified plan means a retirement plan qualified under section 401(a).
For example, where a nonqualified deferred compensation plan provides
as of October 3, 2004, that the time and form of payment to a service
provider or beneficiary will be the same time and form of payment
elected by the service provider or beneficiary under a related
qualified plan, it will not be a violation of section 409A for the plan
administrator to make or commence payments under the nonqualified
deferred compensation plan on or after January 1, 2005, and on or
before December 31, 2006, pursuant to the payment election under the
related qualified plan. Notwithstanding the foregoing, other provisions
of the Internal Revenue Code and common law tax doctrines continue to
apply to any election as to the timing and form of a payment under a
nonqualified deferred compensation plan.
E. Initial Deferral Elections
Notice 2005-1, Q&A-21 provides relief with respect to initial
deferral elections, generally permitting initial deferral elections
with respect to deferrals relating all or in part to services performed
on or before December 31, 2005, to be made on or before March 15, 2005.
No extension is provided with respect to this relief with respect to
initial elections to defer compensation. The Treasury Department and
the IRS believe that sufficient guidance has been provided so that
timely elections may be solicited and received from plan participants.
In combination with the extension of flexibility with respect to
amending the time and form of payments, the Treasury Department and the
IRS believe that participants should be sufficiently informed to make a
decision with respect to deferral elections.
F. Cancellation of Deferrals and Termination of Participation in a Plan
Notice 2005-1, Q&A-20 provides a limited time during which a plan
adopted before December 31, 2005, may provide a participant a right to
terminate participation in the plan, or cancel an outstanding deferral
election with regard to amounts subject to section 409A. Generally to
qualify for this relief, if a plan amendment is necessary to permit the
participant to terminate participation or cancel a deferral election,
the plan amendment must be enacted and effective on or before December
31, 2005, and whether or not the plan is amended, the amount subject to
the termination or cancellation must be includible in income of the
participant in the calendar year 2005 or, if later, in the taxable year
in which the amounts are earned and vested.
The period during which a service provider may cancel a deferral
election or terminate participation in the plan is not extended. This
relief was intended as a temporary period during which service
providers could decide whether to continue to participate in an
arrangement subject to section 409A. The Treasury Department and the
IRS believe that the statute and existing guidance provide sufficient
information for service providers to determine by December 31, 2005,
whether to continue to participate in a particular arrangement, and
that the further extension of this relief, and the relaxation of
constructive receipt rules it entails, is not appropriate.
A termination or cancellation pursuant to Notice 2005-1, Q&A-20 is
treated as effective as of January 1, 2005, for purposes of section
409A, and may apply in whole or in part to one or more plans in which a
service provider participates and to one or more outstanding deferral
elections the service provider has made with regard to amounts subject
to section 409A. The exercise of a stock option, stock appreciation
right or similar equity appreciation right that provides for a
[[Page 57956]]
deferral of compensation, on or before December 31, 2005, will be
treated as a cancellation of a deferral.
G. Terminations of Grandfathered Plans
Notice 2005-1, Q&A-18(c) provides that amending an arrangement on
or before December 31, 2005, to terminate the arrangement and
distribute the amounts of deferred compensation thereunder will not be
treated as a material modification, provided that all amounts deferred
under the plan are included in income in the taxable year in which the
termination occurs. For the same reasons discussed above with respect
to the period during which plans may allow participants to terminate
participation in a plan, the relief provided in Notice 2005-1, Q&A-
18(c) is not extended.
To qualify for the relief provided in Notice 2005-1, Q&A-18(c), the
amendment to the plan must result in the termination of the arrangement
and the distribution of all amounts deferred under the arrangement in
the taxable year of such termination. An amendment to a plan to provide
a participant a right to elect whether to terminate participation in
the plan or to continue to defer amounts under the plan would not be
covered by Q&A-18(c), and therefore would constitute a material
modification of the plan. Accordingly, amounts that were not
distributed pursuant to such an election and continued to be deferred
under the plan would be subject to section 409A.
H. Substitutions of Non-discounted Stock Options and Stock Appreciation
Rights for Discounted Stock Options and Stock Appreciation Rights
Notice 2005-1, Q&A-18(d) provides that it will not be a material
modification to replace a stock option or stock appreciation right
otherwise providing for a deferral of compensation under section 409A
with a stock option or stock appreciation right that would not have
constituted a deferral of compensation under section 409A if it had
been granted upon the original date of grant of the replaced stock
option or stock appreciation right, provided that the cancellation and
reissuance occurs on or before December 31, 2005. The period during
which the cancellation and reissuance may occur is extended until
December 31, 2006, but only to the extent such cancellation and
reissuance does not result in the cancellation of a deferral in
exchange for cash or vested property in 2006. For example, a discounted
option generally may be replaced through December 31, 2006 with an
option that would not have provided for a deferral of compensation,
although the exercise of such a discounted option in 2006 before the
cancellation and replacement generally would result in a violation of
section 409A.
Commentators pointed out that this relief could be interpreted as
failing to cover discounted stock options or stock appreciation rights
that were not earned and vested before January 1, 2005. Where
replacement stock options or stock appreciation rights that would not
constitute deferred compensation subject to section 409A are issued in
accordance with the conditions set forth in Notice 2005-1, Q&A 18(d)
and this preamble, such replacement stock options or stock appreciation
rights will be treated for purposes of section 409A as if granted on
the grant date of the original stock option or stock appreciation
right. For example, provided that the conditions of Notice 2005-1, Q&A-
18(d) and this preamble are met, a discounted stock option granted in
2003 that was not earned and vested before January 1, 2005, may be
replaced with a stock option with an exercise price that would not have
been discounted as of the original 2003 grant date, and the substituted
stock option will be treated for purposes of section 409A as granted on
the original 2003 grant date. Accordingly, if the substituted stock
option would not have been subject to section 409A had it been granted
on the original 2003 grant date, the substituted stock option will not
be subject to section 409A.
Commentators noted that some service recipients may wish to
compensate the service provider for the lost discount. Commentators
proposed three methods to provide such compensation. First, the service
recipient may wish to pay the amount of the discount in 2005 in cash.
As a cancellation of a deferral of compensation on or before December
31, 2005 pursuant to Notice 2005-1, Q&A-20(a), this payment would not
be subject to section 409A. Note that as a payment due to the
cancellation of a deferral, such a payment could not be made in 2006 as
this relief has not been extended beyond December 31, 2005. Where the
stock option remains nonvested during the year of the option
substitution, the service recipient may wish to make the compensation
for the lost discount also subject to a vesting requirement. In that
case, commentators also proposed granting restricted stock with a fair
market value equal to the lost discount, subject to a vesting schedule
parallel to the vesting schedule of the substituted option. As a
transfer of property subject to section 83 that becomes substantially
vested after the year of substitution, this grant would not be subject
to section 409A. Finally, commentators proposed establishing a separate
plan, promising a payment of the lost discount (plus earnings) subject
to a vesting schedule parallel to the vesting schedule of the
substituted option. Provided the right to the payment becomes
substantially vested in a future year and otherwise meets the
requirement of the short-term deferral exception in these regulations,
the right to this payment would not constitute deferred compensation
subject to section 409A. Alternatively, such an arrangement could
itself provide for deferral of compensation beyond the year of
substantial vesting and be subject to the requirements of section 409A,
but if such requirements are met, would not affect the exclusion of the
amended stock option or stock appreciation right from the treatment as
a deferral of compensation subject to section 409A.
XII. Calculation and Timing of Income Inclusion Amounts
To more rapidly issue guidance necessary to allow service
recipients to comply with section 409A, the Treasury Department and the
IRS have not included in these regulations guidance with respect to the
calculation of the amounts of deferrals, or of the amounts of income
inclusion upon the violation of the provisions of section 409A and
these regulations, or the timing of the inclusion of income and related
withholding obligations. The Treasury Department and the IRS anticipate
that these topics will be addressed in subsequent guidance. The
Treasury Department and the IRS request comments with respect to the
calculation and timing of the income inclusion under section 409A, and
specifically request comments in two areas.
First, section 409A generally requires that for any taxable year in
which an amount is deferred under a plan that fails to meet certain
requirements, all amounts deferred must be included in income. This
provision generally treats earnings (whether actual or notional) as
amounts deferred subject to the inclusion provision. Service providers
may experience negative earnings in a calendar year, such that the
amounts to which a service provider has a right in a particular year
are less than the amounts to which a service provider had a right in a
previous year, even where no actual payments have been made. The
Treasury Department and the IRS request comments with respect to
whether and how such negative earnings may be accounted for in
[[Page 57957]]
determining the amount of deferrals and the amount of income inclusion
for a given taxable year, particularly where continuing violations of
section 409A extend to successive tax years.
Second, the Treasury Department and the IRS understand that a
method of calculation of current deferrals and of amounts to be
included in income is needed for service recipients to meet their
reporting and withholding obligations. Comments are requested as to
what transitional relief may be appropriate depending upon when such
future guidance is released. For interim guidance regarding the
information reporting and wage withholding requirements applicable to
deferrals of compensation within the meaning of section 409A, see
Notice 2005-1, Q&A-24 through Q&A-38. Until further guidance is
provided, taxpayers may rely on Notice 2005-1 regarding information
reporting and wage withholding obligations.
XIII. Funding Arrangements
Section 409A(b)(1) provides certain tax consequences for the
funding of deferrals of compensation in offshore trusts (or other
arrangements determined by the Secretary) or pursuant to a change in
the financial health of the employer. The consequences of such funding
are generally consistent with a violation of section 409A with respect
to funded amounts. The Treasury Department and the IRS intend to
address these provisions in future guidance. Commentators have
requested guidance with respect to when assets will be treated as set
aside, especially with respect to service recipients that are, or
include, foreign corporations. Comments are requested as to what types
of arrangements, other than actual trusts, should be treated similarly
to trusts. In addition, these proposed regulations provide guidance
with respect to the types of arrangements that constitute deferred
compensation subject to section 409A. Because the funding rules of
section 409A(b) apply only to amounts set aside to fund deferred
compensation subject to section 409A, many issues raised by
commentators with respect to foreign arrangements and funding may be
addressed or limited through the definition of deferred compensation
contained in these proposed regulations.
Proposed Effective Date
These regulations are proposed to be generally applicable for
taxable years beginning on or after January 1, 2007. As discussed,
taxpayers may rely on these proposed regulations until the effective
date of the final regulations.
Effect on Other Documents
These proposed regulations do not affect the applicability of other
guidance issued with respect to section 409A, including Notice 2005-1
(2005-2 I.R.B. 274 (published as modified on January 6, 2005)).
However, upon the effective date of the final regulations, the Treasury
Department and the IRS anticipate that Notice 2005-1 and certain other
published guidance will become obsolete for periods after the effective
date of the final regulations.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It has also
been determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations, and because
the regulation does not impose a collection of information on small
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not
apply. Pursuant to section 7805(f) of the Code, this notice of proposed
rulemaking will be submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on its impact on small
business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written (a signed original and eight
(8) copies) or electronic comments that are submitted timely to the
IRS. The IRS and Treasury Department request comments on the clarity of
the proposed rules and how they can be made easier to understand. All
comments will be available for public inspection and copying.
A public hearing has been scheduled for January 25, 2006, beginning
at 10 a.m. in the Auditorium of the Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC. Due to building security
procedures, visitors must enter at the Constitution Avenue entrance. In
addition, all visitors must present photo identification to enter the
building. Because of access restrictions, visitors will not be admitted
beyond the immediate entrance area more than 30 minutes before the
hearing starts. For information about having your name placed on the
building access list to attend the hearing, see the FOR FURTHER
INFORMATION CONTACT section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit written or
electronic comments and an outline of the topics to be discussed and
the time to be devoted to each topic (a signed original and eight (8)
copies) by January 4, 2006. A period of 10 minutes will be allotted to
each person for making comments. An agenda showing the scheduling of
the speakers will be prepared after the deadline for receiving outlines
has passed. Copies of the agenda will be available free of charge at
the hearing.
Drafting Information
The principal author of these regulations is Stephen Tackney of the
Office of Division Counsel/Associate Chief Counsel (Tax Exempt and
Government Entities). However, other personnel from the IRS and the
Treasury Department participated in their development.
List of Subjects 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendment to the Regulations.
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Sections 1.409A-1 through 1.409A-6 are added to read as
follows:
Sec. 1.409A-1 Definitions and covered arrangements.
(a) Nonqualified deferred compensation plan--(1) In general. Except
as otherwise provided in this paragraph (a), the term nonqualified
deferred compensation plan means any plan (within the meaning of
paragraph (c) of this section) that provides for the deferral of
compensation (within the meaning of paragraph (b) of this section).
(2) Qualified employer plans. The term nonqualified deferred
compensation plan does not include--
(i) Any plan described in section 401(a) that includes a trust
exempt from tax under section 501(a);
(ii) Any annuity plan described in section 403(a);
(iii) Any annuity contract described in section 403(b);
(iv) Any simplified employee pension (within the meaning of section
408(k));
(v) Any simple retirement account (within the meaning of section
408(p);
(vi) Any arrangement under which an active participant makes
deductible contributions to a trust described in section 501(c)(18);
[[Page 57958]]
(vii) Any eligible deferred compensation plan (within the meaning
of section 457(b)); and
(viii) Any plan described in section 415(m).
(3) Certain foreign plans--(i) Participation addressed by treaty.
With respect to an individual for a taxable year, the term nonqualified
deferred compensation plan does not include any scheme, trust or
arrangement maintained with respect to such individual, where
contributions made by or on behalf of such individual to such scheme,
trust or arrangement are excludable by such individual for Federal
income tax purposes pursuant to any bilateral income tax convention to
which the United States is a party.
(ii) Participation by nonresident aliens and certain resident
aliens. With respect to an alien individual for a taxable year during
which such individual is a nonresident alien or a resident alien
classified as a resident alien solely under section 7701(b)(1)(A)(ii)
(and not section 7701(b)(1)(A)(i)), the term nonqualified deferred
compensation plan does not include any broad-based foreign retirement
plan (within the meaning of paragraph (a)(3)(v) of this section)
maintained by a person that is not a United States person.
(iii) Participation by U.S. citizens and lawful permanent
residents. With respect to an individual for a given taxable year
during which such individual is a U.S. citizen or a resident alien
classified as a resident alien under section 7701(b)(1)(A)(i), and is
not eligible to participate in a qualified employer plan described in
paragraph (a)(2) of this section, the term nonqualified deferred
compensation plan does not include a broad-based foreign retirement
plan (within the meaning of paragraph (a)(3)(v) of this section)
maintained by a service recipient that is not a United States person,
but only with respect to nonelective deferrals of foreign earned income
(as defined in section 911(b)(1)) and only to the extent that the
amounts deferred under such plan in such taxable year do not exceed the
applicable limits under section 415(b) and (c) that would be applicable
if such plan were a plan subject to section 415 and the foreign earned
income of such individual were treated as compensation for purposes of
applying section 415(b) and (c).
(iv) Plans subject to a totalization agreement and similar plans.
The term nonqualified deferred compensation plan does not include any
social security system of a jurisdiction to the extent that benefits
provided under or contributions made to the system are subject to an
agreement entered into pursuant to section 233 of the Social Security
Act with any foreign jurisdiction. In addition, the term nonqualified
deferred compensation plan does not include a social security system of
a foreign jurisdiction to the extent that benefits are provided under
or contributions are made to a government-mandated plan as part of that
foreign jurisdiction's social security system.
(v) Broad-based retirement plan. For purposes of this paragraph
(a)(3), the term broad-based retirement plan means a scheme, trust or
arrangement that--
(A) Is written;
(B) In the case of an employer-maintained plan, is
nondiscriminatory insofar as it (alone or in combination with other
comparable plans) covers a wide range of employees, substantially all
of whom are nonresident aliens or resident aliens classified as
resident aliens solely under section 7701(b)(1)(A)(ii) (and not section
7701(b)(1)(A)(i)), including rank and file employees, and actually
provides significant benefits for the range of covered employees;
(C) In the case of an employer-maintained plan, contains provisions
that generally limit the employees' ability to use plan benefits for
purposes other than retirement or restrict access to plan benefits
prior to separation from service, such as restricting in-service
distributions except in events similar to an unforeseeable emergency
(as defined in Sec. 1.409A-3(g)(3)(i)) or hardship (as defined for
purposes of section 401(k)(2)(B)(i)(IV)), and in all cases is subject
to tax or plan provisions that discourage participants from using the
assets for purposes other than retirement; and
(D) Provides for payment of a reasonable level of benefits at
death, a stated age, or an event related to work status, and otherwise
requires minimum distributions under rules designed to ensure that any
death benefits provided to the participants' survivors are merely
incidental to the retirement benefits provided to the participants.
(vi) Participation by a nonresident alien--de minimis amounts. With
respect to a nonresident alien, the term nonqualified deferred
compensation plan does not include any foreign plan maintained by a
service recipient that is not a United States person for a taxable
year, to the extent that the amounts deferred under the foreign plan
based upon the nonresident alien's services performed in the United
States (including compensation received due to services performed in
the United States) do not exceed $10,000 in the taxable year.
(4) Section 457 plans. A nonqualified deferred compensation plan
under section 457(f) may constitute a nonqualified deferred
compensation plan for purposes of this paragraph (a). The rules of
section 409A apply to nonqualified deferred compensation plans
separately and in addition to any requirements applicable to such plans
under section 457(f). In addition, nonelective deferred compensation of
nonemployees described in section 457(e)(12) and a grandfathered plan
or arrangement described in Sec. 1.457-2(k)(4) may constitute a
nonqualified deferred compensation plan for purposes of this paragraph
(a). The term nonqualified deferred compensation plan does not include
a length of service award to a bona fide volunteer under section
457(e)(11)(A)(ii).
(5) Certain welfare benefits. The term nonqualified deferred
compensation plan does not include any bona fide vacation leave, sick
leave, compensatory time, disability pay, or death benefit plan. For
these purposes, the term disability pay has the same meaning as
provided in Sec. 31.3121(v)(2)-1(b)(4)(iv)(C) of this chapter, and the
term death benefit plan refers to a plan providing death benefits as
defined in Sec. 31.3121(v)(2)-1(b)(4)(iv)(C) of this chapter. The term
nonqualified deferred compensation plan also does not include any
Archer Medical Savings Account as described in section 220, any Health
Savings Account as described in section 223, or any other medical
reimbursement arrangement, including a health reimbursement
arrangement, that satisfies the requirements of section 105 and section
106.
(b) Deferral of compensation--(1) In general. Except as otherwise
provided in paragraphs (b)(3) through (b)(9) of this section, a plan
provides for the deferral of compensation if, under the terms of the
plan and the relevant facts and circumstances, the service provider has
a legally binding right during a taxable year to compensation that has
not been actually or constructively received and included in gross
income, and that, pursuant to the terms of the plan, is payable to (or
on behalf of) the service provider in a later year. A service provider
does not have a legally binding right to compensation if that
compensation may be reduced unilaterally or eliminated by the service
recipient or other person after the services creating the right to the
compensation have been performed. However, if the facts and
circumstances indicate that the discretion to reduce or
[[Page 57959]]
eliminate the compensation is available or exercisable only upon a
condition, or the discretion to reduce or eliminate the compensation
lacks substantive significance, a service provider will be considered
to have a legally binding right to the compensation. Whether the
negative discretion lacks substantive significance depends on the facts
and circumstances of the particular arrangement. However, where the
service provider to whom the compensation may be paid has effective
control of the person retaining the discretion to reduce or eliminate
the compensation, or has effective control over any portion of the
compensation of the person retaining the discretion to reduce or
eliminate the compensation, or is a member of the family (as defined in
section 267(c)(4) applied as if the family of an individual includes
the spouse of any member of the family) of the person retaining the
discretion to reduce or eliminate the compensation, the discretion to
reduce or eliminate the compensation will not be treated as having
substantive significance. For this purpose, compensation is not
considered subject to unilateral reduction or elimination merely
because it may be reduced or eliminated by operation of the objective
terms of the plan, such as the application of an objective provision
creating a substantial risk of forfeiture. Similarly, a service
provider does not fail to have a legally binding right to compensation
merely because the amount of compensation is determined under a formula
that provides for benefits to be offset by benefits provided under a
plan that is qualified under section 401(a), or because benefits are
reduced due to actual or notional investment losses, or in a final
average pay plan, subsequent decreases in compensation.
(2) Earnings. References to the deferral of compensation include
references to earnings. When the right to earnings is specified under
the terms of the arrangement, the legally binding right to earnings
arises at the time of the deferral of the compensation to which the
earnings relate. However, a plan may provide that the right to the
earnings is treated separately from the right to the underlying
compensation. For example, provided that the rules of section 409A are
otherwise met, a plan may provide that earnings will be paid at a
separate time or in a separate form from the payment of the underlying
compensation. For the application of the deferral election rules to
current payments of earnings and dividend equivalents, see Sec.
1.409A-2(a)(13).
(3) Compensation payable pursuant to the service recipient's
customary payment timing arrangement. A deferral of compensation does
not occur solely because compensation is paid after the last day of the
service provider's taxable year pursuant to the timing arrangement
under which the service recipient normally compensates service
providers for services performed during a payroll period described in
section 3401(b), or with respect to a non-employee service provider, a
period not longer than the payroll period described in section 3401(b)
or if no such payroll period exists, a period not longer than the
earlier of the normal timing arrangement under which the service
provider normally compensates non-employee service providers or 30 days
after the end of the service provider's taxable year.
(4) Short-term deferrals--(i) In general. A deferral of
compensation does not occur if, absent an election by the service
provider (including an election under Sec. 1.409A-2(a)(4)) to
otherwise defer the payment of the compensation to a later period, an
amount of compensation is actually or constructively received by the
service provider by the later of the 15th day of the third month
following the service provider's first taxable year in which the amount
is no longer subject to a substantial risk of forfeiture or the 15th
day of the third month following the end of the service recipient's
first taxable year in which the amount is no longer subject to a
substantial risk of forfeiture. In addition, the arrangement must not
otherwise defer the payment to a later period. For example, an
arrangement that deferred a payment until 5 years after the lapsing of
a condition that constituted a substantial risk of forfeiture would
constitute a deferral of compensation even if the amount were actually
paid on the date the substantial risk of forfeiture lapsed. For these
purposes, an amount that is never subject to a substantial risk of
forfeiture is considered to be no longer subject to a substantial risk
of forfeiture on the first date the service provider has a legally
binding right to the amount. For example, an employer with a calendar
year taxable year who on November 1, 2008, awards a bonus so that the
employee is considered to have a legally binding right to the payment
as of November 1, 2008, will not be considered to have provided for a
deferral of compensation if, absent an election to otherwise defer the
payment, the amount is paid or made available to the employee on or
before March 15, 2009. An employer with a taxable year ending August 31
who on November 1, 2008, awards a bonus so that the employee is
considered to have a legally binding right to the payment as of
November 1, 2008, will not be considered to have provided for a
deferral of compensation if, absent an election to otherwise defer the
payment, the amount is paid or made available to the employee on or
before November 15, 2009.
(ii) Delayed payments due to unforeseeable events. A payment that
otherwise qualifies as a short-term deferral under paragraph (b)(4)(i)
of this section but is made after the 15th day of the third month
following the end of the relevant taxable year (the applicable 2\1/2\
month period) may continue to qualify as a short-term deferral if the
taxpayer establishes that it was administratively impracticable to make
the payment by the end of the applicable 2\1/2\ month period or that
making the payment by the end of the applicable 2\1/2\ month period
would have jeopardized the solvency of the service recipient, and, as
of the date upon which the legally binding right to the compensation
arose, such impracticability or insolvency was unforeseeable, and also
the payment is made as soon as reasonably practicable. For example, an
amount that would otherwise qualify as a short-term deferral except
that the payment is made after the applicable 2\1/2\ month period may
continue to qualify as a short-term deferral under this paragraph
(b)(4) to the extent that the delay is caused either because the funds
of the service recipient were not sufficient to make the payment before
the end of the applicable 2\1/2\ month period without jeopardizing the
solvency of the service recipient, or because it was not reasonably
possible to determine by the end of the applicable 2\1/2\ month period
whether payment of such amount was to be made, and the circumstance
causing the delay was unforeseeable as of the date upon which the
legally binding right to the compensation arose. Thus, the amount will
not continue to qualify as a short-term deferral to the extent it was
foreseeable, as of date upon which the legally binding right to the
compensation arose, that the amount would not be paid within the
applicable 2\1/2\ month period. For purposes of this paragraph
(b)(4)(ii), an action or failure to act of the service provider or a
person under the service provider's control, such as a failure to
provide necessary information or documentation, is not an unforeseeable
event.
(5) Stock options, stock appreciation rights and other equity-based
compensation--(i) Stock rights--(A) Nonstatutory stock options not
providing for the deferral of
[[Page 57960]]
compensation. An option to purchase service recipient stock does not
provide for a deferral of compensation if--
(1) The amount required to purchase stock under the option (the
exercise price) may never be less than the fair market value of the
underlying stock (disregarding lapse restrictions as defined in Sec.
1.83-3(i)) on the date the option is granted and the number of shares
subject to the option is fixed on the original date of grant of the
option;
(2) The transfer or exercise of the option is subject to taxation
under section 83 and Sec. 1.83-7; and
(3) The option does not include any feature for the deferral of
compensation other than the deferral of recognition of income until the
later of exercise or disposition of the option under Sec. 1.83-7, or
the time the stock acquired pursuant to the exercise of the option
first becomes substantially vested (as defined in Sec. 1.83-3(b)).
(B) Stock appreciation rights not providing for the deferral of
compensation. A right to compensation equal to the appreciation in
value of a specified number of shares of stock of the service recipient
occurring between the date of grant and the date of exercise of such
right (a stock appreciation right) does not provide for a deferral of
compensation if--
(1) Compensation payable under the stock appreciation right cannot
be greater than the difference between the fair market value of the
stock (disregarding lapse restrictions as defined in Sec. 1.83-3(i))
on the date of grant of the stock appreciation right and the fair
market value of the stock (disregarding lapse restrictions as defined
in Sec. 1.83-3(i)) on the date the stock appreciation right is
exercised, with respect to a number of shares fixed on or before the
date of grant of the right;
(2) The stock appreciation right exercise price may never be less
than the fair market value of the underlying stock (disregarding lapse
restrictions as defined in Sec. 1.83-3(i)) on the date the right is
granted; and
(3) The stock appreciation right does not include any feature for
the deferral of compensation other than the deferral of recognition of
income until the exercise of the stock appreciation right.
(C) Stock rights that may provide for the deferral of compensation.
An option to purchase stock other than service recipient stock, or a
stock appreciation right with respect to stock other than service
recipient stock, generally will provide for the deferral of
compensation within the meaning of this paragraph (b). If under the
terms of an option to purchase service recipient stock (other than an
incentive stock option described in section 422 or a stock option
granted under an employee stock purchase plan described in section
423), the amount required to purchase the stock is or could become less
than the fair market value of the stock (disregarding lapse
restrictions as defined in Sec. 1.83-3(i)) on the date of grant, the
grant of the option may provide for the deferral of compensation within
the meaning of this paragraph (b). If under the terms of a stock
appreciation right with respect to service recipient stock, the
compensation payable under the stock appreciation right is or could be
any amount greater than, with respect to a predetermined number of
shares, the difference between the stock value (disregarding lapse
restrictions as defined in Sec. 1.83-3(i)) on the date of grant of the
stock appreciation right and the stock value (disregarding lapse
restrictions as defined in Sec. 1.83-3(i)) on the date the stock
appreciation right is exercised, the grant of the stock appreciation
right may provide for a deferral of compensation within the meaning of
this paragraph (b).
(D) Feature for the deferral of compensation. To the extent a stock
right grants the recipient a right other than to receive cash or stock
on the date of exercise and such additional rights allow for the
deferral of compensation, the entire arrangement (including the
underlying stock right) provides for the deferral of compensation. For
purposes of this paragraph (b)(5)(i), neither the right to receive
substantially nonvested stock (as defined in Sec. 1.83-3(b)) upon the
exercise of a stock right, nor the right to pay the exercise price with
previously acquired shares, constitutes a feature for the deferral of
compensation.
(E) Rights to dividends declared. For purposes of this paragraph
(b)(5)(i), the right to receive, upon the exercise of a stock right, an
amount equal to all or part of the dividends declared and paid on the
number of shares underlying the stock right between the date of grant
and the date of exercise of the stock right constitutes an offset to
the exercise price of the stock option or an increase in the amount
payable under the stock appreciation right (generally causing such
stock rights to be subject to section 409A), unless the right to the
dividends declared and paid on the number of shares underlying the
stock right is explicitly set forth as a separate arrangement. If set
forth as a separate arrangement, the arrangement may provide for
deferred compensation for purposes of section 409A. However, the
existence of a separate arrangement to receive such an amount that
complies with the requirements of section 409A would not cause a stock
right to fail to satisfy the requirements of the exclusion from the
definition of deferred compensation provided in paragraphs (b)(5)(i)(A)
and (B) of this section.
(ii) Statutory stock options. The grant of an incentive stock
option as described in section 422, or the grant of an option under an
employee stock purchase plan described in section 423 (including the
grant of an option with an exercise price discounted in accordance with
section 423(b)(6) and the accompanying regulations), does not
constitute a deferral of compensation. However, this paragraph
(b)(5)(ii) does not apply to a modification, extension, or renewal of a
statutory option that is treated as the grant of a new option that is
not a statutory option. See Sec. 1.424-1(e). In such event, the option
is treated as if it were a nonstatutory stock option at the date of the
original grant, so that the modification, extension or renewal of the
stock option that caused the stock option to be treated as the grant of
a new option under Sec. 1.424-1(e) is treated as causing the option to
be treated as the grant of a new option for purposes of this paragraph
(b)(5) only if such modification, extension or renewal of the stock
option would have been treated as resulting in the grant of a new
option under paragraph (b)(5)(v) of this section.
(iii) Stock of the service recipient--(A) In general. Except as
otherwise provided in paragraphs (b)(5)(iii)(B) and (C) of this
section, for purposes of this section, stock of the service recipient
means stock that, as of the date of grant, is common stock of a
corporation that is a service recipient (including any member of a
group of corporations or other entities treated as a single service
recipient) that is readily tradable on an established securities
market, or if none, that class of common stock of such corporation
having the greatest aggregate value of common stock issued and
outstanding of such corporation, or common stock with substantially
similar rights to stock of such class (disregarding any difference in
voting rights). However, under no circumstances does stock of the
service recipient include stock that is preferred as to liquidation or
dividend rights or that includes or is subject to a mandatory
repurchase obligation or a put or call right that is not a lapse
restriction as defined in Sec. 1.83-3(i) and is based on a measure
other than the fair market value (disregarding lapse restrictions as
defined in Sec. 1.83-3(i)) of the equity interest in the corporation
represented by the stock.
(B) American depositary receipts. For purposes of this section, an
American
[[Page 57961]]
depositary receipt or American depositary share may constitute service
recipient stock, to the extent that the stock traded on a foreign
securities market to which the American depositary receipt or American
depositary share relates qualifies as service provider stock.
(C) Mutual company units. For purposes of this section, mutual
company units may constitute service recipient stock. For this purpose,
the term mutual company unit means a fixed percentage of the overall
value of a non-stock mutual company. For purposes of determining the
value of the mutual company unit, the unit may be valued in accordance
with the rules set forth in paragraph (b)(5)(iv)(B) of this section
governing valuation of service recipient stock the shares of which are
not traded on an established securities market, applied as if the
mutual company were a stock corporation with one class of common stock
and the number of shares of such stock determined according to the
fixed percentage. For example, an appreciation right based on the
appreciation of 10 mutual company units, where each unit is defined as
1 percent of the overall value of the mutual company, would be valued
as if the appreciation right were based upon 10 shares of a corporation
with 100 shares of common stock and no other class of stock, whose
shares are not readily tradable on an established securities market.
(D) Definition of service recipient--(1) In general. For purposes
of this paragraph (b)(5)(iii), the term service recipient generally has
the same meaning as provided in paragraph (g) of this section, provided
that a stock right, or the plan or arrangement under which the stock
right is granted, may specify that in applying section 1563(a)(1), (2)
and (3) for purposes of determining a controlled group of corporations
under section 414(b), the language ``at least 50 percent'' is used
instead of ``at least 80 percent'' each place it appears in section
1563(a)(1), (2) and (3), and in applying Sec. 1.414(c)-2 for purposes
of determining trades or businesses (whether or not incorporated) that
are under common control for purposes of section 414(c), the language
``at least 50 percent'' is used instead of ``at least 80 percent'' each
place it appears in Sec. 1.414(c)-2. In addition, where the use of
such stock with respect to the grant of a stock right to such service
provider is based upon legitimate business criteria, the term service
recipient has the same meaning as provided in paragraph (g) of this
section, provided that the stock right, or the plan or arrangement
under which the stock right is granted, may specify that in applying
sections 1563(a)(1), (2) and (3) for purposes of determining a
controlled group of corporations under section 414(b), the language
``at least 20 percent'' is used instead of ``at least 80 percent'' at
each place it appears in sections 1563(a)(1), (2) and (3), and in
applying Sec. 1.414(c)-2 for purposes of determining trades or
businesses (whether or not incorporated) that are under common control
for purposes of section 414(c), the language ``at least 20 percent'' is
used instead of ``at least 80 percent'' at each place it appears in
Sec. 1.414(c)-2. For example, stock of a corporation participating in
a joint venture involving an operating business, used with respect to
stock rights granted to employees of the joint venture who are former
employees of such corporation, generally will constitute use of such
stock based upon legitimate business criteria, and therefore could
constitute service provider stock with respect to such employees if the
corporation owns at least 20 percent of the joint venture and the other
requirements of this paragraph (b)(5)(iii) are met. A designation by a
service recipient to use the 50 percent or 20 percent thresholds
described in this paragraph (b)(5)(iii)(D) must be applied consistently
as to all compensatory stock rights for purposes of this paragraph
(b)(5)(iii), and any designation of a different permissible ownership
threshold percentage may not be made effective until 12 months after
the adoption of such change.
(2) Investment vehicles. Notwithstanding the provisions of
paragraph (b)(5)(iii)(D)(1) of this section, except as to a service
provider providing services directly to such corporation, for purposes
of this paragraph (b)(5) the term service recipient does not include
any corporation whose primary purpose is to serve as an investment
vehicle with respect to the corporation's interest in entities other
than the service recipient.
(3) Substitutions and assumptions by reason of a corporate
transaction. If the requirements of paragraph (b)(5)(v)(D) of this
section are met such that the substitution of a new stock right
pursuant to a corporate transaction for an outstanding stock right, or
the assumption of an outstanding stock right pursuant to a corporate
transaction, would not be treated as the grant of a new stock right or
a change in the form of payment for purposes of section 409A, the stock
underlying the stock right that is substituted or assumed will be
treated as service recipient stock for purposes of applying this
paragraph (b)(5) to the replacement stock rights. For example, where by
reason of a spinoff transaction under which a subsidiary corporation is
spun off from a distributing corporation, a distributing corporation
employee's stock option to purchase distributing corporation stock is
replaced with a stock option to purchase distributing corporation stock
and a stock option to purchase the spun off subsidiary corporation's
stock, and where such substitution is not treated as a modification of
the original stock option pursuant to paragraph (b)(5)(v)(D) of this
section, both the distributing corporation stock and the subsidiary
corporation stock are treated as service recipient stock for purposes
of applying this paragraph (b)(5) to the replacement stock options.
(E) Stock rights granted on or before December 31, 2004.
Notwithstanding the requirements of paragraph (b)(5)(iii)(A) of this
section, any class of common stock of the service recipient with
respect to which stock rights were granted to service providers on or
before December 31, 2004, is treated as service recipient stock for
purposes of this paragraph (b)(5)(iii), but only with respect to stock
rights granted on or before December 31, 2004.
(iv) Determination of the fair market value of service recipient
stock--(A) Stock readily tradable on an established securities market.
For purposes of (b)(5)(i) of this section, in the case of service
recipient stock that is readily tradable on an established securities
market, the fair market value of the stock may be determined based upon
the last sale before or the first sale after the grant, the closing
price on the trading day before or the trading day of the grant, or any
other reasonable basis using actual transactions in such stock as
reported by such market and consistently applied. The determination of
fair market value also may be based upon an average selling price
during a specified period that is within 30 days before or 30 days
after the grant, provided that the commitment to grant the stock right
based on such valuation method must be irrevocable before the beginning
of the specified period, and such valuation method must be used
consistently for grants of stock rights under the same and
substantially similar programs.
(B) Stock not readily tradable on an established securities
market--(1) In general. For purposes of paragraph (b)(5)(i) of this
section, in the case of service recipient stock that is not readily
tradable on an established securities market, the fair market value of
the stock as of a valuation date means a value determined by the
reasonable application of a reasonable valuation
[[Page 57962]]
method. The determination of whether a valuation method is reasonable,
or whether an application of a valuation method is reasonable, is made
based on the facts and circumstances as of the valuation date. Factors
to be considered under a reasonable valuation method include, as
applicable, the value of tangible and intangible assets of the
corporation, the present value of future cash-flows of the corporation,
the market value of stock or equity interests in similar corporations
and other entities engaged in trades or businesses substantially
similar to those engaged in by the corporation whose stock is to be
valued, the value of which can be readily determined through objective
means (such as through trading prices on an established securities
market or an amount paid in an arm's length private transaction), and
other relevant factors such as control premiums or discounts for lack
of marketability and whether the valuation method is used for other
purposes that have a material economic effect on the service recipient,
its stockholders or its creditors. The use of a valuation method is not
reasonable if such valuation method does not take into consideration in
applying its methodology, all available information material to the
value of the corporation. Similarly, the use of a value previously
calculated under a valuation method is not reasonable as of a later
date if such calculation fails to reflect information available after
the date of the calculation that may materially affect the value of the
corporation (for example, the resolution of material litigation or the
issuance of a patent) or the value was calculated with respect to a
date that is more than 12 months earlier than the date for which the
valuation is being used. The service recipient's consistent use of a
valuation method to determine the value of its stock or assets for
other purposes, including for purposes unrelated to compensation of
service providers, is also a factor supporting the reasonableness of
such valuation method.
(2) Presumption of reasonableness. For purposes of this paragraph
(b)(5)(iv)(B), the consistent use of any of the following methods of
valuation is presumed to result in a reasonable valuation, provided
that the Commissioner may rebut such a presumption upon a showing that
either the valuation method or the application of such method was
grossly unreasonable:
(i) A valuation of a class of stock determined by an independent
appraisal that meets the requirements of section 401(a)(28)(C) and the
regulations thereunder as of a date that is no more than 12 months
before the relevant transaction to which the valuation is applied (for
example, the grant date of a stock option).
(ii) A valuation based upon a formula that, if used as part of a
nonlapse restriction (as defined in Sec. 1.83-3(h)) with respect to
the stock, would be considered to be the fair market value of the stock
pursuant to Sec. 1.83-5, provided that such stock is valued in the
same manner for purposes of any nonlapse restriction applicable to the
transfer of any shares of such class of stock (or substantially similar
class of stock), and all noncompensatory purposes requiring the
valuation of such stock, including regulatory filings, loan covenants,
issuances to and repurchases of stock from persons other than service
providers, and other third-party arrangements, and such valuation
method is used consistently for all such purposes, and provided further
that this paragraph (b)(5)(iv)(B)(2)(ii) does not apply with respect to
stock subject to a stock right payable in stock, where the stock
acquired pursuant to the exercise of the stock right is transferable
other than through the operation of a nonlapse restriction.
(iii) A valuation, made reasonably and in good faith and evidenced
by a written report that takes into account the relevant factors
described in paragraph (b)(5)(B)(iv)(1) of this section, of an illiquid
stock of a start-up corporation. For this purpose, an illiquid stock of
a start-up corporation is service recipient stock of a service
recipient corporation that has no trade or business that it or any
predecessor to it has conducted for a period of 10 years or more and
has no class of equity securities that are traded on an established
securities market (as defined in paragraph (k) of this section), where
such stock is not subject to any put or call right or obligation of the
service recipient or other person to purchase such stock (other than a
right of first refusal upon an offer to purchase by a third party that
is unrelated to the service recipient or service provider and other
than a right or obligation that constitutes a lapse restriction as
defined in Sec. 1.83-3(i)), and provided that this paragraph
(b)(5)(iv)(B)(2)(iii) does not apply to the valuation of any stock if
the service recipient or service provider may reasonably anticipate, as
of the time the valuation is applied, that the service recipient will
undergo a change in control event as described in Sec. 1.409A-
3(g)(5)(iv) or Sec. 1.409A-3(g)(5)(vi) or make a public offering of
securities within the 12 months following the event to which the
valuation is applied (for example, the grant of a stock option or
exercise of a stock appreciation right). For purposes of this paragraph
(b)(5)(iv)(B)(2)(iii), a valuation will not be treated as made
reasonably and in good faith unless the valuation is performed by a
person or persons with significant knowledge and experience or training
in performing similar valuations.
(3) Consistent use of a method. For purposes of paragraph
(b)(5)(iv)(B)(2) of this section, the consistent use of a valuation
method means the consistent use of the method for all equity-based
compensation arrangements, including with respect to stock rights, for
purposes of determining the exercise price, and with respect to stock
appreciation rights not paid in stock, for purposes of determining the
payment at the date of exercise, and for stock appreciation rights or
stock options paid in stock subject to a put or call right providing
for the potential repurchase by the service recipient, or other
obligation of the service recipient or other person to purchase such
stock, for purposes of determining the payment at the date of the
purchase of such stock. Notwithstanding the foregoing, a service
recipient may change the method prospectively for purposes of new
grants of equity-based compensation, including stock rights. In
addition, where after the date of grant, but before the date of
exercise, of the stock right, the service provider stock to which the
stock right relates becomes readily tradable on an established
securities market, the service recipient must use the valuation method
set forth in paragraph (b)(5)(iv)(A) of this section for purposes of
determining the payment at the date of exercise or the purchase of the
stock, as applicable.
(v) Modifications, extensions, renewals, substitutions and
assumptions of stock rights--(A) Treatment of modified stock right as a
new grant. Any modification of the terms of a stock right, other than
an extension or renewal of the stock right, is considered the granting
of a new stock right. The new stock right may or may not constitute a
deferral of compensation under paragraph (b)(5)(i) of this section,
determined at the date of grant of the new stock right. Where a stock
right is extended or renewed, the stock right is treated as having had
an additional deferral feature from the date of grant.
(B) Modification in general. The term modification means any change
in the terms of the stock right (or change in the terms of the
arrangement pursuant to which the stock right was granted or in the
terms of any other agreement governing the stock right) that may
provide the holder of the stock right with a direct or indirect
reduction in the
[[Page 57963]]
exercise price of the stock right, or an additional deferral feature,
or an extension or renewal of the stock right, regardless of whether
the holder in fact benefits from the change in terms. In contrast, a
change in the terms of the stock right shortening the period during
which the stock right is exercisable is not a modification. It is not a
modification to add a feature providing the ability to tender
previously acquired stock for the stock purchasable under the stock
right, or to withhold or have withheld shares of stock to facilitate
the payment of employment taxes or required withholding taxes resulting
from the exercise of the stock right. In addition, it is not a
modification for the grantor to exercise discretion specifically
reserved under a stock right with respect to the transferability of the
stock right.
(C) Extensions and renewals. An extension of a stock right refers
to the granting to the holder of an additional period of time within
which to exercise the stock right beyond the time originally
prescribed, provided that it is not an extension if the exercise period
of the stock right is extended to a date no later than the later of the
15th day of the third month following the date at which, or December 31
of the calendar year in which, the stock right would otherwise have
expired if the stock right had not been extended, based on the terms of
the stock right at the original grant date. For example, an option
granted January 1, 2011, that expires upon the earlier of January 1,
2021, or 30 days after separation from service will not be considered
to be modified if, upon the holder's separation from service on July 1,
2015, the term is extended to December 31, 2015. Notwithstanding the
foregoing, it is not an extension of a stock right if the expiration of
the stock right is tolled while the stock right is unexercisable
because an exercise of the stock right would violate applicable
securities laws, provided that the period during which the stock right
may be exercised is not extended more than 30 days after the exercise
of the stock right first would no longer violate applicable securities
laws. A renewal of a stock right is the granting by the corporation of
the same rights or privileges contained in the original stock right on
the same terms and conditions.
(D) Substitutions and assumptions of stock rights by reason of a
corporate transaction. If the requirements of Sec. 1.424-1 would be
met if the stock right were a statutory option, the substitution of a
new stock right pursuant to a corporate transaction for an outstanding
stock right or the assumption of an outstanding stock right pursuant to
a corporate transaction will not be treated as the grant of a new stock
right or a change in the form of payment for purposes of section 409A.
For purposes of the preceding sentence, the requirement of Sec. 1.424-
1(a)(5)(iii) will be deemed to be satisfied if the ratio of the
exercise price to the fair market value of the shares subject to the
stock right immediately after the substitution or assumption is not
greater than the ratio of the exercise price to the fair market value
of the shares subject to the stock right immediately before the
substitution or assumption. In the case of a transaction described in
section 355 in which the stock of the distributing corporation and the
stock distributed in the transaction are both readily tradable on an
established securities market immediately after the transaction, for
purposes of this paragraph (b)(5)(v), the requirements of Sec. 1.424-
1(a)(5) may be satisfied by using market quotations for the stock of
the distributing corporation and the stock distributed in the
transaction as of a predetermined date not more than 60 days after the
transaction or based on an average of such market prices over a
predetermined period of not more than 30 days ending not later than 60
days after the transaction.
(E) Acceleration of date when exercisable. If a stock right is not
immediately exercisable in full, a change in the terms of the right to
accelerate the time at which the stock right (or any portion thereof)
may be exercised is not a material modification for purposes of this
section. With respect to a stock right subject to section 409A,
however, such an acceleration may constitute an impermissible
acceleration of a payment date under Sec. 1.409A-3(c). Additionally,
no modification occurs if a provision accelerating the time when a
stock right may first be exercised is removed before the year in which
it would otherwise be triggered.
(F) Discretionary added benefits. If a change to a stock right
provides, either by its terms or in substance, that the holder may
receive an additional benefit under the stock right at the future
discretion of the grantor, and the addition of such benefit would
constitute a modification, then the addition of such discretion is a
modification at the time that the stock right is changed to provide
such discretion.
(G) Change in underlying stock increasing value. A change in the
terms of the stock subject to a stock right that increases the value of
the stock is a modification of such stock right, except to the extent
that a new stock right is substituted for such stock right by reason of
the change in the terms of the stock in accordance with paragraph
(b)(5)(v)(D) of this section.
(H) Change in the number of shares purchasable. If a stock right is
amended solely to increase the number of shares subject to the stock
right, the increase is not considered a modification of the stock right
but is treated as the grant of a new additional stock right to which
the additional shares are subject. Notwithstanding the previous
sentence, if the exercise price and number of shares subject to a stock
right are proportionally adjusted to reflect a stock split (including a
reverse stock split) or stock dividend, and the only effect of the
stock split or stock dividend is to increase (or decrease) on a pro
rata basis the number of shares owned by each shareholder of the class
of stock subject to the stock right, then the stock right is not
modified if it is proportionally adjusted to reflect the stock split or
stock dividend and the aggregate exercise price of the stock right is
not less than the aggregate exercise price before the stock split or
stock dividend.
(I) Rescission of changes. Any change to the terms of a stock right
(or change in the terms of the plan pursuant to which the stock right
was granted or in the terms of any other agreement governing the right)
that would inadvertently result in treatment as a modification under
paragraph (b)(5)(v)(A) of this section is not considered a modification
of the stock right to the extent the change in the terms of the stock
right is rescinded by the earlier of the date the stock right is
exercised or the last day of the calendar year during which such change
occurred. Thus, for example, if the terms of a stock right are changed
on March 1 to extend the exercise period and the change is rescinded on
November 1, then if the stock right is not exercised before the change
is rescinded, the stock right is not considered modified under
paragraph (b)(5)(v)(A) of this section.
(J) Successive modifications. The rules of this paragraph (b)(5)(v)
apply as well to successive modifications, including successive
extensions or renewals.
(6) Restricted Property--(i) In general. If a service provider
receives property from, or pursuant to, a plan maintained by a service
recipient, there is no deferral of compensation merely because the
value of the property is not includible in income in the year of
receipt by reason of the property being substantially nonvested (as
defined in Sec. 1.83-3(b)), or is includible in income
[[Page 57964]]
solely due to a valid election under section 83(b). For purposes of
this paragraph (b)(6)(i), a transfer of property includes the transfer
of a beneficial interest in a trust or annuity plan, or a transfer to
or from a trust or under an annuity plan, to the extent such a transfer
is subject to section 83, section 402(b) or section 403(c).
(ii) Promises to transfer property. A plan under which a service
provider obtains a legally binding right to receive property (whether
or not the property will be substantially nonvested (as defined in
Sec. 1.83-3(b)) at the time of grant) in a future year may provide for
the deferral of compensation and, accordingly, may constitute a
nonqualified deferred compensation plan. The vesting of substantially
nonvested property subject to section 83 may be treated as a payment
for purposes section 409A, including for purposes of applying the
short-term deferral rules under paragraph (b)(4) of this section.
Accordingly, where the promise to transfer the substantially nonvested
property and the right to retain the substantially nonvested property
are both subject to a substantial risk of forfeiture (as defined under
paragraph (d) of this section), the arrangement generally would
constitute a short-term deferral under paragraph (b)(4) of this section
because the payment would occur simultaneously with the vesting of the
right to the property. For example, where an employee participates in a
two-year bonus program such that, if the employee continues in
employment for two years, the employee is entitled to either the
immediate payment of a $10,000 cash bonus or the grant of restricted
stock with a $15,000 fair market value subject to a vesting requirement
of three additional years of service, the arrangement generally would
constitute a short-term deferral under paragraph (b)(4) of this section
because under either alternative the payment would be received within
the short-term deferral period.
(7) Arrangements between partnerships and partners. [Reserved.]
(8) Certain foreign arrangements--(i) Arrangements with respect to
compensation covered by treaty or other international agreement. An
arrangement with a service provider does not provide for a deferral of
compensation for purposes of this paragraph (b) to the extent that the
compensation under the arrangement would have been excluded from gross
income for Federal income tax purposes under the provisions of any
bilateral income tax convention or other bilateral or multilateral
agreement to which the United States is a party if the compensation had
been paid to the service provider at the time that the legally binding
right to the compensation first arose or, if later, the time that the
legally binding right was no longer subject to a substantial risk of
forfeiture.
(ii) Arrangements with respect to certain other compensation. An
arrangement with a service provider does not provide for a deferral of
compensation for purposes of this paragraph (b) to the extent that
compensation under the arrangement would not have been includible in
gross income for Federal tax purposes if it had been paid to the
service provider at the time that the legally binding right to the
compensation first arose or, if later, the time that the legally
binding right was no longer subject to a substantial risk of
forfeiture, due to one of the following--
(A) The service provider was a nonresident alien at such time and
the compensation would not have been includible in gross income under
section 872;
(B) The service provider was a qualified individual (as defined in
section 911(d)(1)) at such time and the compensation would have been
foreign earned income within the meaning of section 911(b)(1) if paid
at such time, the compensation would have been foreign earned income
within the meaning of section 911(b)(1) that is less than the
difference between the maximum exclusion amount under section
911(b)(2)(D) for such taxable year and the amount of foreign earned
income actually excludible from gross income by such qualified
individual for such taxable year under section 911(a)(1);
(C) The compensation would have been excludible from gross income
under section 893; or
(D) The compensation would have been excludible from gross income
under section 931 or section 933.
(iii) Tax equalization arrangements. Compensation paid under a tax
equalization arrangement does not provide for a deferral of
compensation, provided that any payment made under such arrangement is
paid no later than the end of the second calendar year beginning after
the calendar year in which the service provider's U.S. Federal income
tax return is required to be filed (including extension) for the year
to which the tax equalization payment relates. For purposes of this
paragraph (b)(8)(iii), the term tax equalization arrangement refers to
an arrangement that provides payments intended to compensate the
service provider for the excess of the taxes actually imposed by a
foreign jurisdiction on the compensation paid (other than the
compensation under the tax equalization agreement) by the service
recipient to the service provider over the taxes that would be imposed
if the compensation were subject solely to United States Federal income
tax, and provided that the payments made under such arrangement may not
exceed such excess and the amount necessary to compensate for the
additional taxes on the amounts paid under the arrangement.
(iv) Additional foreign arrangements. An arrangement with a service
provider does not provide for a deferral of compensation for purposes
of this paragraph (b) to the extent designated by the Commissioner in
revenue procedures, notices, or other guidance published in the
Internal Revenue Bulletin (see Sec. 601.601(d)(2) of this chapter).
(v) Earnings. Earnings on compensation excluded from the definition
of deferral of compensation pursuant to this paragraph (b)(8) are also
not treated as a deferred compensation. However, amounts that would be
recharacterized as deferred compensation under Sec. 31.3121(v)(2)-
1(d)(2)(iii)(B) of this chapter (nonaccount balance plans), Sec.
31.3121(v)(2)-1(d)(2)(iii)(A) of this chapter (account balance plans),
or similar principles with respect to plans that are neither nonaccount
balance plans nor account balance plans, will not be treated as
earnings for purposes of this paragraph (b)(8)(v).
(9) Separation pay arrangements--(i) In general. An arrangement
that otherwise provides for a deferral of compensation under this
paragraph (b) does not fail to provide a deferral of compensation
merely because the right to payment of the compensation is conditioned
upon a separation from service. However, see paragraphs (b)(9)(ii),
(iii) and (iv) of this section for separation pay arrangements that do
not provide for the deferral of compensation. Notwithstanding any other
provision of this paragraph (b)(9), any payment or benefit, or
entitlement to a payment or benefit, that acts as a substitute for, or
replacement of, amounts deferred by the service recipient under a
separate nonqualified deferred compensation plan constitutes a payment
or a deferral of compensation under the separate nonqualified deferred
compensation plan, and does not constitute a payment or deferral of
compensation under a separation pay arrangement.
(ii) Collectively bargained separation pay arrangements. A
separation pay
[[Page 57965]]
arrangement does not provide for a deferral of compensation if the
arrangement is a collectively bargained separation pay arrangement that
provides for separation pay upon an actual involuntary separation from
service or pursuant to a window program. Only the portion of the
separation pay arrangement attributable to employees covered by a
collective bargaining agreement is considered to be provided under a
collectively bargained separation pay arrangement. A collectively
bargained separation pay arrangement is a separation pay arrangement
that meets the following conditions:
(A) The separation pay arrangement is contained within an agreement
that the Secretary of Labor determines to be a collective bargaining
agreement.
(B) The separation pay provided by the collective bargaining
agreement was the subject of arms-length negotiations between employee
representatives and one or more employers, and the agreement between
employee representatives and one or more employers satisfies section
7701(a)(46).
(C) The circumstances surrounding the agreement evidence good faith
bargaining between adverse parties over the separation pay to be
provided under the agreement.
(iii) Separation pay plans due to involuntary separation from
service or participation in a window program. A separation pay plan
that is not described in paragraph (b)(9)(ii) of this section and that
provides for separation pay upon an actual involuntary separation from
service or pursuant to a window program does not provide for a deferral
of compensation if the plan provides that--
(A) The separation pay (other than amounts described in paragraph
(b)(9)(iv) of this section) may not exceed two times the lesser of--
(1) The sum of the service provider's annual compensation (as
defined in Sec. 1.415-1(d)(2)) for services provided to the service
recipient as an employee and the service provider's net earnings from
self-employment (as defined in section 1402(a)(1)) for services
provided to the service recipient as an independent contractor, each
for the calendar year preceding the calendar year in which the service
provider has a separation from service from such service recipient; or
(2) The maximum amount that may be taken into account under a
qualified plan pursuant to section 401(a)(17) for such year; and
(B) The separation pay must be paid no later than December 31 of
the second calendar year following the calendar year in which occurs
the separation from service.
(iv) Reimbursements and certain other separation payments--(A) In
general. To the extent a separation pay arrangement entitles a service
provider to payment by the service recipient for a limited period of
time of reimbursements that are otherwise excludible from gross income,
of reimbursements for expenses that the service provider can deduct
under section 162 or section 167 as business expenses incurred in
connection with the performance of services (ignoring any applicable
limitation based on adjusted gross income), or of reasonable
outplacement expenses and reasonable moving expenses actually incurred
by the service provider and directly related to the termination of
services for the service recipient, such arrangement does not provide
for a deferral of compensation. To the extent a separation pay
arrangement (including an arrangement involving payments due to a
voluntary separation from service) entitles a service provider to
reimbursement by the service recipient for a limited period of time of
payments of medical expenses incurred and paid by the service provider
but not reimbursed and allowable as a deduction under section 213
(disregarding the requirement of section 213(a) that the deduction is
available only to the extent that such expenses exceed 7.5 percent of
adjusted gross income), such arrangement does not provide for a
deferral of compensation.
(B) In-kind benefits and direct service recipient payments. A
service provider's entitlement to in-kind benefits from the service
recipient, or a payment by the service recipient directly to the person
providing the goods or services to the service provider, will also be
treated as not providing for a deferral of compensation for purposes of
this paragraph (b), if a right to reimbursement by the service
recipient for a payment for such benefits, goods or services by the
service provider would not be treated as providing for a deferral of
compensation under this paragraph (b)(9)(iv).
(C) De minimis payments. In addition, if not otherwise excluded, to
the extent a separation pay arrangement entitles a service provider to
reimbursements or other payments or benefits that do not exceed $5,000
in the aggregate, such arrangement does not provide for a deferral of
compensation.
(D) Limited period of time. For purposes of paragraphs
(b)(9)(iv)(A) and (B), a limited period of time refers to both the
period during which applicable expenses may be incurred, and the period
during which reimbursements must be paid, and may not extend beyond the
December 31 of the second calendar year following the calendar year in
which the separation from service occurred.
(v) Window programs--definition. The term window program refers to
a program established by the service recipient to provide for
separation pay in connection with a separation from service, for a
limited period of time (no greater than one year), to service providers
who separate from service during that period or to service providers
who separate from service during that period under specified
circumstances. A program will not be considered a window program if a
service recipient establishes a pattern of repeatedly providing for
similar separation pay in similar situations for substantially
consecutive, limited periods of time. Whether the recurrence of these
programs constitutes a pattern is determined based on the facts and
circumstances. Although no one factor is determinative, relevant
factors include whether the benefits are on account of a specific
business event or condition, the degree to which the separation pay
relates to the event or condition, and whether the event or condition
is temporary or discrete or is a permanent aspect of the employer's
business.
(c) Plan--(1) In general. The term plan includes any agreement,
method or arrangement, including an agreement, method or arrangement
that applies to one person or individual. A plan may be adopted
unilaterally by the service recipient or may be negotiated or agreed to
by the service recipient and one or more service providers or service
provider representatives. An agreement, method or arrangement may
constitute a plan regardless of whether it is an employee benefit plan
under section 3(3) of the Employee Retirement Income Security Act of
1974 (ERISA), as amended (29 U.S.C. 1002(3)). The requirements of
section 409A are applied as if a separate plan or plans is maintained
for each service provider.
(2) Plan aggregation rules--(i) In general. Except as provided in
paragraph (c)(2)(ii) of this section, with respect to arrangements
between a service provider and a service recipient--
(A) All amounts deferred with respect to that service provider
under all account balance plans of the service recipient (as defined in
Sec. 31.3121(v)(2)-1(c)(1)(ii)(A) of this chapter) other than a
separation pay arrangement described in paragraph (c)(2)(i)(C) of this
section
[[Page 57966]]
are treated as deferred under a single plan;
(B) All amounts deferred with respect to that service provider
under all nonaccount balance plans of the service recipient (as defined
in Sec. 31.3121(v)(2)-1(c)(2)(i) of this chapter) other than a
separation pay arrangement described in paragraph (c)(2)(i)(C) of this
section are treated as deferred under a separate single plan;
(C) All amounts deferred with respect to that service provider
under all separation pay arrangements (as defined in paragraph (m) of
this section) of the service recipient due to an involuntary
termination or participation in a window program are treated as
deferred under a single plan; and
(D) All amounts deferred with respect to that service provider
under all plans of the service recipient that are not described in
paragraph (c)(2)(i)(A), (B) or (C) of this section (for example,
discounted stock options, stock appreciation rights or other equity-
based compensation described in Sec. 31.3121(v)(2)-1(b)(4)(ii) of this
chapter) are treated as deferred under a separate single plan.
(ii) Dual status. Arrangements in which a service provider
participates are not aggregated to the extent the service provider
participates in one set of arrangements due to status as an employee of
the service recipient (employee arrangements) and another set of
arrangements due to status as an independent contractor of the service
recipient (independent contractor arrangements). For example, where a
service provider deferred amounts under an arrangement while providing
services as an independent contractor, and then becomes eligible for
and defers amounts under a separate arrangement after being hired as an
employee, the two arrangements will not be aggregated for purposes of
this paragraph (c)(2). Where an employee also serves as a director of
the service recipient (or a similar position with respect to a non-
corporate service recipient), the arrangements under which the employee
participates as a director of the service recipient (director
arrangements) are not aggregated with employee arrangements, provided
that the director arrangements are substantially similar to
arrangements provided to service providers providing services only as
directors (or similar positions with respect to non-corporate service
recipients). For example, an employee director who participates in an
employee arrangement and a director arrangement generally may treat the
two arrangements as separate plans, provided that the director
arrangement is substantially similar to an arrangement providing
benefits to a non-employee director. Director arrangements and
independent contractor arrangements are aggregated for purposes of this
paragraph (c)(2).
(3) Establishment of arrangement--(i) In general. To satisfy the
requirements of section 409A, an arrangement must be established and
maintained by a service recipient, in both form and operation, in
accordance with the requirements of section 409A and these regulations.
For purposes of this paragraph (c)(3), an arrangement is established on
the latest of the date on which it is adopted, the date on which it is
effective, and the date on which the material terms of the plan are set
forth in writing. For purposes of this paragraph (c)(3)(i), an
arrangement will be deemed to be set forth in writing if it is set
forth in any other form that is approved by the Commissioner. The
material terms of the arrangement include the amount (or the method or
formula for determining the amount) of deferred compensation to be
provided under the arrangement and the time when it will be paid.
Notwithstanding the foregoing, an arrangement will be deemed to be
established as of the date the participant obtains a legally binding
right to deferred compensation, provided that the arrangement is
otherwise established under the rules of this paragraph (c)(3)(i) by
the end of the calendar year in which the legally binding right arises,
or with respect to an amount not payable in the year immediately
following the year in which the legally binding right arises (the
subsequent year), the 15th day of the third month of the subsequent
year.
(ii) Amendments to the arrangement. In the case of an amendment
that increases the amount deferred under an arrangement providing for
the deferral of compensation, the arrangement is not considered
established with respect to the additional amount deferred until the
arrangement, as amended, is established in accordance with paragraph
(c)(3)(i) of this section.
(iii) Transition rule for written plan requirement. For purposes of
this section, an unwritten arrangement that was adopted and effective
before December 31, 2006, is treated as established under this section
as of the later of the date on which it was adopted or became
effective, provided that the material terms of the arrangement are set
forth in writing on or before December 31, 2006.
(iv) Plan aggregation rules. The plan aggregation rules of
paragraph (c)(2)(i) of this section do not apply to the requirements of
paragraphs (c)(3)(i) and (ii) of this section. Accordingly, an
arrangement that fails to meet the requirements of section 409A solely
due to a failure to meet the requirements of paragraph (c)(3)(i) or
(ii) is not aggregated with other arrangements that meet such
requirements.
(d) Substantial risk of forfeiture--(1) In general. Compensation is
subject to a substantial risk of forfeiture if entitlement to the
amount is conditioned on the performance of substantial future services
by any person or the occurrence of a condition related to a purpose of
the compensation, and the possibility of forfeiture is substantial. For
purposes of this paragraph (d), a condition related to a purpose of the
compensation must relate to the service provider's performance for the
service recipient or the service recipient's business activities or
organizational goals (for example, the attainment of a prescribed level
of earnings, equity value or an initial public offering). Any addition
of a substantial risk of forfeiture after the legally binding right to
the compensation arises, or any extension of a period during which
compensation is subject to a substantial risk of forfeiture, in either
case whether elected by the service provider, service recipient or
other person (or by agreement of two or more of such persons), is
disregarded for purposes of determining whether such compensation is
subject to a substantial risk of forfeiture. An amount is not subject
to a substantial risk of forfeiture merely because the right to the
amount is conditioned, directly or indirectly, upon the refraining from
performance of services. For purposes of section 409A, an amount will
not be considered subject to a substantial risk of forfeiture beyond
the date or time at which the recipient otherwise could have elected to
receive the amount of compensation, unless the amount subject to a
substantial risk of forfeiture (ignoring earnings) is materially
greater than the amount the recipient otherwise could have elected to
receive. For example, a salary deferral generally may not be made
subject to a substantial risk of forfeiture. But, for example, where a
bonus arrangement provides an election between a cash payment of a
certain amount or restricted stock units with a materially greater
value that will be forfeited absent continued services for a period of
years, the right to the restricted stock units generally will be
treated as subject to a substantial risk of forfeiture.
(2) Stock rights. A stock right will be treated as not subject to a
substantial risk of forfeiture at the earlier of the first date the
holder may exercise the stock
[[Page 57967]]
right and receive cash or property that is substantially vested (as
defined in Sec. 1.83-3(b)) or the first date that the stock right is
not subject to a forfeiture condition that would constitute a
substantial risk of forfeiture. Accordingly, a stock option that the
service provider may exercise immediately and receive substantially
vested stock will be treated as not subject to a substantial risk of
forfeiture, even if the stock option automatically terminates upon the
service provider's separation from service.
(3) Enforcement of forfeiture condition--(i) In general. In
determining whether the possibility of forfeiture is substantial in the
case of rights to compensation granted by a service recipient to a
service provider that owns a significant amount of the total combined
voting power or value of all classes of equity of the service recipient
or of its parent, all relevant facts and circumstances will be taken
into account in determining whether the probability of the service
recipient enforcing such condition is substantial, including--
(A) The service provider's relationship to other equity holders and
the extent of their control, potential control and possible loss of
control of the service recipient;
(B) The position of the service provider in the service recipient
and the extent to which the service provider is subordinate to other
service providers;
(C) The service provider's relationship to the officers and
directors of the service recipient (or similar positions with respect
to a noncorporate service recipient);
(D) The person or persons who must approve the service provider's
discharge; and
(E) Past actions of the service recipient in enforcing the
restrictions.
(ii) Examples. The following examples illustrate the rules of
paragraph (d)(3)(i) of this section:
Example 1. A service provider would be considered as having
deferred compensation subject to a substantial risk of forfeiture,
but for the fact that the service provider owns 20 percent of the
single class of stock in the transferor corporation. If the
remaining 80 percent of the class of stock is owned by an unrelated
individual (or members of such an individual's family) so that the
possibility of the corporation enforcing a restriction on such
rights is substantial, then such rights are subject to a substantial
risk of forfeiture.
Example 2. A service provider would be considered as having
deferred compensation subject to a substantial risk of forfeiture,
but for the fact that the service provider who is president of the
corporation, also owns 4 percent of the voting power of all the
stock of a corporation. If the remaining stock is so diversely held
by the public that the president, in effect, controls the
corporation, then the possibility of the corporation enforcing a
restriction on the right to deferred compensation of the president
is not substantial, and such rights are not subject to a substantial
risk of forfeiture.
(e) Performance-based compensation--(1) In general. The term
performance-based compensation means compensation where the amount of,
or entitlement to, the compensation is contingent on the satisfaction
of preestablished organizational or individual performance criteria
relating to a performance period of at least 12 consecutive months in
which the service provider performs services. Organizational or
individual performance criteria are considered preestablished if
established in writing by not later than 90 days after the commencement
of the period of service to which the criteria relates, provided that
the outcome is substantially uncertain at the time the criteria are
established. Performance-based compensation may include payments based
on performance criteria that are not approved by a compensation
committee of the board of directors (or similar entity in the case of a
non-corporate service recipient) or by the stockholders or members of
the service recipient. Notwithstanding the foregoing, performance-based
compensation does not include any amount or portion of any amount that
will be paid either regardless of performance, or based upon a level of
performance that is substantially certain to be met at the time the
criteria is established. Except as provided in paragraph (e)(3) of this
section, compensation is not performance-based compensation merely
because the amount of such compensation is based on the value of, or
increase in the value of, the service recipient or the stock of the
service recipient.
(2) Payments based upon subjective performance criteria. The term
performance-based compensation may include payments based upon
subjective performance criteria, provided that--
(i) The subjective performance criteria relate to the performance
of the participant service provider, a group of service providers that
includes the participant service provider, or a business unit for which
the participant service provider provides services (which may include
the entire organization); and
(ii) The determination that any subjective performance criteria
have been met is not made by the participant service provider or a
family member of the participant service provider (as defined in
section 267(c)(4) applied as if the family of an individual includes
the spouse of any member of the family), or a person under the
supervision of the participant service provider or such a family
member, or where any amount of the compensation of the person making
such determination is controlled in whole or in part by the service
provider or such a family member.
(3) Equity-based compensation. Compensation is performance-based
compensation if it is based solely on an increase in the value of the
service recipient, or stock of the service recipient, after the date of
a grant or award. If the amount of compensation the service provider
will receive under a grant or award is not based solely on an increase
in the value of the service recipient, or stock of the service
recipient, after the date of the grant or award (for example, a stock
appreciation right granted with an exercise price that is less than the
fair market value of the stock as of the date of grant), and that other
amount would not otherwise qualify as performance-based compensation,
the compensation attributable to the grant or award does not qualify as
performance-based compensation. Notwithstanding the foregoing, an award
of equity-based compensation may constitute performance-based
compensation if entitlement to the compensation is subject to a
condition that would cause the award to otherwise qualify as
performance-based compensation, such as a performance-based vesting
condition. The eligibility to defer compensation under an equity-based
compensation award constitutes an additional deferral feature with
respect to the award for purposes of the definition of a deferral of
compensation under paragraph (b)(5) of this section.
(f) Service provider--(1) In general. The term service provider
includes--
(i) An individual, corporation, subchapter S corporation or
partnership;
(ii) A personal service corporation (as defined in section
269A(b)(1)), or a noncorporate entity that would be a personal service
corporation if it were a corporation; or
(iii) A qualified personal service corporation (as defined in
section 448(d)(2)), or a noncorporate entity that would be a qualified
personal service corporation if it were a corporation.
(2) Service providers using an accrual method of accounting.
Section 409A does not apply to a deferral under an arrangement between
taxpayers if, for the taxable year in which the service provider
taxpayer obtains a legally binding right to the compensation, the
[[Page 57968]]
service provider uses an accrual method of accounting for Federal tax
purposes.
(3) Independent contractors--(i) In general. Except as otherwise
provided in paragraph (f)(3)(iv) of this section, section 409A does not
apply to an amount deferred under an arrangement between a service
provider and service recipient with respect to a particular trade or
business in which the service provider participates, if during the
service provider's taxable year in which the service provider obtains a
legally binding right to the payment of the amount deferred--
(A) The service provider is actively engaged in the trade or
business of providing services, other than as an employee or as a
director of a corporation;
(B) The service provider provides significant services to two or
more service recipients to which the service provider is not related
and that are not related to one another (as defined in paragraph
(f)(3)(ii) of this section); and
(C) The service provider is not related to the service recipient,
applying the definition of related person contained in paragraph
(f)(3)(ii) of this section subject to the modification that the
language ``50 percent'' is used instead of ``20 percent'' each place it
appears in sections 267(b)(1) and 707(b)(1).
(ii) Related person. For purposes of this paragraph (f)(3), a
person is related to another person if the persons bear a relationship
to each other that is specified in section 267(b) or 707(b)(1), subject
to the modifications that the language ``20 percent'' is used instead
of ``50 percent'' each place it appears in sections 267(b) and
707(b)(1), and section 267(c)(4) is applied as if the family of an
individual includes the spouse of any member of the family; or the
persons are engaged in trades or businesses under common control
(within the meaning of section 52(a) and (b)). In addition, an
individual is related to an entity if the individual is an officer of
an entity that is a corporation, or holds a position substantially
similar to an officer of a corporation with an entity that is not a
corporation.
(iii) Significant services. Whether a service provider is providing
significant services depends on the facts and circumstances of each
case. However, for purposes of paragraph (f)(3)(i) of this section, a
service provider who provides services to two or more service
recipients to which the service provider is not related and that are
not related to one another is deemed to be providing significant
services to two or more of such service recipients for a given taxable
year, if the revenues generated from the services provided to any
service recipient or group of related service recipients during such
taxable year do not exceed 70 percent of the total revenue generated by
the service provider from the trade or business of providing such
services.
(iv) Management services. A service provider is treated as related
to a service recipient for purposes of paragraph (f)(3)(i) of this
section if the service provider provides management services to the
service recipient. For purposes of this paragraph (f)(3)(iv), the term
management services means services that involve the actual or de facto
direction or control of the financial or operational aspects of a trade
or business of the service recipient, or investment advisory services
provided to a service recipient whose primary trade or business
includes the management of financial assets (including investments in
real estate) for its own account, such as a hedge fund or a real estate
investment trust.
(g) Service recipient. Except as otherwise specifically provided in
these regulations, the term service recipient means the person for whom
the services are performed and with respect to whom the legally binding
right to compensation arises, and all persons with whom such person
would be considered a single employer under section 414(b) (employees
of controlled group of corporations), and all persons with whom such
person would be considered a single employer under section 414(c)
(employees of partnerships, proprietorships, etc., under common
control). For example, where the service provider is an employee, the
service recipient generally is the employer. Notwithstanding the
foregoing, section 409A applies to a plan that provides for the
deferral of compensation, even though the payment of the compensation
is not made by the person for whom services are performed.
(h) Separation from service--(1) Employees--(i) In general. An
employee separates from service with the service recipient if the
employee dies, retires, or otherwise has a termination of employment
with the employer. However, for purposes of this paragraph (h)(1), the
employment relationship is treated as continuing intact while the
individual is on military leave, sick leave, or other bona fide leave
of absence (such as temporary employment by the government) if the
period of such leave does not exceed six months, or if longer, so long
as the individual's right to reemployment with the service recipient is
provided either by statute or by contract. If the period of leave
exceeds six months and the individual's right to reemployment is not
provided either by statute or by contract, the employment relationship
is deemed to terminate on the first date immediately following such
six-month period.
(ii) Termination of employment. Whether a termination of employment
has occurred is determined based on the facts and circumstances. Where
an employee either actually or purportedly continues in the capacity as
an employee, such as through the execution of an employment agreement
under which the employee agrees to be available to perform services if
requested, but the facts and circumstances indicate that the employer
and the employee did not intend for the employee to provide more than
insignificant services for the employer, an employee will be treated as
having a separation from service for purposes of this paragraph (h)(1).
For purposes of the preceding sentence, an employer and employee will
not be treated as having intended for the employee to provide
insignificant services where the employee continues to provide services
as an employee at an annual rate that is at least equal to 20 percent
of the services rendered, on average, during the immediately preceding
three full calendar years of employment (or, if employed less than
three years, such lesser period) and the annual remuneration for such
services is at least equal to 20 percent of the average annual
remuneration earned during the final three full calendar years of
employment (or, if less, such lesser period). Where an employee
continues to provide services to a previous employer in a capacity
other than as an employee, a separation from service will not be deemed
to have occurred for purposes of this paragraph (h)(1) if the former
employee is providing services at an annual rate that is 50 percent or
more of the services rendered, on average, during the immediately
preceding three full calendar years of employment (or if employed less
than three years, such lesser period) and the annual remuneration for
such services is 50 percent or more of the annual remuneration earned
during the final three full calendar years of employment (or if less,
such lesser period). For purposes of this paragraph (h)(1)(ii), the
annual rate of providing services is determined based upon the
measurement used to determine the service provider's base compensation
(for example, amounts of time required to earn salary, hourly wages, or
payments for specific projects).
(2) Independent contractors--(i) In general. An independent
contractor is considered to have a separation from
[[Page 57969]]
service with the service recipient upon the expiration of the contract
(or in the case of more than one contract, all contracts) under which
services are performed for the service recipient if the expiration
constitutes a good-faith and complete termination of the contractual
relationship. An expiration does not constitute a good faith and
complete termination of the contractual relationship if the service
recipient anticipates a renewal of a contractual relationship or the
independent contractor becoming an employee. For this purpose, a
service recipient is considered to anticipate the renewal of the
contractual relationship with an independent contractor if it intends
to contract again for the services provided under the expired contract,
and neither the service recipient nor the independent contractor has
eliminated the independent contractor as a possible provider of
services under any such new contract. Further, a service recipient is
considered to intend to contract again for the services provided under
an expired contract if the service recipient's doing so is conditioned
only upon incurring a need for the services, the availability of funds,
or both.
(ii) Special rule. Notwithstanding paragraph (b)(2) of this
section, the plan is considered to satisfy the requirement described in
paragraph (a) of this section that no amounts deferred under the plan
be paid or made available to the participant before the participant has
a separation from service with the service recipient if, with respect
to amounts payable to a participant who is an independent contractor, a
plan provides that--
(A) No amount will be paid to the participant before a date at
least 12 months after the day on which the contract expires under which
services are performed for the service recipient (or, in the case of
more than one contract, all such contracts expire); and
(B) No amount payable to the participant on that date will be paid
to the participant if, after the expiration of the contract (or
contracts) and before that date, the participant performs services for
the service recipient as an independent contractor or an employee.
(i) Specified employee--(1) In general. The term specified employee
means a key employee (as defined in section 416(i) without regard to
section 416(i)(5)) of a service recipient any stock of which is
publicly traded on an established securities market or otherwise. For
purposes of this paragraph (i)(1), an employee is a key employee if the
employee meets the requirements of section 416(i)(1)(A)(i), (ii) or
(iii) (applied in accordance with the regulations thereunder and
disregarding section 416(i)(5)) at any time during the 12-month period
ending on an identification date. If a person is a key employee as of
an identification date, the person is treated as a specified employee
for the 12-month period beginning on the first day of the fourth month
following the identification date. A service recipient may designate
any date in a calendar year as the identification date provided that a
service recipient must use the same identification date with respect to
all arrangements, and any change to the identification date may not be
effective for a period of 12 months. If no identification date is
designated, the identification date is December 31. The service
recipient may designate an identification date through inclusion in
each plan document or through a separate document, provided that the
service recipient will not be treated as having designated an
identification date on any date before the execution of the document
containing the designation. Notwithstanding the foregoing, any
designation of an identification date made on or before December 31,
2006, may be applied to any separation from service occurring on or
after January 1, 2005. Whether any stock of a service recipient is
publicly traded on an established securities market or otherwise must
be determined as of the date of the employee's separation from service.
(2) Spinoffs and mergers. Where a new corporation or entity (new
corporation) is established as part of a corporate division governed by
section 355 from a corporation that is publicly traded on an
established securities market or otherwise (old corporation), any
employee of the new corporation who was a key employee of the old
corporation immediately prior to the spinoff is a key employee of the
new corporation until the end of the 12-month period beginning on the
first day of the fourth month following the old corporation's last
identification date preceding the spinoff transaction. Where two
corporations (pre-merger corporations) are merged or become part of the
same controlled group of corporations so as to be treated as a single
service recipient under paragraph (g) of this section, any employee of
the merged corporation who was a key employee of either of the pre-
merger corporations immediately before the merger is a key employee of
the merged corporation until the first day of the fourth month after
the identification date of the merged corporation next following the
merger.
(3) Nonresident alien employees. For purposes of determining key
employees, a service recipient generally must include all employees,
including employees who are nonresident aliens. However, a plan may
provide without causing an amount to be treated as an additional
deferral as to any affected participant that for purposes of applying
the six-month delay to specified employees, all employees that are
nonresident aliens during the entire 12-month period ending with the
relevant identification date are excluded for purposes of determining
which employees meet the requirements of section 416(i)(1)(A)(i), (ii)
or (iii) (applied in accordance with the regulations thereunder and
disregarding section 416(i)(5)); provided that a service recipient must
apply such exclusion with respect to all arrangements of the service
recipient, and any change to include such nonresident alien employees
may not be effective for a period of 12 months.
(j) Nonresident alien--(1) Except as provided in paragraph (j)(2)
of this section, for purposes of this section the term nonresident
alien means an individual who is--
(i) A nonresident alien within the meaning of section
7701(b)(1)(B); or
(ii) A dual resident taxpayer within the meaning of Sec.
301.7701(b)-7(a)(1) of this chapter with respect to any taxable year in
which such individual is treated as a nonresident alien for purposes of
computing the individual's U.S. income tax liability.
(2) The term nonresident alien does not include--
(i) A nonresident alien with respect to whom an election is in
effect for the taxable year under section 6013(g) to be treated as a
resident of the United States;
(ii) A former citizen or long-term resident (within the meaning of
section 877(e)(2)) who expatriated after June 3, 2004, and has not
complied with the requirements of section 7701(n); or
(iii) An individual who is treated as a citizen or resident of the
United States for the taxable year under section 877(g).
(k) Established securities market. For purposes of section 409A and
the regulations thereunder, the term established securities market
means an established securities market within the meaning of Sec.
1.897-1(m).
(l) Stock right. For purposes of section 409A and these
regulations, the term stock right means a stock option (other than an
incentive stock option described in section 422 or an option granted
pursuant to an employee stock purchase
[[Page 57970]]
plan described in section 423) or a stock appreciation right.
(m) Separation pay arrangement. For purposes of section 409A and
the regulations thereunder, the term separation pay arrangement means
any arrangement that provides separation pay or, where an arrangement
provides both amounts that are separation pay and that are not
separation pay, that portion of the arrangement that provides
separation pay. For purposes of this paragraph (m), the term separation
pay means any amount of compensation where one of the conditions to the
right to the payment is a separation from service, whether voluntary or
involuntary, including payments in the form of reimbursements of
expenses incurred, and the provision of other taxable benefits.
Separation pay includes amounts payable due to a separation from
service, regardless of whether payment is conditioned upon the
execution of a release of claims, noncompetition or nondisclosure
provisions, or other similar requirement. Notwithstanding the
foregoing, any amount, or entitlement to any amount, that acts as a
substitute for, or replacement of, amounts deferred by the service
recipient under a separate nonqualified deferred compensation plan
constitutes a payment of compensation or deferral of compensation under
the separate nonqualified deferred compensation plan, and does not
constitute separation pay.
Sec. 1.409A-2 Deferral elections.
(a) Initial elections as to the time and form of payment--(1) In
general. An arrangement that is, or constitutes part of, a nonqualified
deferred compensation plan meets the requirements of section
409A(a)(4)(B) only if the arrangement provides that compensation for
services performed during a service provider's taxable year (the
service year) may be deferred at the service provider's election only
if the election to defer such compensation is made and becomes
irrevocable not later than the end of such period as may be permitted
in this paragraph (a). An election will not be considered to be
revocable merely because the service provider may make an election to
change the time and form of payment pursuant to paragraph (b) of this
section. Whether an arrangement provides a service provider an
opportunity to elect the time or form of payment of compensation is
determined based upon all the facts and circumstances surrounding the
determination of the time and form of payment of the compensation. For
purposes of this section, an election to defer includes an election as
to the time of the payment, an election as to the form of the payment
or an election as to both the time and the form of the payment, but
does not include an election as to the medium of payment (for example,
an election between a payment of cash or a payment of property). Except
as otherwise provided in these regulations, an election will not be
considered made until such election becomes irrevocable under the terms
of the relevant arrangement. Thus, a plan may provide that an election
to defer may be changed at any time prior to the last permissible date
for making such an election. Where an arrangement provides the service
provider a right to make an initial deferral election, and further
provides that the election remains in effect until terminated or
modified by the service provider, the election will be treated as made
as of the date such election becomes irrevocable as to compensation for
services performed during the relevant service year. For example, where
an arrangement provides that a service provider's election to defer a
set percentage will remain in effect until changed or revoked, but that
as of each December 31 the election becomes irrevocable with respect to
salary payable with respect to services performed in the immediately
following year, the initial deferral election with respect to salary
payable with respect to services performed in the immediately following
year will be deemed to have been made as of the December 31 upon which
the election became irrevocable.
(2) General rule. An arrangement that is, or constitutes part of, a
nonqualified deferred compensation plan meets the requirements of
section 409A(a)(4)(B) if the plan provides that compensation for
services performed during a service provider's taxable year (the
service year) may be deferred at the service provider's election only
if the election to defer such compensation is made not later than the
close of the service provider's taxable year next preceding the service
year.
(3) Initial deferral election with respect to short-term deferrals.
With respect to a legally binding right to a payment of compensation in
a subsequent taxable year that, absent a deferral election, would not
be treated as a deferral of compensation pursuant to Sec. 1.409A-
1(b)(4), an election to defer such compensation may be made in
accordance with the requirements of paragraph (b) of this section,
applied as if the amount were a deferral of compensation and the
scheduled payment date for the amount were the date the substantial
risk of forfeiture lapses. Notwithstanding the requirements of
paragraph (b) of this section, such a deferral election may provide
that the deferred amounts will be payable upon a change in control
event (as defined in Sec. 1.409A-3(g)(5)) without regard to the 5-year
additional deferral requirement.
(4) Initial deferral election with respect to certain forfeitable
rights. With respect to a legally binding right to a payment in a
subsequent year that is subject to a forfeiture condition requiring the
service provider's continued services for a period of at least 12
months from the date the service provider obtains the legally binding
right, an election to defer such compensation may be made on or before
the 30th day after the service provider obtains the legally binding
right to the compensation, provided that the election is made at least
12 months in advance of the earliest date at which the forfeiture
condition could lapse.
(5) Initial deferral election with respect to a service recipient
with a fiscal year other than the calendar year. In the case of a
service recipient with a fiscal year other than the calendar year, a
plan may provide that fiscal year compensation may be deferred at the
service provider's election only if the election to defer such
compensation is made not later than the close of the service
recipient's fiscal year next preceding the first fiscal year in which
are performed any services for which such compensation is payable. For
purposes of this paragraph (a)(5), the term fiscal year compensation
means compensation relating to a period of service coextensive with one
or more consecutive fiscal years of the service recipient, of which no
amount is paid or payable during the service period. For example,
fiscal year compensation generally would include a bonus based on a
service period of the two consecutive fiscal years ending September 30,
2009, where the amount will be paid after the completion of the service
period, but would not include either a bonus based on a calendar year
service period or salary that would otherwise be paid during the
service recipient's fiscal year.
(6) First year of eligibility. In the case of the first year in
which a service provider becomes eligible to participate in a plan (as
defined in Sec. 1.409A-1(c)), the service provider may make an initial
deferral election within 30 days after the date the service provider
becomes eligible to participate in such plan, with respect to
compensation paid for services to be performed subsequent to the
election. In the case of a plan that does not provide for service
provider
[[Page 57971]]
elections with respect to the time or form of a payment, the time and
form of the payment must be specified on or before the date that is 30
days after the date the service provider becomes eligible to
participate in such plan. For compensation that is earned based upon a
specified performance period (for example, an annual bonus), where a
deferral election is made in the first year of eligibility but after
the beginning of the service period, the election will be deemed to
apply to compensation paid for services performed subsequent to the
election if the election applies to the portion of the compensation
equal to the total amount of the compensation for the service period
multiplied by the ratio of the number of days remaining in the
performance period after the election over the total number of days in
the performance period.
(7) Performance-based compensation. In the case of any performance-
based compensation based upon a performance period of at least 12
months, provided that the service provider performed services
continuously from a date no later than the date upon which the
performance criteria are established through a date no earlier than the
date upon which the service provider makes an initial deferral
election, an initial deferral election may be made with respect to such
performance-based compensation no later than the date that is six
months before the end of the performance period, provided that in no
event may an election to defer performance-based compensation be made
after such compensation has become both substantially certain to be
paid and readily ascertainable.
(8) Nonqualified deferred compensation arrangements linked to
qualified plans. With respect to an amount deferred under an
arrangement that is, or constitutes part of, a nonqualified deferred
compensation plan, where under the terms of the nonqualified deferred
compensation arrangement the amount deferred under the plan is the
amount determined under the formula under which benefits are determined
under a qualified employer plan (as defined in Sec. 1.409A-1(a)(2))
applied without respect to one or more limitations applicable to
qualified employer plans under the Internal Revenue Code or other
applicable law, or is determined as an amount offset by some or all of
the benefits provided under the qualified employer plan, the operation
of the qualified employer plan with respect to changes in benefit
limitations applicable to qualified employer plans under the Internal
Revenue Code or other applicable law does not constitute a deferral
election even if such operation results in an increase of amounts
deferred under the nonqualified deferred compensation arrangement,
provided that such operation does not otherwise result in a change in
the time or form of a payment under the nonqualified deferred
compensation plan. In addition, with respect to such a nonqualified
deferred compensation arrangement, the following actions or failures to
act will not constitute a deferral election under the nonqualified
deferred compensation arrangement even if in accordance with the terms
of the nonqualified deferred compensation arrangement, the actions or
inactions result in an increase in the amounts deferred under the
arrangement, provided that such actions or inactions do not otherwise
affect the time or form of payment under the nonqualified deferred
compensation plan:
(i) A service provider's action or inaction under the qualified
plan with respect to whether to elect to receive a subsidized benefit
or an ancillary benefit under the qualified plan.
(ii) The amendment of a qualified plan to add or remove a
subsidized benefit or an ancillary benefit, or to freeze or limit
future accruals of benefits under the qualified plan.
(iii) A service provider's action or inaction under a qualified
plan subject to section 402(g), including an adjustment to a deferral
election under the qualified plan subject to section 402(g), provided
that for any given calendar year, the service provider's action or
inaction does not result in an increase in the amounts deferred under
all nonqualified deferred compensation arrangements in which the
service provider participates in excess of the limit with respect to
elective deferrals under section 402(g) in effect for the taxable year
in which such action or inaction occurs.
(iv) A service provider's action or inaction under a qualified plan
with respect to elective deferrals or after-tax contributions by the
service provider to the qualified plan that affects the amounts that
are credited under a nonqualified deferred compensation arrangement as
matching amounts or other amounts contingent on service provider
elective deferrals or after-tax contributions, provided that such
matching or contingent amounts, as applicable, are either forfeited or
never credited under the nonqualified deferred compensation arrangement
in the absence of such service provider's elective deferral or after-
tax contribution, and provided further that all of the service
provider's actions or inactions do not result in an increase during
such taxable year in the amounts deferred under all nonqualified
deferred compensation arrangements in which the service provider
participates in excess of the limit with respect to elective deferrals
under section 402(g) in effect for the taxable year in which such
action or inaction occurs. See paragraph (b)(6) of this section,
Example 12 and Example 13.
(9) Separation pay. In the case of separation pay (as defined in
Sec. 1.409A-1(b)(9)(i)) due to an actual involuntary separation from
service, where such separation pay is the subject of bona fide, arm's
length negotiations, the initial deferral election may be made at any
time up to the time the service provider obtains a legally binding
right to the payment. In the case of separation pay due to
participation in a window program (as defined in Sec. 1.409A-
1(b)(9)(v)), the initial deferral election may be made at any time up
to the time the election to participate in the window program becomes
irrevocable.
(10) Commissions. For purposes of this paragraph (a), in the case
of commission compensation, a service provider earning such
compensation is treated as providing the services to which such
compensation relates only in the year in which the customer remits
payment to the service recipient. For purposes of this paragraph
(a)(10), the term commission compensation means compensation or
portions of compensation earned by a service provider if a substantial
portion of the services provided by such service provider to a service
recipient consist of the direct sale of a product or service to a
customer, the compensation paid by the service recipient to the service
provider consists of either a portion of the purchase price for the
product or service or an amount calculated solely by reference to the
volume of sales, and payment of the compensation is contingent upon the
service recipient receiving payment from an unrelated customer for the
product or services. For this purpose, a customer is treated as an
unrelated customer only if the customer is not related to either the
service provider or the service recipient. A person is treated as
related to another person if the person would be treated as related to
the other person under Sec. 1.409A-1(f)(3)(ii) or the person would be
treated as providing management services to the other person under
Sec. 1.409A-1(f)(3)(iv).
(11) Initial deferral elections with respect to compensation paid
for final payroll period--(i) In general. Unless an arrangement
provides otherwise, compensation payable after the last day
[[Page 57972]]
of the service provider's taxable year solely for services performed
during the final payroll period described in section 3401(b) containing
the last day of the service provider's taxable year or, with respect to
a non-employee service provider, a period not longer than the payroll
period described in section 3401(b), where such amount is payable
pursuant to the timing arrangement under which the service recipient
normally compensates service providers for services performed during a
payroll period described in section 3401(b), or with respect to a non-
employee service provider, a period not longer than the payroll period
described in section 3401(b), is treated as compensation for services
performed in the subsequent taxable year. The preceding sentence does
not apply to any compensation paid during such period for services
performed during any period other than such final payroll period, such
as a payment of an annual bonus. Any amendment of an arrangement after
December 31, 2006, to add a provision providing for a differing
treatment of such compensation may not be effective for 12 months from
the date the amendment is executed and enacted.
(ii) Transition rule. For purposes of this paragraph (a)(11), an
arrangement that was adopted and effective before December 31, 2006,
whether written or unwritten, will be treated as designating such
compensation for service performed in the taxable year in which the
payroll period ends, unless otherwise set forth in writing before
December 31, 2006.
(12) Designation of time and form of payment with respect to a
nonelective arrangement. An arrangement that provides for a deferral of
compensation for services performed during a service provider's taxable
year that does not provide the service provider with an opportunity to
elect the time of payment of such compensation must specify the time of
payment no later than the time the service provider first has a legally
binding right to the compensation. Similarly, an arrangement that
provides for a deferral of compensation for services performed during a
service provider's taxable year that does not provide the service
provider with an opportunity to elect the form of payment of such
compensation must specify the form of payment no later than the time
the service provider first has a legally binding right to the
compensation. Such designation shall be treated as an initial deferral
election for purposes of this section.
(13) Designation of time and form of payment with respect to
earnings. An arrangement that provides for actual or notional earnings
to be credited on amounts of deferred compensation may specify, in
accordance with the requirements of this paragraph (a), that such
earnings will be paid by a date not later than the 15th day of the
third month following the calendar year for which the earnings are
credited. To satisfy the requirements of this paragraph (a)(13), actual
or notional earnings must be credited at least annually and the measure
for such earnings must be either a specified, nondiscretionary interest
rate (or a specified, nondiscretionary formula describing an interest
rate such as, for example, the interest on a Treasury bond + 2 percent)
or a predetermined actual investment within the meaning of Sec.
31.3121(v)(2)-1(d)(2) of this chapter. For these purposes, a right to
dividend equivalents with respect to a specified number of shares of
service recipient stock (as defined in Sec. 1.409A-1(b)(5)(iii)) may
be treated as a right to actual or notional earnings on an amount of
deferred compensation.
(b) Subsequent changes in time and form of payment--(1) In general.
The requirements of section 409A(a)(4)(C) are met if, in the case of a
plan that permits a subsequent election to delay a payment or to change
the form of payment of an amount of deferred compensation, the
following conditions are met:
(i) The plan requires that such election may not take effect until
at least 12 months after the date on which the election is made.
(ii) In the case of an election related to a payment not described
in Sec. 1.409A-3(a)(2) (payment on account of disability), Sec.
1.409A-3(a)(3) (payment on account of death) or Sec. 1.409A-3(a)(6)
(payment on account of the occurrence of an unforeseeable emergency),
the plan requires that the payment with respect to which such election
is made be deferred for a period of not less than 5 years from the date
such payment would otherwise have been paid (or in the case of a life
annuity or installment payments treated as a single payment, 5 years
from the date the first amount was scheduled to be paid).
(iii) The plan requires that any election related to a payment
described in Sec. 1.409A-3(a)(4) (payment at a specified time or
pursuant to a fixed schedule) may not be made less than 12 months prior
to the date the payment is scheduled to be paid (or in the case of a
life annuity or installment payments treated as a single payment, 12
months prior to the date the first amount was scheduled to be paid).
(2) Definition of payments for purposes of subsequent changes in
the time or form of payment--(i) In general. Except as provided in
paragraphs (b)(2)(ii) and (iii) of this section, the term payment
refers to each separately identified amount to which a service provider
is entitled to payment under a plan on a determinable date, and
includes amounts applied for the benefit of the service provider. An
amount is separately identified only if the amount may be objectively
determined. For example, an amount identified as 10 percent of the
account balance as of a specified payment date would be a separately
identified amount. A payment includes the provision of any taxable
benefit, including payment in cash or in kind. In addition, a payment
includes, but is not limited to, the transfer, cancellation or
reduction of an amount of deferred compensation in exchange for
benefits under a welfare benefit plan, fringe benefit excludible under
section 119 or section 132, or any other benefit that is excluded from
gross income.
(ii) Life annuities. The entitlement to a life annuity is treated
as the entitlement to a single payment. For purposes of this paragraph
(b)(2)(ii), the term life annuity means a series of substantially equal
periodic payments, payable not less frequently than annually, for the
life (or life expectancy) of the service provider or the joint lives
(or life expectancies) of the service provider and the service
provider's designated beneficiary. A change in the form of a payment
from one type of life annuity to another type of life annuity before
any annuity payment has been made is not considered a change in the
time and form of a payment, provided that the annuities are actuarially
equivalent applying reasonable actuarial assumptions.
(iii) Installment payments. The entitlement to a series of
installment payments that is not a life annuity is treated as the
entitlement to a single payment, unless the arrangement provides at all
times with respect to the amount deferred that the right to the series
of installment payments is to be treated as a right to a series of
separate payments. For purposes of this paragraph (b)(2)(iii), a series
of installment payments refers to an entitlement to the payment of a
series of substantially equal periodic amounts to be paid over a
predetermined period of years, except to the extent any increase in the
amount reflects reasonable earnings through the date the amount is
paid.
(iv) Transition rule. For purposes of this section, an arrangement
that was adopted and effective before December 31, 2006, whether
written or unwritten,
[[Page 57973]]
that fails to make a designation as to whether the entitlement to a
series of payments is to be treated as an entitlement to a series of
separate payments under paragraph (b)(2)(iii) of this section is
treated as having made such designation as of the later of the date on
which the arrangement was adopted or became effective, provided that
such designation is set forth in writing before December 31, 2006.
(3) Coordination with prohibition against acceleration of payments.
For purposes of applying the prohibition against the acceleration of
payments contained in Sec. 1.409A-3(c), the definition of payment is
the same as the definition provided in paragraph (b)(2) of this
section. However, even though a change in the form of a payment that
results in a more rapid schedule for payments generally may not
constitute an acceleration of a payment, the change in the form of
payment must comply with the subsequent deferral rules. For example,
although a change in form from a 10-year installment payment treated as
a single payment to a lump-sum payment would not constitute an
acceleration, the change in the form of the payment must still comply
with the requirements of paragraph (b)(1) of this section, generally
meaning that the election to change to a lump-sum payment could not be
effective for 12 months and the lump-sum payment could not be made
until at least 5 years after the date the installment payments were
scheduled to commence.
(4) Application to multiple payment events. In the case of a plan
that permits a payment upon each of a number of potential permissible
payment events, such as the earlier of a fixed date or separation from
service, the requirements of paragraph (b)(1) of this section are
applied separately to each payment (as defined in paragraph (b)(2) of
this section) due upon each payment event. Notwithstanding the
foregoing, the addition of a permissible payment event to amounts
previously deferred is subject to the rules of this paragraph (b) where
the addition of the permissible payment event may result in a change in
the time or form of payment of the amount deferred. For application of
the rules governing accelerations of payments to the addition of a
permissible payment event to amounts deferred, see Sec. 1.409A-3.
(5) Delay of payments under certain circumstances. A plan may
provide, or be amended to provide, that a payment will be delayed to a
date after the designated payment date under any of the following
circumstances, and the provision will not fail to meet the requirements
of establishing a permissible payment event and the delay in the
payment will not constitute a subsequent deferral election, provided
that once such a provision is applicable to an amount of deferred
compensation, any failure to apply such a provision or modification of
the plan to remove such a provision will constitute an acceleration of
any payment to which such provision applied:
(i) Payments subject to section 162(m). A plan may provide that a
payment will be delayed where the service recipient reasonably
anticipates that the service recipient's deduction with respect to such
payment otherwise would be limited or eliminated by application of
section 162(m); provided that the terms of the arrangement require the
payment to be made either at the earliest date at which the service
recipient reasonably anticipates that the deduction of the payment of
the amount will not be limited or eliminated by application of section
162(m) or the calendar year in which the service provider separates
from service.
(ii) Payments that would violate a loan covenant or similar
contractual requirement. A plan may provide that a payment will be
delayed where the service recipient reasonably anticipates that the
making of the payment will violate a term of a loan agreement to which
the service recipient is a party, or other similar contract to which
the service recipient is a party, and such violation will cause
material harm to the service recipient; provided that the terms of the
arrangement require the payment to be made at the earliest date at
which the service recipient reasonably anticipates that the making of
the payment will not cause such violation, or such violation will not
cause material harm to the service recipient, and provided that the
facts and circumstances indicate that the service recipient entered
into such loan agreement (including such covenant) or other similar
contract for legitimate business reasons, and not to avoid the
restrictions on deferral elections and subsequent deferral elections
under section 409A.
(iii) Payments that would violate Federal securities laws or other
applicable law. A plan may provide that a payment will be delayed where
the service recipient reasonably anticipates that the making of the
payment will violate Federal securities laws or other applicable law;
provided that the terms of the arrangement require the payment to be
made at the earliest date at which the service recipient reasonably
anticipates that the making of the payment will not cause such
violation. For purposes of this paragraph (b)(5)(iii), the making of a
payment that would cause inclusion in gross income or the application
of any penalty provision or other provision of the Internal Revenue
Code is not treated as a violation of applicable law.
(iv) Other events and conditions. A service recipient may delay a
payment upon such other events and conditions as the Commissioner may
prescribe in generally applicable guidance published in the Internal
Revenue Bulletin.
(6) Examples. The following examples illustrate the application of
the provisions of this section:
Example 1. Initial election to defer salary. Employee A is an
individual employed by Employer X. Employer X sponsors an
arrangement under which Employee A may elect to defer a percentage
of Employee A's salary. Employee A has participated in the
arrangement in prior years. To satisfy the requirements of this
section with respect to salary earned in calendar year 2008, if
Employee A elects to defer any amount of such salary, the deferral
election (including an election as to the time and form of payment)
must be made no later than December 31, 2007.
Example 2. Designation of time and form of payment where an
initial deferral election is not provided. Employee A is an
individual employed by Employer X. Employer X has a fiscal year
ending September 30. On July 1, 2007, Employer X enters into a
legally binding obligation to pay Employee A a $10,000 bonus. The
amount is not subject to a substantial risk of forfeiture. Employer
X does not provide Employee A an election as to the time and form of
payment. Unless the amount is paid in accordance with the short-term
deferral rule of Sec. 1.409A-1(b)(4), to satisfy the requirements
of this section, Employer X must specify the time and form of
payment on or before July 1, 2007.
Example 3. Initial election to defer bonus payable based on
services during calendar year. Employee A is an individual employed
by Employer X. Employer X has a fiscal year ending September 30.
Employee A participates in a bonus plan under which Employee A is
entitled to a bonus for services performed during the calendar year
that, absent an election by Employee A, will be paid on March 15 of
the following year. The amount is not subject to a substantial risk
of forfeiture and does not qualify as performance based
compensation. If Employee A elects to defer the payment of the bonus
with respect to calendar year 2008, to satisfy the requirements of
this paragraph, Employee A must elect the time and form of payment
not later than December 31, 2007.
Example 4. Initial election to defer bonus payable based on
services during fiscal year other than calendar year. Employee A is
an individual employed by Employer X. Employer X has a fiscal year
ending September 30. Employee A participates in a bonus plan under
which Employee A is entitled to a bonus for services performed
during Employer X's fiscal year that, absent an election by Employee
A, will be paid on December 15 of the calendar year in which
[[Page 57974]]
the fiscal year ends. The amount is not subject to a substantial
risk of forfeiture and does not qualify as performance based
compensation as described in Sec. 1.409A-1(e). The amount qualifies
as fiscal year compensation. If Employee A elects to defer the
payment of the amount related to the fiscal year ending September
30, 2008, to satisfy the requirements of this section Employee A
must elect the time and form of payment not later than September 30,
2007.
Example 5. Initial election to defer bonus payable only if
service provider completes at least 12 months of services after the
election. Employee A is an individual employed by Employer X.
Employer X has a calendar year fiscal year. On March 1, 2006,
Employer X grants Employee A a $10,000 bonus, payable on March 1,
2008, provided that Employee A continues performing services as an
employee of Employer X through March 1, 2008. The amount does not
qualify as performance-based compensation as described in Sec.
1.409A-1(e), and Employee A already participates in another account
balance nonqualified deferred compensation plan. Employee A may make
an initial deferral election on or before March 31, 2006 (within 30
days after obtaining a legally binding right), because at least 12
months of additional services are required after the date of
election for the risk of forfeiture to lapse.
Example 6. Initial election to defer bonus that would otherwise
constitute a short-term deferral. The same facts as Example 5,
except that Employee A does not make an initial deferral election on
or before March 31, 2006. Because the right to the compensation
would not be treated as a deferral of compensation pursuant to Sec.
1.409A-1(b)(4) absent a deferral election (because the arrangement
would be treated as a short-term deferral), Employee A may make an
initial deferral election provided that the election may not become
effective for 12 months and must defer the payment at least 5 years
from March 1, 2008 (the first date the payment could become
substantially vested). Accordingly, Employee A may make an election
before March 1, 2007, provided that the election defers the payment
to a date on or after March 1, 2013 (other than a payment due to
death, disability, unforeseeable emergency, or a change in control
event).
Example 7. Initial election to defer commissions. Employee A is
an individual employed by Employer X. Employer X has a calendar year
fiscal year. As part of Employee A's services for Employer X,
Employee A sells refrigerators. Under the employment arrangement,
Employee A is entitled to 10 percent of the sales price of any
refrigerator Employee A sells, payable only upon the receipt of
payment from the customer who purchased the refrigerator. For
purposes of the initial deferral rule, Employee A is treated as
performing the services related to each refrigerator sale in the
taxable year in which each customer pays for the refrigerator.
Example 8. Initial election to defer renewal commissions. The
same facts as Example 7, except that Employee A also sells
warranties related to the refrigerators sold. Under the warranty
arrangement, refrigerator warranty customers are entitled in a
future year to extend the warranty for an additional cost to be paid
at the time of the extension. Under Employee A's arrangement with
Employer X, Employee A is entitled to 10 percent of the amount paid
for an extension of any warranty, payable upon the receipt of
payment from the customer extending the warranty. For purposes of
the initial deferral rule, Employee A is treated as performing the
services related to the amount paid for the extension of the
warranty in the taxable year in which the customer pays for the
warranty extension.
Example 9. Initial election to defer negotiated separation pay.
Employee A is an individual employed by Employer X. Under the terms
of a separation pay arrangement, Employee A is entitled upon an
involuntary separation from service to an amount equal to two weeks
of pay for every year of service at Employer X. Employer X decides
to terminate Employee A's employment involuntarily. As part of the
process of terminating Employee A, Employer X enters into bona fide,
arm's length negotiations with respect to the terms of Employee A's
termination of employment. As part of the process, Employer X offers
Employee A an amount that is in addition to any amounts to which
Employee A is otherwise entitled, payable either as a lump sum
payment at the end of three years or in three annual payments
starting at the date of termination of employment. The election of
the time and form of payment by Employee A may be made at any time
before Employee A accepts the offer and obtains a legally binding
right to the additional amount.
Example 10. Election of time and form of payments under a window
program. Employee A is an individual employed by Employer X.
Employer X establishes a window program, as defined in Sec. 1.409A-
1(b)(9)(v). Individuals who elect to terminate employment under the
window program are entitled to receive an amount equal to two weeks
pay multiplied by every year of service with Employer X. The
individuals participating in the window program may elect to receive
the payment as either a lump sum payment payable on the first day of
the month after making the election to participate in the window
program, or as a payment of two equal annual installments on each
January 1 of the first two years following the election to
participate in the window program. Employee A is eligible to
participate in the window program. Employee A may make the election
as to the time and form of payment on or before the date Employee
A's election to participate in the window program becomes
irrevocable.
Example 11. Initial election to defer salary earned during final
payroll period beginning in one calendar year and ending in the
subsequent calendar year. Employee A performs services as an
employee of Employer X. Employer X pays the salary of its employees,
including Employee A, on a bi-weekly basis. One bi-weekly payroll
period runs from December 24, 2006, through January 6, 2007, with a
scheduled payment date of January 13, 2001. Employer X sponsors, and
Employee A participates in, a nonqualified deferred compensation
arrangement under which Employee A may defer a specified percentage
of his annual salary. The arrangement does not specify that any
salary compensation paid for the payroll period in which falls
January 1 is to be treated as compensation for services performed
during the year preceding the year in which falls that January 1.
For purposes of applying the initial deferral election rules,
Employee A is deemed to have performed the services for the payroll
period December 24, 2006, through January 6, 2007, during the
calendar year 2007.
Example 12. Application of deferral election rules and anti-
acceleration rules to a section 401(k) wrap plan. Employee A
participates in a qualified retirement plan under section 401(a)
with a qualified cash or deferred arrangement under section 401(k).
Employee A also participates in a nonqualified deferred compensation
arrangement. Under the terms of the nonqualified deferred
compensation arrangement, Employee A elects, on or before December
31, to defer a specified percentage of his salary for the subsequent
calendar year. Under the terms of the nonqualified deferred
compensation arrangement and the qualified plan, as of the earliest
date administratively practicable following the end of the year in
which the salary is earned, the maximum amount that may be deferred
under the qualified cash or deferred arrangement (not in excess of
the amount specified under section 402(g) for the plan year) is
credited to Employee A's account under the qualified plan, and
Employee A's deferral under the nonqualified deferred compensation
arrangement is reduced by a corresponding amount. The reduction has
no effect on any other nonqualified deferred compensation
arrangement in which Employee A participates. The reduction of
Employee A's account under the nonqualified deferred compensation
arrangement is not treated as an accelerated payment of deferred
compensation for purposes of section 409A.
Example 13. Application of deferral election rules and anti-
acceleration rules to a nonqualified deferred compensation
arrangement linked to a qualified defined benefit plan. Employee A
participates in a qualified retirement plan that is a defined
benefit plan. Employee A also participates in a nonqualified
deferred compensation arrangement, under which the benefit payable
is calculated under a formula, with that benefit then reduced by any
benefit which Employee A has accrued under the qualified retirement
plan. In 2007, Employee A fails to elect a subsidized benefit under
the qualified retirement plan, with the effect that the amounts
payable under the nonqualified deferred compensation arrangement are
increased relative to the lesser benefit payable under the qualified
plan. Also, in 2007, Employer X amends the qualified retirement plan
to increase benefits under the plan, resulting in a relative
decrease in the amounts payable under the nonqualified deferred
compensation arrangement relative to the greater benefit payable
under the qualified plan. Neither of these actions constitute a
deferral election or an acceleration of a payment under the
nonqualified deferred compensation arrangement.
[[Page 57975]]
Example 14. Subsequent deferral election. Employee A
participates in a nonqualified deferred compensation arrangement.
Employee A elects to be paid in a lump sum payment at the earlier of
age 65 or separation from service. Employee A anticipates that he
will work after age 65, and wishes to defer payment to a later date.
Provided that Employee A continues in employment and makes the
election by his 64th birthday, Employee A may elect to receive a
lump sum payment at the earlier of age 70 or separation from
service.
Example 15. Grant of right to current payment of dividends paid
with respect to restricted stock. Employer X grants Employee A stock
that is not substantially vested for purposes of section 83, and
Employee A does not make an election under section 83(b). As part of
the restricted stock grant, Employee A receives the right to
payments in an amount equal to the dividends payable with respect to
the restricted stock. At the time Employer B grants Employee A the
right to the dividend payments, the grant also specifies that each
dividend payment will be made no later than the end of the calendar
year in which the dividends are paid to shareholders of that class
of stock or, if later, the 15th day of the third month following the
date the dividends are paid to shareholders of that class of stock.
The grant of the rights to dividend payments satisfies the
requirement that deferred amounts be paid at a specified time or
pursuant to a specified schedule.
Example 16. Subsequent deferral election rule--change in form of
payment from lump sum payment to life annuity. Employee A
participates in a nonqualified deferred compensation arrangement.
Employee A elects to be paid in a lump sum payment at age 65.
Employee A wishes to change the payment form to a life annuity.
Provided that Employee A makes the election on or before his 64th
birthday, Employee A may elect to receive a life annuity commencing
at age 70.
Example 17. Subsequent deferral election rule--change in form of
payment from life annuity to lump sum payment. Employee A
participates in a nonqualified deferred compensation arrangement.
Employee A elects to be paid in a life annuity at age 65. Employee A
wishes to change the payment form to a lump sum payment. Provided
that Employee A makes the election on or before his 64th birthday,
Employee A may elect to receive a lump sum payment at age 70.
Example 18. Subsequent deferral election rule--installment
payments designated as separate payments. Employee A participates in
a nonqualified deferred compensation arrangement that provides for
payment in a series of 5 equal annual amounts, each designated as a
separate payment. The first payment is scheduled to be made on
January 1, 2008. Provided that Employee A makes the election on or
before January 1, 2007, Employee A may elect for the first payment
to be made on January 1, 2013. If Employee A makes that election,
the remaining payments may continue to be due upon January 1 of the
four calendar years commencing on January 1, 2009.
Example 19. Subsequent deferral election rule--change in form of
payment from installment payments to lump sum payment. Employee A
participates in a nonqualified deferred compensation arrangement
that provides for payment in a series of 5 equal annual amounts that
are not designated as a series of 5 separate payments. The first
amount is scheduled to be paid on January 1, 2008. Employee A wishes
to receive the entire amount equal to the sum of all five of the
amounts to be paid as a lump sum payment. Provided that Employee A
makes the election on or before January 1, 2007, Employee A may
elect to receive a lump sum payment on or after January 1, 2013.
Example 20. Subsequent deferral election rule--change in time of
payment from payment at specified age to payment at later of
specified age or separation from service. Employee A participates in
a nonqualified deferred compensation arrangement that provides for a
lump sum payment at age 65. Employee A wishes to add a payment
provision such that the payment is payable upon the later of a
predetermined age or separation from service. Provided that Employee
A makes such election on or before his 64th birthday, Employee A may
elect to receive a lump sum payment upon the later of age 70 or
separation from service.
(c) Special rules for certain resident aliens. For the first
calendar year in which an individual is classified as a resident alien,
a nonqualified deferred compensation arrangement is deemed to meet the
requirements of paragraph (a) of this section if, with respect to
compensation payable for services performed during that first calendar
year or with respect to compensation the right to which is subject to a
substantial risk of forfeiture as of January 1 of that first calendar
year, an initial deferral election is made by the end of such first
calendar year, provided that the initial deferral election may not
apply to amounts paid or first payable on or before the date of such
initial deferral election. For any year subsequent to the first
calendar year in which an individual is classified as a resident alien,
this paragraph (c) does not apply, provided that a calendar year may
again be treated as the first calendar year in which an individual is
classified as a resident alien if such individual has not been
classified as a resident alien for at least five consecutive calendar
years immediately preceding the year in which the individual is again
classified as a resident alien.
Sec. 1.409A-3 Permissible payments.
(a) In general. The requirements of this section are met only if
the arrangement provides that an amount of deferred compensation may be
paid only on account of one or more of the following:
(1) The service provider's separation from service (as defined in
Sec. 1.409A-1(h)).
(2) The service provider becoming disabled (in accordance with
paragraph (g)(4) of this section).
(3) The service provider's death.
(4) A time (or pursuant to a fixed schedule) specified under the
plan (in accordance with paragraph (g)(1) of this section).
(5) A change in the ownership or effective control of the
corporation, or in the ownership of a substantial portion of the assets
of the corporation (in accordance with paragraph (g)(5) of this
section).
(6) The occurrence of an unforeseeable emergency (in accordance
with paragraph (g)(3) of this section).
(b) Designation of payment upon a permissible payment event. Except
as otherwise specified in this section, an arrangement provides for the
payment upon an event described in paragraph (a)(1), (2), (3), (5) or
(6) of this section if the arrangement provides for a payment date that
is objectively determinable at the time the event occurs (for example,
3 months following the date of initial disability or December 31 of the
calendar year in which the disability first occurs). In addition, an
arrangement may provide that a payment is to be made during an
objectively determinable calendar year following the year in which the
event occurs (for example, the calendar year following the year in
which the service provider dies), provided that where no specific date
within such calendar year is objectively determinable, the payment date
is deemed to be January 1 of such calendar year for purposes of
applying the subsequent deferral election rules of Sec. 1.409A-
1(b)(4). An arrangement may provide for payment upon the earliest or
latest of more than one event, provided that each event is described in
paragraphs (a)(1) through (6) of this section. An arrangement may also
provide that a payment upon an event described in paragraph (a)(1),
(2), (3), (5) or (6) of this section is to be made in accordance with a
fixed schedule that is objectively determinable based on the date of
the event, provided that the schedule must be fixed at the time the
permissible payment event is designated, and any change in the fixed
schedule will constitute a change in the time and form of payment. For
example, an arrangement may provide that a service provider is entitled
to three substantially equal payments payable on each of the first
three anniversaries of the date of the service provider's separation
from service. In addition, an arrangement may provide that payments are
to be made pursuant to a schedule of payments based upon objectively
determinable calendar years following
[[Page 57976]]
the year in which the event occurs, (for example, three substantially
equal payments to be made during the three calendar years following the
year in which the service provider dies), provided that where payment
dates within such calendar years are not specified under the terms of
the arrangement, the payment dates are deemed to be January 1 of such
calendar years for purposes of applying the subsequent deferral
election rules of Sec. 1.409A-2(b).
(c) Designation of alternative specified dates or payment schedules
based upon date of permissible event. In general, in the case of an
arrangement that provides that a payment upon an event described in
paragraph (a)(1), (2), (3), (5) or (6) of this section is to be made on
an objectively determinable date or year in accordance with paragraph
(b) of this section, or in accordance with a fixed schedule that is
objectively determinable based on the date of the event in accordance
with paragraph (b) of this section, the objectively determined date or
fixed schedule must apply consistently regardless of the date on which
the specified event occurs. However, an arrangement may allow for an
alternative payment schedule if the event occurs on or before one (but
not more than one) specified date. For example, an arrangement may
provide that a service provider will receive a lump sum payment of the
service provider's entire benefit under the arrangement on the first
day of the month following a separation from service before age 55, but
will receive 5 substantially equal annual payments commencing on the
first day of the month following a separation from service on or after
age 55.
(d) When a payment is treated as made upon the designated payment
date. Except as otherwise specified in this section, a payment is
treated as made upon the date specified under the arrangement
(including a date specified under paragraph (a)(4) of this section) if
the payment is made at such date or a later date within the same
calendar year or, if later, by the 15th day of the third calendar month
following the date specified under the arrangement. If calculation of
the amount of the payment is not administratively practicable due to
events beyond the control of the service provider (or service
provider's estate), the payment will be treated as made upon the date
specified under the arrangement if the payment is made during the first
calendar year in which the payment is administratively practicable.
Similarly, if the funds of the service recipient are not sufficient to
make the payment at the date specified under the plan without
jeopardizing the solvency of the service recipient, the payment will be
treated as made upon the date specified under the arrangement if the
payment is made during the first calendar year in which the funds of
the service recipient are sufficient to make the payment without
jeopardizing the solvency of the service recipient.
(e) Disputed payments and refusals to pay. If a payment is not
made, in whole or in part, as of the date specified under the
arrangement because the service recipient refuses to make such payment,
the payment will be treated as made upon the date specified under the
arrangement if the service provider accepts the portion (if any) of the
payment that the service recipient is willing to make (unless such
acceptance will result in a forfeiture of the claim to the remaining
amount), makes prompt and reasonable, good faith efforts to collect the
payment, and the payment is made during the first calendar year in
which the service recipient and the service provider enter into a
legally binding settlement of such dispute, the service recipient
concedes that the amount is payable, or the service recipient is
required to make such payment pursuant to a final and nonappealable
judgment or other binding decision. For purposes of this paragraph (e),
a service recipient is not treated as having refused to make a payment
where pursuant to the terms of the plan the service provider is
required to request payment, or otherwise provide information or take
any other action, and the service provider has failed to take such
action. In addition, for purposes of this paragraph (e), the service
provider is deemed to have requested that a payment not be made, rather
than the service recipient having refused to make such payment, where
the service recipient's decision to refuse to make the payment is made
by the service provider or a member of the service provider's family
(as defined in section 267(c)(4) applied as if the family of an
individual includes the spouse of any member of the family), or any
person or group of persons over whom the service provider or service
provider's family member has effective control, or any person any
portion of whose compensation is controlled the service provider or
service provider's family member.
(f) Special rule for certain resident aliens. An arrangement that
is, or constitutes part of, a nonqualified deferred compensation plan
is deemed to meet the requirements of this section with respect to any
amount payable in the first calendar year in which a service provider
is classified as a resident alien, and with respect to any amount
payable in a subsequent calendar year if no later than the December 31
of the first calendar year in which the service provider is classified
as a resident alien, the plan is amended as necessary so that the times
and forms of payment of amounts payable in a subsequent year comply
with the provisions of this section. For any year subsequent to the
first calendar year in which an individual is classified as a resident
alien, this paragraph (f) does not apply, provided that a calendar year
may again be treated as the first calendar year in which an individual
is classified as a resident alien if such individual has not been
classified as a resident alien for at least five consecutive calendar
years immediately preceding the year in which the service provider is
again classified as a resident alien.
(g) Definitions and special rules--(1) Specified time or fixed
schedule. Amounts are payable at a specified time or pursuant to a
fixed schedule if objectively determinable amounts are payable at a
date or dates that are objectively determinable at the time the amount
is deferred. An amount is objectively determinable for this purpose if
the amount is specifically identified or if the amount may be
determined pursuant to a nondiscretionary formula (for example, 50
percent of an account balance). A specified time or fixed schedule also
includes the designation of a calendar year or years that are
objectively determinable at the time the amount is deferred, provided
that for purposes of the application of the subsequent deferral rules
contained in Sec. 1.409A-2(b), the specified time or fixed schedule of
payments is deemed to refer to January 1 of the relevant calendar year
or years. An arrangement may provide that a payment upon the lapse of a
substantial risk of forfeiture is to be made in accordance with a fixed
schedule that is objectively determinable based on the date the
substantial risk of forfeiture lapses (disregarding any acceleration of
the lapsing of the substantial risk of forfeiture other than due to the
occurrence of a condition applicable as of the date the legally binding
right to the payment arose that itself would constitute a substantial
risk of forfeiture), provided that the schedule must be fixed at the
time the time and form of payment are designated, and any change in the
fixed schedule will constitute a change in the time and form of
payment. For example, an arrangement that provides for a bonus
[[Page 57977]]
payment subject to the condition that the service provider complete
three years of service, but provided further that such requirement of
continued services would lapse upon the occurrence of an initial public
offering that if applied alone would subject the right to the payment
to a substantial risk of forfeiture, may provide that a service
provider is entitled to substantially equal payments on each of the
first three anniversaries of the date the substantial risk of
forfeiture lapses (the earlier of three years of service or the date of
an initial public offering).
(2) Required delay in payment to a specified employee pursuant to a
separation from service. In the case of any specified employee (as
defined in Sec. 1.409A-1(i)), the requirements of paragraph (a)(1) of
this section permitting a payment upon a separation from service are
satisfied only if payments may not be made before the date that is six
months after the date of separation from service (or, if earlier, the
date of death of the specified employee). The arrangement must provide
the manner in which the six-month delay will be implemented in the case
of a service provider who is a specified employee. For example, an
arrangement may provide that payments to which a specified employee
would otherwise be entitled during the first six months following the
date of separation from service are accumulated and paid at another
specified date or specified schedule, such as the first date of the
seventh month following the date of separation from service. The
arrangement may also provide that each installment payment to which a
specified employee is entitled upon a separation from service is
delayed by six months. A service recipient may amend a plan at any time
to change the method for applying the six-month delay, provided that
the amendment may not be effective for a period of 12 months.
Notwithstanding the foregoing, an amendment to a plan may be effective
immediately in the case of a service recipient that amends the
arrangement prior to the date upon which the service recipient's stock
first becomes readily tradable on an established securities market.
Notwithstanding the foregoing, this paragraph (g)(2) also does not
apply to a payment made under the circumstances described in paragraph
(h)(2)(i) (domestic relations order), (h)(2)(ii) (conflicts of
interest), or (h)(2)(v) (payment of employment taxes) of this section.
(3) Unforeseeable Emergency--(i) Definition. For purposes of
paragraph (a)(6) of this section, an unforeseeable emergency is a
severe financial hardship of the service provider or beneficiary
resulting from an illness or accident of the service provider or
beneficiary, the service provider's or beneficiary's spouse, or the
service provider's or beneficiary's dependent (as defined in section
152(a)); loss of the service provider's or beneficiary's property due
to casualty (including the need to rebuild a home following damage to a
home not otherwise covered by insurance, for example, not as a result
of a natural disaster); or other similar extraordinary and
unforeseeable circumstances arising as a result of events beyond the
control of the service provider or beneficiary. For example, the
imminent foreclosure of or eviction from the service provider's or
beneficiary's primary residence may constitute an unforeseeable
emergency. In addition, the need to pay for medical expenses, including
non-refundable deductibles, as well as for the costs of prescription
drug medication, may constitute an unforeseeable emergency. Finally,
the need to pay for the funeral expenses of a spouse or a dependent (as
defined in section 152(a)) may also constitute an unforeseeable
emergency. Except as otherwise provided in this paragraph (g)(3)(i),
the purchase of a home and the payment of college tuition are not
unforeseeable emergencies. Whether a service provider or beneficiary is
faced with an unforeseeable emergency permitting a distribution under
this paragraph is to be determined based on the relevant facts and
circumstances of each case, but, in any case, a distribution on account
of unforeseeable emergency may not be made to the extent that such
emergency is or may 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 arrangement may provide for a payment upon any
unforeseeable emergency, but does not have to provide for a payment
upon all unforeseeable emergencies, provided that any event upon which
a payment may be made qualifies as an unforeseeable emergency.
(ii) Amount of payment permitted upon an unforeseeable emergency.
Distributions because of an unforeseeable emergency must be limited to
the amount reasonably necessary to satisfy the emergency need (which
may include amounts necessary to pay any Federal, state, or local
income taxes or penalties reasonably anticipated to result from the
distribution). Determinations of amounts reasonably necessary to
satisfy the emergency need must take into account any additional
compensation that is available if the plan provides for cancellation of
a deferral election upon a payment due to an unforeseeable emergency.
See paragraph (h)(2)(vii) of this section. The payment may be made from
any arrangement in which the service provider participates that
provides for payment upon an unforeseeable emergency, provided that the
arrangement under which the payment was made must be designated at the
time of payment.
(4) Disability--(i) In general. For purposes of this section, a
service provider is considered disabled if the service provider meets
one of the following requirements:
(A) The service provider is unable to engage in any substantial
gainful activity by reason of any medically determinable physical or
mental impairment that can be expected to result in death or can be
expect to last for a continuous period of not less than 12 months.
(B) The service provider is, by reason of any medically
determinable physical or mental impairment that can be expected to
result in death or can be expected to last for a continuous period of
not less than 12 months, receiving income replacement benefits for a
period of not less than 3 months under an accident and health plan
covering employees of the service provider's employer.
(ii) Limited plan definition of disability. An arrangement may
provide for a payment upon any disability, and need not provide for a
payment upon all disabilities, provided that any disability upon which
a payment may be made under the arrangement complies with the
provisions of this paragraph (g)(4).
(iii) Determination of disability. An arrangement may provide that
a service provider will be deemed disabled if determined to be totally
disabled by the Social Security Administration. An arrangement may also
provide that a service provider will be deemed disabled if determined
to be disabled in accordance with a disability insurance program,
provided that the definition of disability applied under such
disability insurance program complies with the requirements of this
paragraph (g)(4).
(5) Change in the ownership or effective control of a corporation,
or a change in the ownership of a substantial portion of the assets of
a corporation--(i) In general. Pursuant to section 409A(a)(2)(A)(v), an
arrangement may permit a payment upon the occurrence of a change in the
ownership of the
[[Page 57978]]
corporation (as defined in paragraph (g)(5)(v) of this section), a
change in effective control of the corporation (as defined in paragraph
(g)(5)(vi) of this section), or a change in the ownership of a
substantial portion of the assets of the corporation (as defined in
paragraph (g)(5)(vii) of this section) (collectively referred to as a
change in control event). To qualify as a change in control event, the
occurrence of the event must be objectively determinable and any
requirement that any other person, such as a plan administrator or
board of directors compensation committee, certify the occurrence of a
change in control event must be strictly ministerial and not involve
any discretionary authority. The arrangement may provide for a payment
on any change in control event, and need not provide for a payment on
all such events, provided that each event upon which a payment is
provided qualifies as a change in control event. For rules regarding
the ability of the service recipient to terminate the arrangement and
pay amounts of deferred compensation upon a change in control event,
see paragraph (h)(2)(viii)(B) of this section.
(ii) Identification of relevant corporation--(A) In general. To
constitute a change in control event as to the service provider, the
change in control event must relate to--
(1) The corporation for whom the service provider is performing
services at the time of the change in control event;
(2) The corporation that is liable for the payment of the deferred
compensation (or all corporations liable for the payment if more than
one corporation is liable); or
(3) A corporation that is a majority shareholder of a corporation
identified in paragraph (g)(5)(ii)(A)(1) or (2) of this section, or any
corporation in a chain of corporations in which each corporation is a
majority shareholder of another corporation in the chain, ending in a
corporation identified in paragraph (g)(5)(ii)(A)(1) or (2) of this
section.
(B) Majority shareholder. For purposes of this paragraph
(g)(5)(ii), a majority shareholder is a shareholder owning more than 50
percent of the total fair market value and total voting power of such
corporation.
(C) Example. The following example illustrates the rules of this
paragraph (g)(5)(ii):
Example. Corporation A is a majority shareholder of Corporation
B, which is a majority shareholder of Corporation C. A change in
ownership of Corporation B constitutes a change in control event to
service providers performing services for Corporation B or
Corporation C, and to service providers for which Corporation B or
Corporation C is solely liable for payments under the plan (for
example, former employees), but is not a change in control event as
to Corporation A or any other corporation of which Corporation A is
a majority shareholder. Notwithstanding the foregoing, a sale of
Corporation B may constitute an independent change in control event
for Corporation A, Corporation B and Corporation C if the sale
constitutes a change in the ownership of a substantial portion of
Corporation A's assets (see paragraph (g)(5)(vii) of this section).
(iii) Attribution of stock ownership. For purposes of paragraph
(g)(5) of this section, section 318(a) applies to determine stock
ownership. Stock underlying a vested option is considered owned by the
individual who holds the vested option (and the stock underlying an
unvested option is not considered owned by the individual who holds the
unvested option). For purposes of the preceding sentence, however, if a
vested option is exercisable for stock that is not substantially vested
(as defined by Sec. 1.83-3(b) and (j)), the stock underlying the
option is not treated as owned by the individual who holds the option.
(iv) Special rule for certain delayed payments pursuant to a change
in control event. Compensation payable pursuant to the purchase by the
service recipient of service recipient stock or a stock right held by a
service provider, or payment of amounts of deferred compensation
calculated by reference to the value of service recipient stock, may be
treated as paid at a specified time or pursuant to a fixed schedule in
conformity with the requirements of section 409A if paid on the same
schedule and under the same terms and conditions as payments to
shareholders generally pursuant to a change in control event described
in paragraph (g)(5)(v) of this section (change in the ownership of a
corporation) or as payments to the service recipient pursuant to a
change in control event described in paragraph (g)(5)(vii) of this
section (change in the ownership of a substantial portion of a
corporation's assets), and any amounts paid pursuant to such a schedule
and such terms and conditions will not be treated as violating the
initial or subsequent deferral elections rules, to the extent that such
amounts are paid not later than five years after the change in control
event.
(v) Change in the ownership of a corporation--(A) In general. For
purposes of section 409A, a change in the ownership of a corporation
occurs on the date that any one person, or more than one person acting
as a group (as defined in paragraph (g)(5)(v)(B) of this section),
acquires ownership of stock of the corporation that, together with
stock held by such person or group, constitutes more than 50 percent of
the total fair market value or total voting power of the stock of such
corporation. However, if any one person, or more than one person acting
as a group, is considered to own more than 50 percent of the total fair
market value or total voting power of the stock of a corporation, the
acquisition of additional stock by the same person or persons is not
considered to cause a change in the ownership of the corporation (or to
cause a change in the effective control of the corporation (within the
meaning of paragraph (g)(5)(vi) of this section)). An increase in the
percentage of stock owned by any one person, or persons acting as a
group, as a result of a transaction in which the corporation acquires
its stock in exchange for property will be treated as an acquisition of
stock for purposes of this section. This section applies only when
there is a transfer of stock of a corporation (or issuance of stock of
a corporation) and stock in such corporation remains outstanding after
the transaction (see paragraph (g)(5)(vii) of this section for rules
regarding the transfer of assets of a corporation).
(B) Persons acting as a group. For purposes of paragraph
(g)(5)(v)(A) of this section, persons will not be considered to be
acting as a group solely because they purchase or own stock of the same
corporation at the same time, or as a result of the same public
offering. However, persons will be considered to be acting as a group
if they are owners of a corporation that enters into a merger,
consolidation, purchase or acquisition of stock, or similar business
transaction with the corporation. If a person, including an entity,
owns stock in both corporations that enter into a merger,
consolidation, purchase or acquisition of stock, or similar
transaction, such shareholder is considered to be acting as a group
with other shareholders in a corporation prior to the transaction
giving rise to the change and not with respect to the ownership
interest in the other corporation. See Sec. 1.280G-1, Q&A-27(d),
Example 4.
(vi) Change in the effective control of a corporation--(A) In
general. For purposes of section 409A, notwithstanding that a
corporation has not undergone a change in ownership under paragraph
(g)(5)(v) of this section, a change in the effective control of a
corporation occurs only on the date that either--
[[Page 57979]]
(1) Any one person, or more than one person acting as a group (as
determined under paragraph (g)(5)(v)(B) of this section), acquires (or
has acquired during the 12-month period ending on the date of the most
recent acquisition by such person or persons) ownership of stock of the
corporation possessing 35 percent or more of the total voting power of
the stock of such corporation; or
(2) A majority of members of the corporation's board of directors
is replaced during any 12-month period by directors whose appointment
or election is not endorsed by a majority of the members of the
corporation's board of directors prior to the date of the appointment
or election, provided that for purposes of this paragraph (g)(5)(vi)(A)
the term corporation refers solely to the relevant corporation
identified in paragraph (g)(5)(ii) of this section, for which no other
corporation is a majority shareholder for purposes of that paragraph
(for example, if Corporation A is a publicly held corporation with no
majority shareholder, and Corporation A is the majority shareholder of
Corporation B, which is the majority shareholder of Corporation C, the
term corporation for purposes of this paragraph (g)(5)(vi)(A)(2) would
refer solely to Corporation A).
(B) Multiple change in control events. A change in effective
control also may occur in any transaction in which either of the two
corporations involved in the transaction has a change in control event
under paragraphs (g)(5)(v) or (g)(5)(vii) of this section. Thus, for
example, assume Corporation P transfers more than 40 percent of the
total gross fair market value of its assets to Corporation O in
exchange for 35 percent of O's stock. P has undergone a change in
ownership of a substantial portion of its assets under paragraph
(g)(5)(vii) of this section and O has a change in effective control
under this paragraph (g)(5)(vi) of this section.
(C) Acquisition of additional control. If any one person, or more
than one person acting as a group, is considered to effectively control
a corporation (within the meaning of this paragraph (g)(5)(vi)), the
acquisition of additional control of the corporation by the same person
or persons is not considered to cause a change in the effective control
of the corporation (or to cause a change in the ownership of the
corporation within the meaning of paragraph (g)(5)(v) of this section).
(D) Persons acting as a group. Persons will not be considered to be
acting as a group solely because they purchase or own stock of the same
corporation at the same time, or as a result of the same public
offering. However, persons will be considered to be acting as a group
if they are owners of a corporation that enters into a merger,
consolidation, purchase or acquisition of stock, or similar business
transaction with the corporation. If a person, including an entity,
owns stock in both corporations that enter into a merger,
consolidation, purchase or acquisition of stock, or similar
transaction, such shareholder is considered to be acting as a group
with other shareholders in a corporation only with respect to the
ownership in that corporation prior to the transaction giving rise to
the change and not with respect to the ownership interest in the other
corporation. See Sec. 1.280G-1, Q&A-27(d), Example 4.
(vii) Change in the ownership of a substantial portion of a
corporation's assets--(A) In general. Change in the ownership of a
substantial portion of a corporation's assets. For purposes of section
409A, a change in the ownership of a substantial portion of a
corporation's assets occurs on the date that any one person, or more
than one person acting as a group (as determined in paragraph
(g)(5)(v)(B) of this section), acquires (or has acquired during the 12-
month period ending on the date of the most recent acquisition by such
person or persons) assets from the corporation that have a total gross
fair market value equal to or more than 40 percent of the total gross
fair market value of all of the assets of the corporation immediately
prior to such acquisition or acquisitions. For this purpose, gross fair
market value means the value of the assets of the corporation, or the
value of the assets being disposed of, determined without regard to any
liabilities associated with such assets.
(B) Transfers to a related person--(1) There is no change in
control event under this paragraph (g)(5)(vii) when there is a transfer
to an entity that is controlled by the shareholders of the transferring
corporation immediately after the transfer, as provided in this
paragraph (g)(5)(vii)(B). A transfer of assets by a corporation is not
treated as a change in the ownership of such assets if the assets are
transferred to--
(i) A shareholder of the corporation (immediately before the asset
transfer) in exchange for or with respect to its stock;
(ii) An entity, 50 percent or more of the total value or voting
power of which is owned, directly or indirectly, by the corporation;
(iii) A person, or more than one person acting as a group, that
owns, directly or indirectly, 50 percent or more of the total value or
voting power of all the outstanding stock of the corporation; or
(iv) An entity, at least 50 percent of the total value or voting
power of which is owned, directly or indirectly, by a person described
in paragraph (g)(5)(vii)(B)(1)(iii) of this section.
(2) For purposes of this paragraph (g)(5)(vii)(B) and except as
otherwise provided, a person's status is determined immediately after
the transfer of the assets. For example, a transfer to a corporation in
which the transferor corporation has no ownership interest before the
transaction, but which is a majority-owned subsidiary of the transferor
corporation after the transaction is not treated as a change in the
ownership of the assets of the transferor corporation.
(C) Persons acting as a group. Persons will not be considered to be
acting as a group solely because they purchase assets of the same
corporation at the same time. However, persons will be considered to be
acting as a group if they are owners of a corporation that enters into
a merger, consolidation, purchase or acquisition of assets, or similar
business transaction with the corporation. If a person, including an
entity shareholder, owns stock in both corporations that enter into a
merger, consolidation, purchase or acquisition of assets, or similar
transaction, such shareholder is considered to be acting as a group
with other shareholders in a corporation only to the extent of the
ownership in that corporation prior to the transaction giving rise to
the change and not with respect to the ownership interest in the other
corporation. See 1.280G-1, Q&A-27(d), Example 4.
(6) Certain back-to-back arrangements--(i) In general.
Notwithstanding the generally applicable limitations on payments
described under paragraph (a) of this section, an arrangement between a
service recipient and a service provider that is also a service
recipient (a service provider/service recipient) may provide for
payment upon the occurrence of a payment event described in paragraph
(a)(1), (2), (3), (5) or (6) of this section, where the time and form
of payment is defined as the same time and form of payment provided
under an arrangement subject to section 409A between the service
provider/service recipient and a specified service provider to the
service provider/service recipient, if the arrangement between the
service provider/service recipient and the service recipient expressly
provides for such time and form of payment and otherwise satisfies the
requirements of section 409A.
[[Page 57980]]
(ii) Example. The provisions of this paragraph (g)(6) are
illustrated by the following example:
Example. Company B (service provider/service recipient) provides
services to Company C (service recipient). Employee A (service
provider) provides services to Company B. Pursuant to a nonqualified
deferred compensation plan meeting the requirements of section 409A,
Employee A is entitled to a payment of deferred compensation upon a
separation from service from Company B. Under an arrangement between
Company B and Company C, Company C agrees to pay an amount of
deferred compensation to Company B upon Employee A's separation from
service from Company B, in accordance with the time and form of
payment provided in the nonqualified deferred compensation plan
between Employee A and Company B. Provided that the arrangement
between Company B and Company C and the arrangement between Employee
A and Company B otherwise comply with the requirements of section
409A, Company C's payment to Company B of the amount due upon the
separation from service of Employee A from Company B may constitute
a permissible payment event for purposes of paragraph (a) of this
section.
(h) Prohibition on acceleration of payments--(1) In general. Except
as provided in paragraph (h)(2) of this section, an arrangement that
is, or constitutes part of, a nonqualified deferred compensation plan
may not permit the acceleration of the time or schedule of any payment
or amount scheduled to be paid pursuant to a payment under the
arrangement. For purposes of this paragraph (h), an impermissible
acceleration does not occur if payment is made in accordance with plan
provisions or an election as to the time and form of payment in effect
at the time of initial deferral (or added in accordance with the rules
applicable to subsequent deferral elections under Sec. 1.409A-2(b))
pursuant to which payment is required to be made on an accelerated
schedule as a result of an intervening event that is an event described
in paragraph (a)(1), (2), (3), (5) or (6) of this section. For example,
a plan may provide that a participant will receive six installment
payments commencing at separation from service, and also provide that
if the participant dies after such payments commence but before all
payments have been made, all remaining amounts will be paid in a lump
sum payment. Additionally, it is not an acceleration of the time or
schedule of payment of a deferral of compensation if a service
recipient waives or accelerates the satisfaction of a condition
constituting a substantial risk of forfeiture applicable to such
deferral of compensation, provided that the requirements of section
409A (including the requirement that the payment be made upon a
permissible payment event) are otherwise satisfied with respect to such
deferral of compensation. For example, if a nonqualified deferred
compensation arrangement provides for a lump sum payment of the vested
benefit upon separation from service, and the benefit vests under the
plan only after 10 years of service, it is not a violation of the
requirements of section 409A if the service recipient reduces the
vesting requirement to 5 years of service, even if a service provider
becomes vested as a result and receives a payment in connection with a
separation from service before the service provider would have
completed 10 years of service.
(2) Exceptions--(i) Domestic relations order. An arrangement may
permit such acceleration of the time or schedule of a payment under the
arrangement to an individual other than the service provider as may be
necessary to fulfill a domestic relations order (as defined in section
414(p)(1)(B)).
(ii) Conflicts of interest. An arrangement may permit such
acceleration of the time or schedule of a payment under the arrangement
as may be necessary to comply with a certificate of divestiture (as
defined in section 1043(b)(2)).
(iii) Section 457 plans. An arrangement subject to section 457(f)
may permit an acceleration of the time or schedule of a payment to a
service provider to pay Federal, state, local and foreign income taxes
due upon a vesting event, provided that the amount of such payment is
not more than an amount equal to the Federal, state, local and foreign
income tax withholding that would have been remitted by the employer if
there had been a payment of wages equal to the income includible by the
service provider under section 457(f) at the time of the vesting.
(iv) De minimis and specified amounts--(A) In general. An
arrangement that does not otherwise provide for mandatory lump sum
payments of benefits that do not exceed a specified amount may be
amended to permit the acceleration of the time or schedule of a payment
to a service provider under the arrangement, provided that--
(1) The payment accompanies the termination of the entirety of the
service provider's interest in the arrangement, and all similar
arrangements that would constitute a nonqualified deferred compensation
plan under Sec. 1.409A-1(c);
(2) The payment is made on or before the later of December 31 of
the calendar year in which occurs the service provider's separation
from service from the service recipient, or the 15th day of the third
month following the service provider's separation from service from the
service recipient;
(3) The payment is not greater than $10,000; and
(4) The participant is provided no election with respect to receipt
of the lump sum payment.
(B) Prospective deferrals. An amendment described in paragraph
(h)(2)(iv)(A) of this section may be made with respect to previously
deferred amounts under the arrangement as well as amounts to be
deferred in the future. In addition, a nonqualified deferred
compensation arrangement that otherwise complies with section 409A may
provide, or be amended with regard to future deferrals to provide,
that, if a service provider's interest under the arrangement has a
value below an amount specified by the plan at the time that amounts
are payable under the plan, then the service provider's entire interest
under the plan must be distributed as a lump sum payment. However, once
such a payment feature applies to an amount deferred, any change or
elimination of such feature is subject to the rules governing changes
in the time and form of payment.
(v) Payment of employment taxes. An arrangement may permit the
acceleration of the time or schedule of a payment to pay the Federal
Insurance Contributions Act (FICA) tax imposed under section 3101,
section 3121(a) and section 3121(v)(2), where applicable, on
compensation deferred under the arrangement (the FICA Amount).
Additionally, an arrangement may permit the acceleration of the time or
schedule of a payment to pay the income tax at source on wages imposed
under section 3401 or the corresponding withholding provisions of
applicable state, local, or foreign tax laws as a result of the payment
of the FICA Amount, and to pay the additional income tax at source on
wages attributable to the pyramiding section 3401 wages and taxes.
However, the total payment under this acceleration provision must not
exceed the aggregate of the FICA Amount, and the income tax withholding
related to such FICA Amount.
(vi) Payments upon income inclusion under section 409A. An
arrangement may permit the acceleration of the time or schedule of a
payment to a service provider under the plan at any time the
arrangement fails to meet the requirements of section 409A and these
regulations. Such payment may not exceed the amount required to be
included in income as a result of the
[[Page 57981]]
failure to comply with the requirements of section 409A and the
regulations.
(vii) Cancellation of deferrals following an unforeseeable
emergency or hardship distribution. An arrangement may permit a
cancellation of a service provider's deferral election due to an
unforeseeable emergency or a hardship distribution pursuant to Sec.
1.401(k)-1(d)(3). The deferral election must be cancelled, and not
postponed or otherwise delayed, such that any later deferral election
will be subject to the provisions governing initial deferral elections.
See Sec. 1.409A-2(a).
(viii) Arrangement terminations. An arrangement may permit an
acceleration of the time and form of a payment where the right to the
payment arises due to a termination of the arrangement in accordance
with one of the following:
(A) The service recipient's discretion under the terms of the
arrangement to terminate the arrangement within 12 months of a
corporate dissolution taxed under section 331, or with the approval of
a bankruptcy court pursuant to 11 U.S.C. 503(b)(1)(A), provided that
the amounts deferred under the plan are included in the participants'
gross incomes in the latest of--
(1) The calendar year in which the plan termination occurs;
(2) The calendar year in which the amount is no longer subject to a
substantial risk of forfeiture; or
(3) The first calendar year in which the payment is
administratively practicable.
(B) The service recipient's discretion under the terms of the
arrangement to terminate the arrangement within the 30 days preceding
or the 12 months following a change in control event (as defined in
Sec. 1.409A-2(g)(4)(i)). For purposes of this paragraph (h)(2)(viii),
an arrangement will be treated as terminated only if all substantially
similar arrangements sponsored by the service recipient are terminated,
so that the participant in the arrangement and all participants under
substantially similar arrangements are required to receive all amounts
of compensation deferred under the terminated arrangements within 12
months of the date of termination of the arrangements.
(C) The service recipient's discretion under the terms of the
arrangement to terminate the arrangement, provided that--
(1) All arrangements sponsored by the service recipient that would
be aggregated with any terminated arrangement under Sec. 1.409A-1(c)
if the same service provider participated in all of the arrangements
are terminated;
(2) No payments other than payments that would be payable under the
terms of the arrangements if the termination had not occurred are made
within 12 months of the termination of the arrangements;
(3) All payments are made within 24 months of the termination of
the arrangements; and
(4) The service recipient does not adopt a new arrangement that
would be aggregated with any terminated arrangement under Sec. 1.409A-
1(c) if the same service provider participated in both arrangements, at
any time within five years following the date of termination of the
arrangement.
(D) Such other events and conditions as the Commissioner may
prescribe in generally applicable guidance published in the Internal
Revenue Bulletin (see Sec. 601.601(d)(2) of this chapter).
(ix) Certain distributions to avoid a nonallocation year under
section 409(p). An arrangement may provide for an acceleration of
payment to prevent the occurrence of a nonallocation year (within the
meaning of section 409(p)(3)) in the plan year of the employee stock
ownership plan next following the current plan year, provided that the
amount distributed may not exceed 125 percent of the minimum amount of
distribution necessary to avoid the occurrence of a nonallocation year.
Solely for purposes of determining permissible distributions under this
paragraph (h)(2)(ix), synthetic equity (within the meaning of section
409(p)(6)(C)) granted during the current employee stock ownership plan
plan year is disregarded for purposes of determining whether the
subsequent plan year would result in a nonallocation year.
(3) Nonqualified deferred compensation arrangements linked to
qualified plans. With respect to amounts deferred under an arrangement
that is, or constitutes part of, a nonqualified deferred compensation
plan, where under the terms of the nonqualified deferred compensation
arrangement the amount deferred under the plan is the amount determined
under the formula determining benefits under a qualified employer plan
(as defined in Sec. 1.409A-1(a)(2)) applied without respect to one or
more limitations applicable to qualified employer plans under the
Internal Revenue Code or other applicable law, or is determined as an
amount offset by some or all of the benefits provided under the
qualified employer plan, the operation of the qualified employer plan
with respect to changes in benefit limitations applicable to qualified
employer plans under the Internal Revenue Code or other applicable law,
does not constitute an acceleration of a payment under the nonqualified
deferred compensation arrangement regardless of whether such operation
results in a decrease of amounts deferred under the nonqualified
deferred compensation arrangement. In addition, with respect to such
nonqualified deferred compensation arrangements, the following actions
or failures to act will not constitute an acceleration of a payment
under the nonqualified deferred compensation arrangement regardless of
whether in accordance with the terms of the nonqualified deferred
compensation arrangement, the actions or inactions result in a decrease
in the amounts deferred under the arrangement:
(i) A service provider's action or inaction under the qualified
employer plan with respect to whether to elect to receive a subsidized
benefit or an ancillary benefit under the qualified employer plan.
(ii) The amendment of a qualified employer plan to increase
benefits provided under the qualified plan, or to add or remove a
subsidized benefit or an ancillary benefit.
(iii) A service provider's action or inaction with respect to an
elective deferral election under a qualified employer plan subject to
section 402(g), including an adjustment to a deferral election made
during a calendar year, provided that for any given calendar year, the
service provider's actions or inactions do not result in a decrease in
the amounts deferred under all nonqualified deferred compensation plans
in which the service provider participates in excess of an amount equal
to the limit with respect to elective deferrals under section 402(g) in
effect for the taxable year in which such action or inaction occurs.
(iv) A service provider's action or inaction under a qualified
employer plan with respect to elective deferrals or after-tax
contributions by the service provider to the qualified employer plan
that affects the amounts that are credited under a nonqualified
deferred compensation arrangement as matching amounts or other amounts
contingent on service provider elective deferrals or after-tax
contributions, provided that such matching or contingent amounts, as
applicable, are either forfeited or never credited under the
nonqualified deferred compensation arrangement in the absence of such
service provider's elective deferral or after-tax contribution, and
provided further that for any given calendar year, the service
provider's actions and inactions do not result in a decrease in the
amounts deferred under all nonqualified deferred compensation plans in
which the
[[Page 57982]]
service provider participates in excess of an amount equal to the limit
with respect to elective deferrals under section 402(g) in effect for
the taxable year in which such action or inaction occurs. See Sec.
1.409A-2(b)(6), Example 12 and Example 13.
Sec. 1.409A-4 Calculation of income inclusion. [Reserved].
Sec. 1.409A-5 Funding. [Reserved].
Sec. 1.409A-6 Statutory effective dates.
(a) Statutory effective dates --(1) In general. Except as otherwise
provided in this section, section 409A is effective with respect to
amounts deferred in taxable years beginning after December 31, 2004,
and amounts deferred in taxable years beginning before January 1, 2005,
if the plan under which the deferral is made is materially modified
after October 3, 2004. Section 409A is effective with respect to
earnings on amounts deferred only to the extent that section 409A is
effective with respect to the amounts deferred. Accordingly, section
409A is not effective with respect to earnings on amounts deferred
before January 1, 2005, unless section 409A is effective with respect
to the amounts deferred.
(2) Identification of date of deferral for statutory effective date
purposes. For purposes of determining whether section 409A is
applicable with respect to an amount, the amount is considered deferred
before January 1, 2005, if before January 1, 2005, the service provider
had a legally binding right to be paid the amount, and the right to the
amount was earned and vested. For purposes of this paragraph (a)(2), a
right to an amount was earned and vested only if the amount was not
subject to a substantial risk of forfeiture (as defined in Sec. 1.83-
3(c)) or a requirement to perform further services. Amounts to which
the service provider did not have a legally binding right before
January 1, 2005 (for example because the service recipient retained
discretion to reduce the amount), will not be considered deferred
before January 1, 2005. In addition, amounts to which the service
provider had a legally binding right before January 1, 2005, but the
right to which was subject to a substantial risk of forfeiture or a
requirement to perform further services after December 31, 2004, are
not considered deferred before January 1, 2005, for purposes of the
effective date. Notwithstanding the foregoing, an amount to which the
service provider had a legally binding right before January 1, 2005,
but for which the service provider was required to continue performing
services to retain the right only through the completion of the payroll
period (as defined in Sec. 1.409A-1(b)(3)) that includes December 31,
2004, is not treated as subject to a requirement to perform further
services (or a substantial risk of forfeiture) for purposes of the
effective date. For purposes of this paragraph (a)(2), a stock option,
stock appreciation right or similar compensation that on or before
December 31, 2004, was immediately exercisable for cash or
substantially vested property (as defined in Sec. 1.83-3(b)) is
treated as earned and vested, regardless of whether the right would
terminate if the service provider ceased providing services for the
service recipient.
(3) Calculation of amount of compensation deferred for statutory
effective date purposes--(i) Nonaccount balance plans. The amount of
compensation deferred before January 1, 2005, under a nonqualified
deferred compensation plan that is a nonaccount balance plan (as
defined in Sec. 31.3121(v)(2)-1(c)(2)(i) of this chapter) equals the
present value as of December 31, 2004, of the amount to which the
service provider would be entitled under the plan if the service
provider voluntarily terminated services without cause on December 31,
2004, and received a payment of the benefits with the maximum value
available from the plan on the earliest possible date allowed under the
plan to receive a payment of benefits following the termination of
services. Notwithstanding the foregoing, for any subsequent calendar
year, the grandfathered amount may increase to equal the present value
of the benefit the service provider actually becomes entitled to,
determined under the terms of the plan (including applicable limits
under the Internal Revenue Code), as in effect on October 3, 2004,
without regard to any further services rendered by the service provider
after December 31, 2004, or any other events affecting the amount of or
the entitlement to benefits (other than a participant election with
respect to the time or form of an available benefit).
(ii) Account balance plans. The amount of compensation deferred
before January 1, 2005, under a nonqualified deferred compensation plan
that is an account balance plan (as defined in Sec. 31.3121(v)(2)-
1(c)(1)(ii) of this chapter) equals the portion of the service
provider's account balance as of December 31, 2004, the right to which
is earned and vested (as defined in paragraph (a)(2) of this section)
as of December 31, 2004.
(iii) Equity-based compensation plans. For purposes of determining
the amounts deferred before January 1, 2005, under an equity-based
compensation plan, the rules of paragraph (a)(3)(ii) of this section
governing account balance plans are applied except that the account
balance is deemed to be the amount of the payment available to the
service provider on December 31, 2004 (or that would be available to
the service provider if the right were immediately exercisable) the
right to which is earned and vested (as defined in paragraph (a)(2) of
this section) as of December 31, 2004. For this purpose, the payment
available to the service provider excludes any exercise price or other
amount that must be paid by the service provider.
(iv) Earnings. Earnings on amounts deferred under a plan before
January 1, 2005, include only income (whether actual or notional)
attributable to the amounts deferred under a plan as of December 31,
2004, or such income. For example, notional interest earned under the
plan on amounts deferred in an account balance plan as of December 31,
2004, generally will be treated as earnings on amounts deferred under
the plan before January 1, 2005. Similarly, an increase in the amount
of payment available pursuant to a stock option, stock appreciation
right or other equity-based compensation above the amount of payment
available as of December 31, 2004, due to appreciation in the
underlying stock after December 31, 2004, or accrual of other earnings
such as dividends, is treated as earnings on the amount deferred. In
the case of a nonaccount balance plan, earnings include the increase,
due solely to the passage of time, in the present value of the future
payments to which the service provider has obtained a legally binding
right, the present value of which constituted the amounts deferred
under the plan before January 1, 2005. Thus, for each year, there will
be an increase (determined using the same interest rate used to
determine the amounts deferred under the plan before January 1, 2005)
resulting from the shortening of the discount period before the future
payments are made, plus, if applicable, an increase in the present
value resulting from the service provider's survivorship during the
year. However, an increase in the potential benefits under a nonaccount
balance plan due to, for example, an application of an increase in
compensation after December 31, 2004, to a final average pay plan or
subsequent eligibility for an early retirement subsidy, does not
constitute earnings on the amounts deferred under the plan before
January 1, 2005.
[[Page 57983]]
(v) Definition of plan. For purposes of this paragraph (a), the
term plan has the same meaning provided in Sec. 1.409A-1(c), except
that the provisions treating all nonaccount balance plans under which
compensation is deferred as a single plan does not apply for purposes
of the actuarial assumptions used in paragraph (a)(3)(ii) of this
section. Accordingly, different reasonable actuarial assumptions may be
used to calculate the amounts deferred by a service provider in two
different arrangements each of which constitutes a nonaccount balance
plan.
(4) Material modifications--(i) In general. Except as otherwise
provided, a modification of a plan is a material modification if a
benefit or right existing as of October 3, 2004, is materially enhanced
or a new material benefit or right is added, and such material
enhancement or addition affects amounts earned and vested before
January 1, 2005. Such material benefit enhancement or addition is a
material modification whether it occurs pursuant to an amendment or the
service recipient's exercise of discretion under the terms of the plan.
For example, an amendment to a plan to add a provision that payments of
deferred amounts earned and vested before January 1, 2005, may be
allowed upon request if service providers are required to forfeit 20
percent of the amount of the payment (a haircut) would be a material
modification to the plan. Similarly, a material modification would
occur if a service recipient exercised discretion to accelerate vesting
of a benefit under the plan to a date on or before December 31, 2004.
However, it is not a material modification for a service recipient to
exercise discretion over the time and manner of payment of a benefit to
the extent such discretion is provided under the terms of the plan as
of October 3, 2004. It is not a material modification for a service
provider to exercise a right permitted under the plan as in effect on
October 3, 2004. The amendment of a plan to bring the plan into
compliance with the provisions of section 409A will not be treated as a
material modification. However, a plan amendment or the exercise of
discretion under the terms of the plan that materially enhances an
existing benefit or right or adds a new material benefit or right will
be considered a material modification even if the enhanced or added
benefit would be permitted under section 409A. For example, the
addition of a right to a payment upon an unforeseeable emergency of an
amount earned and vested before January 1, 2005, would be considered a
material modification. The reduction of an existing benefit is not a
material modification. For example, the removal of a haircut provision
generally would not constitute a material modification. The
establishment of or contributions to a trust or other arrangement from
which benefits under the plan are to be paid is not a material
modification of the plan, provided that the contribution to the trust
or other arrangement would not otherwise cause an amount to be
includible in the service provider's gross income.
(ii) Adoptions of new arrangements. It is presumed that the
adoption of a new arrangement or the grant of an additional benefit
under an existing arrangement after October 3, 2004, and before January
1, 2005, constitutes a material modification of a plan. However, the
presumption may be rebutted by demonstrating that the adoption of the
arrangement or grant of the additional benefit is consistent with the
service recipient's historical compensation practices. For example, the
presumption that the grant of a discounted stock option on November 1,
2004, is a material modification of a plan may be rebutted by
demonstrating that the grant was consistent with the historic practice
of granting substantially similar discounted stock options (both as to
terms and amounts) each November for a significant number of years.
Notwithstanding paragraph (a)(4)(i) and this paragraph (a)(4)(ii), the
grant of an additional benefit under an existing arrangement that
consists of a deferral of additional compensation not otherwise
provided under the plan as of October 3, 2004, will be treated as a
material modification of the plan only as to the additional deferral of
compensation, if the plan explicitly identifies the additional deferral
of compensation and provides that the additional deferral of
compensation is subject to section 409A. Accordingly, amendments to
conform a plan to the requirements of section 409A with respect to
deferrals under a plan occurring after December 31, 2004, will not
constitute a material modification of the plan with respect to amounts
deferred that are earned and vested on or before December 31, 2004,
provided that there is no concurrent material modification with respect
to the amount of, or rights to, amounts deferred that were earned and
vested on or before December 31, 2004. Similarly, a grant of an
additional benefit under a new arrangement adopted after October 3,
2004, and before January 1, 2005, will not be treated as a material
modification of an existing plan to the extent that the new arrangement
explicitly identifies additional deferrals of compensation and provides
that the additional deferrals of compensation are subject to section
409A.
(iii) Suspension or termination of a plan. A cessation of deferrals
under, or termination of, a plan, pursuant to the provisions of such
plan, is not a material modification. Amending an arrangement to stop
future deferrals thereunder is not a material modification of the
arrangement or the plan. Amending an arrangement to provide
participants an election whether to terminate participation in a plan
constitutes a material modification of the plan.
(iv) Changes to investment measures--account balance plans. With
respect to an account balance plan (as defined in Sec. 31.3121(v)(2)-
1(c)(1)(ii) of this chapter), it is not a material modification to
change a notional investment measure to, or to add to existing
investment measures, an investment measure that qualifies as a
predetermined actual investment within the meaning of Sec.
31.3121(v)(2)-1(d)(2) of this chapter or, for any given taxable year,
reflects a reasonable rate of interest (determined in accordance with
Sec. 31.3121(v)(2)-1(d)(2)(i)(C) of this chapter). For this purpose,
if with respect to an amount deferred for a period, a plan provides for
a fixed rate of interest to be credited, and the rate is to be reset
under the plan at a specified future date that is not later than the
end of the fifth calendar year that begins after the beginning of the
period, the rate is reasonable at the beginning of the period, and the
rate is not changed before the reset date, then the rate will be
treated as reasonable in all future periods before the reset date.
(v) Rescission of modifications. Any modification to the terms of a
plan that would inadvertently result in treatment as a material
modification under this section is not considered a material
modification of the plan to the extent the modification in the terms of
the plan is rescinded by the earlier of a date before the right is
exercised (if the change grants a discretionary right) or the last day
of the calendar year during which such change occurred. Thus, for
example, if a service recipient modifies the terms of a plan on March 1
to allow an election of a new change in the time or form of payment
without realizing that such a change constituted a material
modification that would subject the plan to the requirements of section
409A, and the modification is rescinded on November 1, then if no
change in the time or form of payment has been made pursuant to the
[[Page 57984]]
modification before November 1, the plan is not considered materially
modified under this section.
(vi) Definition of plan. For purposes of this paragraph (a)(4), the
term plan has the same meaning provided in Sec. 1.409A-1(c), except
that the provision treating all account balance plans under which
compensation is deferred as a single plan, all nonaccount balance plans
under which compensation is deferred as a separate single plan, all
separation pay arrangements due to an actual involuntary separation
from service or participation in a window program as a separate single
plan, and all other nonqualified deferred compensation plans as a
separate single plan, does not apply.
(b) [Reserved].
Mark E. Matthews,
Deputy Commissioner of Services and Enforcement.
[FR Doc. 05-19379 Filed 9-29-05; 8:45 am]
BILLING CODE 4830-01-P