Dec 26, 2007
Recent IRS Guidance Under Code Section 409A
IRS extends transition relief under Section 409A.

The Internal Revenue Service (“IRS”) recently issued Notice 2007-86 which generally extends the transitional relief provided with respect to Section 409A of the Internal Revenue Code of 1986, as amended (the Code.) 

As detailed in previous memoranda from Royse Law Firm, Code Section 409A was enacted as part of the 2004 Jobs Creation Act and dramatically changed the way certain deferred compensation arrangements are treated for tax purposes.  Under 409A and the Regulations issued thereunder, a deferral of compensation occurs if a service provider (i.e. employees and certain independent contractors) obtains a legally binding right to a payment in one tax year which will be paid in a subsequent tax year or years. Unless certain requirements are satisfied, the amounts deferred will be subject tax and included in the income of the employee in the year the compensation was earned and will additionally be subject to a 20% penalty and potentially interest charges for underreporting. Section 409A casts a wide net and potentially impacts, without limitation, the following: stock appreciation rights, stock options, deferred bonus arrangements, and severance plans. 

Following the enactment of 409A, the IRS and the Treasury issued a series of transitional guidance to aid taxpayers as they adapt to the new regulatory environment. This guidance began with Notice 2005-1, which was followed by proposed regulations, and ultimately final regulations, which were finalized in April of this year. In addition, the IRS has issued a series of Notices which have delayed the effective date of the final regulations.    

Notice 2007-86 postpones the effective date for the final regulations until January 1, 2009. This means that documentation of deferred compensation arrangements may be amended for another full year so that such arrangements comply with or avoid the application of Section 409A. A non-exhaustive list of action items includes: (i) identifying and replacing discounted stock options (options that were granted with an exercise price below fair market value at the date of grant) with non-discounted options which thereby avoid the application of 409A; (ii) permitting participants under a deferred compensation arrangement to select a new “409A-compliant” payment option; (iii) permitting employees to make new deferral elections (provided that such new elections meet certain requirements specified in Notice 2007-86); and, (iv) removing provisions of a plan which would violate 409A (such as provisions permitting “haircuts” and similar features). As a general matter, Notice 2007-86 does not alter the mechanics of complying with 409A. 

Notice 2007-86, like its predecessors, does not change the requirement that deferred compensation arrangements must still operate in good faith compliance with Section 409A. Such operational compliance has been mandated since January 1, 2005. Unlike prior transition relief, Notice 2007-86 provides that taxpayers will now be deemed to operate in good faith compliance only if they satisfy the requirements set forth in Notice 2005-1 or the final Regulations; taxpayers are no longer permitted to rely on any proposed regulations except as they may specifically pertain to partnerships. 

As in previous newsletters, we urge all taxpayers to undertake an exacting review of their deferred compensation arrangements. Given the pervasive nature of the statute, the myriad of situations in which a violation of 409A can occur, to say nothing of the severity of the consequences in the event of a violation, it is critical that all taxpayers take advantage of the transition relief as we move toward the effective date for the final regulations. 

IRS provides additional guidance with regard to correcting certain unintentional violations under Section 409A.Following the issuance of Notice 2007-86, discussed above, the IRS issued Notice 2007-100, which provides guidance and correctional procedures with respect to certain deferred compensation arrangements which result in an unintentional violation of Section 409A. As noted above, the consequences for failing to comply with Section 409A are severe, resulting in the current taxation of amounts that are deferred and not received until a later year or years by the employee as well as a 20% penalty.

Notice 2007-100 addresses a variety of situations in which a plan’s operation results in an unintentional violation or Section 409A. Further, the Notice provides a series of helpful examples which demonstrate the scope of the transition relief.

Specifically Notice 2007-100 provides that Section 409A will not apply to the following unintentional violations provided they are corrected in the year of occurrence and provided further that the procedures recited in the Notice are followed: (i) failure to defer correct amounts or incorrect payment amounts; (ii) payments which violate Section 409A; (iii) excess deferrals of compensation; and (iv) correction of the exercise price of stock rights such as options and stock appreciation rights. 

The Notice provides additional, albeit less generous, relief in the event the unintentional violations set forth above are not corrected in the year in which they occur.  Provided that such violations (i) are corrected prior to 2010, (ii) do not exceed a certain dollar amount specified in the Notice, and (iii) are corrected utilizing the methods described in the Notice, taxpayers may be able to reduce, although not completely avoid, the penalties under Section 409A. Moreover, unintentional violations involving the exercise price of stock options and similar rights are not able to take advantage of this limited relief and must therefore be corrected in the year in which such violations occur to avoid the assessment of a penalty.

As noted, any relief under the Notice is predicated on the violation being unintentional. Pursuant to the examples, it appears the relief is targeted at what are essentially clerical errors. Moreover, the Notice requires that employers take reasonable measures to avoid the reoccurrence of the violation in the future. In all cases, the burden is on the taxpayer to establish the unintentional nature of the violation.

Finally, the Notice states that the IRS is currently designing a voluntary compliance program with regard to certain operational failures under Section 409A. We will provide further details with respect to this program as they become available.

CIRCULAR 230 DISCLOSURE
THE DISCUSSION OF TAX CONSIDERATIONS WAS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED BY ANY TAXPAYER, FOR THE PURPOSE OF AVOIDING TAX PENALTIES THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE. ANY TAX ADVICE CONTAINED HEREIN WAS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED BY THE WRITTEN ADVICE. EACH PARTY SHOULD SEEK ADVICE BASED ON THE PARTY’S PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISOR.