On October 4, 2006, the Internal Revenue Service issued Notice 2006-79, announcing the extension of certain transition relief under Section 409A of the Internal Revenue Code of 1986 (“Section 409A”), which sets forth stringent requirements for nonqualified deferred compensation and significant penalties for noncompliance.  This notice extends the current deadline from December 31, 2006, to December 31, 2007, for the following compliance requirements under Section 409A:

• The deadline for amending plans that were adopted on or prior to December 31, 2007, if such plans are operated in good faith compliance with the requirements of Section 409A through that date;
• Except as described below, the deadline for bringing discounted stock options, stock appreciation rights and other stock-based-awards (e.g., phantom stock or restricted stock units) that provide for a deferral of compensation (collectively “stock rights”) into compliance with Section 409A, including the deadline for (a) substituting non-discounted stock options and stock appreciation rights (“stock rights”) for discounted stock rights or (b) amending and restating discounted stock rights to provide for (or allow the holder to elect) fixed payment terms that are consistent with Section 409A without such election being treated as an election change or an acceleration of a payment under Section 409A;
• The deadline for new elections as to time and form of payment, without such elections being treated as an election change or acceleration subject to the rules of Section 409A (however, elections made in 2006 may apply only to amounts not otherwise payable in 2006 and may not accelerate a payment into 2006 that would not otherwise be payable in 2006 and, similarly, elections made in 2007 may apply only to amounts not otherwise payable in 2007 and may not accelerate a payment into 2007 that would not otherwise be payable in 2007); and
• The ability to link the payment provision of a nonqualified plan to a qualified plan for payments made or commenced on or prior to December 31, 2007 (with respect to the terms of a nonqualified deferred compensation plan as in effect on October 3, 2004).

In addition, further transition relief is provided for plans under collective bargaining agreements in effect on October 3, 2004, to require compliance with 409A by the earlier of the date on which the collective bargaining agreement terminates (determined without regard to any extension thereof after October 3, 2004) and December 31, 2009. 

The extension of transition relief does not apply to certain discounted stock options and stock appreciation rights subject to “backdating” concerns.  Specifically, there is no extension of the transition relief for any stock option or stock appreciation right that (1) was granted with respect to a publicly traded issuer, (2) was granted to a person who, as of the date of grant, was subject to the disclosure requirements of Section 16(a) of the Securities Exchange Act of 1934 with respect to the issuer, and (3) with respect to such grant, the corporation has reported (or reasonably expects to report) a financial expense that was not timely reported on prior financial statements and which should have been reported under generally accepted accounting principles.  Accordingly, the transition relief for such options and stock appreciation rights will expire on December 31, 2006.

Good faith operational compliance has been required with respect to all nonqualified deferred compensation since January 1, 2005 and this requirement continues to apply.  However, the notice clarifies various operational issues under the existing Section 409A guidance, including:

• that multiple plan amendments or election changes can be made during the transition period to comply with Section 409A (e.g., plans that were amended in 2005 to comply with Section 409A can be amended again to change the terms of payment subject to the provisions of the notice);
• that for purposes of amending stock rights, the stock right will not be treated as payable in a year simply because it is exercisable in such year as long as such stock right is reasonably expected to be exercisable in a later year;
• that employer discretion contained in a plan that is exercised in a manner that fails to comply with Section 409A will cause the plan to be considered to be operated in violation of section 409A with respect to all plan participants; and
• that if a participant chooses to exercise a right he has under the terms of a plan that has not been amended to comply with Section 409A and if the exercise of that right causes the plan to fail to meet the requirements of Section 409A (for example, a participant takes an in-service “haircut withdrawal”), the exercise of that non-compliant right will cause the plan to fail to comply with Section 409A with respect to that participant only and not with respect to all other participants in the plan; and
• that to the extent that Notice 2005-1, the proposed Section 409A regulations and the final Section 409A regulations are inconsistent with each other, an employer may rely on either the final Section 409A regulations, the proposed Section 409A regulations or Notice 2005-1.

The IRS also announced that it intends to issue final regulations under Section 409A before the end of 2006, but that the final regulations will not become effective until January 1, 2008. 

To discuss any of these developments, please contact any one of our Employee Benefits and Executive Compensation Section members:

Austin
Maria Elena Bickerton  512.542.8542
Ronald F. Bradshaw  512.542.8408
Dusty M. Burke  512.542.8425
Laura P. Irani  512.542.8607

Dallas
Alex N. Clark 214.220.7824
David C. D'Alessandro 214.220.7890
Felicia A. Finston 214.220.7990
Casey C. Fisk 214.220.7964
Gary G. Short 214.220.7828
Mary J. Steichen 214.220.7806
Shane M. Tucker 214.220.7803

Houston
Brian R. Bloom  713.758.2623
Dorene B. Cohen  713.758.1174
Melinda M. Hurr  713.758.4542
Regina K. Ibarra  713.758.4788
Carol H. Jewett  713.758.2798
Stephany Lin-Abney  713.758.2423
Alan J. Robin  713.758.2442
Pamela H. Stabler  713.758.2956
Michael D. Stuart   713.758.3716

Prior issues of our Benefits Bulletin may be accessed by clicking here.