Last fall Congress enacted section 409A, which added substantial new restrictions on the use of nonqualified deferred compensation arrangements. In December the IRS issued Notice 2005-1, which provided the first round of guidance under section 409A. The guidance provided in Notice 2005-1 dealt primarily with a number of limited issues such as providing information about how to determine amounts grandfathered (i.e., amounts accrued and vested as of December 31, 2004), certain definitional rules and certain transitional relief for 2005. As set forth in Notice 2005-1, the full effective date of section 409A is January 1, 2006.

Since then the IRS has been working on the second round of guidance under section 409A. This guidance would make permanent some of the temporary rules in Notice 2005-1, as well as provide additional guidance -- particularly guidance that is needed in order to draft or revise plans to bring them into compliance with section 409A by the full effective date of these new rules. AALU has submitted extensive comments to the IRS with respect to this guidance and, together with ACLI and NAIFA, met with the government officials to discuss potential relief for split-dollar life insurance plans.

The working group at the IRS and the Treasury Department that has been dealing with section 409A has completed the initial drafting of the second round of guidance. That package of guidance is being circulated within the government for approval. Notwithstanding that the initial drafting has been completed, it is unlikely that the guidance will be issued before August and, depending on how fast the approval process takes, it may be issued as late as September. Unlike the first round of guidance, which was issued in the form of a notice, this guidance is likely to be mostly, if not entirely, in the form of regulations, some of which may be proposed and some of which may be temporary.

Final decisions on exactly what form the guidance will take have not yet been made. As drafted, however, the guidance is extensive and much longer than the guidance provided in Notice 2005-1, running well in excess of 100 pages.

While final decisions have not been made and some or all of the guidance may be revised over the course of the summer, it appears that it is at least in some ways likely to contain features that will be favorably viewed once the regulations are issued. At this point there is a good chance that the guidance will include the following favorable developments:

1. The 2 1/2 month, short-term deferral rule is likely to remain in the guidance and be a permanent part of the rules; that is, amounts that are paid out within 2½ months after the end of the calendar year in which they vest will not be considered deferred compensation and will not be subject to 409A.
2. A special exception may be included for broad-based severance plans. This exception could provide that these plans are not deemed to be subject to 409A. The exception probably will be limited to finesse the possibility that employers will set up executive deferred compensation plans and try to put them in a classification of broad-based severance plans to avoid the application of 409A.
3. The full effective date of these rules is likely to be postponed, at least in part due to the efforts of AALU and its counsel. This postponement or some portion thereof may be for as much as a year. Because the regulations almost certainly will not be issued until the latter half of this year, it appears that the IRS has recognized that employers will not have enough time to consider these changes and properly revise their plans, receive elections and take all the other steps necessary to be in full compliance by January 1, 2006. As a consequence, it is likely that there will be some deferral in the effective date with possibly different parts of the 409A requirements becoming effective at different times. For example, there might be relief into 2006 for making elections but plans might have to be drafted in full compliance by as late as possibly the next calendar year, i.e., January 1, 2007. Alternatively, the effective date might provide for a true-up provision that would require plans to be in compliance with the new rules earlier than January 1, 2007 but provide some transition relief under which certain adjustments or corrections could be made as long as all those corrections were made by the end of 2006.
4. Under Notice 2005-1, stock appreciation rights can be continued but generally only for publicly traded companies. This rule is likely to be extended to privately held companies as well as publicly traded companies.
5. There has been considerable uncertainty about how the redeferral rule in 409A would work. For example, if an amount that has been deferred to a fixed date, is, in accordance with the requirements of section 409A, redeferred for a five-year period, then the question that has been under consideration for some time is whether other deferred amounts also have to be redeferred for five years. Some government officials in the past have suggested, for example, that the redeferral might require the redeferral of all deferred compensation amounts for five years or, alternatively, when amounts are being paid in installments or as annuities the whole integrated package of deferred amounts might have to be redeferred for the five years. A number of other uncertainties regarding how this rule will work have also been debated. It appears now, however, that the rule will generally allow redeferrals of single deferral amounts without having to redefer entire groups of deferrals for the five-year period. For example, if an executive has a $10,000 deferral due in 2008, in 2006 the individual could redefer that amount until 2013 without having to also defer amounts that would be due in other years as well.

This second round of guidance will not deal with all of the issues under section 409A. It is expected that this guidance will not include issues such as the calculation of the penalties and measurement of the amounts deferred for penalty purposes. The guidance probably also will not include the "funding" rules in 409A (b). Those "funding" rules apply currently to property in an off-shore trust and to payment triggers that are based on the employer's financial health. At least partially because Congress may pass a technical correction bill dealing with the off-shore trust issue, it appears likely that the second round of guidance will not cover these subjects directly.

The third round of guidance is, however, being internally targeted for release before the end of the year. As a consequence, if the second round of guidance is issued in August or September, the third round can probably reasonably be expected by December, at least under the currently contemplated timelines.

Source: AALU Bulletin 05-70