Client Alert

Earlier this month, the IRS issued Notice 2006-79 (the "Notice"), extending the plan amendment deadline for most, but not all, nonqualified deferred compensation plans that are subject to Section 409A of the Internal Revenue Code, as amended ("Code"). ¹ The Notice states that while the IRS and Treasury Department expect to issue the final regulations necessary to amend nonqualified plans before the end of 2006, those regulations will not become effective until January 1, 2008. In the interim, plans must continue to operate in reasonable, good faith compliance with Code Section 409A and other applicable guidance published with an effective date prior to January 1, 2008.
The first part of this Alert provides a brief description of the transition relief provided by Notice 2006 79. The second part describes several year-end actions that either must be taken by December 31, 2006, or that employers or employees may wish to take before that time.

Ability to Change Payment Elections Until December 31, 2007
As part of the extension of the transition relief under Code Section 409A, the Notice allows new payment elections to be made on or before December 31, 2007 with respect to the time or form of payment. In addition, the Notice allows a deferral election to be made with respect to any amounts that are "short-term deferrals," provided that the election is made before January 1, 2008 and before the year in which the amount would otherwise have been paid.
The Notice also clarifies that employees or employers may change payment elections more than one time, provided that all such changes are made in accordance with the Notice and other applicable guidance. However, payments cannot be changed during the year in which they are otherwise to be made, and payments in future years cannot be made payable in the current year. For example, payments that are to be made in 2006 cannot be extended until later years and payments to be made in later years cannot be made payable during 2006.
Extension of Relief for Discount Stock Options and Stock Appreciation Rights
The Notice also extends the transition relief for discount stock options and stock appreciation rights that are subject to Code Section 409A (collectively, "stock rights"). Stock rights may be amended through December 31, 2007 to comply with Code Section 409A by providing for exercise on a fixed date or other permissible distribution event. The Notice also extends the time to bring discounted options into compliance with Code Section 409A by substituting an option with an exercise price of fair market value on the original date of grant for the discounted option. While cash or vested property cannot be paid to the optionee to make up for the lost discount amount during the year the option is amended to comply, the Notice confirms that other methods of making up the lost discount are still available.
The extension of the transition relief through 2007, however, does not apply to so-called "backdated" stock rights granted by a public company to a person who (at the time of grant) was subject to the disclosure requirements of section 16(a) of the Securities Exchange Act, as amended, where the company has or reasonably expects to report a financial expense because the discounted stock rights were not timely reported on financial statements or reports for the period in which the expense should have been reported. This means that any companies currently investigating such stock rights will need to correct them under the transition relief by December 31, 2006, to avoid the penalties under Code Section 409A.
Payments Linked to Qualified Plans
The Notice extends through 2007 the ability to link a payment election under a nonqualified plan to an election made under a qualified plan. The Notice also extends this transition relief to nonqualified plans that are linked to Code Section 403(b) annuities, Code Section 457(b) eligible plans, and certain foreign broad-based plans. Thus, it will not be a violation of Code Section 409A to make or commence payments under a nonqualified plan on or before December 31, 2007, based on a payment election made under a qualified plan.
Extension of Amendment for 2005 Extended Deferral Period
Notice 2005-1 provided a one-time extended deferral election period until March 15, 2005 for compensation that was otherwise payable in 2005. Notice 2006-79 provides that although plan amendments to allow for such extended deferral period were to have been made by December 31, 2005, Treasury is extending the time period for such amendments until December 31, 2007 to enable compliance.

Year-End Reminders Under Code Section 409A
We wanted to remind you briefly of several actions that employers and employees may either need or wish to take before the end of this year (December 31, 2006): 

• Comply in operation with Code Section 409A. Employers have been required to operate covered plans and arrangements in good faith compliance with Code Section 409A since January 1, 2005. Employers must continue to operate plans in good faith compliance with Code Section 409A throughout the transition relief period in 2007. 
• Make or cease deferrals for calendar year 2007. As noted above, all plans subject to Code Section 409A must comply in operation with Code Section 409A. This means that any elections to defer any compensation to be received for services performed in 2007 must be made by December 31, 2006. Likewise, any election to revoke an evergreen election for compensation related to services performed in 2007 must be made by December 31, 2006. If evergreen elections are to be made, care should be taken to ensure that they meet the special requirements for such elections. Compensation that meets the "bonus plan" exception may be eligible for an extended deferral period. 
• To the extent desired, defer payments to be made in 2007 or bring into 2007 payments to be made at a later time. Notice 2006-79 prohibits, during 2007, (1) payments that are to be made in 2007 from being deferred to a later date and (2) payments that are to be made in later years from being accelerated into 2007. Therefore, if employers or employees wish to utilize the transition guidance to have payments made in 2007 that are currently to be made in later years, or to defer until a later year payments that are currently scheduled to be made in 2007, such elections must be made by December 31, 2006. Care should be taken to ensure that, even with the use of the transition rules, constructive receipt doctrines will not cause unintended taxation of these amounts. 
• Bring certain discounted stock rights into compliance if backdated. As noted above, certain stock rights—specifically backdated stock rights for Section 16 individuals of publicly-traded companies that have or reasonably expect to report a financial expense because the discounted stock rights were not timely reported on financial statements or reports for the period in which the expense should have been reported—are not given extended transition relief through December 31, 2007. Rather, these stock rights must be brought into compliance with Code Section 409A through one of the permissible methods by December 31, 2006 to avoid sanctions. 
• Watch for transition guidance for reporting and withholding requirements. Code Section 409A requires yearly reporting of deferrals and earnings as well as reporting and withholding when a Code Section 409A violation occurs. While these requirements were suspended in 2005, Treasury has not suspended them in 2006. Treasury officials have indicated that they will provide guidance before the end of the year with respect to reporting and withholding of amounts that are included in income as a result of a Code Section 409A violation. Treasury officials have not indicated whether they will issue guidance before the end of the year with respect to reporting of deferred amounts that are not currently includible in income.

1  Enacted in 2004, Code Section 409A generally provides that unless certain requirements are met, amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income. Such amounts are also subject to interest and a 20% tax penalty.