CHAPTER 2.

§409A COMPLIANCE FLOWCHART

2:1 §409A Compliance Flowchart - Description

As an aid to understanding § 409A, the following flowchart offers a bird’s eye

view of a typical 409A analysis. The numeric references are to a more detailed outline of §
409A issues in the various sections of Chapter 3, which also contains a compliance audit guide.
In turn, Chapter 3 provides references to the more detailed discussion in subsequent chapters in
the ThomsonReuters book “The 409A Administration Handbook” (the link to the book is
http://west.thomson.com/productdetail/155303/40888478/productdetail.aspx). In addition,
numerous frequently considered questions and answers appear in Chapter 12 of the book.

2:2 § 409A Compliance Flowchart - Flowchart

3.1 DEFERRED NO
COMPENSATION

WRITTEN COMPLIANCE EXEMPTIONS

YES
3.2 GRANDFATHER
NO 3.6 ELECTION
Y/N
YES
MODIFIED NO
NO 3.7 PAYMENT TIMING
YES
YES
3.3 SEPARATION YES
3.8 ANTI-ACCELERATION
NO
NO
3.4 MISC. YES
YES

NO
NO 3.9 CHANGE OF
FORM/ELECTION NO 3.5 SHORT-TERM
DEFERRAL
YES
YES

3.10 TRANSITION OPERATIONAL

ELIGIBLE COMPLIANCE
YES

NO NO

3.11 VOLUNTARY
YES
CORRECTION
NO

YES 3.12 PLAN

AGGREGATION

3.14 LIMITED 3.13 FULL NO 409A

SANCTIONS SANCTIONS PROBLEM
 CHAPTER 3. OUTLINE OF § 409A.

3:1 Outline of § 409A--Deferred Compensation.

A. § 409A is designed to discourage the movement of taxable compensation

from one tax year to another. In order for compensation to be subject to § 409A, it must be
“deferred compensation” which generally applies if a “service provider” has a legally binding
right to compensation for services rendered to the “service recipient” and that compensation is
payable in a later taxable year. See § 5:1 below.

While by no means exhaustive, the following plans or arrangements are candidates

for potential deferred compensation:

(i) Agreements to defer salary or bonuses

(ii) Agreements to make up for amounts not allowable under qualified

retirement plans such as 401(k) plans

(iii) Supplemental executive retirement plans

(iv) Stock option and stock compensation plans (although numerous potential
exemptions often apply)

(v) Restricted stock unit plans

(vi) Bonus arrangements

(vii) Expense reimbursement plans

(viii) Severance arrangements--including those in employment or other

agreements

(ix) Deferred payment or “earnout” arrangements pursuant to merger or

business purchase agreements

(x) Deferred payments in connection with a covenant not to compete

(xi) Payments deferred past the date of performance such as royalty or similar
payments to artists for subsequent sales, distributions, records,
broadcasts, etc.

B. A service provider is:

Any employee, director, consultant or independent contractor

However - there is a very significant exception for independent

contractors providing substantial services to others (this exception does
 not apply to the extent the services provided are “management services”
or investment or advisory services to companies whose business is
primarily the investment or financial or real estate assets. See § 5:3
below.

C. The service recipient is the person, company or entity for whom services are
performed. Generally this includes any related entity that is owned at least 80% in a
parent/subsidiary line or 50% in a brother/sister relationship. See § 5:4 below. Determining who
is the service recipient is important for several purposes, including:

i. Whether there is service recipient stock for purposes of determining

whether a stock option or SAR is exempt from § 409A. See §§ 3:1 and
6:8 below.

ii. Whether there has been a separation from service which would justify a
distribution at that time under § 409A. See §§ 3:7D and 8:13 below.
Note that the definition is broadened here to include parent/subsidiary
relationships of 50%.

iii. As for the “change in control” determination under § 409A, note that the
technical definition of service recipient--which includes any entity in an
80% parent/subsidiary chain or 50% brother sister--does not apply, but
rather a more limited rule applies (and thus the circumstances that count
as a change in control is more limited). See §§ 3:7F and 8:18 below.

D. 409A does not apply to the typical grant of restricted stock. See 6:7 below.

i. i.e., stock which is issued but subject to forfeiture or repurchase at cost if

vesting requirements are not met

ii. This is true even if a § 83(b) election accelerates income

iii. However, other deferral may features may implicate 409A, e.g., restricted
stock units where shares are not actually delivered unit the vesting date or
later.

E. Stock Options. Stock options are often exempt from § 409A:

Stock Options which satisfy the rules of “incentive stock options” under
Internal Revenue Code §422 are not subject to §409A. Nonqualified stock options or stock
appreciation rights (“SARs”) can be exempt from §409A as discussed below if: (1) the option or
SAR is a right to purchase or is with respect to stock that qualifies as “service recipient stock”
(which generally means the stock is common stock issued by an eligible issuer), and (2) the
exercise or grant price cannot at any time be less than the fair market value of the stock at the
date of grant (which cannot occur until the minimum price, the maximum number of shares and
class of stock are known). See § 6:7 below.

(i) Fair Market Value

1. Date of grant is the date of the last corporate action necessary to
create the employee’s legally binding right to the option. See §
6:10 below. The date of grant cannot be before the minimum
exercise price, maximum number of shares and class of stock are
known. Generally, the grant can be made conditional on certain
events (such as date of hire). Also, the price can be a grant value
determined by an appraisal yet to be completed, so long as the
exercise price is expressly provided as the fair market value of the
stock to be determined and the exercise price cannot be less than a
specific amount set forth on the date of grant.

2. Public Company. For stock in a class which is publicly traded

(generally on any established market, including the “Pink Sheets”),
fair market value is generally the closing price of the day before or
the day of the transaction, though other methods as described are
allowed. See § 6:11 below.

3. Private Company. For stock in a class which is not publicly traded,

fair market value is determined by a reasonable application of a
reasonable valuation method. See § 6:11 below.

a. A method is reasonable if it considers:

(i) The value of tangible and intangible assets .

(ii) The present value of anticipated future cash flows

(iii) Readily determinable market value of similar

companies in substantially similar trade of business.

(iv) Recent purchases of stock.

(v) Discounts for marketability, minority ownership, etc.

(vi) All other relevant information.

b. A valuation is not reasonably applied if it is more than 12

months old or subsequent material factors are ignored.

(i) Unless it is determined the previous assumptions and

circumstances are unchanged.

c. If the method is reasonable and reasonably applied, the

determination should be upheld even if the determination
turns out to be incorrect—though a substantially incorrect
number necessarily casts doubt on whether a reasonable
method was in fact used or was in fact reasonably applied.
 d. Use of certain “presumptions” in favor of a fair market value
determination for private companies:

(i) A valuation performed by an independent appraiser if

the valuation date is not more than 12 months from
date of transaction. See § 6:12 below.

(ii) A more informal determination for start-ups, the

illiquid start-up presumption, applies if the following
are satisfied. See §6:13 below.

(1) The entity has not been in business for more

than 10 years.

(2) There is no reasonable anticipation that the

valuation date is within 90 days before a
change in control or 180 days before an IPO.

(3) The determination is documented in writing and

is performed by a person (whether or not
related to the entity) with 5 years of “relevant”
experience in the business, in valuations,
finance accounting, investment banking,
private equity or secured lending or with other
comparable experience.

(iii) Formula Valuation, see § 6:14 below, which is

(1) Also used for I.R.C.§ 83 purposes in

determining the taxable for restricted stock
and

(2) Applied to any sales to the company or 10%

shareholders, except certain arm’s length
sales of all or substantially all stock.

(ii) Service Recipient Stock.

1. must be common stock within meaning of IRC § 305. See § 6:8

below.

2. no longer has to be best class of common

3. can have no dividend preference other than liquidation

4. cannot be subject to mandatory put or call except for repurchase of

unvested stock
 5. must be issued by an eligible issuer. That is, the company or entity
whose stock is purchasable upon exercise of the option must be an
entity:

a. in a chain of at least 50% owner of entities ending with at

least 50% ownership of the employer receiving the services
(thus, the issuer has to be a 50% owner “up” the chain that
includes the employer receiving the services-- not down the
chain or a brother/sister entity) or

b. at least a 20% owner of the employer receiving the services

(e.g. a joint venture) if legitimate business purposes.

(iii) Modification of stock options (See § 6:16 below).

1. Effect: The option is treated as newly granted as of the date of

modification--the main § 409A concern being that the old exercise
price might be less than the fair market value of the stock on the
new grant date, thus making the option ineligible for the stock
option exception from § 409A.

2. Definition: any change that lowers the exercise price

a. But only if the new exercise price is less than the fair market
of the stock on the new grant date: therefore a typical
repricing to fair market value at the date of the repricing is not
a modification.

b. It is not a modification to accelerate the date of vesting or

exercise or to change the medium of exercise (for example, a
change permitting the exercise of an option with previously
owned stock, etc).

(iv) Extension (see § 6:17 below)

1. Effect: the option is treated as deferred compensation subject to §

409A from the original date of grant--which often means the
option will not have satisfied the 409A requirements that exercise
occur on one of the six permissible times or events (death,
disability, change in control, termination of employment, date
certain or hardship).

2. Definition: at a time when the option is “in the money” (i.e., the fair
market value of the stock is higher than the exercise price), it is:

a. amended to extend the exercise period past the original option

term or past ten years from the date of grant;
 b. exchanged for a legally binding right to receive stock in a
future year; or

c. amended to add an additional deferral feature--such as

settlement in a year following the date of exercise

3. Thus, it is not an extension subject to § 409A if the option is

amended to extend the post-termination exercise period from 90
days after termination to, for example, 18 months after termination,
so long as the extension is not to a date later than the earlier of (i)
original option exercise period, or (ii) ten years from the date of
grant (such an extension would cause the loss of incentive stock
option (“ISO”) eligibility under I.R.C. § 422 and there are
accounting implications, even if often incidental)

3:2 Outline of § 409A-- Grandfather rule (see § 1.1).

A. Compensation granted prior to January 1, 2005 is exempt from § 409A,

provided however:

(i) Benefits or payments which vest after December 31, 2004 are not
exempted from § 409A and

(ii) Benefits or payments pursuant to an agreement which is materially

modified after October 3, 2004 are not exempted from § 409A.

3:3 Outline of § 409A-- “Separation pay exception”. (see § 6:22 below). The
separation pay exception and the short term deferral exception (see § 6:3 below) are two of the
most common and significant exceptions to § 409A. § 409A does not apply to the extent a
payment (see § 3:3E below) meets the requirements in (B) and (C):

B. The payment amount does not exceed twice the lesser of:

(i) The individual’s annualized compensation for preceding tax year.

(ii) The annual compensation limit used for many purposes in the qualified
plan rules under IRC § 401 and related provisions ($245,000 in 2009).

C. The payment is made within 2 years following the separation from

service (see § 3:7D below).

D. The termination qualifies as an involuntary separation from service (see §

6:23 below)

(i) A voluntary termination for good reason (see § 6:24 below) can qualify
as an involuntary termination if based on a material and negative
unilateral employer action related to pay, benefits, duties and/or
conditions of employment.
 (ii) The regulations provide for a good reason safe harbor which requires
employee notice and opportunity to cure.

E. A “payment” (see § 7:15 below) is determined as follows:

(i) Each separately identifiable and objectively determinable amount under

the written contract is a separate payment.

(ii) All payments under a life annuity (which is generally monthly, quarterly,
annual or other periodic payments for life) are treated as a single
payment, which makes it difficult for life annuities to satisfy the
separation pay exception (because all installments of the annuity will not
be paid within two years) or the short term deferral exception described
in short-term deferral exception in below (because the annuity
installments will not be completed within the first 2-1/2 months of the
year following the year of vesting).

(iii) All payments under an installment payment (which is generally monthly,

quarterly, annual or other periodic payments in substantially equal
amounts over a period of years) which is not a life annuity are treated as a
single payment unless the plan expressly states that the right to the
installment payments is to be treated as a right to a series of separate
payments.

F. Thus, in order for an installment payment to satisfy the separation pay

or short term deferral exception, it is often essential that this statement
appear in the written plan document.

3:4 Outline of § 409A--Miscellaneous exceptions from 409A may apply as

follows:

A. Qualified retirement plans, IRAs etc. (see § 6:2 below).

B. Typical non-taxable health and medical plans (insured or uninsured),

vacation, sick leave, disability, death and health savings accounts, medical plans to extent
excludable from income (see § 6:2 below).

C. Employment claim settlements, indemnity obligations (see § 6:2 below)

D. Foreign plans (see § 6:2 below)

E. Treaty tax exclusions and certain foreign income provisions (see § 6:2
below).

F. Other separation pay exceptions:

 (i) Reimbursement of business, moving, out-placement expenses (see § 6:27
below). This exception requires compliance with the “limited period of
time” rules (see § 6:26 below)

1. The expense or item must be incurred by end of second taxable year

following year of separation, and

2. Actual payment must occur by end of third year

(ii) In-kind benefits such as financial planning, use of property, etc. (see
§6:29 below) during the “limited period of time”

(iii) Collective bargaining plans (see § 6:25 below)

(iv) Reimbursement of medical expenses (see § 6:28 below)

(v) Other up to annual 401(k) deferral limit ($16,500 in 2009) (see § 6:30
below).

3:5 Outline of § 409A--The “short term deferral exception” (see § 6:3 below) is one
of the most common and significant exceptions to § 409A (see also the separation pay exception
at § 3:3E above).

A. To qualify for the short term deferral exception, the written agreement must
require the payment (see § 3:3E above for summary of what constitutes a payment) to be made
and completed.

(i) Within the 2 ½ month period following the end of the year in which the
payment vests--that is, the payment is no longer subject to a substantial
risk of forfeiture (see §6:6 below).

(ii) This is why a payment due when there is a voluntary termination is

usually not eligible for the short term deferral rule--the payment
essentially vests when the agreement arises, so unless termination is
required very quickly after the agreement arises, it will be possible, often
likely, that the payment will not be made until after the 2-1/2 period
expires.

(iii) This exception is unlimited as to amount.

B. In certain instances payments which are required to be made by the 2-1/2

month deadline but are not actually made in time, such as for administrative difficulty, going
concern or 162(m) reasons, can still qualify under the short term deferral exception

C. Note that although payments are exempt from § 409A, certain changes to
defer the payment date will have to satisfy the election change rules of § 409A (and thus
payment might have to be delayed five years if changed). See §§ 3:9 and 7:11 below).
 D. However, the anti-acceleration rules described in § 3:8 and 7:13 below
generally do not apply to an acceleration in the payment date of an amount otherwise exempt
under the short term deferral rule.

3:6 Outline of § 409A--Election Rules. The election rules are important for several
reasons. First, if an employee has a right to defer compensation, such election must be made in
such manner and at such time as required by the following election rules. Second, in such
cases where an election may be made by the employee, one of the six permissible dates or
events (see § 7:1 above) for payment must be irrevocably designated by the time required by
the following election rules. Third, in the case of a deferred payment subject to § 409A which
is not subject to an election of deferral by the employee (and is thus designated by the
employer), one of the six permissible dates or events for payment must irrevocably designated
by the employer by the later of the date the employee obtains the legally binding right to a
payment (typically the date the agreement is entered into--even if payment is later) or the time
required by the election rules below applied as if the employee had an election to defer. See §
7:1 below.

A. In general, the time and form of payment (including the amount) must be
elected (and become irrevocable) in the calendar year prior to the year services are performed
(see § 7:2 below).

B. If applicable, an election may also be made within 30 days of the

employee’s initial eligibility in a plan. See § 7:3 below.

(i) Note however, that the concept of plan is determined on an aggregated

basis. Thus, if the employee had been eligible to participate in any other
plan which must be aggregated with the plan under consideration, this
special rule likely would not apply (see § 5:5 below).

(ii) Because of the plan aggregation issue, this rule often only helps in the
case of new hires.

C. Performance-based compensation. See § 7:4 below.

(i) In the case of performance-based compensation, an election may be made

prior to the earlier of

1. six months before the end of the performance period and

2. the time the amount payable is readily ascertainable

(ii) Performance-based compensation is similar, though not identical, to that

defined in the “million dollar cap” rules of I.R.C. § 162(m). Payment of
the compensation must be contingent upon satisfaction of pre-established
organizational or individual performance criteria over a performance
period of at least twelve months. To be pre-established, the criteria must
be set forth in writing not later than 90 days after the beginning of the
service period and at a time when the outcome is still substantially
 uncertain. Unlike § 162(m) performance-based compensation,
shareholder approval is not required nor is it necessary to have the
compensation approved by an independent committee of the board.
Compensation is not performance-based if it can be paid if the
performance standards are not met or if set when they are substantially
certain to be met.

D. Elections as to unvested amounts may be made within 30 days of

obtaining a legally binding right to the payment if:

(i) Vesting occurs more than 12 months after the date the legally binding
right arises, and

(ii) The election precedes the vesting date by 12 months. See §7:5 below.

E. Other election rules.

(i) Amounts eligible for the short term deferral exception. As noted in §
3:5 above, amounts which are payable within 2-1/2 months of the end of
the tax year in which the payment vests can be exempt from § 409A
because of the short term deferral exception. If the employee then
becomes entitled to elect to defer that payment, that election must be
consistent with the rules described in § 7:12 below regarding changes of
the time and format of payments.

(ii) If as a result of arm’s length bargaining, an employee becomes entitled to

separation pay to which he or she was not previously entitled or which
does not replace other deferred compensation, that employee may make
an election to defer up until the employee obtains the binding legal right
to the separation pay. See § 7:6 below. This exception applies whether
or not the separation is involuntary.

(iii) For special rules where the employer and employee tax years are not the
same, see § 7:9.

(iv) Miscellaneous rules. Other special rules relate to:

1. certain automatic increases in deferrals under nonqualified plans

linked to qualified plans (such as those permitting additional
deferrals and matches above the amounts permitted for plans under
I.R.C. §401(k)),

2. certain changes with respect to cafeteria plans under I.R.C. §125

that affect the definition of compensation under the deferred
compensation plan, and

3. elections to annualize recurring part-year compensation.

 F. Also, initial elections are deemed to satisfy § 409A to the extent the
election is provided to satisfy the Uniformed Services Employment and Reemployment Rights
Act of 1994, as amended. See § 7:10 below.

3:7 Outline of § 409A—Payment timing rules. §409A requires that any payment or
benefit may be paid or made available only on one of the permissible dates or events. These
permissible dates and events include five express permissible events which are based on actual
events (see § 8:1 below) and one time based date--a specified date. In the case of options or
SARs, distribution means the date of exercise--thus while most options and SARs are designed
to be exempt from § 409A, for those which are not exempt, exercise must occur one of the six
permissible dates or events.

A. Thus, under § 409A, payment or exercise must be made on account of one of

the following dates or events:

(i) Death

(ii) Disability (see § 8:17 below)

(iii) Separation from service (see § 8:13 below)

(iv) Change in control (see § 8:18 below)

(v) Unforeseeable emergency (see § 8:24 below)

(vi) A specified date (see § 8:9 below)

B. By the end of the applicable election period (see § 3:6A above) payment date
must be designated in writing and it must be one of the six permissible dates or events. See ____
below.

(i) Payment may also be designated to occur on or within any of the

following so long as the date or period is determinable as of the date of
one of the five express permissible events occurs (or in the case of (2)
and (3) where the payment is based on specified date, as of that date) and
is not subject to discretion:

1. On another date determined by reference to one of the five express

permissible events. Thus, for example, it is permissible to make a
payment on the fifth anniversary of the date of death, or in four
equal annual installments starting on the date of separation from
service and on each of the following three anniversaries,

2. For any of the six permissible dates or events (thus including a

specified date) within any designated taxable year for any event or
date. Thus, for the examples in (1) above, payment could be
designated to occur at any time in the taxable year which includes
the fifth anniversary of death or in four equal annual installments
 each to be made in the four successive taxable years starting in the
year of separation from service,

3. For any of the six permissible dates or events (thus including a

specified date) within any designated period following the date or
event so long as:

a. Payment occurs within the same taxable year of the

employee, or

b. Is not greater than 90 days and the employee may not

designate the year of payment.

4. Payment may be made on the earliest or latest of more than one of

the six permissible dates or events. For example, payment will
occur on January 1, 2015, or separation from service, if earlier.
See § 8:1 below.

a. May not have more than one form for each event: for
example, payment over 5 years for separation from service in
the first half of the year but payment immediately for
separation from service in the last half of the year.

b. However, there may be a different forms of payment for

separation from service events as follows:

(1) A form of payment for separation from service

(voluntary or involuntary) occurring within 2 years
following change in control.

(2) Another form is permitted for a separation occurring

before or after a specified date or period of service (for
example, a form of payment which occurs because the
employee reaches age 65, or because the employee
reaches ten years of service, or even a provision
requiring the employee to reach both the age and service
requirements).

(3) And yet a third form is permissible for other types of

separation.

C. Once designated consistent with (b) above, actual payment may be made (see
§ 8:2 below):

(i) On the designated date;

(ii) At any time later in the same taxable year of the designated date;
 (iii) If later than the period allowed in (ii), by the 15th day of the third calendar
month following the designated payment date, so long as the employee
may not designate the actual year of payment; or

(iv) Within 30 days prior to a designated date provided the employee may not
designate the year of payment.

D. What is a separation from service (see §§ 8:13-15)?

(i) Employee—when both parties reasonably anticipate no further services

will be provided, or that services (employment or consulting) will be less
than 20% of the previous 36 month level.

1. If actual is less than 20%, presume separation from service (subject

to rebuttal).

2. If actual is greater than 50%, presume no separation from service

(subject to rebuttal).

3. If actual service is in between, there is no presumption, but rather,

the facts and circumstances are determinative without having to
overcome a presumption.

(ii) Independent contractor

1. Good faith complete termination of all services.

2. Note dual status rule in the regulations—if serve as both an

employee and an independent contractor, a separation from service
does not occur until both rules are satisfied (e.g., change from
employee to independent contractor). There is an exception
however if an employee also serves as a board member—
termination of service in one status can be a separation from service
fro plans covering only that status (i.e., as a board member or as an
employee) even if the person continues service in the other status.

3. Dual status can be in conflict with the employee rule—if employee

starts as employee, unofficial IRS suggestions are that the employee
rule must be met—thus, if there are subsequent consulting services
performed, but below the 20% level, a separation from service is
presumed.

E. Key employee—six month prohibition on payments for separation from

service with a public company (see § 8:16 below).

(i) Applicable to key employees of companies with stock traded on an

established market (including pink sheets).
 F. Payments may be made on account of a “change in control “ (see § 8:18 et
seq.).

(i) With respect to any particular employee, only ownership or control

changes of the following companies can constitute a change in control:

1. the company for whom the services by the employee are performed,

2. the company liable for payment but only if the company actually
receives the services attributable to the deferred compensation or
there is a bona fide business purpose for making the payment, or

3. a company holding a majority interest in a line of companies

holding majority interests, ending with any of the companies in (1)
or (2) above (thus, entities “up the ownership chain” from the
employer qualify for purposes of determining whether a change in
control has occurred, but entities “down the chain” do not qualify).

(ii) With respect to a company in (i) above, a change in control can occur in
any of the following three instances:

1. Change in ownership (see § 8:19 below)—occurs when the voting

control of one person (or more than one person if acting as a group)
moves from below 50% to at least 50%

(iii) Change in effective control (see § 8:20 below) occurs if:

1. One person (or more than one person if acting as a group) acquires
at least 30% of voting control over a 12 month period, or

2. There is a change in the majority of the board over a twelve month

period (and any such new directors are not approved by a majority
of the board in place before the election or appointment of that
member).

(iv) Change in ownership of substantial portion of assets (see § 8:21 below)

occurs if any person (or more than one person if acting as a group)
acquires at least 40% of the total gross asset value of the company.

G. Post change in control payments or benefits (see § 8:22 below).

(i) If actually paid on the same terms applicable to other shareholders:

1. An “earnout” is deemed to be paid on the date of the change in

control if it is paid within 5 years of the change in control and is
made on the same basis as made to other shareholders.
 2. Payment pursuant to a newly imposed vesting schedule is eligible
for the short term deferral exception from § 409A (see § 8:22
above) if the new schedule is imposed on the payment as a result of
change in control and payment (or exercise in the case of a non-
exempt stock option or SAR) actually occurs within 2 ½ months
after the end of the year in which vesting occurs.

3:8 Outline of § 409A--Anti-acceleration Rules. See § 7:13 below.

A. As noted in § 3:7 above, payment dates based on one of the six

permissible dates or events must be designated in advance.

(i) Subsequent changes to accelerate the date of payment are generally

prohibited.

(ii) This acceleration prohibition does not apply to accelerate a payment

excepted from § 409A under the short term deferral exception discussed
in § 3:5 above (though as noted in § 7:11 the subsequent change rules as
discussed in 7:14 below apply to a subsequent deferral of a payment
covered by the short term deferral exception).

(iii) A vesting date may be accelerated but the actual payment may not be
accelerated.

(iv) An employer may subsequently amend a plan to permit earlier (not later)
payment on account of death, disability or unforeseeable emergency.

B. An employer may unilaterally provide for earlier payment in the following

instances:

(i) Pursuant to domestic relations orders

(ii) Small amount cashouts up to the annual 401(k) plan deferral limit
($16,500 for 2009)

(iii) Payment of income or FICA withholding

(iv) Payment because of 409A violation

(v) Cancellation of elections to defer because of disability or unforeseeable

emergency

(vi) In connection with a plan termination because of bankruptcy or

dissolution

(vii) Plan termination in connection with a change in control

(viii) Certain plan other terminations

 (ix) Offset of certain employer debt up to $5,000

(x) To settle a bona fide dispute—generally the settlement must be less than
75% of original amount due

(xi) Miscellaneous

1. To comply with Federal, state, local or foreign ethics or conflict of

interest requirements

2. Certain payments and taxes accelerated in connection with a plan

subject to Code § 457(f)

3. Certain distributions to avoid a non-allocation year in an ESOP

under Code § 409(p)

4. Payment of certain state, local or foreign taxes applicable to a

deferral prior to payment

C. If a nonqualified plan is designed to make up for benefits that are limited

under an associated qualified retirement plan (such as a 401(k) plan) or a broad based foreign
plan,

(i) decreases in the amount deferred under the nonqualified plan as a result
of the operation of the qualified plan, including changes in the benefit
limitations applicable to the qualified plan are permissible accelerations

(ii) the employee’s election or failure to elect a subsidized benefit is a

permissible acceleration

(iii) the employer’s amendment of the qualified retirement plan or broad

based foreign plan to increase benefits or to add or remove a subsidized
or ancillary benefit is a permissible acceleration

(iv) the employee’s action or inaction with respect to elective or pre-tax

deferrals under a qualified employer plan is a permissible acceleration
provided the total decrease to all nonqualified plans as a result of such
decrease is not greater than $16,500 for 2009

(v) the employee’s action or inaction with respect to elective and pre-tax
deferrals or after tax contributions under a qualified employer plan that
affect matching contributions under a nonqualified plan is a permissible
acceleration provided the total matching contributions to the nonqualified
plans do not exceed 100% of the amount that could be provided under the
qualified plans without regard to applicable I.R.C. limits.

D. For nonqualified plans which base their deferrals or benefits on the

compensation of the particular employee, a change to a cafeteria plan election which in turn
changes the compensation used in determining the nonqualified deferral or benefit is a
permissible acceleration.

3:9 Outline of § 409A--Change of time or form of payment. See §7:14 below.

A. In addition to the prohibition on acceleration of payment discussed in §

3:8 above, § 409A requires that other changes to the time and form of payment (whether made
effective by the unilateral action of the employer, the election of the employee or the agreement
of both) must:

(i) Be made at least twelve months before a scheduled payment date or start
of payment in the case of an annuity, or installment which is not
designated as a series of separate payments (see § 3:3E above for
discussion of what is a payment);

(ii) Not take effect for at least twelve months after the change ; and

(iii) Except for death, disability or unforeseeable emergency, push the

payment date (or start for an annuity or installment not designated as a
series of separate payments) back five years!

3:10 Outline of § 409A--Transition Guidance

A. In general:

(i) § 409A is effective now and has been since January 1, 2005

(ii) Definitive guidance on many issues in the Final Regulations became

mandatory January 1, 2009

(iii) Good faith compliance on most issues was allowed until January 1, 2009

(iv) Until then many problems of “form” (i.e., problems in the plan document
or agreement itself, as opposed to operational problems in trying to
comply with the plan) generally could be fixed (Notice 2007-86, see
Chapter 10 below)

(v) Transition guidance generally did not permit operational errors except in
good faith compliance

(vi) Prior to 2009 could permit new elections or designation of payment dates
except:

1. Could not accelerate payment due after year of change to year of

change. Likewise, could not defer payment due in year of change
to year after change.
 2. Could not (and still may not) add a substantial risk of forfeiture
without increasing the amount payable (see § 6:6 below).

(vii) With respect to options (i.e., correction of discounted stock options) (see
§ 10:7 below).

1. Could require a year in which exercise had to occur, or option

would expire.

2. For purposes of Option correction, an Option was not “payable” in

a year just because it was exercisable then, so long as reasonable to
assume it could be exercised in a later year.

3. Could not cure an option already exercised.

4. Could increase the exercise price—even reimburse for lost discount

but not for cash or vested stock in the year of correction (see __
below).

(viii) With respect to severance.

1. the parties could revise a definition of good reason by end 2009.

2. However, if the prior definition of good reason did not satisfy the
definition discussed above, a new one could be added only if there
was a material increase to the award payable (see § §10:9 below).

3. Transition rules permitted eliminating good reason entirely.

B. With respect to calculation of § 409A violation amounts and other income

inclusion rules:

(i) the temporary guidance in 2005-2008 has been largely extended

indefinitely in Notice 2008-115 (see § 9:2 below); or

(ii) Taxpayers may rely on the “Proposed Income Inclusion Regulations”

provided all guidance in such proposed regulations is followed. See __
below).

3:11 Outline of § 409A--Voluntary Correction.

A. Revised correction program. In December, 2008, the IRS expanded and

clarified its pervious correction program. See Chapter 11 below.

(i) Applies to unintentional operational errors (not errors in the written plan).

(ii) Generally, the following relief is available:

1. No sanctions, for:
 a. Correction in the same year for:

(1) Failure to defer when required or to pay deferred

amounts when required;

(2) Failure to meet the six month post-termination

requirement for key employees of public reporting
companies;

(3) Excess deferrals;

(4) Option exercise price below grant date fair market

value.

b. Correction in the calendar year immediately following the

year of the violation for non-Insiders only for:

(1) Failure to defer when required or to pay deferred

amounts when required;

(2) Failure to meet the six month post-termination

requirement for key employees of public reporting
companies;

(3) Excess deferrals

(4) Option exercise price below grant date fair market

value.

2. Limited Sanctions for certain violations. Limited Sanctions means

that only the amount of the violation is taxed and subject to the 20%
additional tax. Thus, other vested amounts, (including under
aggregated plans—see § 5:5 below) are not penalized as required
under the full sanctions of § 409A and the premium interest is not
payable. Limited sanction are available for :

a. Violations for a Limited Amount (no more than the annual

401(k) deferral limit--$16,500 in 2009) for:

(1) Failure to defer when required or to pay deferred

amounts when required;

(2) Failure to meet the six month post-termination

requirement for key employees of public reporting
companies;

(3) Excess deferrals.

 b. Correction by the end of the second calendar year following
the year of violation for:

(1) Failure to defer when required or to pay deferred

amounts when required;

(2) Failure to meet the six month post-termination

requirement for key employees of public reporting
companies;

(3) Excess deferrals.

c. Certain information and reporting requirements apply. See §§

11:4 and 11:5.

3:12 Outline of § 409A--Plan Aggregation.

A. For important purposes such as elections within 30 days of becoming

eligible for the plan, or sanctions, various plans are considered as one. Each separate plan gets
lumped into all others in its category as set forth below (see § 5:5 below):

B. Class of plans:

(i) Employee deferral Account Balance;

(ii) Employer Account Balance (including matching contributions);

(iii) Nonaccount Balance—e.g., defined benefit plans;

(iv) Separation pay;

(v) Stock rights (options, etc.);

(vi) In-kind benefits or reimbursements;

(vii) Split dollar;

(viii) Foreign plans with substantially all non-resident aliens; and

(ix) All others.

3:13 Outline of § 409A--Full Sanctions

A. All vested deferred amounts under the aggregated plans are taxed to
employee in year of noncompliance (as opposed to when the payments are received under the
normal rules)

(i) For rules prior to finalization of the Proposed Income Inclusion

Regulations, see § 9:20 below.
 (ii) Prior to finalization of the Proposed Income Exclusion Regulations,
such proposed regulation may be relied upon on an all or nothing basis.
See § 9:3 below. Proposed Income Inclusion Regulations make it clear
that only amounts vested on December 31 of the year of noncompliance
are included in income. Amounts vesting in later years are not included in
income if the plan is then compliant. IRS can include nonvested amounts
if employer establishes a pattern or practice of impermissibly changing
elections.

B. Premium interest--interest rate on unpaid taxes increased by

1% from the vesting date. As suggested in §9:3 regarding the Proposed Income Inclusion
Regulations, this penalty can be quite substantial. Although a violation is assessed on the
amount vested in the year of the violation (meaning income inclusion and a 20% additional tax is
applies at that time), the premium interest applies from the earlier date of deferral, or vesting date
if later! Adding up the years, this can be quite substantial.

C. 20% additional tax on employee for amount vested

D. Plus any state sanctions (e.g., California imposes an additional 20% tax
and premium interest)

E. Reporting and Withholding

(i) In 2006, 2007 and 2008 and beyond until further notice, reporting and
withholding are governed by Notices 2006 -100, 2007-89 and 2008-115
respectively. See § 9:2 below.

1. For violations, report income on W-2 or 1099 as applicable;

2. Withholding for employees at supplemental rates;

3. No withholding for the 20% tax which is added by return;

4. Income based on year-end vested amount less income previously

reported;

5. Until further guidance, not required to report all deferred

compensation (i.e., whether compliant and non-compliant).

3:14 Outline of § 409A--Voluntary correction.

A. Notice 2008-115. See Chapter 11 below.

B. Applies to unintentional errors in operation. Must establish rules to avoid

recurrence, not available once an employee is under audit.

(i) No sanctions--corrections in same year.

  Amounts paid or made available at wrong time but which were still
payable or to be made available in the same year.

 Amounts not paid or made available when due.

 Amounts paid in violation of the six month prohibition for key

employees of public companies.

 Excess deferrals.

 Corrections of option exercise price.

(ii) No sanctions—corrected in immediate succeeding year, for non-Insiders

only.

 Amounts paid or made available at wrong time but which were still
payable or to be made available in the same year.

 Amounts not paid or made available when due.

 Amounts paid in violation of the six month prohibition for key

employees of public companies.

 Excess deferrals.

(iii) Limited sanctions: only amount of violation (not entire account) is a

violation. Additional 20% tax applies, but not premium interest.

 Limited amounts—less than $16,500.

 Certain corrections by second year following violation.

(iv) I.R.S. reporting requirements must be met in connection with violation.

3:15 Outline of § 409A—Compliance Audit. Identify any agreement or promise

where compensation or benefits can be paid in later year, including:

A. Compliance Agreements:

(i) Employment agreement;

(ii) Severance, post-termination benefits, payment of bonuses;

(iii) Option agreement;

(iv) Expense reimbursement policy;

(v) Foregone salary;

 (vi) Any agreement where compensation is paid. Even if not intended to be a
deferred compensation plan, such as a current bonus plan, sales
compensation plan, investment commission plan or other, have a payment
deadline date that does not even permit a deferral of compensation.

B. Look to see if an exemption applies or if grandfathered.

(i) Short term deferral

(ii) Severance.

C. Other.

D. Fully documented.

E. Not possible to receive another amount in lieu of any amount not paid
under a deferred compensation plan.

F. Separation Pay

(i) To qualify for exemption, must be strictly payable on involuntary

termination (including voluntary termination for good reason, provided
definition complies with § 409A).

(ii) Cannot even be payable in the event of disability! (even though most
disability payments are not subject to § 409A by themselves, disability is
a permissible form of payment for a benefit subject to § 409A—however,
if reliance for exemption is placed on the separation pay exception,
payment cannot also be made for disability).

G. Definition of payment:

(i) If installment payment, can it qualify for short-term deferral or

severance?

H. Cannot act on a non-compliant provision.

I. Drafting

(i) Cannot just have plan ignore provisions that do not comply or say the
plan is to be interpreted consistent with 409A.

(ii) But can define specific term by reference to the regulations.

(iii) Any written form okay, even e-mails.

J. Service recipient stock—if the option is not in common stock, or not

issued up the chain of control, the stock is subject to 409A.
 K. Options—any concerns should be addressed regarding the determination
of fair market value and ability to satisfy 409A standard.

(i) Vests after 2004?

(ii) Award modified or extended?

(iii) Is the exercise price at least fair market value on the date of grant? Cheap
stock assigned by accountants generally not relevant—“hindsight
adjustments” are not generally relevant in determining fair market value
(though in some instances--generally not including the cheap stock issue-
-subsequent factors could perhaps shed some doubt on the reasonableness
of the valuation, though they should not absent bad faith or other unique
factors).

1. Evidence of incorrect grant date.

2. Was the proper grant authority followed?

3. Is the exercise price at least fair market value on the date of grant.

(iv) Does the stock qualified as service recipient stock for 409A purposes?

M. Dividend equivalent—while the underlying instrument itself could be exempt

from § 409A, e.g., in the case of restricted stock, a cash dividend equivalent payment could be
deferred compensation so care has to be taken to analyze the dividend equivalent separately.
Also, dividend equivalents which are dependent on exercise of an option or SAR can be treated
as a reduction in the exercise price—which would result in an in the money grant that would be
ineligible for the option exemption from 409A.

N. If plan provides payment on termination of employment—does definition of

termination comply with 409A?

(i) Or could continuing consulting or services permit payment but not

constitute a qualifying termination.

(ii) If plan permits consulting service—need to plan and determine when

termination occurs.

O. Provide what happens to specified employee--are suspended payments made

in a lump sum at the expiration of the six month period or are all payments
pushed back six months from their original payment date?

(i) Should be addressed in private company contracts because stock could

become publicly traded.

(ii) Should be specific—don’t just say all payable after 6 months—could

convert exempt compensation to 409A deferred compensation.
 P. Good reason definition:

(i) Does it qualify?

(ii) Triggers must be adverse to employee and material.

1. If not, need to remove or revise and add consideration.

Q. If an agreement is subject to §409A, is the distribution date:

(i) Locked in and irrevocable;

(ii) Based on one of the six events;

(iii) Subject to acceleration without regard to one of the six events.

R. Is there a desire to change distribution event?

(i) May have to comply with the change rules, see § 7:14.

S. Does an employment agreement condition payment on the execution of a

waiver?

(i) Can waiver be submitted outside the short-term deferral or separation

window?

(ii) Also, do not make severance payable upon non-renewal of contract

unless termination also occurs

T. Where an agreement relies on the short-term deferral exception to avoid

409A, it should specify a date, because if miss payment by the short term deferral date, can still
meet the distribution rules by payment later in year.

U. Election of benefits.

(i) Post-employment choice of cash or medical (always dangerous from the

standpoint of raising a constructive receipt issue, but it occurs in
agreements sometimes) raises a 409A issue.

(ii) Also, for golden parachutes under IRC § 280G: if the three times base
compensation safe harbor of I.R.C § 280G is exceeded, employee often
has the right to choose which to reject—should exempt 409A benefits
from the choice to avoid an impermissible payment date.

V. Change of Control.

(i) Is payment based on separation from service? If so, then the definition of
change in control may not need to satisfy 409A (because the payment is
triggered by separation from service--itself an acceptable 409A trigger).
 W. However, if the form of payment for separation from service following a
change in control is different from separation from service payments not made in connection
with a change in control, the definition of change in control may have to comply with § 409A.

X. Reimbursement of legal expenses is exempt from 409A.