The clock is rapidly ticking down to zero for Corporate America to comply with new regulations governing deferred compensation agreements under Section 409A of the tax code. The new rules go into effect on Jan. 1, 2009, so by now most companies should be wrapping up their efforts to bring all affected compensation arrangements into compliance.
The key phrase in that last sentence is “should be.” But even for the, ahem, errant few who aren’t nearly finished, experts say it isn’t too late to get their Section 409A houses in order.
Capwell
“It’s definitely not too late, but the door is starting to close,” warns Jeffrey Capwell, head of the executive compensation and employee benefits group at the law firm McGuireWoods.
Section 409A of the Internal Revenue Code includes a tangle of complex requirements that deferred compensation arrangements must satisfy, or risk severe tax consequences to employees. A “good faith” transition period for compliance is in effect until Dec. 31, 2008. Any arrangement subject to Section 409A must be amended to comply with the final regulations by that date. The final regulations, issued by the Internal Revenue Service in 2007, become fully effective Jan. 1, 2009.
Based on what he’s seen, William Hoffman, a partner in the law firm DLA Piper, says 409A compliance efforts “are a pretty mixed bag.”
“Some companies are completely done, while others have barely started,” he says.
To be sure, many companies have been toiling away at compliance efforts for months; the original deadline to bring plan documents into compliance was Dec. 31, 2007, until the IRS—to the relief of many—gave a one year reprieve. That means many companies have done at least some of the necessary paperwork, which is voluminous.
Hoffman
But Hoffman says certain companies (smaller businesses with limited resources or those in the midst of acquisitions, for example) are bound to be late to the compliance party. For instance, Hoffman says, he’s come across companies acquiring privately held businesses that “don’t realize they have a 409A problem until they start due diligence.”
Still, there’s no need to panic just yet. Companies still have five months left to focus on what needs to be done and to amend their plans as necessary, Capwell says.
Stephen Fackler of the law firm Gibson, Dunn & Crutcher puts it somewhat more bluntly: “It’s high time for companies to get a timeline in place to get this wrapped up,” he says. “We don’t anticipate any further IRS guidance, and we’ve heard multiple times with abundant clarity that there won’t be any further extensions.”
Fackler
To be fair, Fackler, Capwell, and others say most employers are on track to be in full compliance by year-end. Some wrapped up compliance efforts last fall before the IRS granted its extension; others delayed making any changes to give participants in classic non-qualified plans more time to make distribution elections, Fackler says.
“Most companies have made all the necessary changes, but not all of those changes have taken effect yet,” he says.
CALL TO ACTION
Below is an excerpt of a recent Gibson Dunn & Crutcher legal bulletin providing action items for last-minute compliance with Section 409A.
1. Identify Arrangements Subject to Section 409A. Employers should review all compensation arrangements for Section 409A compliance. We recommend using the nine categories of “plans” set forth in the final regulations as a basis for organization and classification. Some of the types of arrangements that potentially are subject to Section 409A absent a regulatory exception include:
Traditional SERPs and other deferred compensation plans, including “wrap-around” 401(k) plans;
Employment, change in control and severance agreements;
Severance plans;
Stock options, stock appreciation rights, restricted stock units and other equity awards, including substitution or assumption of such awards upon a reorganization or a similar corporate transaction;
Post-retirement reimbursement and in-kind benefit arrangements (e.g., retiree medical benefits, outplacement services, first-class travel rights, continued payment of country club dues);
Annual bonus and long-term incentive plans;
Non-U.S. benefit plans that cover U.S. employees;
Employee stock purchase plans not covered by Section 423 of the Code; and
“Earn-outs” and other arrangements entered into in connection with corporate transactions.
2. Amend Arrangements to Bring Them into Compliance with Section 409A. Arrangements subject to Section 409A should be amended no later than December 31, 2008 so that they either (i) reflect the requirements of Section 409A, or (ii) fall outside the coverage of Section 409A.
3. Adopt Amendments. The corporate body with authority to amend the relevant arrangements (e.g., the board of directors or the compensation committee) should adopt the amendments. Since many boards meet only a few times a year, this may require advance planning, highlighting the need to ensure that the review process is well underway.
4. Review Stock Option and SAR Grants and Take Any Necessary Corrective Action. Any stock options and stock appreciation rights that were issued on or after January 1, 2005 and any such stock rights that were issued before that date but were not vested as of December 31, 2004 generally are subject to Section 409A if the exercise price was less than the fair market value of the underlying stock on the date of grant (“discount options”). Most discount options can be “fixed" by December 31, 2008 by either raising the exercise price to fair market value as of the date of grant or “hard-wiring” the exercise date to a single, specified date or a Section 409A-compliant event (such as termination of employment). Failure to implement one of these fixes to discount options by year-end generally will result in a Section 409A violation on January 1, 2009.
5. Change Payment Elections under Transition Rule. Section 409A generally places severe restrictions on the ability to amend payment elections once made. However, IRS Notice 2007-86 provided a special transition rule that generally permits any changes as long as no distributions are moved into or out of 2008. This will be the last “bite at the apple” for allowing participants flexibility in changing distribution elections.
6. Implement Procedures for Operational Compliance. Even if the plan documents are in order, an operational failure will subject the employee or other service provider to the adverse tax treatment under Section 409A. Thus, procedures should be put in place to ensure operational compliance. In this regard, agreements with outside service providers should be reviewed to determine whether any changes are necessary.
Source
Gibson Dunn & Crutcher (June 26, 2008).
Likewise, Capwell says many companies he sees are “well along” in their compliance efforts.
Obstacles Abound
Even for those businesses that are fully compliant, getting there has not been easy.
Most experts say the biggest obstacle to compliance has been determining which compensation arrangements are subject to the rules, because the scope of what’s considered deferred compensation under Section 409A is so broad. Arrangements potentially subject to the rules run from traditional non-qualified deferred compensation and retirement plans to any manner of employment, change-in-control, and severance agreements, and many types of equity compensation plans.
“The final regs are so broad, almost any compensatory arrangement could be subject to 409A,” says Gregory Schick, a partner with the law firm Sheppard, Mullin, Richter & Hampton. “Most things did need some change or amendment.”
Fackler agrees. “The rules impact virtually every major category of incentive plan and executive agreement companies put in place,” he says. For example, he notes that many companies grandfathered the pre-2005 accruals under their traditional non-qualified deferred compensation plans, because the necessary changes to make those plans comply with the rules are so significant.
Hoffman says one of most problematic areas for many companies has been separation pay arrangements. “Those arrangements are particularly difficult to make work under 409A, because many things that seem reasonable and non-abusive just don’t work,” he says.
For some employment agreements with severance or separation pay provisions, compliance was a matter of changing the triggering events, while others necessitated that companies change their plan definition of “good reason” or required the delay of payments for six months to comply, Fackler says.
Other common changes involved defining fixed periods for some payments and ensuring that severance provisions to provide for compensation upon involuntary termination conform to the requirements of 409A, Schick says.
Programs that award discounted stock options and plans that provide for benefit offsets also required amendments to comply with the rules, says Capwell. For instance, some U.S. subsidiaries with foreign parent companies had programs that granted discounted stock options that had to be amended.
While many compensation arrangements simply needed some minor amendments to bring them into compliance with the final rules, Capwell notes that some companies opted to terminate others, such as split-dollar life insurance arrangements, rather than try to make them work under the final regulations.
For the Late-Comers
Regardless of when you start, the first step for Section 409A compliance is to inventory all existing compensation deals to determine which ones are subject to Section 409A. Since any right to compensation paid in a later tax year could potentially be treated as deferred compensation, “we tell people it’s better to err on the side of being over-inclusive," says Schick.
Once that’s done, companies must determine which agreements need to be amended and make the necessary changes. In most cases, the board’s compensation committee will need to give its approval.
Schick
Schick and others emphasize the need to act quickly. “Depending on how many agreements and the level of any needed changes and the board and employee approvals companies may need to get, that can take quite a bit of time,” he says.
Although time is of the essence, Capwell warns companies not to rush when considering their alternatives for bringing arrangements into compliance. “There’s not always a single answer for how to address a problem,” he says. “Companies will want to spend some time considering their alternatives so they can pick the one that’s optimal.”
Public companies should also create an overarching policy to identify key employees who are subject to a Section 409A provision that requires no payments be made until six months after separation from the company, Capwell says. Determining who those “key employees” are can be complicated, he says, particularly if there’s been a merger or acquisition during the year.
Once they’ve amended all of their plans, companies still have to ensure they have procedures to ensure operational compliance going forward. Even beyond the Jan. 1, 2009, effective date, “This doesn’t go away,” Schick says. “Companies aren’t ever really done, because there are always going to be new agreements that will have to comply,” he says.
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