June 14, 2007Client Alert

Section 409A – Compliance with Final Regulations

In April 2007, the Internal Revenue Service issued the much anticipated final regulations under Section 409A of the Internal Revenue Code. While the final regulations generally follow the proposed regulations, they expand or clarify prior guidance in several key areas, discussed below. Nonetheless, Section 409A and its accompanying regulations contain the most significant changes affecting employee equity-based compensation in the last twenty years.

Scope of Section 409A

The scope of Section 409A is largely unchanged by the final regulations. With certain noted exceptions, Section 409A applies to all arrangements in which there is a deferral of compensation. Section 409A generally states that if certain requirements regarding the timing of deferred compensation are not met, then all deferred amounts are immediately included in income unless subject to a substantial risk of forfeiture. In addition to regular income tax, Section 409A imposes an additional 20% tax plus interest on the deferred compensation.


Qualified plans, bona fide sick leave or vacation plans, disability plans, death benefit plans, and certain non-taxable medical reimbursement arrangements all remain exempt from Section 409A. Additionally, as under the proposed regulations, the final regulations provide that stock options and stock appreciation rights that are priced at fair market value and do not provide for discounts or deferral features are not subject to 409A, nor are short-term deferrals of compensation paid within 2½ months of the end of the calendar year in which the compensation became vested.

Plan Documentation Requirement

The final regulations confirm that the material terms of arrangements subject to Section 409A must be in writing. At a minimum, such writings must specify:

the amount of the deferred compensation (or the method or formula to calculate it);

the time and form of payment;

the conditions for deferral elections under the plan; and

for public companies, the six-month delay requirement for specified top executives.

A savings clause that attempts to render provisions of an existing plan compliant with Section 409A will not be sufficient. Existing deferred compensation plans must comply with the documentation requirement by December 31, 2007.

Short-Term Deferrals

As mentioned above, the final regulations retain the exemption from Section 409A’s requirements for compensation paid within 2½ months of the end of the calendar year in which the compensation became vested. Additionally, the final regulations provide that short-term deferrals can extend beyond the 2½ month period if:

• the payment would jeopardize the ability of the employer to remain in business;

• the payment is “administratively impracticable” for reasons that could not have been foreseen; or

• a delay is required because the payment could not be deducted due to the Code §162 $1 million limit.

Separation from Service

The final regulations clarify when a “separation from service” occurs (one of the six permitted payment events under Section 409A). Generally, there is a separation from service when the employee dies, retires, or otherwise has a termination of employment. A termination of employment occurs if the level of services to be performed by the employee after the termination is no more than 20% of the average amount performed over the prior 36 months. There will be no separation from service if the anticipated level of services to be performed is 50% or more.

Severance Pay Exclusion

The proposed regulations exempted from Section 409A severance pay arrangements paid due to involuntary separation from service, provided the payments did not exceed two times the lesser of the employee’s annual compensation or the Code Section 401(a)(17) annual compensation limit ($225,000 for 2007). The final regulations continue this exemption, and provide the helpful clarification that only the portion of the severance payment which exceeds the two-times limit will be subject to Section 409A. Thus, the amount of the payment up to the two-times limit will not be subject to Section 409A, regardless of the total severance payment amount.

“Good Reason” Voluntary Terminations

For purposes of applying Section 409A to severance pay arrangements, the final regulations establish a new rule under which certain “good reason” voluntary terminations can be treated as involuntary terminations. If treated as an involuntary termination, severance pay due to a “good reason” voluntary termination can be made to an employee and still qualify for the two-times compensation exception (discussed above). A general “facts and circumstances” test can be used to determine when a termination is for good reason, though the regulations also provide a safe harbor definition of a good reason termination.

Specified Employees of Public Companies

With respect to “specified employees” (key employees) of public companies, the final regulations retain the requirement that payment of nonqualified deferred compensation following separation from service must be delayed six months after the date of separation from service. The final regulations do provide, however, greater flexibility to employers in identifying the group of employees who will be subject to the six-month delay.

Plan Aggregation

The proposed regulations provided that a violation of Section 409A by one plan would result in all of the employee’s nonqualified deferred compensation plans within the same category being treated as noncompliant. While the final regulations retain this aggregation rule, the number of plan categories has been expanded from four to nine. Account balance plans have been split into two categories (elective and non-elective plans), and four new categories have been added: split-dollar life insurance arrangements, reimbursement plans, stock rights, and foreign plans. This expansion of categories potentially lessens the impact of plan violations because only plans that fall into the same, now narrower, aggregation category will be adversely affected.

Service Recipient Stock

Generally, stock options and stock appreciation rights issued with an exercise price equal to the fair market value of the stock on the date of the grant are exempt from Section 409A. The proposed regulations, however, provided that only stock options granted on stock that is publicly traded (or, if none, stock with the highest aggregate value of any common class of stock) were exempt from Section 409A. The final regulations expand this definition to allow stock options to be granted with respect to services performed for certain subsidiaries of the parent corporation so long as the stock class does not have a preference as to dividends (though a liquidation preference is allowable).

Stock Option Extensions

The final regulations allow for extension of the exercise period of a stock option or stock appreciation right, without the option or right becoming subject to Section 409A, if the option is “underwater” (that is, the exercise price exceeds the fair market value of the underlying stock) on the date of the extension, or if the option or right is not extended beyond the earlier of the maximum term of the option or ten years from the date of the option grant. Extensions of the exercise period under the proposed regulations would have rendered the option or right subject to Section 409A.

Valuations of Company Stock

For privately held companies, the final regulations confirmed the three presumptively reasonable valuation methods: (1) independent appraisal, (2) repurchase valuation formula and (3) illiquid start-up. The final regulations considerably augmented the scope of when the illiquid start-up method can be used and who may prepare it, making it available to many more companies. For public companies, the final regulations are fairly consistent with the proposed regulations. The final regulations permit the use of an average selling price in determining fair market value, up to a period of 30 days. When using an average price, there must be an irrevocable commitment to grant the stock right prior to the commencement of the period in which the stock is valued.

Tax Gross-Ups

The final regulations provide that tax gross-up payments will not be subject to Section 409A penalties as long as they are paid by the end of the calendar year after the year the taxes are paid to the government. Under the proposed regulations, most tax gross-ups would have been subject to Section 409A penalties.

Split-Dollar Life Insurance Plans

Coincident with the release of the final regulations, the IRS issued Notice 2007-34, the first guidance to address the application of Section 409A to split-dollar life insurance arrangements. Split-dollar life insurance arrangements entered into prior to September 18, 2003 that are grandfathered under the final split-dollar regulations (from September 2003) will generally not be subject to Section 409A. Additionally, modifications to these grandfathered arrangements necessary to comply with Section 409A, or to avoid the application of Section 409A, will not be treated as material modifications destroying the grandfathered treatment under the final split dollar regulations.

Action Items for Clients

To ensure compliance with the December 31, 2007 documentation deadline, employers should identify those plans, contracts and other arrangements potentially subject to Section 409A, and establish a schedule to ensure review and timely adoption of any required amendments. Many arrangements that involve a deferral of compensation, even arrangements adopted many years ago, will need to be brought into documentary and operational compliance by the end of 2007. As a rule of thumb, every plan, contract or other arrangement currently in place that has a deferred compensation component that extends beyond the end of 2007 should be reviewed and if applicable amended before January 1, 2008.

Effective Date of Regulations

The final regulations are applicable for tax years beginning on or after January 1, 2008.

For more information, contact your Michael Best attorney or one of the following attorneys: John L. Barlament at 414.225.2793 or; John C. Lapinski at 414.225.4941 or; Hamang B. Patel at 608.283.2278 or; or Matthew Storms at 608.283.0103 or


Michael Best is hosting a teleweb seminar on these new changes. The teleweb will be on June 28 from 1:00-2:00 CST. Replays of the teleweb will be available.

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