CHAPTER 2. §409A COMPLIANCE FLOWCHART

2:1 §409A Compliance Flowchart - Description

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

2:2 § 409A Compliance Flowchart - Flowchart

3.1 DEFERRED COMPENSATION

3.2 GRANDFATHER

MODIFIED

3.3 SEPARATION

3.4 MISC.

3.5 SHORT-TERM DEFERRAL

3.6 ELECTION

3.7 PAYMENT TIMING

3.8 ANTI-ACCELERATION

3.9 CHANGE OF FORM/ELECTION

3.10 TRANSITION ELIGIBLE

OPERATIONAL COMPLIANCE

3.11 VOLUNTARY CORRECTION

3.12 PLAN AGGREGATION

3.14 LIMITED SANCTIONS

3.13 FULL SANCTIONS

NO 409A PROBLEM

WRITTEN COMPLIANCE EXEMPTIONS

YES

YES

YES

NO

NO

NO

NO

Y/N

YES

YES

YES

NO

NO

NO

NO

NO

YES

YES

YES

NONO

NO

YES

YES

YES

CHAPTER 3. OUTLINE OF § 409A.

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

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

While by no means exhaustive, the following plans or arrangements are candidates for potential deferred compensation:

(i) Agreements to defer salary or bonuses

(ii) Agreements to make up for amounts not allowable under qualified retirement plans such as 401(k) plans

(iii) Supplemental executive retirement plans

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

(v) Restricted stock unit plans

(vi) Bonus arrangements

(vii) Expense reimbursement plans

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

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

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

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

B. A service provider is:

Any employee, director, consultant or independent contractor

However - there is a very significant exception for independent contractors providing substantial services to others (this exception does

not apply to the extent the services provided are “management services” or investment or advisory services to companies whose business is primarily the investment or financial or real estate assets. See § 5:3 below.

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

i. Whether there is service recipient stock for purposes of determining whether a stock option or SAR is exempt from § 409A. See §§ 3:1 and 6:8 below.

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

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

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

i. i.e., stock which is issued but subject to forfeiture or repurchase at cost if vesting requirements are not met

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

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

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

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

(i) Fair Market Value

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

2. Public Company. For stock in a class which is publicly traded (generally on any established market, including the “Pink Sheets”), fair market value is generally the closing price of the day before or the day of the transaction, though other methods as described are allowed. See § 6:11 below.

3. Private Company. For stock in a class which is not publicly traded, fair market value is determined by a reasonable application of a reasonable valuation method. See § 6:11 below.

a. A method is reasonable if it considers:

(i) The value of tangible and intangible assets .

(ii) The present value of anticipated future cash flows

(iii) Readily determinable market value of similar companies in substantially similar trade of business.

(iv) Recent purchases of stock.

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

(vi) All other relevant information.

b. A valuation is not reasonably applied if it is more than 12 months old or subsequent material factors are ignored.

(i) Unless it is determined the previous assumptions and circumstances are unchanged.

c. If the method is reasonable and reasonably applied, the determination should be upheld even if the determination turns out to be incorrect—though a substantially incorrect number necessarily casts doubt on whether a reasonable method was in fact used or was in fact reasonably applied.

d. Use of certain “presumptions” in favor of a fair market value determination for private companies:

(i) A valuation performed by an independent appraiser if the valuation date is not more than 12 months from date of transaction. See § 6:12 below.

(ii) A more informal determination for start-ups, the illiquid start-up presumption, applies if the following are satisfied. See §6:13 below.

(1) The entity has not been in business for more than 10 years.

(2) There is no reasonable anticipation that the valuation date is within 90 days before a change in control or 180 days before an IPO.

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

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

(1) Also used for I.R.C.§ 83 purposes in determining the taxable for restricted stock and

(2) Applied to any sales to the company or 10% shareholders, except certain arm’s length sales of all or substantially all stock.

(ii) Service Recipient Stock.

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

2. no longer has to be best class of common

3. can have no dividend preference other than liquidation

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

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

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

b. at least a 20% owner of the employer receiving the services (e.g. a joint venture) if legitimate business purposes.

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

1. Effect: The option is treated as newly granted as of the date of modification--the main § 409A concern being that the old exercise price might be less than the fair market value of the stock on the new grant date, thus making the option ineligible for the stock option exception from § 409A.

2. Definition: any change that lowers the exercise price

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

b. It is not a modification to accelerate the date of vesting or exercise or to change the medium of exercise (for example, a change permitting the exercise of an option with previously owned stock, etc).

(iv) Extension (see § 6:17 below)

1. Effect: the option is treated as deferred compensation subject to § 409A from the original date of grant--which often means the option will not have satisfied the 409A requirements that exercise occur on one of the six permissible times or events (death, disability, change in control, termination of employment, date certain or hardship).

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

a. amended to extend the exercise period past the original option term or past ten years from the date of grant;

b. exchanged for a legally binding right to receive stock in a future year; or

c. amended to add an additional deferral feature--such as settlement in a year following the date of exercise

3. Thus, it is not an extension subject to § 409A if the option is amended to extend the post-termination exercise period from 90 days after termination to, for example, 18 months after termination, so long as the extension is not to a date later than the earlier of (i) original option exercise period, or (ii) ten years from the date of grant (such an extension would cause the loss of incentive stock option (“ISO”) eligibility under I.R.C. § 422 and there are accounting implications, even if often incidental)

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

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

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

(ii) Benefits or payments pursuant to an agreement which is materially modified after October 3, 2004 are not exempted from § 409A.

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

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

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

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

C. The payment is made within 2 years following the separation from service (see § 3:7D below).

D. The termination qualifies as an involuntary separation from service (see § 6:23 below)

(i) A voluntary termination for good reason (see § 6:24 below) can qualify as an involuntary termination if based on a material and negative unilateral employer action related to pay, benefits, duties and/or conditions of employment.

(ii) The regulations provide for a good reason safe harbor which requires employee notice and opportunity to cure.

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

(i) Each separately identifiable and objectively determinable amount under the written contract is a separate payment.

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

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

F. Thus, in order for an installment payment to satisfy the separation pay or short term deferral exception, it is often essential that this statement appear in the written plan document.

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

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

B. Typical non-taxable health and medical plans (insured or uninsured), vacation, sick leave, disability, death and health savings accounts, medical plans to extent excludable from income (see § 6:2 below).

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

D. Foreign plans (see § 6:2 below)

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

F. Other separation pay exceptions:

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

1. The expense or item must be incurred by end of second taxable year following year of separation, and

2. Actual payment must occur by end of third year

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

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

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

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

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

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

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

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

(iii) This exception is unlimited as to amount.

B. In certain instances payments which are required to be made by the 2-1/2 month deadline but are not actually made in time, such as for administrative difficulty, going concern or 162(m) reasons, can still qualify under the short term deferral exception

C. Note that although payments are exempt from § 409A, certain changes to defer the payment date will have to satisfy the election change rules of § 409A (and thus payment might have to be delayed five years if changed). See §§ 3:9 and 7:11 below).

D. However, the anti-acceleration rules described in § 3:8 and 7:13 below generally do not apply to an acceleration in the payment date of an amount otherwise exempt under the short term deferral rule.

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

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

B. If applicable, an election may also be made within 30 days of the employee’s initial eligibility in a plan. See § 7:3 below.

(i) Note however, that the concept of plan is determined on an aggregated basis. Thus, if the employee had been eligible to participate in any other plan which must be aggregated with the plan under consideration, this special rule likely would not apply (see § 5:5 below).

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

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

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

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

2. the time the amount payable is readily ascertainable

(ii) Performance-based compensation is similar, though not identical, to that defined in the “million dollar cap” rules of I.R.C. § 162(m). Payment of the compensation must be contingent upon satisfaction of pre-established organizational or individual performance criteria over a performance period of at least twelve months. To be pre-established, the criteria must be set forth in writing not later than 90 days after the beginning of the service period and at a time when the outcome is still substantially

uncertain. Unlike § 162(m) performance-based compensation, shareholder approval is not required nor is it necessary to have the compensation approved by an independent committee of the board. Compensation is not performance-based if it can be paid if the performance standards are not met or if set when they are substantially certain to be met.

D. Elections as to unvested amounts may be made within 30 days of obtaining a legally binding right to the payment if:

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

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

E. Other election rules.

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

(ii) If as a result of arm’s length bargaining, an employee becomes entitled to separation pay to which he or she was not previously entitled or which does not replace other deferred compensation, that employee may make an election to defer up until the employee obtains the binding legal right to the separation pay. See § 7:6 below. This exception applies whether or not the separation is involuntary.

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

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

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

2. certain changes with respect to cafeteria plans under I.R.C. §125 that affect the definition of compensation under the deferred compensation plan, and

3. elections to annualize recurring part-year compensation.

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

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

A. Thus, under § 409A, payment or exercise must be made on account of one of the following dates or events:

(i) Death

(ii) Disability (see § 8:17 below)

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

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

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

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

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

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

1. On another date determined by reference to one of the five express permissible events. Thus, for example, it is permissible to make a payment on the fifth anniversary of the date of death, or in four equal annual installments starting on the date of separation from service and on each of the following three anniversaries,

2. For any of the six permissible dates or events (thus including a specified date) within any designated taxable year for any event or date. Thus, for the examples in (1) above, payment could be designated to occur at any time in the taxable year which includes the fifth anniversary of death or in four equal annual installments

each to be made in the four successive taxable years starting in the year of separation from service,

3. For any of the six permissible dates or events (thus including a specified date) within any designated period following the date or event so long as:

a. Payment occurs within the same taxable year of the employee, or

b. Is not greater than 90 days and the employee may not designate the year of payment.

4. Payment may be made on the earliest or latest of more than one of the six permissible dates or events. For example, payment will occur on January 1, 2015, or separation from service, if earlier. See § 8:1 below.

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

b. However, there may be a different forms of payment for separation from service events as follows:

(1) A form of payment for separation from service (voluntary or involuntary) occurring within 2 years following change in control.

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

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

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

(i) On the designated date;

(ii) At any time later in the same taxable year of the designated date;

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

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

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

(i) Employee—when both parties reasonably anticipate no further services will be provided, or that services (employment or consulting) will be less than 20% of the previous 36 month level.

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

2. If actual is greater than 50%, presume no separation from service (subject to rebuttal).

3. If actual service is in between, there is no presumption, but rather, the facts and circumstances are determinative without having to overcome a presumption.

(ii) Independent contractor

1. Good faith complete termination of all services.

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

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

E. Key employee—six month prohibition on payments for separation from service with a public company (see § 8:16 below).

(i) Applicable to key employees of companies with stock traded on an established market (including pink sheets).

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

(i) With respect to any particular employee, only ownership or control changes of the following companies can constitute a change in control:

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

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

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

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

1. Change in ownership (see § 8:19 below)—occurs when the voting control of one person (or more than one person if acting as a group) moves from below 50% to at least 50%

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

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

2. There is a change in the majority of the board over a twelve month period (and any such new directors are not approved by a majority of the board in place before the election or appointment of that member).

(iv) Change in ownership of substantial portion of assets (see § 8:21 below) occurs if any person (or more than one person if acting as a group) acquires at least 40% of the total gross asset value of the company.

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

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

1. An “earnout” is deemed to be paid on the date of the change in control if it is paid within 5 years of the change in control and is made on the same basis as made to other shareholders.

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

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

A. As noted in § 3:7 above, payment dates based on one of the six permissible dates or events must be designated in advance.

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

(ii) This acceleration prohibition does not apply to accelerate a payment excepted from § 409A under the short term deferral exception discussed in § 3:5 above (though as noted in § 7:11 the subsequent change rules as discussed in 7:14 below apply to a subsequent deferral of a payment covered by the short term deferral exception).

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

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

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

(i) Pursuant to domestic relations orders

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

(iii) Payment of income or FICA withholding

(iv) Payment because of 409A violation

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

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

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

(viii) Certain plan other terminations

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

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

(xi) Miscellaneous

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

2. Certain payments and taxes accelerated in connection with a plan subject to Code § 457(f)

3. Certain distributions to avoid a non-allocation year in an ESOP under Code § 409(p)

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

C. If a nonqualified plan is designed to make up for benefits that are limited under an associated qualified retirement plan (such as a 401(k) plan) or a broad based foreign plan,

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

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

(iii) the employer’s amendment of the qualified retirement plan or broad based foreign plan to increase benefits or to add or remove a subsidized or ancillary benefit is a permissible acceleration

(iv) the employee’s action or inaction with respect to elective or pre-tax deferrals under a qualified employer plan is a permissible acceleration provided the total decrease to all nonqualified plans as a result of such decrease is not greater than $16,500 for 2009

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

D. For nonqualified plans which base their deferrals or benefits on the compensation of the particular employee, a change to a cafeteria plan election which in turn

changes the compensation used in determining the nonqualified deferral or benefit is a permissible acceleration.

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

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

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

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

(iii) Except for death, disability or unforeseeable emergency, push the payment date (or start for an annuity or installment not designated as a series of separate payments) back five years!

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

A. In general:

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

(ii) Definitive guidance on many issues in the Final Regulations became mandatory January 1, 2009

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

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

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

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

1. Could not accelerate payment due after year of change to year of change. Likewise, could not defer payment due in year of change to year after change.

2. Could not (and still may not) add a substantial risk of forfeiture without increasing the amount payable (see § 6:6 below).

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

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

2. For purposes of Option correction, an Option was not “payable” in a year just because it was exercisable then, so long as reasonable to assume it could be exercised in a later year.

3. Could not cure an option already exercised.

4. Could increase the exercise price—even reimburse for lost discount but not for cash or vested stock in the year of correction (see __ below).

(viii) With respect to severance.

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

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

3. Transition rules permitted eliminating good reason entirely.

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

(i) the temporary guidance in 2005-2008 has been largely extended indefinitely in Notice 2008-115 (see § 9:2 below); or

(ii) Taxpayers may rely on the “Proposed Income Inclusion Regulations” provided all guidance in such proposed regulations is followed. See __ below).

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

A. Revised correction program. In December, 2008, the IRS expanded and clarified its pervious correction program. See Chapter 11 below.

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

(ii) Generally, the following relief is available:

1. No sanctions, for:

a. Correction in the same year for:

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

(2) Failure to meet the six month post-termination requirement for key employees of public reporting companies;

(3) Excess deferrals;

(4) Option exercise price below grant date fair market value.

b. Correction in the calendar year immediately following the year of the violation for non-Insiders only for:

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

(2) Failure to meet the six month post-termination requirement for key employees of public reporting companies;

(3) Excess deferrals

(4) Option exercise price below grant date fair market value.

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

a. Violations for a Limited Amount (no more than the annual 401(k) deferral limit--$16,500 in 2009) for:

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

(2) Failure to meet the six month post-termination requirement for key employees of public reporting companies;

(3) Excess deferrals.

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

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

(2) Failure to meet the six month post-termination requirement for key employees of public reporting companies;

(3) Excess deferrals.

c. Certain information and reporting requirements apply. See §§ 11:4 and 11:5.

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

A. For important purposes such as elections within 30 days of becoming eligible for the plan, or sanctions, various plans are considered as one. Each separate plan gets lumped into all others in its category as set forth below (see § 5:5 below):

B. Class of plans:

(i) Employee deferral Account Balance;

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

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

(iv) Separation pay;

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

(vi) In-kind benefits or reimbursements;

(vii) Split dollar;

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

(ix) All others.

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

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

(i) For rules prior to finalization of the Proposed Income Inclusion Regulations, see § 9:20 below.

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

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

C. 20% additional tax on employee for amount vested

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

E. Reporting and Withholding

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

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

2. Withholding for employees at supplemental rates;

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

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

5. Until further guidance, not required to report all deferred compensation (i.e., whether compliant and non-compliant).

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

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

B. Applies to unintentional errors in operation. Must establish rules to avoid recurrence, not available once an employee is under audit.

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

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

Amounts not paid or made available when due.

Amounts paid in violation of the six month prohibition for key employees of public companies.

Excess deferrals.

Corrections of option exercise price.

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

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

Amounts not paid or made available when due.

Amounts paid in violation of the six month prohibition for key employees of public companies.

Excess deferrals.

(iii) Limited sanctions: only amount of violation (not entire account) is a violation. Additional 20% tax applies, but not premium interest.

Limited amounts—less than $16,500.

Certain corrections by second year following violation.

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

3:15 Outline of § 409A—Compliance Audit. Identify any agreement or promise where compensation or benefits can be paid in later year, including:

A. Compliance Agreements:

(i) Employment agreement;

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

(iii) Option agreement;

(iv) Expense reimbursement policy;

(v) Foregone salary;

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

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

(i) Short term deferral

(ii) Severance.

C. Other.

D. Fully documented.

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

F. Separation Pay

(i) To qualify for exemption, must be strictly payable on involuntary termination (including voluntary termination for good reason, provided definition complies with § 409A).

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

G. Definition of payment:

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

H. Cannot act on a non-compliant provision.

I. Drafting

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

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

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

J. Service recipient stock—if the option is not in common stock, or not issued up the chain of control, the stock is subject to 409A.

K. Options—any concerns should be addressed regarding the determination of fair market value and ability to satisfy 409A standard.

(i) Vests after 2004?

(ii) Award modified or extended?

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

1. Evidence of incorrect grant date.

2. Was the proper grant authority followed?

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

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

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

N. If plan provides payment on termination of employment—does definition of termination comply with 409A?

(i) Or could continuing consulting or services permit payment but not constitute a qualifying termination.

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

O. Provide what happens to specified employee--are suspended payments made in a lump sum at the expiration of the six month period or are all payments pushed back six months from their original payment date?

(i) Should be addressed in private company contracts because stock could become publicly traded.

(ii) Should be specific—don’t just say all payable after 6 months—could convert exempt compensation to 409A deferred compensation.

P. Good reason definition:

(i) Does it qualify?

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

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

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

(i) Locked in and irrevocable;

(ii) Based on one of the six events;

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

R. Is there a desire to change distribution event?

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

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

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

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

T. Where an agreement relies on the short-term deferral exception to avoid 409A, it should specify a date, because if miss payment by the short term deferral date, can still meet the distribution rules by payment later in year.

U. Election of benefits.

(i) Post-employment choice of cash or medical (always dangerous from the standpoint of raising a constructive receipt issue, but it occurs in agreements sometimes) raises a 409A issue.

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

V. Change of Control.

(i) Is payment based on separation from service? If so, then the definition of change in control may not need to satisfy 409A (because the payment is triggered by separation from service--itself an acceptable 409A trigger).

W. However, if the form of payment for separation from service following a change in control is different from separation from service payments not made in connection with a change in control, the definition of change in control may have to comply with § 409A.

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