Compensation

July 2007
Analyzing Deferred Compensation Arrangements Under the Section 409A Final Regulations: A Six-Step Analytic Process
By Stewart Reier
This is the rst installment of Stewart Reier's Six-Step Analysis. We will present Parts III and IV in the August issue, and conclude with Parts V and VI in the September issue.
n April 10, 2007, the United States Treasury Department (Treasury) issued nal regulations (the Final Regs) under Internal Revenue Code Section 409A (Code Sec. 409A).1 Congress enacted Code Sec. 409A in October 2004 to strictly regulate the use of deferred compensation arrangements. Under Code Sec. 409A, deferred compensation includes not only employee-elective deerre c ed compensation, but also includes supplemental ferred com ex cuti re emen plan (SER xec ive executive retirement plans (SERPs), severance-related ar ngeme , rran em c in ca arrangements, and certain cash-based and equityba ed i ce ase incentive compensation arrangements. mpensation based inc nt e com h F dress d es with The Final Regs addressed many issues w respect rre compensation tax law. The major a o w h to the new deferred compensation ta law The majo issues addressed or claried were the following: various denitions, including: deferral of compensation nonqualied deferred compensation plan service provider service recipient specied employee service recipient stock change in control event; plans and arrangements that are exempt from Code Sec. 409A;
Stewart Reier is a Shareholder with the law rm of Vedder, Price, Kaufman & Kammholz, P.C. in New York City and heads its New York executive compensation practice group.
permissible distribution/payment events; subsequent deferral elections; equity-based compensation; and separation from service, including a good reason termination. The Final Regs failed to address the following items: partnerships; offshore trusts; split-dollar life insurance arrangements (however, Notice 2007-34,2 which was released along with the Final Regs, addressed split-dollar life insurance arrangements to some extent); e reporting, withholding and calculation of deferred amo m ferred amounts; and penalties. Generally, the Final Regs bring to a close a process begun in December 2004 when the Treasury and the Internal Revenue Service (the IRS) rst began to address the many substantive and technical issues created by the enactment of Code Sec. 409A. Although more Code Sec. 409A regulations are still to come, the Final Regs now provide the means to fully analyze compensatory arrangements to determine if such arrangements are subject to Code Sec. 409A, and if so, whether such arrangements comply with the requirements of Code Sec. 409A. This article presents a concise analytic framework based on the Final Regs to determine whether compensation is subject toand compliant withCode Sec. 409A.
2007 S. Reier
CORPORATE BUSINESS TAXATION MONTHLY
Analyzing Deferred Compensation Arrangements

underpayment interest rate. In addition, the interest is measured from the point in time when the On October 11, 2004, Congress passed the American deferred compensation was rst deferred or not Jobs Creation Act of 2004 (the Jobs Act),3 which subject to a substantial risk of forfeiture. President Bush signed into law on October 22, 2004. Finally, and most importantly, the recipient of Section 885 of the Jobs Act amended the Internal the deferred compensation will be subject to Revenue Code of 1986 (the Code) by adding a new an additional 20-percent penalty tax on the Code Sec. 409A, Inclusion in Gross Income of Dedeferred compensation. ferred Compensation Under Nonqualied Deferred It is important to note that Section 132 of the RevCompensation Plans. Generally, Code Sec. 409A sets enue Act of 19784 was not repealed. Act Sec. 132 a very high bar for compensation to qualify for tax provided that the IRS could no longer regulate or isdeferral. Code Sec. 409A also generally proscribes sue rulings (other than private letter rulings (LTRs)) the use of offshore rabbi trusts as permissible regarding the constructive receipt of deferred comfunding arrangements for deferred compensation pensation after February 1, 1978.5 Act Sec. 132 thus arrangements (although this is a separate analysis effectively froze deferred compensation law as of and not the subject of this February 1, 1978. Since article). If the deferred 1978, the IRS generally The Final Regs only apply to compensation arrangehas adhered to the proment violates Code Sec. scription under Act Sec. compensatory relationships 409As strict requirements, 132 other than issuing between one that provides the then the compensation two revenue procedures services (a service provider) and in 1992: will be treated as constructively received in the year Rev. Proc. 92-646 created one that receives such services (a of deferral. a model rabbi trust that service recipient). The heading to Code needed to be followed in Sec. 409A(a) is Rules Reorder for a taxpayers to lating to Constructive Receipt. That section provides receive a favorable LTR; and that [I]f at any time during a taxable year a nonRev. Proc. 92-657 amplified Rev. Proc. 71qualied deferred compensation plan fails to meet the 19,8 the original revenue procedure that guided requirements of [Code Sec. 409A] or is not operated taxpayers when requesting a LTR on a deferred n acco ord in accordance with [the Code Sec. 409A requirecompensation arrangement, generally by addmen ] m nts], all mpensation deferred under the plan for ments], all compensation defe ing rules with respect to the new plan and new th tax he taxable a d reced the t able year and all preceding taxable years shall participants. e includible n gross income ncl n dib be includ ble in gross income for the taxable year to Since the Jobs Act did not repeal Act Sec. 132, u o v the extent not subject to a substantial risk of forfeiture individual taxpayers and employers must realize that usl ncluded gross ncome. u ed o e defer ed compensation is now subject to two tax e m and not previously included in gros income. deferred comp Deferred compensation that fails to comply with regimes superimposed over one another: Code Sec. 409A produces onerous results: The principles underlying constructive receipt, genThe noncompliant deferred compensation will be erally still frozen as of February 1, 1978; and treated as taxable income with respect to the year The explicit requirements under Code Sec. 409A. in which the Code Sec. 409A violation occurs. On December 20, 2004, the IRS issued Notice Ordinary income tax applies to this compensa2005-1,9 which set forth initial guidance with respect tion. This tax becomes due even if the recipient to the new tax law. On September 29, 2005, the IRS of the deferred compensation has yet to receive released proposed regulations (Proposed Regs) such compensation. under Code Sec. 409A, which were published in the Since Code Sec. 409A applies to compensation Federal Register on October 4, 2005.10 constructively paid but never taxed in the same tax Following the issuance of the Proposed Regs, the year, the taxpayer not only owes ordinary income IRS issued ve more notices in 2006: tax on this compensation but also interest on the Notice 2006-4,11 which provided guidance with underpayment of taxes. That interest rate for this respect to stock options and stock appreciation purpose is set at one percent above the standard rights granted before January 1, 2005, and is
Overview
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July 2007
obsoleted for taxable years after January 1, 2008 except for the Q&A sections with respect to: application to arrangements covered by Code Sec. 457, application to partners and partnerships, and information reporting and withholding guidance. Notice 2006-33, 12 which related to Code Sec. 409A compliance of offshore trusts due to technical corrections made to Code Sec. 409A(b) under the Gulf Opportunity Zone Act of 2005,13 and which is not affected by the Final Regs. Notice 2006-64, 14 which provided relief for the acceleration of deferred compensation due to federal conflict-of-interest rules, and which is superseded by the Final Regs for any service providers tax year beginning on or after January 1, 2008. Notice 2006-79, 15 which extended Code Sec. 409A compliance for all written plans from December 31, 2006 to December 31, 2007 and provided additional transition relief, and which is not affected by the Final Regs. Notice 2006-100, 16 which provided interim reporting rules, and which is not affected by the Final Regs. Announcement 2007-18, 17 which provided relief to rank-and-file employees who may have inadvertently been subject to Code Sec. 40 4 9A due to backdated stock options. 409A Along w ng Along with the release of the Final Regs, the release IR iss ed Notice 2 7-34 entitled Application RS sue IRS issued o 2007-34 of Sect n 4 9A to Sp t-Do f Sect tio Section 409A to Split-Dollar Life Insurance in erre C atio o Nonqualified Deferred Compensation Plan Are e rangements. Thi Notice general provides that This generally provides split-dollar life insurance arrangements are arrangements that will be tested like other deferred compensation arrangements, and thus may be subject to Code Sec. 409A. However, a modication to an existing grandfathered split-dollar life insurance arrangement in order to bring the arrangement into Code Sec. 409A compliance will not be treated as a material modication under the split-dollar life insurance Treasury Regs, and thus will preserve grandfathering for purposes of applying the splitdollar life insurance grandfathering regulations under Reg. 1.61-22 and 1.7872-15. Finally, taxes pursuant to the Federal Insurance Contributions Act (FICA) (i.e.,Social Security and Medicare tax) on deferred compensation imposed under Code Sec. 3121(v) are, for the most part, not impacted by Code Sec. 409A. Accordingly, taxpayers are obligated to pay FICA taxes under the existing taxing regime established by Reg. 31.3121(v)(2)-1 and 31.3121(v)(2)-2. These FICA taxes are generally relevant when there is no longer a substantial risk of forfeiture,18 regardless of whether the compensation is paid or continues to be deferred.
Important and Immediate Action to be Taken by Companies

Companies (referred to under the Final Regs as service recipients) have struggled with Code Sec. 409A ever since its enactment in October 2004. The requirement that all existing nongrandfathered deferred compensation arrangements fully comply with Code Sec. 409A rst had a deadline at the end of 2005. Then the IRS pushed this back to the end of 2006, and then further pushed the deadline back to the end of 2007 in Notice 2006-10. The Final Regs have retained the December 31, 2007 full compliance date. Thus, companies need to undertake the following procedures: immediately inventory: all deferred compensation plans, programs, agreements and arrangements; all compensatory plans, programs, agreem e n t s a n d a r ra n g e m e n t s ( i n c l u d i n g cash-based and equity-based incentive compensation plans); and all written and unwritten employment arrangements (including employment agreements, individual severance agreem e n t s ( b o t h ch a n g e - i n - c o n t r o l a n d nonchange-in-control), severance plans (both change-in-control and nonchangein-control); then review all such plans, programs, agreements and arrangements to determine if they are subject to Code Sec. 409A; and then amend all such plans, programs, agreements and arrangements (other than grandfathered arrangements) to bring such arrangements into Code Sec. 409A compliance on or prior to December 31, 2007. Companies need to be very careful to ensure that all arrangements are reviewed and amended (if necessary), as deferred compensation arrange-
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ments subject to Code Sec. 409A can be found in a wide array of documents (e.g., a simple employment offer letter or a retention agreement). reported under Form W-2 or under Form 1099. This reporting obligation not only includes compliant deferred compensation, which has passed Steps 3 and 4 above, but also noncompliant deferred compensation.
Analytic Steps
Code Sec. 409A and the Final Regs generally create an analytic framework involving six basic steps to determine whether compensation is deferred and subject to Code Sec. 409A. Step 1: Determine whether the compensation is under a grandfathered arrangement. Generally this grandfathering situation means that the arrangement was in effect prior to October 4, 2004 and the arrangement has never been materially modied. Step 2: Determine whether the compensation is actually deferred compensation under Code Sec. 409A. This requires an analysis of whether the compensation meets the regulatory definition of deferral of compensation, and then whether the compensation can be characterized as either: short-term deferred compensation, which generally is exempt from Code Sec. 409A, or Code Sec. 83 property, which involves a careful analysis of whether the transferred property satisfies the strict requirements for the Code Sec. 409A exemption. Step 3: If the compensation meets the regulatory definition of deferral of compensation, the the t en t next step is to determine whether the then compe ation is deferred under a nonqualified c mp p compensation s deferred def d ferre compensation plan (NQDCP). Code on p deferred co e Sec 409 would not apply if the compensaSec 4 A would n ot ap c c. Sec. 409A i Q p d tion is not a NQDCP, perhaps based on certain s, uch as tax-qualified pension a ed o exemptions, such a s ta x-qua ifie d p ensio n plans, certain welfare plans, certain separation pay plans and certain foreign plans. Step 4: If the deferred compensation is deferred under a NQDCP, then the next step is to determine whether the NQDCPs provisions relating to initial deferral elections and subsequent deferral elections with respect to the deferred compensation comply with Code Sec. 409A. Step 5: The next step is to determine whether the NQDCPs provisions relating to the distribution/payment of the deferred compensation comply with Code Sec. 409A. Step 6: The final step is to determine whether the deferred compensation has been properly
Definitions
The Final Regs and the Six-Step Analysis below use specific terms with specific definitions. Below is a list of these terms and the location of their definitions in the Six-Step Analysis (CCH Note: Some of these definitions are located in the second or third installment of this three-part article): account balance plansee I.B. anti-acceleration rulesee V.B. broad-based retirement plansee III.B.2.c. change in control event (CIC)see V.A.7. commission compensationsee IV.A.10. controlling interestsee II.E.3.b. date of grant of an optionsee II.E.2.a.v. domestic relation ordersee IV.B.2.d established securities marketsee II.E.2. exercise datesee II.E.2.a.vii. exercise pricesee II.E.2.a.vi. fiscal year compensationsee IV.A.4. gross fair market valuesee V.A.7.c. groupsee V.A.7. initial deferral electionsee IV.A.1. life annuitysee IV.B.2.a. management servicessee II.A.1. material modificationsee I.G. modified foreign earned incomeIII.B.2.c. mutual company unitsee II.E.3.a. nonaccount balance plansee I.C. n nonqualified deferred compensation plan n onqua if (NQDCP)see III.A.1. nonresident aliensee III.B.2.a option or stock optionsee II.E.2.a.ii. performance-based compensationsee II.2.1.b. permissible distribution/payment eventsee V.A.1. plansee III.A.1 related to another personsee II.A.2. separation paysee II.D.2. separation pay arrangementssee II.D.2. service providersee II.A.1. service recipientsee II.A.2. service recipient stocksee II.E.3. 70-percent Safe Harbor rulesee II.A.1.
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July 2007
Analytic Framework
Based on the Final Regs and the above Six-Step Approach, the following analysis can be used to determine whether compensation is subject to Section 409A, and if so, then whether such compensation complies with the Section 409A Final Regs: Non-Application Due to Grandfathering October 4, 2004 cut-off date Calculation of grandfathered account balance plan amounts Calculation of grandfathered nonaccount balance plan amounts Calculation of grandfathered equity-based compensation Calculation of grandfathered earnings on grandfathered deferred compensation Denition of plan for grandfathering purposes Material modication of a grandfathered plan Denition of deferred compensation subject to Section 409A Establishment of the service provider/service recipient relationship Denition of service provider Denition of service recipient Denition of deferral of compensation Earnings on deferred compensation When deferred compensation is not subject to Section 409A Short-term deferrals (the short-term or 2-1/2 month rule) Certain delayed payments Substantial risk of forfeiture Performance-based compensation Separation pay plans Collectively bargained arrangements Window programs Foreign separation pay plans Involuntary separation from service Good Reason separation from service Reimbursements and certain other separation payments Certain indemnication and liability insurance plans Legal settlements Certain educational benets Customary timing arrangements Certain foreign plans, arrangements and situations Arrangements with respect to compensation covered by treaty or other international agreement Arrangements with respect to certain other compensation Tax equalization agreements Certain limited deferrals of a nonresident alien Foreign plan earnings Additional foreign plans as designated by the IRS Commissioner When equity-based compensation is subject to Section 409A Exemption for compensation that is Section 83 property Stock rights on service recipient stock
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Certain denitions and concepts Denition of stock right Denition of option Denition of stock appreciation right or SAR Denitions of stock, established securities market, and readily tradable Determination of the date of grant of an option or SAR Denition of exercise price When an exercise of an option occurs Denition of transfer Basic rules ISOs and ESPPs Dividends and dividend equivalents Stock right modications Extensions and renewals Substitutions or assumptions of stock rights by reason of a corporate transaction Acceleration of date when exercisable Discretionary-added benets Change in underlying stock increasing value Change in the number of shares purchasable Rescission of changes Successive modications and extensions Service recipient stock Basic rule Eligible issuer of service recipient stock Fair market valuation of service recipient stock if publicly traded Fair market valuation of service recipient stock if not publicly traded Nonqualied Deferred Compensation Plans (NQDCPs) Denition of NQDCP Denition and establishment of plan Exempt plans Qualied employer plans Certain foreign plans Denition of nonresident alien Participation by nonresident aliens, certain resident aliens, and bona de residents of possessions Participation by U.S. citizens and lawful permanent residents Broad-based foreign retirement plans Plans subject to a totalization agreement and similar plans Certain welfare-benet plans IRC Section 457 plans Aggregation rules Deferral Provisions Permissible initial deferral elections Basic rule Initial deferral election with respect to short-term deferrals Initial deferral election with respect to certain forfeitable rights
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July 2007
Initial deferral election with respect to scal year compensation Initial deferral election with respect to rst year of eligibility Initial deferral election with respect to performance-based compensation Initial deferral elections with respect to certain separation pay Initial deferral elections with respect to certain commissions Initial deferral elections with respect to compensation paid for nal payroll period Elections to annualize recurring part-year compensation NQDCPs linkage to qualied employer plans and certain other arrangements Changes in elections under a cafeteria plan USERRA rights Subsequent changes in time and form of payment Basic rule Denition of payments for purposes of subsequent changes in time and form of payment Life annuities Installment payments Beneciaries Domestic relations orders Coordination with anti-acceleration rule Application to multiple payment events Delay of payment under certain circumstances Payments subject to IRC Section 162(m) Payments that would violate Federal securities laws or other applicable law Other events or conditions USERRA rights Special rules for certain resident aliens Distribution/Payment Provisions Permissible distributions/payment events Basic rules Designation of alternative specied dates or payment schedules based upon date of permissible distribution/payment event When a payment is treated as made upon the designated payment date Disputed payments and refusals to pay Designation of time and form of payment with respect to earnings Substitutions Special rules for certain resident aliens Specied time or xed schedule Reimbursement or in-kind benets plans Tax gross-up payments Death Disability Unforeseeable emergency Separation from service Independent contractors Employees Specied employees Mandatory 6-month delay of payment Denition of specied employee Denition of compensation for specied employee identication
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Specied employee identication date Specied employee effective date Alternative method for satisfying the six-month delay rule Corporate transactions (1) Mergers and acquisitions of public service recipients (2) Mergers and acquisitions of non public service recipients (3) Spinoffs (4) Public offerings and other corporate transactions (5) Alternative method of compliance Nonresident alien employees Elections affecting the identication of specied employees Asset purchase transactions Dual status Collectively bargained plans covering multiple employers Change in control events (CIC) Type 1 CIC: Change in the ownership of a corporation Type 2 CIC: Change in the effective control of a corporation Type 3 CIC: Change in the ownership of a substantial portion of a corporations assets Certain back-to-back arrangements Special rules for certain delayed payments pursuant to a CIC Certain transaction-based compensation Certain nonvested compensation Anti-acceleration rule Basic rule Exceptions to the anti-acceleration rule Domestic relations order Conicts of interest IRC Section 457(f) Limited cashouts Payment of employment taxes Payments upon income inclusion under Section 409A Cancellation of deferrals following an unforeseeable emergency or hardship distribution Termination and liquidation of a NQDCP Certain distributions to avoid a nonallocation year under IRC Section 409(p) Linkage to qualied employer plans and certain other arrangements Payment of state, local or foreign taxes Cancellation of deferral elections due to disability Certain offset Bona de disputes as to a right to a payment Changes in elections under a cafeteria plan Reporting, Withholding and Calculation of Section 409A Deferred Compensation Service recipients Reporting and withholding Calculation of amounts Service provider Amounts required to be included in income by a service provider Calculation of additional tax
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July 2007
ture (as dened under the Code Sec. 83 regulations)19 or a requirement to perform further services, on an amount deferred that is not subject to a substantial risk of forfeiture or a requirement to perform further services, is not treated as earnings on the amount deferred, but a separate right to compensation. The amount is considered deferred before January 1, 2005 if, before January 1, 2005, the service provider had a legally binding right (as described in more detail at II.B. below) to be paid the amount, and the right to the amount was earned and vested. A right to an amount was earned and vested only if the amount was not subject to a substantial risk of forfeiture or a requirement to perform further services.20 Amounts to which the service provider did not have a legally binding right before January 1, 2005 (e.g., Six-Step Analysis because the service recipient retained discretion to I. Nonapplication Due to reduce the amount), will not be considered deferred before January 1, 2005. Grandfathering In addition, amounts A plan that otherwise provides to which the service proA. October 4, 2004 vider (e.g., the employee) for a deferral of compensation Cut-Off Date had a legally binding right does not fail to provide a deferral before January 1, 2005 Final Reg. 1.409A-6(a) of compensation merely because but the right to which provides that Code Sec. the right to payment of the was subject to a substan409A applies with respect to: compensation is conditioned upon tial risk of forfeiture or a requirement to perform amounts deferred in a separation from service. further services after Detax years beginning cember 31, 2004 are not after December 31, considered deferred before January 1, 2005 for pur200 , 2 04, 2004, and poses of the effective date. However, an amount to am un deferred amou amounts deferred in tax y years beginning before which the service provider had a legally binding right Jan ary 2005 i the plan under which the deferJ nua January 1, 2 if before January 1, 2005 but for which the service proral m e materially modied after October ma m ral is made is mater ally m vider was required to continue performing services r 3, 2004. retain right e g to retain the rig only through the completion of the For amounts de erred in tax yea beginning bedeferred years payroll period,21 is not treated as subject to a requirefore January 1, 2005 under a plan that is materially modied after October 3, 2004, whether the plan ment to perform further services (or a substantial risk complies with the requirements of Code Sec. 409A of forfeiture) for purposes of the effective date. and the Final Regs is determined by reference to the A stock option, stock appreciation right or similar terms of the plan in effect as of, and any actions taken compensation that on or before December 31, 2004, under the plan on or after, the date of the material was immediately exercisable for cash or substantially modication. vested property22 is treated as earned and vested, Code Sec. 409A is applicable with respect to earnregardless of whether the right would terminate if ings on amounts deferred only to the extent that Code the service provider ceased providing services for Sec. 409A is applicable with respect to the amounts the service recipient. deferred. Accordingly, Code Sec. 409A does not Finally, Code Sec. 409A does not apply with respect apply with respect to earnings on amounts deferred to amounts deferred under a plan maintained pursubefore January 1, 2005 unless Code Sec. 409A apant to one or more bona de collective bargaining plies with respect to the amounts deferred. A right to agreements in effect on October 3, 2004, for the peearnings that is subject to a substantial risk of forfeiriod ending on the earlier of the date on which the last short-term (or 2-1/2 month) deferral rule II.D.1. six-month delay rulesee V.A.6.c.i. specified employeesee V.A.6.c.i. stock appreciation right or SARsee II.E.2.a.iii. stock rightII.E.2.a.i. stock right modificationsee II.E.2.c. subsequent deferral election (or change in the time or form of payment)see IV.B.1. substantial risk of forfeituresee II.D.1.b. transaction-based compensationV.A.7.e.i. two-times rulesee II.D.2.b. window programsee II.D.2.b.
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of such collective bargaining agreements terminates (determined without regard to any extension thereof after October 3, 2004) or December 31, 2009. plan to receive a payment of benets following the termination of services, and receive the benets in the form with the maximum value. Note that for any subsequent tax year of the service provider, the grandfathered amount may increase to equal the present value of the benet the service provider actually becomes entitled to, in the form and at the time actually paid, 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 benets (other than a participant election with respect to the time or form of an available benet). For purposes of calculating the present value of a benet, reasonable actuarial assumptions and methods must be used, which will be determined as of each date the benet is valued for purposes of determining the grandfathered benet, provided that any reasonable actuarial assumptions and methods that were used by the service recipient with respect to such benet as of December 31, 2004, will continue to be treated as reasonable assumptions and methods for purposes of calculating the grandfathered benet. Actuarial assumptions and methods will be presumed reasonable if they are the same as those used to value benets under a qualied plan sponsored by the service recipient the benets under which are part of the benet formula under, or otherwise impact the amount of benets under, the nonaccount balance plan.
B. Calculation of Grandfathered Account Balance Plan Amounts

Final Reg. 1.409A-1(c)((2)(i)(A) provides that the term account balance plan means: an agreement, method, program, or other arrangement that is an account balance plan as defined in Reg. 31.3121(v)(2)-1(c)(1)(ii)(A), including mandatorily bifurcating the agreement, method, program, or other arrangement in accordance with the rules provided in Reg. 31.3121(v)-1(c)(1)(iii)(B); or an agreement, method, program, or other arrangement that would be described in the bullet above if the service provider were an employee. The amount of compensation deferred before January 1, 2005, under a NQDCP that is an account balance plan equals the portion of the service providers account balance as of December 31, 2004, the right to which is earned and vested23 as of December 31, 2004, plus any future contributions to the account, the right to which was earned and vested as of December 31, 2004, to the extent such contributions are actually made.
C. Calculation of Grandfathered Nonaccount Balance Plan Amounts

ina R g al Reg. Final Reg 1.409A-1(c)((2)(i)(C) provides that the term n na ount balance pl e m non term nonaccount balance plan means: An agreement, method, program, or other arA ag m gr hod, ran ran em t tha is a nona ngeme nge rangement that nonaccount balance plan g 3 )( 2) as defined in Reg. 31.3121(v)(2)-1(c)(2)(i), o g including ma datorily bifurca ng the agreemandatorily bifurcating e agreement, method, program or other arrangement in accordance with the rules provided in Reg. 31.3121(v)-1(c)(1)(iii)(B); or An agreement, method, program, or other arrangement that would be described in the bullet above if the service provider were an employee. The amount of compensation deferred before January 1, 2005, under a NQDCP that is a nonaccount balance plan equals the present value of the amount to which the service provider would have been entitled under the plan if the service provider voluntarily terminated services without cause on December 31, 2004, and received a payment of the benets with the maximum value available from the plan on the earliest possible date allowed under the
D. Calculation of Grandfathered Equity-Based Compensation

The a amount of compensation deferred before January 1, 2005 under an equity-based compensation plan n 2005 under is determined similar to a grandfathered account balance plan, 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 vested24 as of December 31, 2004. Note that the payment available to the service provider excludes any exercise price or other amount that must be paid by the service provider.
E. Calculation of Grandfathered Earnings on Grandfathered Deferred Compensation

Final Reg. 1.409A-6(a)(1)(i) provides that Code Sec. 409A:
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F. Denition of Plan for is applicable with respect to earnings on amounts Purposes of Grandfathering deferred only to the extent that Code Sec. 409A is applicable with respect to the amounts deferred, and The term plan generally has the same meaning is not applicable with respect to earnings on provided in the Final Regs with respect to deferred amounts deferred before January 1, 2005, uncompensation that is not grandfathered (see III.A. beless Code Sec. 409A applies with respect to the low), except that the plan aggregation rules (see III.C. amounts deferred. below) treating all nonaccount balance plans under Final Reg. 1.409A-6(a)(3)(iv) provides that earnwhich compensation is deferred as a single plan do ings on amounts deferred under a plan before January not apply for purposes of the actuarial assumptions 1, 2005, include only income (whether actual or and methods used to determine the grandfathered notional) attributable to the amounts deferred under amounts. Accordingly, different reasonable actuarial a plan as of December 31, 2004, or to such income. assumptions and methods may be used to calculate Thus, notional interest earned under the plan on the amounts deferred by a service provider in two amounts deferred in an account balance plan as of different agreements, methods, programs or other arDecember 31, 2004, generally will be treated as earnrangements each of which constitutes a nonaccount ings on amounts deferred balance plan. under the plan before When the right to earnings is G. Material January 1, 2005. Similarly, an increase Modication specied under the terms of the in the amount of payof a Grandfathered plan, the legally binding right to ment available pursuant Plan earnings arises at the time of the to a stock option, stock appreciation right or other Final Reg. 1.409A-6(a)(4) deferral of the compensation to equity-based compensaprovides that a modicawhich the earnings relate. tion above the amount of tion of a grandfathered payment available as of plan is a material modiDecember 31, 2004 due to appreciation in the cation if a benet or right existing as of October 3, underlying stock after December 31, 2004, or ac2004, is materially enhanced or a new material bencrual of other earnings such as dividends, is treated et or right is added, and such material enhancement as earnings on the amount deferred. In the case of or addition affects amounts earned and vested before no acc ona a nonaccount balance plan, earnings include the January 1, 2005. Such material benet enhancein eas , due solely ncre se, increase, d sole y to the p passage of time, in the ment or addition is a material modication whether pr ent va res val o the future p ure payments to which the present v value of he it occurs pursuant to an amendment or the service se ice pr erv e ro ervice prov er has obtained service provider has obtained a legally binding right, recipients exercise of discretion under the terms of f which d the the present value of wh h constituted th amounts the p plan. Note that a reduction of an existing benet efore January 1, is not a materia modication. o a deferred under th plan be the before Janu ry 1 2005. not material Thus, for each year, there will be an increase For purposes of analyzing a material modication, (determined using the same interest rate used to dethe term plan has the same meaning as discussed termine the amounts deferred under the plan before immediately above at I.F. except that the aggregation January 1, 2005) resulting from the shortening of rules discussed in III.C. below treating all account the discount period before the future payments are balance plans under which compensation is deferred made, plus, if applicable, an increase in the present as a single plan, all nonaccount balance plans under value resulting from the service providers survivorwhich compensation is deferred as a separate single ship during the year. However, an increase in the plan, all separation pay arrangements due to an actual potential benets under a nonaccount balance plan involuntary separation from service or participation in a due to, for example, an application of an increase in window program as a separate single plan, and all other compensation after December 31, 2004, to a nal NQDCPs as a separate single plan, do not apply. average pay plan or to subsequent eligibility for an Thus, a material modication would occur under early retirement subsidy, does not constitute earnany of the following: ings on the amounts deferred under the plan before The amendment of a plan to add a provision January 1, 2005. that payments of deferred amounts earned and
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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 (typically referred to as a haircut). Allowing a service recipient to exercise discretion so as to accelerate vesting of a benefit under the plan to a date on or before December 31, 2004. The addition of a right to a payment upon an unforeseeable emergency of an amount earned and vested before January 1, 2005. The amendment of a plan or the exercise of discretion under the terms of the plan that materially enhances an existing benet or right or adds a new material benet or right (even if the enhanced or added benet would be permitted under Code Sec. 409A). On the other hand, a material modication would not occur under any of the following: Allowing 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. Allowing 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 Code Sec. 409A. T e re The removal of a haircut provision. T e est shm nt The establishment of or co contributions to a trust or oth o her arrangement om which benets under the other a ng e from wh pla pla are o an plan a to be paid provi paid, provided that the contribui e t tion to the trust or other arrangement would not au e mou e includible otherwise cause an am unt to be includible in amount the service providers gross income. The establishment of or contributions to a trust or other arrangement from which benets under the plan are to be paid, provided that the contribution to the trust or other arrangement would not otherwise cause an amount to be includible in the service providers gross income. The modication of a provision requiring the immediate cancellation of a current deferral election, to require the cancellation of deferrals for the same length of time beginning with the rst date at which the application of such cancellation would not violate Code Sec. 409A (e.g., the rst date of the service providers rst tax year following the cancellation). Compliance with a domestic relations order25 with respect to payments to an individual other than the service provider, or an amendment to a plan to require compliance with a domestic relations order with respect to payments to an individual other than the service provider. The modication of a plan providing a life annuity form of payment to permit an election between the existing life annuity form of payment and other forms of annuity payments that would be treated as a single form of payment with the existing life annuity form of payment (as described in IV.B.2.a. below). The modication of a grandfathered plan to add a limited cashout feature that qualied as an exception to the anti-acceleration rule under the Final Regs (see V.B. below). The Final Regs presume that the adoption of a new plan or the grant of an additional benet under an existing plan after October 3, 2004 and before January 1, 2005 constitutes a material modication of a plan. However, the presumption may be rebutted by demonstrating that the adoption of the plan or grant of the additional benet was consistent with the service recipients historical compensation practices. For example, the presumption that the grant of a discounted stock option on November 1, 2004 is a material modication 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 signicant number of years. The grant of an additional benet under an existing plan that consists of a deferral of additional compensation not otherwise provided under the plan as of on October 2004 October 3, 200 will be treated as a material modio cation of the plan only as to the additional deferral of compensation, if the plan explicitly identies the additional deferral of compensation and provides that the additional deferral of compensation is subject to Code Sec. 409A. Accordingly, amendments to conform a plan to the requirements of Code Sec. 409A with respect to deferrals under a plan occurring after December 31, 2004, will not constitute a material modication 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 modication 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
20
July 2007
of an additional benet under a new plan adopted March 1 to allow an individual employee to elect a after October 3, 2004 and before January 1, 2005 new change in the time or form of payment without will not be treated as a material modication of an realizing that such a change constituted a material existing plan to the extent that the new plan explicitly modication that would subject the plan to the reidenties additional deferrals of compensation and quirements of Code Sec. 409A, and the modication provides that the additional deferrals of compensation is rescinded on November 1, then the plan is not are subject to Code Sec. 409A. considered materially modied if no change in the A cessation of deferrals under, or termination of, a time or form of payment has been made pursuant to plan, pursuant to the provisions of such plan, is not the modication before November 1. a material modication. Amending a plan to provide II. Definition of Deferred participants an election whether to terminate parCompensation Subject to ticipation in a plan generally constitutes a material modication of the plan. Code Sec. 409A With respect to an account balance plan, it is not A. Establishment of the Service Provider/ a material modication to change a notional investment measure, or to add to an existing investment Service Recipient Relationship measure, to an investment measure that qualies as a predetermined actual investment26 or, for any given Th e Fi n a l R e g s o n l y a p p l y t o c o m p e n s a 27 tory relationships between one that provides tax year, reects a reasonable rate of interest For this the services (a service purpose, if with respect to provider) and one that an amount deferred for a Even though deferred receives such services period, a plan provides for compensation may fall within (a service recipient). a xed rate of interest to be the denition of a deferral of Typically, this relationcredited, and the rate is to be reset under the plan at compensation, there are instances ship will be either a standard employee/ema specied future date that where the deferred compensation ployer relationship or an is not later than the end may be recharacterized and independent contractor of the fth tax year that providing services to an begins after the beginning become completely exempt from individual, a company or of the period, the rate is Code Sec. 409A. easo ab on other entity. reasonable at the beginni g of the period, and ing th eriod and d, ning o t 1. Denition of Service Provider th r e is n c he ge efore the rate s not changed before the reset date, then the ra will be t ated as reasonab in all future periods ate rate will b treated reasonable Final Reg. 1.409A-1(f) provides that the term sere before the reset date. vice p provider includes: tio extension e o a an individual, n The modication, extension or re ewal of a stock renewal f stock an individu corporation, subchapter S corporaright (as dened in II.E.2 below) will not constitute a tion or partnership; material modication of the stock right, if the modia personal service corporation (as dened in cation, extension or renewal would not be treated as Code Sec. 269A(b)(1)), or a noncorporate entity the grant of a new stock right under the Final Regs and that would be a personal service corporation if would not result in the stock right being treated as havit were a corporation; or ing had a deferral feature from the date of grant. a qualied personal service corporation (as deAny modication to the terms of a plan that would ned in Code Sec. 448(d)(2)), or a noncorporate inadvertently result in treatment as a material modientity that would be a qualied personal service cation is not considered a material modication of corporation if it were a corporation; the plan to the extent the modication in the terms for any taxable year in which such individual, of the plan is rescinded by the earlier of a date before corporation, subchapter S corporation, partnerthe right is exercised (if the change grants a discretionship, or other entity accounts for gross income ary right) or the last day of the tax year of the service from the performance of services under the cash provider during which such change occurred. Thus, receipts and disbursements method of accountif a service recipient modies the terms of a plan on ing. The term service provider also includes a
21

person who has separated from service (a former service provider). Code Sec. 409A generally does not apply to an amount deferred under a plan between a service provider and a service recipient with respect to a particular trade or business in which the service provider participates, including earnings credited to such deferred amount, if during the service providers taxable year in which the service provider obtains a legally binding right to the payment of the amount deferred all of the following applies: The service provider is actively engaged in the trade or business of providing services, other than as an employee or as a member of the board of directors of a corporation (or similar position with respect to an entity that is not a corporation). The service provider provides signicant services (see below) to two or more service recipients to which the service provider is not related and that are not related to one another person (see below). The service provider is not related to the service recipient, subject to the modication that the language 20 percent is not used instead of 50 percent each place 50 percent appears in Code Secs. 267(b) and 707(b)(1). Whether a service provider is providing signicant services depends on the facts and circumstances of each case. However, the Final Regs do provide for a 70-Percent Safe Harbor under two sets of facts: A service provider who provides services to two or more service recipients to which the service o mo provider is not related, and that are not related to pro de p ovid s elated, one another, is deemed to be providing signicant o e ano e de ed b services to two or more of such service recipients more services s vic ce for a given tax year if the revenues generated from f e g n the services p vided to any ser ce recipient or provided to service group of related service recipients during such tax year do not exceed 70 percent of the total revenue generated by the service provider from the trade or business of providing such services. In the case of a service provider who has been providing services in a trade or business for a period of not less than three consecutive years, 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 signicant services to two or more of such service recipients for a given tax year if, in each of the prior three tax years, the revenues generated from the services provided to any service recipient or group of related service recipients during such prior tax years did not exceed 70 percent of the total revenue generated by the service provider from the trade or business of providing such services, and at the time an amount is deferred, the service provider does not know or have reason to anticipate that the revenues generated from the services provided to any service recipient or group of related service recipients during the current year will exceed 70 percent of the total revenue generated by the service provider from the trade or business of providing such services. A person is related to another person if the persons bear a relationship to each other that is specied in the related taxpayer rules under Code Sec. 267(b) or Code Sec. 707(b)(1), subject to the modications that: The language 20 percent is used instead of 50 percent each place it appears in Code Secs. 267(b) and 707(b)(1), Code Sec. 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.28 In addition, an individual is related to an entity if the individual is an ofcer of an entity that is a corporation, or holds a position substantially similar to an ofcer of a corporation with an entity that is not a corporation. With respect to services provided to related persons, Code Sec. 409A does not apply to an amount deferred under a plan that is a bona de agreement, h method, program or other arrangement between a serv ce provider o service prov de and a related service recipient arising in the ordinary course of a particular trade or business in which the service provider is engaged to the extent that: The service provider provides services to the service recipient as an independent contractor. During the service providers tax year in which the amount is deferred, the service provider qualies for the 70-percent Safe Harbor with respect to such trade or business. Such agreement, method, program or other arrangement and the practices thereunder (including billing and collection practices), are substantially similar to the agreements, methods, programs or other arrangements and practices applicable to one or more unrelated service re-
22
July 2007
cipients to whom the service provider provides substantial services and that produce a majority of the total revenue that the service provider earns from the trade or business of providing such services during the tax year. Code Sec. 409A applies to a service provider providing management services to a service recipient. The term management services means services that involve the actual or de facto direction or control of the nancial or operational aspects of a trade or business of the service recipient, or investment management or advisory services provided to a service recipient whose primary trade or business includes the investment of nancial assets (including investments in real estate), such as a hedge fund or a real estate investment trust. Code Sec. 414(c), at least 50 percent is used instead of at least 80 percent each place it appears in Reg. 1.414(c)-2. A plan may provide with respect to a deferral of compensation under the plan that in applying: Code Secs. 1563(a)(1), (2) and (3) for purposes of determining a controlled group of corporations under Code Sec. 414(b), another dened percentage greater than 50 percent, but not greater than 80 percent, is used instead of at least 80 percent at each place it appears in Code Secs. 1563(a)(1), (2) and (3); and Reg. 1.414(c)-2 for purposes of determining trades or businesses (whether or not incorporated) that are under common control for purposes of Code Sec. 414(c), another dened percentage greater than 50 percent, but not greater than 80 percent, is used instead of at least 80 percent at each place it appears in Reg. 1.414(c)-2. In addition, where the use of such denition of service recipient for purposes of determining a separation from service is based upon legitimate business criteria, the plan may provide that for purposes of a deferral of compensation under the plan that in applying: Code Secs. 1563(a)(1), (2) and (3) for purposes of determining a controlled group of corporations under Code Sec. 414(b), the language at least 20 percent or another dened percentage not less than 20 percent but not greater than 50 percent is used instead of at least 80 percent at each place it appears in Code Secs. 1563(a)(1), (2) and (3); and Reg. 1.414(c)-2 for purposes of determining trades or businesses (whether or not incorporated) that are under common control for purposes h of Code Se 414(c), the language at least 20 Sec. o percent or another dened percentage not less than 20 percent but not greater than 50 percent is used instead of at least 80 percent at each place it appears in Reg. 1.414(c)-2. Where a plan denes service recipient or employer other than the denition under the 50 percent standard, the plan must designate in writing the alternate denition no later than the last date at which the time and form of payment of the applicable amount deferred must be elected in accordance with the initial deferral rules under the Final Regs. Any such change in the denition for such amounts deferred will constitute a change in the time and form of payment subject to the rules governing subsequent deferral elections and the acceleration of payments.
2. Denition of Service Recipient

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. A service recipient includes all persons with whom such person would be considered a single employer under: Code Sec. 414(b) Employees of Controlled Group of Corporations, or Code Sec. 414(c) Employees of Partnerships, Proprietorships, etc., under Common Control. Thus, if the service provider is an employee, the service recipient generally is the employer (including all pe persons treated as a single employer under ng a p g Code S c. 414(b) or (c)) It is important to note that Sec. 4(b) or (c)). Code Sec Code S c. 409A applies to a plan that provides for Sec. 9 pp Code Sec the def ra of com th d fer al f compensation, even if the payment he deferral mpensation of the compensation is not made by the person for h on t whom services ar perform d. are performed. med There are additional special rules associated with the denition of service recipient (and employer) with respect to a service providers separation from service. The term service recipient or employer means the service recipient as dened above, provided that and applying: Code Secs. 1563(a)(1), (2) and (3) for purposes of determining a controlled group of corporations under Code Sec. 414(b), the language at least 50 percent is used instead of at least 80 percent each place it appears in Code Secs. 1563(a)(1), (2) and (3); and Reg. 1.414(c)-2 for purposes of determining trades or businesses (whether or not incorporated) that are under common control for purposes of
23

tion to reduce or eliminate the compensation, or has Final Reg. 1.409A-1(b)(1) generally provides that effective control over any portion of the compensathere is a deferral of compensation (and thus, tion of the person retaining the discretion to reduce deferred compensation) if, under the terms of or eliminate the compensation, or is a member of the compensation plan or arrangement and the the family30 of the person retaining the discretion to relevant facts and circumstances, the service reduce or eliminate the compensation. provider has a legally binding right during a tax Compensation is not considered subject to unilateryear to compensation that, pursuant to the terms al reduction or elimination merely because it may be of the plan, is or may be payable to (or on behalf reduced or eliminated by operation of the objective of) the service provider terms of the plan, such as in a later tax year. A the application of a nonlegally binding right to discretionary, objective The general rule is that property an amount that will be provision creating a subtransferred in connection with the excluded from income stantial risk of forfeiture. performance of services and which Similarly, a service prowhen and if received is taxed under Code Sec. 83 is does not constitute a vider does not fail to have deferral of compensaa legally binding right exempt from Code Sec. 409A. tion, unless the service to compensation merely provider has received the because the amount of right in exchange for, or has the right to exchange compensation is determined under a formula that the right for, an amount that will be includible in provides for benets to be offset by benets provided income (other than due to participation in a cafunder another plan (including a plan that is qualied eteria plan described in Code Sec. 125). under Code Sec. 401(a)), or because benets are The Final Regs do not precisely dene what is a reduced due to actual or notional investment losses, legally binding right. The preamble to the Final Regs or in a nal average pay plan, subsequent decreases states that [a] legally binding right includes a conin compensation. tractual right that is enforceable under the applicable C. Earnings on Deferred Compensation law or laws governing the contract. A legally binding right also includes an enforceable right created under Final Reg. 1.409A-1(b)(2) provides that references other applicable law, such as a statute.29 to the deferral of compensation or deferred comTh Fin he The Final Regs state that a service provider does pensation include references to earnings. When no ha ot ave gally binding r not have a legally binding right to compensation the right to earnings is specied under the terms of o th ex he xte t c pensa to the extent that compensation may be reduced the plan, the legally binding right to earnings arises un ate lly or eliminated nila eral y ate unilaterally o elim nated by t service recipient or the at the time of the deferral of the compensation to v g c other person after the services creating the right to which the earnings relate. A plan may provide that on ave been performed. Practitioners en c o e the time and fo of payment of earnings is treated n the compensation have been perform d. Practitioners time and form commonly refer to power as negative discretion. separately from the time and form of payment of It should be noted, however, that a service provider the underlying compensation, so that, provided will be considered to have a legally binding right that the rules of Code Sec. 409A are otherwise to the compensation if the facts and circumstances met, a plan may provide that earnings will be paid indicate that the discretion to reduce or eliminate the at a separate time or in a separate form from the compensation is available or exercisable only upon payment of the underlying compensation. For the a condition, or the discretion to reduce or eliminate application of the deferral election rules to current the compensation lacks substantive signicance. payments of earnings and dividend equivalents, Whether the negative discretion lacks substantive see V.A.1.d. below. signicance depends on all of the relevant facts and Whether a deferred amount constitutes earnings circumstances. However, the discretion to reduce on an amount deferred, or actual or notional income or eliminate the compensation will not be treated attributable to an amount deferred, is determined as having substantive signicance where the service under the principles defining income attributprovider to whom the compensation may be paid has able to the amount taken into account under Reg. effective control of the person retaining the discre1.3121(v)(2)-1(d)(2). Accordingly, with respect to
B. Denition of Deferral of Compensation
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July 2007
an account balance plan, earnings on an amount deferred generally include an amount credited on behalf of a service provider under the terms of the plan that reects a rate of return that does not exceed either the rate of return on a predetermined actual investment or, if the income does not reect the rate of return on a predetermined actual investment, a reasonable rate of interest. With respect to nonaccount balance plans, earnings on an amount deferred generally include an 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 amount deferred (determined as of the date such amount was deferred), but only if the amount deferred was determined using reasonable actuarial assumptions and methods. A right to earnings on an amount deferred generally is treated as a right to a deferral of compensation. However, the use of an unreasonable rate of return, or unreasonable actuarial assumptions and methods, generally will result in the treatment of some or all of such a right to deferred compensation as a right only to deferred compensation, and not a right to earnings on deferred compensation, so that the provision will not be applicable. With respect to plans that are neither account balance plans nor nonaccount balance plans, these rules apply by analogy. the last day of the applicable 2-1/2 month period described below. The following rules apply for purposes of the 2-1/2 month rule: The applicable 2-1/2 month period is the period ending on the later of the 15th day of the third month following the end of the service providers rst taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture or the 15th day of the third month following the end of the service recipients rst taxable year in which the right to the payment is no longer subject to a substantial risk of forfeiture. A payment is treated as actually or constructively received if the payment is includible in income, including if the payment is includible in income under Code Sec. 83, the economic benet doctrine, Code Sec. 402(b), or Code Sec. 457(f). A right to a payment 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 rst date the service provider has a legally binding right to the payment. A plan provides for a deferred payment if the plan provides that any payment will be made or completed on or after any date, or upon or after the occurrence of any event, that will or may occur later than the end of the applicable 2-1/2 month period, such as a separation from service, death, disability, CIC (as dened in V.A.7 below), specied time or schedule of payment, or unforeseeable emergency, regardless of whether an amount is actually paid as a result of the occurrence of such a payment date or event during h the applicable 2-1/2 month period. A plan mig provide that the service provider or might service recipient may make an election under the plan (including an initial deferral election with respect to short-term deferrals) of a different payment date, schedule or event. Such right is disregarded for this purpose. In such cases, whether a plan provides for a deferred payment is determined based on the payment date, schedule or event that would apply if no such election were made, except that if the plan would not provide for a deferred payment absent such an election, and the service provider or service recipient makes such an election, whether the plan provides for a deferred payment is determined based upon the payment date, schedule, or event that the service provider or service recipient in fact elected.
D. When Deferred Compensation Is Not Subj ct to Code Sec. 409A bjec j Subject
Ev n though deferred compen ven houg Even th ug deferred compensation may fall within th d ni he ni iti o d ral the denition of a deferral of compensation, there ar inst nces where the deferr compensation may re instances where tan are inst deferred h c plet be recharacterized and become completely exempt from Code Sec. 4 9A. 409A.
1. Short-Term Deferrals (The Short-Term or 2-1/2 Month Rule)

The basic rule is that even if compensation satises the denition of a deferral of compensation, if the deferred compensation is paid within a short or 2-1/2 month period of time after certain events (e.g., the lapse of a substantial risk of forfeiture, the satisfaction of a performance goal), the compensation is exempt from Code Sec. 409A. Final Reg. 1.409A-1(b)(4) provides that a deferral of compensation does not occur if the plan under which a payment is made does not provide for a deferred payment and the service provider actually or constructively receives such payment on or before
25

A stock right provides for a deferred payment if such right includes any provision pursuant to which the holder of the stock right will or may have the right to exercise the stock right after the applicable 2-1/2 month period. The 2-1/2 month rule is applied separately to each payment required to be made under a plan. If a plan provides for a deferred payment with respect to part of a payment (for example a life annuity or a series of installment amounts treated as a single payment), the plan provides for a deferred payment with respect to the entire payment. a. Certain Delayed Payments A payment that otherwise qualies as a short-term deferral but is made after 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 and, as of the date upon which the legally binding right to the compensation arose, such impracticability was unforeseeable, or the taxpayer establishes that making the payment by the end of the applicable 2-1/2 month period would have jeopardized the ability of the service recipient to continue as a going concern. In addition, payment must be made as soon as administratively practicable or as soon as the payment would no longer have such effect. An action or failure to act of the service provider or a person under the service providers control, such as a failure nde t er to pr vide necessary info provide o prov e cessa y information or documentation, ormat is no a un re a not an unforeseeable event event. ot Finally, a payment t hat ot Fin lly, na lly aym ent that otherwise qualifies as a short-term deferral but is made after the aph t t plicable 2-1/2 month period may continue to p e riod m y c ontinue qualify as a short-term deferral if the taxpayer establishes that the service recipient reasonably anticipated that the service recipients deduction with respect to such payment otherwise would not be permitted by application of Code Sec. 162(m), and provided that: as of the date the legally binding right to the payment arose, a reasonable person would not have anticipated the application of Code Sec. 162(m) at the time of the payment, and the payment is made as soon as reasonably practicable following the rst date on which the service recipient anticipates or reasonably should anticipate that, if the payment were made on such date, the service recipients deduction with respect to such payment would no longer be restricted due to the application of Code Sec. 162(m). b. Substantial Risk of Forfeiture Deferred compensation that is subject to a substantial risk of forfeiture may take advantage of the short-term deferral rule, and thus, if it is paid within the 2-1/2 month short-term deferral period following vesting, the compensation is exempt from Code Sec. 409A. It can also take advantage of special initial deferral election rules as described in IV.A.3. below. It is important to note that the substantial-risk-offorfeiture standard used for purposes of Code Sec. 409A is quite different from the substantial-risk-offorfeiture standard used for purposes of Code Secs. 83, 402(b) and 457(f). Final Reg. 1.409A-1(d) provides that 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. A condition related to a purpose of the compensation must relate to the service providers performance for the service recipient or the service recipients business activities or organizational goals (e.g., the attainment of a prescribed level of earnings or equity value or completion of an initial public offering). Moreover, if a service providers entitlement to the amount is conditioned on the occurrence of the service providers involuntary separation from service without cause, the right is subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial. An amount is not subject to a substantial risk of forfeiture merely because the right to the amount is i conditioned, di cond tioned, directly or indirectly, upon the refraining o d from the performance of services. Other than certain transaction-based compensation (see V.A.7.e.i. below), the addition of any 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 risk of forfeiture, is disregarded for purposes of determining whether such compensation is subject to a substantial risk of forfeiture. 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 present value of the amount subject to a substantial risk of forfeiture (disregarding, in determining the present value, the risk of forfeiture) is materially greater than the present value of
26
July 2007
the amount the recipient otherwise could have elected to receive absent such risk of forfeiture. This means that compensation that the service provider would receive for continuing to perform services regardless of whether the service provider elected to receive the amount that is subject to a substantial risk of forfeiture is not taken into account in determining whether the present value of the right to the amount subject to a substantial risk of forfeiture is materially greater than the amount the recipient otherwise could have elected to receive absent such risk of forfeiture. Thus, a salary deferral generally may not be made subject to a substantial risk of forfeiture. However, where a bonus plan provides an election between a cash payment or restricted stock units with a present value that is materially greater (disregarding the risk of forfeiture) than the present value of such cash payment and 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. With respect to stock rights, a stock right is not subject to a substantial risk of forfeiture at the earlier of the rst date the holder may exercise the stock right and receive cash or property that is substantially vested or the rst 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 is not subject to a substantial risk of forfeiture, even if he s the stock option automatically terminates upon the stock service pr e e providers separation from service. service pro ers separation f Th fol he llo in it ons a The following situations apply in determining w ethe he whe er th possibility fo whether the possibility of forfeiture is substantial h hts o on in the case of rights to compensation granted by en ervice provider e a service recipient to a se service pro ider that owns owns a signicant amount of the total combined voting power or value of all classes of equity of the service recipient. The substantial possibility of forfeiture occurs where the service providers ownership is determined with application of the attribution rules under Code Sec. 318 if the service recipient is a corporation, or if the service recipient is an entity that is not a corporation, with application by analogy of the attribution rules under Code Sec. 318). All such relevant facts and circumstances are to be taken into account in determining whether the probability of the service recipient enforcing such condition is substantial, including: The service providers relationship to other equity holders and the extent of their control, potential control and possible loss of control of the service recipient; The position of the service provider in the service recipient and the extent to which the service provider is subordinate to other service providers; The service providers relationship to the ofcers and directors of the service recipient (or similar positions with respect to a noncorporate service recipient); The person or persons who must approve the service providers discharge; and Past actions of the service recipient in enforcing the restrictions. c. Performance-Based Compensation Performance-based compensation, where the compensation does not vest or become payable until certain performance goals are met, is a variant of compensation subject to a substantial risk of forfeiture. It can also take advantage of special initial deferral election rules as described in IV.A.6. below. Code Sec. 409A performance-based compensation is similar tobut not the same asCode Sec. 162(m) performance-based compensation. The term performance-based compensation means compensation the amount of which, or the entitlement to which, is contingent on the satisfaction of pre-established organizational or individual performance criteria relating to a performance period of at least 12 consecutive months. Organizational or individual performance criteria are considered pre-established 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. r Performance-based compensation may include Per ormance a 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 noncorporate service recipient) or by the stockholders or members of the service recipient. Performancebased 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. In addition, compensation generally is not performance-based compensation merely because the amount of such compensation is determined by reference to the value of the service recipient or the stock of the service recipient. Where a portion of an
27

amount of compensation would qualify as performance-based compensation if the portion were the sole amount available under the plan, that portion of the award will not fail to qualify as performancebased compensation if that portion is designated separately or otherwise separately identiable under the terms of the plan, and the amount of each portion is determined independently of the other. Compensation may be performance-based compensation where the amount will be paid regardless of satisfaction of the performance criteria due to the service providers death, disability or a CIC, provided that a payment made under such circumstances without regard to the satisfaction of the performance criteria will not constitute performance-based compensation. Generally, a disability refers to any medically determinable physical or mental impairment resulting in the service providers inability to perform the duties of his or her position or any substantially similar position, where such impairment can be expected to result in death or can be expected to last for a continuous period of not less than six months. In addition, the term performance-based compensation may include payments based upon subjective performance criteria, provided that: the subjective performance criteria are bona de and relate to the performance of the participant service provider, a group of service providers that includes the participant service provider, or b a bus business unit for which the participant service pro de p ovid provides services des provider provid service (which may include t e entire o ni nt organization), a on), and the en the d e determination that any subjective perforthe dete mina ion that a e mance criteria have been met is not m made by the am y member mi m participant se ice provider or a family member service provider of the participant service provider,31 or a person under the effective control of the participant service provider or such a family member, and no amount of the compensation of the person making such determination is effectively controlled in whole or in part by the service provider or such a family member. With respect to equity-based compensation, compensation is performance-based compensation if it is based solely on an increase in the value of the service recipient, or a share of stock in the service recipient, after the date of a grant or award. However, compensation payable for a service period that is equal to the value of a pre-determined number of shares of stock, and is variable only to the extent that the value of such shares appreciates or depreciates, generally will not be performancebased compensation. The attainment of a prescribed value for the service recipient (or a portion thereof), or a share of stock in the service recipient, may be used as a pre-established organizational criterion for purposes of providing performance-based compensation, provided that the other requirements stated above are satised. In addition, 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. A provision that allows a service provider to defer compensation that would be realized upon the exercise of a stock right generally constitutes an additional deferral feature for purposes of the denition of a deferral of compensation under the Final Regs.
2. Separation Pay Plans

A plan that otherwise provides for a deferral of compensation 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, the following are exceptions where the severance pay will not constitute deferred compensation: collectively bargained separation pay plans; certain involuntary separation from service plans; window programs; foreign separation pay plans; and certain reimbursements. These exceptions may be used in combination, so that c compensation under a plan that would be excepted under one d cepted under o exception may be treated as being excepted under another. However, any payment or benet, or entitlement to a payment or benet, that acts as a substitute for, or replacement of, amounts deferred by the service recipient under a separate NQDCP constitutes a payment or a deferral of compensation under the separate NQDCP, and does not constitute a payment or deferral of compensation under a separation pay plan. If a service provider receives a payment at separation from service and also has a legally binding right to an amount of deferred compensation that would be forfeited upon the separation from service, whether the payment acts as an acceleration of vesting and substitute payment for the amount of deferred compensation forfeited, or whether the
28
July 2007
deferred compensation is treated as forfeited and the amount paid is treated as a separate payment of current compensation, is determined based on the facts and circumstances, provided that, where the separation from service is voluntary, it is presumed that the payment results from an acceleration of vesting followed by a payment of the deferred compensation that is subject to Code Sec. 409A. Accordingly, any change in the payment schedule to accelerate or defer the payments would be subject to the rules of Code Sec. 409A. The presumption that a right to a payment is not a new right, but is instead a right substituted for a pre-existing forfeited right, may be rebutted by demonstrating that the service provider would have obtained the right to the payment regardless of the forfeiture of the nonvested right. A factor indicating that the service provider would have obtained a right to a payment regardless of the forfeiture of the nonvested right is that the amount to which the service provider obtains a right is materially less than an amount equal to the present value of the forfeited amount, multiplied by a fraction. The numerator of the fraction is the period of service the service provider actually completed. The denominator of the fraction is the full period of service the service provider would have been required to complete to receive the full amount of the payment. Thus, a service provider might be entitled to a future payment only if the service provider completes three years of service and at the time of termination the servic provider has completed one year of serservice he s vice. n that vent, he service vi . In th event, the service provider can rebut the ice ha presumption f payment pr um tio if the pa ent to the service provider is res mpt materially present m e ally less materia y le than the presen value of one-third of eria the nonvested amount. A o unt. Another such factor is that the acto payment to the se ice provider is o a type customservice provider s of type customov yp m arily made to service providers who separate from service with the service recipient and do not forfeit nonvested rights to deferred compensation (e.g., a payment of accrued but unused leave or a payment for a release of actual or potential claims). The term separation pay plan means any plan that provides separation pay or, where a plan provides both amounts that are separation pay and that are not separation pay, that portion of the plan that provides separation pay. The term separation pay means any deferral of compensation that will not be paid under any circumstances unless the service provider has had a separation from service, whether voluntary or involuntary, including payments in the form of reimbursements of expenses incurred, and the provision of in-kind benets. A deferral of compensation that the service provider may receive without a separation from service does not become separation pay merely because the service provider elects to receive or receives the payment after or upon a separation from service. A deferral of compensation does not fail to be separation pay merely because the payment is conditioned upon the execution of a release of claims, noncompetition or nondisclosure provisions, or other similar requirements. Again, it should be noted that any amount, or entitlement to any amount, that acts as a substitute for, or replacement of, amounts deferred by the service recipient under a NQDCP constitutes a payment of compensation or deferral of compensation under such NQDCP. a. Collectively Bargained Arrangements A separation pay plan does not provide for a deferral of compensation to the extent the plan is a collectively bargained separation pay plan that provides for separation pay only upon an involuntary separation from service or pursuant to a window program. Only the portion of the separation pay plan attributable to employees covered by a bona de collective bargaining agreement is considered to be provided under a collectively bargained separation pay plan. A collectively bargained separation pay plan is a separation pay plan that meets the following three conditions: The separation pay plan is contained within an agreement that the Secretary of Labor determines to be a collective bargaining agreement. 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 e the agreem between employee representatives the agreement and one or more employers satises Code Sec. 7701(a)(46). The circumstances surrounding the agreement evidence good faith bargaining between adverse parties over the separation pay to be provided under the agreement. To the extent a plan is subject to a bona de collective bargaining agreement covering services performed for multiple employers under which an employee must separate from service with all such employers in order to receive a payment, such plan may use any reasonable denition of involuntary separation from service, provided that: such denition is consistent with any denition of a separation from service adopted for purposes
29

of collectively bargained plan covering multiple employers (see V.A.6.f . below), and the denition of an involuntary separation from service provided by the collective bargaining agreement was the subject of arms length negotiations between employee representatives and two or more employers, the agreement between employee representatives and such employers satises Code Sec. 7701(a)(46), and the circumstances surrounding the agreement evidence good faith bargaining between adverse parties over such denition. b. Window Programs The term window program refers to a program established by a service recipient in connection with an impending separation from service to provide separation pay, where such program is made available by the service recipient for a limited period of time (no longer than 12 months) to service providers who separate from service during that period or to service providers who separate from service during that period under specied 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 benets are on account of a specic wh wheth business vent condition, bus b sines event or conditio the degree to which pay lates the separation pa relates to the event or condit e se at ep tion; tion and tion a n; whether the event or c condition is temporary or h e discrete or is a permanent aspec of the employs permanent aspect the employm t h p ers business. A separation pay plan that is not a collectively bargained separation pay plan and that provides for separation pay only pursuant to a window program does not provide for a deferral of compensation to the extent that the separation pay, or portion of the separation pay, provided under the plan meets the following requirements (referred to as the twotimes rule): The separation pay does not exceed two times the lesser of: the sum of the service providers annualized compensation based upon the annual rate of pay for services provided to the service recipient for the tax year of the service provider preceding the tax year of the service provider in which the service provider has a separation from service with such service recipient. This amount is adjusted for any increase during that year that was expected to continue indenitely if the service provider had not separated from service; or the maximum amount that may be taken into account under a qualied plan pursuant to Code Sec. 401(a)(17) (which was increased from $220,000 to $225,000 in 2007) for the year in which the service provider has a separation from service. The plan provides that the separation pay described above must be paid no later than the last day of the second tax year of the service provider following the tax year of the service provider in which occurs the separation from service. c. Foreign Separation Pay Plans A separation pay plan, including a plan providing payments upon a voluntary separation from service, does not provide for deferred compensation to the extent the plan provides for amounts of separation pay required to be provided under the applicable law of a foreign jurisdiction. A provision of foreign law is be considered applicable only to foreign earned income32 from sources within the foreign country that promulgated such law. d. Involuntary Separation from Service As discussed in II.D.1.b. above, the Final Regs explicitly provide that a payment conditioned on an involuntary separation from service without cause may be treated as being subject to a substantial risk of forfeiture if the possibility of forfeiture is substantial. This p potentially exempts severance payments made in connection with the involuntary separation from connection t service without cause from Code Sec. 409A if the payment satises the short-term deferral rule. In addition, a separation pay plan that is not a collectively bargained separation pay plan and that provides for separation pay only upon an involuntary separation from service does not provide for a deferral of compensation to the extent that the separation pay, or portion of the separation pay, provided under the plan satises the two-times rule described above. The term involuntary separation from service means a separation from service due to the independent exercise of the unilateral authority of the service recipient to terminate the service providers services, other than due to the service providers implicit or explicit request, where the service provider was
30
July 2007
willing and able to continue performing services. An involuntary separation from service may include the service recipients failure to renew a contract at the time such contract expires, provided that the service provider was willing and able to execute a new contract providing terms and conditions substantially similar to those in the expiring contract and to continue providing such services. The determination of whether a separation from service is involuntary is based on all the facts and circumstances. Any characterization of the separation from service as voluntary or involuntary by the service provider and the service recipient in the documentation of the separation from service is presumed to properly characterize the nature of the separation from service. However, the presumption may be rebutted where the facts and circumstances indicate otherwise (e.g., if a separation from service is designated as a voluntary separation from service or resignation, but the facts and circumstances indicate that absent such voluntary separation from service the service recipient would have terminated the service providers services, and that the service provider had knowledge that the service provider would be so terminated, the separation from service is involuntary). e. Good Reason Separation from Service A service providers voluntary separation from service will be treated as an involuntary separation from service if the separation from service occurs under certain l erta n limited bona fide conditions, where the ain avoidance requirements av dance of the requiremen of Code Sec. 409A voi not purpose the clusi is no a pu se of th inclusion of these conditions ot ur in the pla o of the actions b the service recipient n the p an or the actions by he h plan in connection with the satisfaction of th these condit tions, and a voluntary sepa un ry separation from se ce unde e aration from service under n ervic such conditions effectively constitutes an involuntary separation from service. Generally such conditions will be pre-specied under an agreement to provide compensation upon a separation from service for good reason. Such a good reason (or a similar condition) must be dened to require actions taken by the service recipient resulting in a material negative change to the service provider in the service relationship, such as the duties to be performed, the conditions under which such duties are to be performed, or the compensation to be received for performing such services. Other factors taken into account in determining whether a separation from service for good reason effectively constitutes an involuntary separation from service include: the extent to which the payments upon a separation from service for good reason are in the same amount and are to be made at the same time and in the same form as payments available upon an actual involuntary separation from service; and whether the service provider is required to give the service recipient notice of the existence of the condition that would result in treatment as a separation from service for good reason and a reasonable opportunity to remedy the condition. If a plan provides that a voluntary separation from service will be treated as an involuntary separation from service if the separation from service occurs under certain express conditions, a separation from service satisfying the conditions set forth in the plan will be treated as an involuntary separation from the service if the necessary conditions (or set of conditions) require the following: The separation from service must occur during a pre-determined limited period of time not to exceed two years following the initial existence of one or more of the following conditions arising without the consent of the service provider: a material diminution in the service providers base compensation; a material diminution in the service providers authority, duties, or responsibilities; a material diminution in the authority, duties or responsibilities of the supervisor to whom the service provider is required to report, including a requirement that a service provider report to a corporate ofcer or employee instead of reporting directly to the board of directors of a corporation (or similar governing body with respect to an entity other than corpo a corporation); a material diminution in the budget over which the service provider retains authority; a material change in the geographic location at which the service provider must perform the services; or any other action or inaction that constitutes a material breach by the service recipient of the agreement under which the service provider provides services. The amount, time and form of payment upon the separation from service must be substantially identical to the amount, time and form of payment payable due to an actual involuntary separation from service, to the extent such a right exists.
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The service provider must be required to provide notice to the service recipient of the existence of the material diminution, change or breach described above within a period not to exceed 90 days of the initial existence of the condition, upon the notice of which the service recipient must be provided a period of at least 30 days during which it may remedy the condition and not be required to pay the amount. f. Reimbursements and Certain Other Separation Payments To the extent a separation pay plan (including a plan providing payments upon a voluntary separation from service) entitles a service provider to payment by the service recipient of reimbursements: that are not otherwise excludible from gross income; for expenses that the service provider could otherwise deduct under Code Sec. 162 or Code Sec. 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 plan does not provide for a deferral of compensation to the extent such rights apply during a limited period of time (regardless of whether such rights extend beyond the limited period of time). g ts e ght ext The rei bu emen of reason Th reimbursement reasonable moving expenses he imb includes th reimbursement o all or part of any loss in ude t nclu es the e ur ent of the service provider actually incurs due to the sale of th serv ce p ovider actually in he serv vic a primary residence in connection with a separation i n from service. To the extent a separation pay plan (including a plan providing payments due to a voluntary separation from service) entitles a service provider to reimbursement by the service recipient of payments of medical expenses incurred and paid by the service provider but not reimbursed by a person other than the service recipient and allowable as a deduction under Code Sec. 213 (disregarding the requirement of Code Sec. 213(a) that the deduction is available only to the extent that such expenses exceed 7.5 percent of adjusted gross income). In that event, such medical expense plan does not provide for a deferral of compensation to the extent such rights apply during the period of time during which the service provider would be entitled (or would, but for such plan, be entitled) to continuation coverage under a group health plan of the service recipient under Code Sec. 4980B (COBRA health continuation) if the service provider elected such coverage and paid the applicable premiums. A service providers 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, is treated as not providing for a deferral of compensation 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. The term in-kind benefits refers to services provided to or on behalf of a service provider, such as financial planning services, or tangible personal or real property made available for use by or on behalf of the service provider, such as the use of an aircraft or vehicle, and does not refer to a transfer of property within the meaning of Code Sec. 83. If not otherwise excluded, a taxpayer may treat a right or rights under a separation pay plan to a payment or payments as not providing for a deferral of compensation to the extent such payments in the aggregate do not exceed the applicable dollar amount under Code Sec. 402(g)(1)(B) for the year of the separation from service. For purposes of receiving this exception, a limited period of time in which expenses may be incurred, or in which in-kind benefits may be provided by the service recipient or a third party that the service recipient will pay, does not include pese riods beyond the last day of the second tax year of riods beyond t o o the service provider following the taxable year of the service provider in which the separation from service occurred, provided that the period during which the reimbursements for such expenses must be paid may not extend beyond the third taxable year of the service provider following the taxable year of the service provider in which the separation from service occurred.
3. Certain Indemnication and Liability Insurance Plans

A plan in which a service provider participates might not provide for a deferral of compensation to the extent that the plan provides (to the extent permissible under applicable law), for the indemnication of, or
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July 2007
the purchase of an insurance policy providing for payments of, all or part of the expenses incurred or damages paid or payable by a service provider with respect to a bona de claim against the service provider or service recipient, including amounts paid or payable by the service provider upon the settlement of a bona de claim against the service provider or service recipient. This situation arises where such claim is based on actions or failures to act by the service provider in his or her capacity as a service provider of the service recipient. and the accompanying regulations, and does not refer to any benets provided for the education of any other person, including any spouse, child, or other family member of the service provider.
6. Customary Timing Arrangements

A deferral of compensation does not occur solely because compensation is paid after the last day of the service providers 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 Code Sec. 3401(b), or with respect to a nonemployee service provider, a period not longer than the payroll period described in Code Sec. 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 nonemployee service providers or 30 days after the end of the service providers taxable year.
4. Legal Settlements
An agreement to which a service provider is a party might not provide for a deferral of compensation to the extent that the agreement provides for amounts paid as settlements or awards resolving bona de legal claims based on wrongful termination, employment discrimination, the Fair Labor Standards Act, or workers compensation statutes. These legal provisions includes claims under applicable federal, state, local or foreign laws, or for reimbursements or payments of reasonable attorneys fees or other reasonable expenses incurred by the service provider related to such bona de legal claims, regardless of whether such settlements, awards, or reimbursement or payment of expenses pursuant to such claims are treated as compensation or wages for federal tax purposes. An execution of a waiver of any or all of such types of claims indicates that the amounts are paid as an ward award or settlement of an actual bona de claim for damage u am ges under applicable damages un r app icable law is determined based on th f ts a circumstances. Th rule does not apply to he facts and the fact an irc st es. This an def red amounts that did n arise as a result of an ny deferred mounts that ferr any def not l bona de claim fo d aim for damages under applicable nde er actual b ou ts d e e law, such as amounts that would ha e been deferred would have been deferred or paid regardless of the existence of such claim, even if such amounts are paid or modied as part of a settlement or award resolving an actual bona de claim. A provision of foreign law is considered applicable only to foreign earned income33 from sources within the foreign country that promulgated such law.
7. Certain Foreign Plans, Arrangements and Situations

a. Arrangements with Respect to Compensation Covered by Treaty or Other International Agreement A plan in which a service provider participates does not provide for a deferral of compensation to the extent that the compensation under the plan 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 p provider at the time that the legally binding right to the com compensation rst arose, orif later, the time that the legally binding right was no longer subject to a substantial risk of forfeiture. b. Arrangements with Respect to Certain Other Compensation A plan in which a service provider participates does not provide for a deferral of compensation to the extent that compensation under the plan 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 rst 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: The service provider was a nonresident alien at such time and the compensation would not have
5. Certain Educational Benets

A plan in which a service provider participates does not provide for a deferral of compensation to the extent the plan provides for taxable educational benets. The term educational benets refers solely to benets provided to a service provider, consisting solely of educational assistance for the education of the service provider, as dened in Code Sec. 127(c)
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been includible in gross income under Code Sec. 872. The service provider was a qualied individual (as dened in Code Sec. 911(d)(1)) at such time, the compensation would have been foreign earned income34 if paid at such time, and the amount of such compensation was equal to or less than the excess (if any) of the maximum exclusion amount under Code Sec. 911(b)(2)(D) for such taxable year over the amount of foreign earned income actually excluded from gross income by such qualied individual for such taxable year under Code Sec. 911(a)(1). The compensation would have been excludible from gross income under Code Sec. 893 (i.e., compensation of employees of foreign governments or international organizations). The compensation would have been excludible from gross income under Code Sec. 931 (i.e., income from sources within Guam, America Samoa or the Northern Mariana Islands) or Code Sec. 934 (i.e., limitation on reduction in income tax liability incurred to the Virgin Islands). c. Tax Equalization Agreements Compensation paid under a tax equalization agreement does not provide for a deferral of compensation if: payments made under such tax equalization agreement are made no later than the end of the second taxable year of the service provider beginning after the taxable year of the service provider in which the service providers U.S. pro p ovi federal return fed al come f dera income tax return is required to be led (including any extensions) for the year to which (inc ud ( clu g a e sions the comp the co ensat on subject to the tax equalization e compensation subject om payment relates, orif later, , f the second yea of the service pr vider beginning year the service provider beginning h e e after the latest such taxable year in which the service providers foreign tax return or payment is required to be led or made for the year to which the compensation subject to the tax equalization payment relates. Where such payments arise due to an audit, litigation or similar proceeding, the right to the payments are not treated as resulting in a deferral of compensation if the payments are scheduled and made in accordance with the rule relating to the timing of tax gross-up payments (see V.A.2.b. below). The term tax equalization agreement refers to an agreement, method, program, or other arrangement that provides payments intended to compensate the service provider for: some or all of the excess of the taxes actually imposed by a foreign jurisdiction on the compensation paid by the service recipient to the service provider over the taxes that would be imposed if the compensation were subject solely to U.S. federal, state and local income tax, or some or all of the excess of the U.S. federal, state and local income tax actually imposed on the compensation paid by the service to the service provider over the taxes that would be imposed if the compensation were subject solely to taxes in the foreign jurisdiction The payment made under such agreement, method, program, or other arrangement may not exceed such excess and the amount necessary to compensate for the additional taxes on the amount paid under the agreement, method, program or other arrangement. d. Certain Limited Deferrals of a Nonresident Alien With respect to a nonresident alien, a foreign plan does not provide for a deferral of compensation if the amounts deferred under the foreign plan based upon services performed by the nonresident alien in the United States (including amounts deferred based upon service credits or compensation received due to services performed in the United States) do not exceed the applicable dollar amount under Code Sec. 402(g)(1)(B) for the tax year (increased from $15,000 to $15,500 in 2007). If the amounts deferred under the foreign plan based upon the services performed by the nonresident alien in the United States exceed the applicable dollar amount, an amount of such deferrals equal to such amount is treated as not deferred under a NQDCP. The term foreign plan means a plan that, together with a substantially similar plans, is maintained by all a serv service recip vice recipient for a substantial number of parc ticipants, substantially all of whom are nonresident aliens or resident aliens classied as resident aliens solely under Code Sec. 7701(b)(1)(A)(ii) (and not Code Sec. 7701(b)(1)(A)(i)).
e. Foreign Plan Earnings

Earnings on compensation excluded from the denition of deferral of compensation with respect to the above foreign plan exception are also not treated as a deferral of compensation.
f. Additional Foreign Plans as Designated by the IRS Commissioner

A plan in which a service provider participates does not provide for a deferral of compensation to the ex-
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July 2007
tent designated by the IRS Commissioner in revenue procedures, notices or other guidance published in the Internal Revenue Bulletin. purchase plan (ESPP) described in Code Sec. 423), or a stock appreciation right (a SAR). ii. Denition of Option The term option or stock option means the right or privilege of an individual to purchase stock from a corporation by virtue of an offer of the corporation continuing for a stated period of time, whether or not irrevocable, to sell such stock at a price determined under the Final Regs, such individual being under no obligation to purchase. While no particular form of words is necessary, the option must express an offer to sell at the option price, the maximum number of shares purchasable under the option, and the period of time during which the offer remains open. The term option includes a warrant that meets the requirements of the Final Regs. An option may be granted as part of or in conjunction with an employee stock purchase plan or subscription contract. An option must be in writing (in paper or electronic form) provided that such writing is adequate to establish an option right or privilege that is enforceable under applicable law. iii. Definition of Stock Appreciation Right or SAR The term stock appreciation right or SAR means a right to compensation equal to the appreciation in value of a specied number of shares of service recipient stock occurring between the date of grant and the date of exercise of such right. iv. Denitions of Stock, Established Securities Market, and Readily Tradable The term stock means capital stock of any class, including voting or nonvoting common or preferred stock. Except as otherwise provided, the term stock includes both treasury stock and stock of original isu sue. Special cl Special classes of stock authorized to be issued a to and held by employees are within the scope of the term stock for this purpose, provided such stock otherwise possesses the rights and characteristics of capital stock. The term established securities market means an established securities market within the meaning of Reg. 1.897-1(m). The term readily tradable means that stock is treated as readily tradable if it is regularly quoted by brokers or dealers making a market in such stock. v. Determination of "Date of Grant of Option" The term the date of grant of the option, option grant date, and similar phrases refer to the date when the granting corporation completes the corporate action necessary to create the legally binding right
E. When Equity-Based Compensation is Subject to Code Sec. 409A 1. Exemption for Compensation that is Code Sec. 83 Property
The general rule is that property transferred in connection with the performance of services and which is taxed under Code Sec. 83 is exempt from Code Sec. 409A. 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 by reason of the property being substantially nonvested,35 or is includible in income solely due to a valid election under Code Sec. 83(b). A transfer of property includes the transfer of a benecial 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 Code Sec. 83, Code Sec. 402(b) or Code Sec. 403(c). A right to compensation income that will be required to be included in income under taxability of a beneciary of a nonexempt trust under Code Sec. 402(b)(4)(A) due to failure of the minimum coverage rules under Code Sec. 410(b) is not a deferral of compensation. p an pla A plan under which a service provider obtains a leg lly bin g right receive ega y nd legally binding right to receive property in a future tax ye r w re e ear whe p b year where the property will be substantially vested t the time of transfer of he h me at the tim o tran fer of the property may provide h comp s us, such a plan for the deferral of compensation. Thus, s e A g may constitute a NQDCP (see III.A. below). A lega ly NQDCP (see III.A. elow). legally binding right to receive property in a future tax year where the property will be substantially nonvested at the time of transfer of the property will not provide for the deferral of compensation and, accordingly, will not constitute a NQDCP unless offered in conjunction with another legally binding right that constitutes a deferral of compensation.
2. Stock Rights on Service Recipient Stock

a. Certain Denitions and Concepts i. Denition of Stock Right The term stock right means: a stock option (other than an incentive stock option (ISO) described in Code Sec. 422 or an option granted pursuant to an employee stock
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constituting the option. A corporate action creating the legally binding right constituting the option is not considered complete until the date on which the maximum number of shares that can be purchased under the option and the minimum exercise price are xed or determinable, and the class of underlying stock and the identity of the service provider is designated. Ordinarily, if the corporate action provides for an immediate offer of stock for sale to a service provider, or provides for a particular date on which such offer is to be made, the date of the granting of the option is the date of such corporate action if the offer is to be made immediately, or the date provided as the date of the offer, as the case may be. However, an unreasonable delay in the giving of notice of such offer to the service provider will be taken into account as indicating that the corporation provided that the offer was to be made at the subsequent date on which such notice is given. If the corporation imposes a condition on the granting of an option (as distinguished from a condition governing the exercise of the option), such condition generally will be given effect in accordance with the intent of the corporation. However, if the grant of an option is subject to approval by stockholders, the date of grant of the option will be determined as if the option had not been subject to such approval. A condition that does not require corporate action, such as the approval of, or registration with, some regulatory or government agency, for example, a ock e stock exc exchange or the U.S. Securities and Exchange Com iss mm sio ordinar ly co Commission, is ordinarily considered a condition up n the ex pon he exercise upon th e c of the optio unless the corporate option ac on clear indicates that t option is not to be ctio clearly indicates on ea action cle the d o a granted until such condition has been satised. n imposed upon the mpo e h In general, a condition im osed u on the exercise of an option will not operate to make ineffective the granting of the option. For example, on June 1, 2008, Corporation A grants to X, an employee, an option to purchase 5,000 shares of the corporations common stock, exercisable by X on or after June 1, 2009, provided X is employed by the corporation on June 1, 2009, and provided that As prots during the scal year preceding the year of exercise exceed $200,000. Such an option is granted to X on June 1, 2008, and will be treated as outstanding as of such date. vi. Denition of Exercise Price The term exercise price means the consideration in cash or property that, pursuant to the terms of the option, is the price at which the stock subject to the option is purchased. The term exercise price does not include any amounts paid as interest under a deferred payment plan or treated as interest. vii. When an Exercise of an Option Occurs The term exercise, when used in reference to an option, means the act of acceptance by the holder of the option of the offer to sell contained in the option. In general, the time of exercise is the time when there is a sale or a contract to sell between the corporation and the individual. A promise to pay the exercise price does not constitute an exercise of the option unless the holder of the option is subject to personal liability on such promise. An agreement or undertaking by the service provider to make payments under a stock purchase plan does not constitute the exercise of an option to the extent the payments made remain subject to withdrawal by or refund to the service provider. viii. Denition of Transfer The term transfer, when used in reference to the transfer to an individual of a share of stock pursuant to the exercise of an option, means the transfer of ownership of such share, or the transfer of substantially all the rights of ownership. Such transfer must, within a reasonable time, be evidenced on the books of the corporation. A transfer may occur even if a share of stock is subject to a substantial risk of forfeiture or is not otherwise transferable immediately after the date of exercise. A transfer does not fail to occur merely because, under the terms of the arrangement, the individual may not dispose of the share for a specied period of time, or the share is subject to a right of rst refusal or a right to acquire the share at the shares fair market value at the time of the sale. b. Basic Rules An option to purchase service recipient stock does not p provide for a deferral of compensation if all of the follow ng a met: following are g The exercise price may never be less than the fair market value of the underlying stock36 on the date the option is granted and the number of shares subject to the option is xed on the original date of grant of the option; The transfer or exercise of the option is subject to taxation under Code Sec. 83 and Reg. 1.83-7. The option does not include any feature for the deferral of compensation other than the deferral of recognition of income until the later of the following: the exercise or disposition of the option under Reg. 1.83-7; or the time the stock acquired pursuant to the exercise of the option rst becomes substantially vested.
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A SAR does not provide for a deferral of compensation if all of the following are met: Compensation payable under the SAR cannot be greater than the excess of the fair market value of the stock on the date the SAR is exercised over an amount specied on the date of grant of the SAR (the SAR exercise price), with respect to a number of shares xed on or before the date of grant of the right. The SAR exercise price may never be less than the fair market value of the underlying stock on the date the right is granted. The SAR does not include any feature for the deferral of compensation other than the deferral of recognition of income until the exercise of the SAR. An option to purchase stock other than service recipient stock, or a SAR with respect to stock other than service recipient stock, generally will provide for the deferral of compensation. If under the terms of an option to purchase service recipient stock (other than an ISO or an ESPP option), the exercise price is or could become less than the fair market value of the stock on the date of grant, the grant of the option generally will provide for the deferral of compensation. If under the terms of a SAR with respect to service recipient stock, the compensation payable under the SAR is or could be any amount greater than, with respect to a predetermined number of shares, the xce ess excess of the fair market value of the stock on the date th S R is e rcise over the f market value of the he the SAR s exercised over fair stock o th da of grant of t stock appreciation nt the stock on the date rig t, th gra t of the stock ap ght he right, the grant the stock appreciation right generi r deferral mpen ally will provide for a de r of compensation. g o e t t To the extent a st ck right provides a right other than stock right provides right other the right to receive cash or stock on the date of exercise and such additional right would otherwise allow compensation to be deferred beyond the date of exercise, the entire arrangement (including the underlying stock right) provides for the deferral of compensation. Neither the right to receive substantially nonvested stock 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. c. ISOs and ESPPs The grant of an ISO or the grant of an option under an ESPP (including the grant of an option with an exercise price discounted in accordance with Code Sec. 423(b)(6), does not constitute a deferral of compensation. However, the ISO/ESPP exemption does not apply to a modication, extension, or renewal of an ISO or ESPP option that is treated as the grant of a new option that is not an ISO or an ESPP.37 In such event, the option is treated for purposes Code Sec. 409A as if it had been a nonstatutory stock option from the date of the original grant. Accordingly, if such modication, extension, or renewal of the stock option would have been treated as the grant of a new option or as causing the option to have had a deferral feature from the date of grant, the modication, extension or renewal of the stock option is treated as the grant of a new option or as causing the option to have had a deferral feature from the date of grant for purposes of Code Sec. 409A. d. Dividends and Dividend Equivalents The right, directly or indirectly contingent upon the exercise of a stock right, to receive an amount equal to all or part of the dividends or other distributions (other than stock dividends as described in II.E.2.k.below) 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 right to be subject to Code Sec. 409A). A plan providing a right to dividends or other distributions declared and paid on the number of shares underlying a stock right, the payment of which is not contingent upon, or otherwise payable on, the exercise of the stock right, may provide for a deferral of compensation, but the existence of the right to receive such an amount will not be treated as a reduction to the exercise price of (or an increase to the compensation payable under) the stock right. e Thus, a right to such dividends or distributions that is not contingent, directly or indirectly, upon the exercise of a stock right will not cause the related stock right to fail to satisfy the requirements of the exclusion from the denition of a deferral of compensation. e. Stock Right Modications Any modication 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, 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. The term stock right modicaton means any change in the terms of the stock right (or change in
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the terms of the plan 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 exercise price of the stock right, whether or not the holder in fact benets from the change in terms. However, the Final Regs explicitly provide that the term stock right modication does not mean: a change in the terms of the stock right shortening the period during which the stock right is exercisable; adding a feature providing the ability to tender previously acquired stock for the stock purchasable under the stock right; adding a feature providing the ability to tender previously acquired stock to withhold or have withheld shares of stock to facilitate the payment of the exercise price or the employment taxes or required withholding taxes resulting from the exercise of the stock; or When the grantor exercises discretion specically reserved under a stock right with respect to the transferability of the stock right. f. Extensions and Renewals An extension of a stock right refers to the provision to the holder of an additional period of time within which to exercise the stock right beyond the time originally prescribed under the terms of the stock right, the conversion or exchange of a stock right for a legally binding right to compensation in a future taxable y axable year, or the addition of any feature for the e deferral of compensation not permitted under the de erra o efe al mpensation Final R gs to th terms of the stock right, other than Fina Reg al Regs the rm f at a tim w n the exercise p exercise price of the stock right t time wh me when equals or exceeds the fair m market value of the service l f recipient stock tha could be purch ed ( n the case that purchased (in c of an option) or the fair market value of the service recipient stock used to determine the payment to the service provider (in the case of a SAR), and includes a renewal of such right that has such effect. It is not an extension if the exercise period of a stock right is extended to a date no later than the earlier of the latest date upon which the stock right could have expired by its original terms under any circumstances or the 10th anniversary of the original date of grant of the stock right. If the exercise period of a stock right is extended at a time when the exercise price of the stock right equals or exceeds the fair market value of the service recipient stock that could be purchased (in the case of an option) or the fair market value of the service recipient stock used to determine the payment to the service provider (in the case of a SAR), it is not an extension of the original stock right. Instead, in such a case, the original stock right is treated as modied rather than extended and a new stock right is treated as having been granted. In addition, it is not an extension of a stock right if the expiration of the stock right is tolled while the holder cannot exercise the stock right because such an exercise would violate an applicable federal, state, local or foreign law, or would jeopardize the ability of the service recipient to continue as a going concern, 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 rst would no longer violate an applicable federal, state, local and foreign laws or would rst no longer jeopardize the ability of the service recipient to continue as a going concern. For this purpose, a provision of foreign law shall be considered applicable only to foreign earned income38 from sources within the foreign country that promulgated such law. A special rule applies to the extension of a stock right before April 10, 2007. An extension of a stock right before April 10, 2007, solely in order to provide the holder of such stock right an additional period of time beyond the time originally prescribed under the terms of such stock right within which to exercise the stock right is disregarded for purposes of applying the above rule. But an extension of a stock right on and after April 10, 2007 results in such stock right being treated as having specied at the date of grant the time within which to exercise such stock right that was prescribed under the terms of such stock right in effect on April 9, 2007. This special rule does not affect any other action trea ed as the extension of a stock right, including e treated the addition of a deferral feature. g. Substitutions and Assumptions of Stock Rights By Reason of a Corporate Transaction The rule for determining whether these is a modication due to a substitution and/or assumption of a stock right with respect to a corporate transaction generally is based on the statutory option rules under Code Sec. 424(a) and Reg. 1.424-1 (but without regard to the requirement described in Reg. 1.424-1(a)(2) that an eligible corporation be the employer of the optionee). Basically, 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
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as the grant of a new stock right or a change in the form of payment. The Reg. 1.424-1(a)(5)(iii) ratio test is 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 Code Sec. 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, the requirements of Reg. 1.424-1(a)(5) related to the fair market value of the stock may be satised by: using the last sale before or the rst sale after the specied date as of which such valuation is being made, the closing price on the last trading day before or the trading day of a specied date, the arithmetic mean of the high and low prices on the last trading day before or the trading day of such specied date, or any other reasonable method using actual transactions in such stock as reported by such market on a specied date, for the stock of the distributing corporation and the stock distributed in the transaction, provided the specied date is designated before such specied date, and such specied date is not more than 60 day d ys a y days after the transaction; usi g u ng the arithmetic mean of such market prices metic using th arithm o tra g ad s ng on trading days during a specied period design ign ed efore nated nate ignated before the beginn beginning of such specied uch s ec od period, where such specied period is not longer s and r than 60 than 30 days a d ends no later t an 60 days afte after the transaction; or using an average of such prices during such prespecied period weighted based on the volume of trading of such stock on each trading day during such pre-specied period. h. Acceleration of Date When Exercisable A change in the terms of the right solely to accelerate or delay, within the original term of the stock right, the time at which the stock right (or any portion of such stock right) may be exercised is not a modication, with respect to a stock right subject to Code Sec. 409A although with respect to a stock right not immediately exercisable in full Such an acceleration may constitute an impermissible acceleration of a payment date or a subsequent deferral. i. Discretionary-Added Benets If a change to a stock right provides, either by its terms or in substance, that the holder may receive an additional benet under the stock right at the future discretion of the grantor, and the addition of such benet would constitute a modication or extension, then the addition of such discretion is a modication or extension at the time that the stock right is changed to provide such discretion. j. 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 modication 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 the rules relating to substitution and/or assumption of a stock right with respect to a corporate transaction. k. 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 modication of the stock right but is treated as the grant of a new additional stock right to which the additional shares are subject. However, if the exercise price and number of shares subject to a stock right are proportionally adjusted to reect 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 there is no modication of the stock right if it is proportionally adjusted to reect the stock split or stock dividend and the aggregate exercise price of the stock right t is not less than the aggregate exercise price before not o the stock split or stock dividend. l. Rescission of Changes A 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, is not considered a modication or extension 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 service providers taxable year during which such change occurred. Thus, if the terms of a stock right granted to an individual employee with a calendar year tax year are changed on March 1 in a manner that would result in an extension of the stock right, and the change is rescinded on November 1
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of the same year, and the stock right is not exercised before the change is rescinded, the stock right is not considered extended under the Final Regs. m. Successive Modications and Extensions The rules relating to modications and extensions above apply as well to successive modications and extensions. There is a special rule for modications and/or extension in effect on October 23, 2004: if a legally binding right to a modication or extension of such stock right existed on October 23, 2004, such modication or extension is disregarded, and the stock right is treated as if granted with the terms and conditions in effect on October 23, 2004. An interest in an entity other than a corporation or nonstick mutual company or association may constitute service recipient stock to the extent designated by the IRS Commissioner in revenue procedures, notices or other guidance published in the Internal Revenue Bulletin. b. Eligible Issuer of Service Recipient Stock The term eligible issuer of service recipient stock means only the corporation for which the service provider provides direct services on the date of grant of the stock right (if the entity receiving such services is a corporation), and any corporation in a chain of corporations or other entities in which each corporation or other entity has a controlling interest in another corporation or other entity in the chain, ending with the corporation or other entity that has a controlling interest in the corporation or other entity for which the service provider provides direct services on the date of grant of the stock right. The term controlling interest has the same meaning as provided in Reg. 1.414(c)-2(b)(2)(i), provided that the language at least 50 percent is used instead of at least 80 percent each place it appears in Reg. 1.414(c)-2(b)(2)(i). 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 controlling interest has the same meaning as provided in Reg. 1.414(c)-2(b)(2)(i), provided that the language at least 20 percent is used instead of at least 80 percent each place it appears in Reg. 1.414(c)-2(b)(2)(i). For purposes of determining ownership of an interest in an organization, the rules of Reg. 1.414(c)-3 and 1.414(c)-4 apply. The determination of whether a grant is based on legitimate business criteria is based on the facts and circumstances, focusing primarily h on whether th whether there is a sufcient nexus between the service provider and the issuer of the stock right so that the grant serves a legitimate non-tax business purpose other than simply providing compensation to the service provider that is excluded from the requirements of Code Sec. 409A. Thus, stock of a corporation that owns an interest in a joint venture involving an operating business, used with respect to stock rights granted to service providers of the joint venture who are former service providers of such corporation, generally will constitute use of service recipient stock based upon legitimate business criteria, and therefore could constitute service recipient stock with respect to such service providers if the corporation owns at least 20 percent of the joint venture and the other requirements of the Final Regs are met.
3. Service Recipient Stock

a. Basic Rule The term stock of the service recipient or service recipient stock means a class of stock that, as of the date of grant, is common stock for purposes of Code Sec. 305 and the regulations thereunder of a corporation that is an eligible issuer of service recipient stock (see below). The term service recipient stock does not include a class of stock that has any preference as to distributions other than distributions of service recipient stock and distributions in liquidation of the issuer. The term service recipient stock also does not include any stock that is subject to a mandatory repurchase obligation (other than a right of rst refusal), or a put or call right that is not a lapse restriction as dened in Reg. 1.83-3(i), if the stock price under such right or obligation is based on a measure other uch righ h g th n the f than th fai market value of th equity interest in the han he fair arke value the co poratio ep en corporation represented by th stock. orp on the Also, an American deposita Also, an American depositary receipt (ADR) or American depositary share (ADS) may constitute i y e ( y service recipient stock, to t e exte that the stock nt ock, the extent that stock traded on a foreign securities market to which the ADR or ADS relates qualies as service recipient stock. A mutual company unit may constitute service recipient stock. The term mutual company unit means a xed percentage of the overall value of a non-stock mutual company or association. For purposes of determining the value of the mutual company unit, the unit may be valued in accordance with the rules set forth below 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 such xed percentage.
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Similarly, the legitimate business criteria requirement generally would be met if the corporate venturer issued such a right to an employee of the joint venture who it reasonably expected would in the future become an employee of the corporate venturer. However, where a service provider has no real nexus with a corporate venturer, such as generally happens when the corporate venturer is a passive investor in the service recipient joint venture, a stock right issued to that employee on the investor corporations stock generally would not be based upon legitimate business criteria. Similarly, where a corporation holds only a minority interest in an entity that in turn holds a minority interest in the entity for which the service provider performs services, such that the corporation holds only an insubstantial indirect interest in the entity receiving the services, legitimate business criteria generally would not exist for issuing a stock right on the corporations stock to the service provider. Except as to a service provider providing services directly to such corporation, an eligible issuer of service recipient stock does not include any corporation whose primary purpose is to serve as an investment vehicle with respect to the corporations minority ownership interests in entities other than the service recipient. An eligible issuer of service recipient stock does not include any corporation within a group of entities treated as a single service recipient if a purpose of the establishment of the structure of the ownership, or a pu p purpose of a signicant transaction between or r purp among two more entities comprising a single seramong tw or more entities co mo g wo vice recipient, vi re pi , is to provide d ice ecip pie o ide deferred compensation not sub no sub ct to the application of Code Sec. 409A. If an ot subject he application o bjec entity b becomes a member o a group of co corporations emb of c or other entities tr ated as a s ngle s rvice recipient treated single service recipient, ge ce e and the primary source of income or value of such entity arises from the provision of management services to other members of the service recipient group, it is presumed that such structure was established for purposes of avoiding the application of Code Sec. 409A if any stock rights are issued with respect to such entity. c. Fair Market Valuation of Service Recipient Stock if Publicly Traded 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 rst sale after the grant, the closing price on the trading day before or the trading day of the grant, the arithmetic mean of the high and low prices on the trading day before or the trading day of the grant, or any other reasonable method using actual transactions in such stock as reported by such market. The determination of fair market value also may be determined using an average selling price during a specied period that is within 30 days before or 30 days after the applicable valuation date, provided that the program under which the stock right is granted, including a program with a single participant, must irrevocably specify the commitment to grant the stock right with an exercise price set using such an average selling price before the beginning of the specied period. For this purpose, the term average selling price refers to the arithmetic mean of such selling prices on all trading days during the specied period, or the average of such prices over the specied period weighted based on the volume of trading of such stock on each trading day during such specied period. To satisfy this requirement, the service recipient must designate the recipient of the stock right, the number and class of shares of stock that are subject to the stock right, and the method for determining the exercise price including the period over which the averaging will occur, before the beginning of the specied averaging period. Where applicable foreign law requires that a compensatory stock right be priced based upon a specic price averaging method and period, a stock right granted in accordance with such applicable foreign law will be treated as meeting the requirements of the Final Regs, provided that the averaging period does not exceed 30 days. d. Fair Market Valuation of Service Recipient Stock if not Publicly Traded In the case of service recipient stock that is not readily tradable on an established securities market, the fair a market value of the stock as of a valuation date means marke value et u a value determined by the reasonable application of a reasonable valuation method. The determination 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 anticipated future cashows 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 the stock of which is to be valued;
41

the value of which can be readily determined through nondiscretionary, objective means (such as through trading prices on an established securities market or an amount paid in an arms length private transaction); recent arms length transactions involving the sale or transfer of such stock or equity interests; 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 reect information available after the date of the calculation that may materially affect the value of the corporation (e.g., 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 recipients 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. aluation The u e of any of the follow following methods of valuaTh use o ny he tion is pre me to r tio on presumed result in a reasonable valuation, es t provided tha the IR Commis IRS Commissioner may rebut such pr vide that rov ed vide RS a presumption upon a showing that either the valuw he ation method or th application of s ch method was r the application such method p o grossly unreasonable: a valuation of a class of stock determined by an independent appraisal that meets the requirements of Code Sec. 401(a)(28)(C) and the related Treasury Regs as of a date that is no more than 12 months before the relevant transaction to which the valuation is applied (for example, the date of grant of a stock option). a valuation based upon a formula that, if used as part of a nonlapse restriction39 with respect to the stock, would be considered to be the fair market value of the stock pursuant to Reg. 1.835, 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 any substantially similar class of stock) to the issuer or any person that owns stock possessing more than 10 percent of the total combined voting power of all classes of stock of the issuer (applying the stock attribution rules of Reg. 1.424-1(d)), other than an arms-length transaction involving the sale of all or substantially all of the outstanding stock of the issuer, and such valuation method is used consistently for all such purposes. This formula rule 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. A valuation, made reasonably and in good faith and evidenced by a written report that takes into account the relevant reasonable valuation method factors described above, of illiquid stock of a start-up corporation. For this purpose, illiquid stock of a start-up corporation means service recipient stock of a corporation that has no material 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, where such stock is not subject to any put, call or other right or obligation of the service recipient or other person to purchase such stock (other than a right of rst refusal upon an offer to purchase by a third party that is unrelated to the service recipient or service provider and other h than a right or obligation that constitutes a Code Sec. 3 lapse Sec. 83 lap restriction, and provided that this reasonable good faith rule 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 either a Type 1 CIC or a Type 3 CIC within the 90 days following the action to which the valuation is applied, or make a public offering of securities within the 180 days following the action to which the valuation is applied. However, a valuation will not be treated as made reasonably and in good faith unless the valuation is performed by a person or persons that the corporation reasonably determines is qualied to perform such a valuation
Continued on page 65
42
July 2007
To be eligible for amnesty, a taxpayer must pay all taxes due, in full, related to the amnesty returns led. Eligible taxpayers include taxpayers that did not le a required return or report; misrepresented or omitted any tax liability on a previously led return; or erroneously claimed credits or deductions. The amnesty program is not available for assessments already identified by the Comptroller. In addition, taxpayers are not allowed to participate in the amnesty program if they are currently under audit or review or if they have already been contacted by the Comptroller about an audit or possible deciency. forcing the law based on hindsight alone and the National Office wanted to correct that, at least conceptually. Maybe it took so long to say this plainly because it is hard for the government to give up pure hindsight. used to determine the value at the date of the repurchase of stock pursuant to a put or call right. However, once an exercise price or amount to be paid has been established, the exercise price or amount to be paid may not be changed through the retroactive use of another valuation method. In addition, where after the date of grant, but before the date of exercise or transfer, of the stock right, the service recipient stock to which the stock right relates becomes readily tradable on an established securities market, the service recipient must use the valuation method for service recipient stock that is publicly traded for purposes of determining the payment at the date of exercise or the purchase of the stock, as applicable.
ENDNOTES
1
AM-2007-007 (March 15, 2007).
Deferred Compensation
Continued from page 42
Virginia
A company that licenses, sells and supports software is liable for sales/use tax on royalty payments for software that was delivered electronically because the sales invoice provide for delivery in tangible form. In order for the sale of electronically delivered software to be exempt, at a minimum, the sales invoice, contract m, mum, or o er s s ag eement m r oth sales agreement must other ex ressly c if that the softw xpr y expressly certify at software w de vere electronically and was delivered electronically a eliv edium for that no tangible medium fo that een software has been or will be furwill be nished to the customer. Without such documentation, it will be assumed that the software is conveyed in a tangible form. Va. Dept. of Tax., Rulings of Tax Comn'r PD 07-22 (March 27, 2007).
International Taxation
Continued from page 8
Conclusion
Why did this question have to be claried and why has it taken so long? Presumably agents were en-
based on the persons or persons signicant knowledge, experience, education or training. Generally, a person will be qualied to perform such a valuation if a reasonable individual, upon being apprised of such knowledge, experience, education, and training, would reasonably rely on the advice of such person with respect to valuation in deciding whether to accept an offer to purchase or sell the stock being valued. For this purpose, signicant experience generally means at least ve years of relevant experience in business valuation or appraisal, nancial m accounting, investment bankng, private equity, secured g y e ue ing, priva equity, secured lending, or other comparable experience in the line of business or industry in which the service recipient operates. A different valuation method may be used for each separate action for which a valuation is relevant, provided that a single valuation method is used for each separate action and, once used, may not retroactively be altered. Thus, one valuation method may be used to establish the exercise price of a stock option, and a different valuation method may be
ENDNOTES
1
4 5
6 7 8 9
10 11 12 13
14 15 16 17
18
19 20
The Final Regs were published in the Federal Register on April 17, 2007, see 72 FR 19234. Notice 2007-34, IRB 2007-17, April 10, 2007. American Jobs Creation Act of 2004 (P.L. 108-357). Revenue Act of 1978 (P.L. 95-600). Code Sec. 132 provided that The taxable year of inclusion in gross income of [deferred compensation] shall be determined in accordance with the principles set fort in regulations, rulings, and judicial decisions relating to deferred compensation which were in effect on February 1, 1978. Rev. Proc. 92-64, 1992-2 CB 422. Rev. Proc. 92-65, 1992-2 CB 428. Rev. Proc. 71-19, 1971-1 CB 698 . Notice 2005-1, IRB 2005-2, 274, 2005-1 CB 274, modied on January 6, 2005. 70 FR 57930. Notice 2006-4, IRB 2006-3, 307. Notice 2006-33, IRB 2006-15, 754. Gulf Opportunity Zone Act of 2005 (P.L. 109-135). Notice 2006-64, IRB 2006-29, 88. Notice 2006-79, IRB 2006-43, 763. Notice 2006-100, IRB 2006-51, 1109. Announcement 2007-18, IRB 2007-9, 625. Generally as described under Reg. 1.833(c). Id. Id.
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July 2007

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

Important and Immediate Action to be Taken by Companies

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

B. Calculation of Grandfathered Account Balance Plan Amounts

C. Calculation of Grandfathered Nonaccount Balance Plan Amounts

D. Calculation of Grandfathered Equity-Based Compensation

E. Calculation of Grandfathered Earnings on Grandfathered Deferred Compensation

Analyzing Deferred Compensation Arrangements

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

2. Denition of Service Recipient

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

B. Denition of Deferral of Compensation

1. Short-Term Deferrals (The Short-Term or 2-1/2 Month Rule)

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

2. Separation Pay Plans

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

3. Certain Indemnication and Liability Insurance Plans

6. Customary Timing Arrangements

7. Certain Foreign Plans, Arrangements and Situations

5. Certain Educational Benets

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

e. Foreign Plan Earnings

f. Additional Foreign Plans as Designated by the IRS Commissioner

2. Stock Rights on Service Recipient Stock

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

3. Service Recipient Stock

CORPORATE BUSINESS TAXATION MONTHLY

Analyzing Deferred Compensation Arrangements

AM-2007-007 (March 15, 2007).

CORPORATE BUSINESS TAXATION MONTHLY

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