The Internal Revenue Service (IRS) issued proposed regulations that clarify or modify specific provisions of the final regulations under Internal Revenue Code (“Code”) Section 409A. Although the proposed regulations do not become effective until finalized, taxpayers may rely on them immediately.

Code Section 409A governs whether amounts deferred under a nonqualified deferred compensation plan (NQDC Plan) are taxable. Generally, deferred compensation exists under Code Section 409A when a service provider (i.e., an employee) has a legally binding right to a payment in one tax year, but the payment is or may be made by the service recipient (i.e., the employer) in a later tax year. Amounts deferred are includible into income at the time of deferral to the extent that they are not subject to a substantial risk of forfeiture (i.e., conditioned upon the future performance of substantial services). However, if the NQDC Plan meets, and is operated in accordance with, the distribution, acceleration of benefit, and election requirements under Code Section 409A, amounts deferred are taxable to the taxpayer upon distribution from the NQDC Plan or when the risk of forfeiture lapses, if earlier.

Below is a summary of the key proposed clarifications and modifications to the existing regulations that resonate most with our clients in the design and implementation of their NQDC Plans:

• The rules under Code Section 409A apply to NQDC Plans separately and in addition to the rules under Code Section 457A. Code Section 457A generally provides that any compensation that is deferred under a NQDC Plan of a nonqualified entity, defined as certain foreign corporations and partnerships, is includible in gross income when there is no substantial risk of forfeiture of the rights to such compensation. This clarification aligns the tax treatment of NQDC Plans under Code Section 457A to that of NQDC Plans under Code Section 457(f). Under a 457(f) plan of a tax-exempt employer, benefits are subject to income tax when the participant’s right to benefits are no longer no longer subject to a substantial risk of forfeiture.

• The short-term deferral exception under the regulations is modified to permit a delay in payments for the purpose of avoiding a violation of federal securities laws or other applicable law; provided that the payment is made as soon as reasonably practicable following the first date that the service recipient anticipates or reasonably should anticipate that making the payment would not cause a violation.

• A stock right that does not otherwise provide for a deferral of compensation will not be treated as providing for a deferral of compensation solely because the amount payable under the stock right upon an involuntary separation from service for cause, or the occurrence of a condition within the service provider’s control, is based on a measure that is less than fair market value. This modification is intended to permit service recipients to reduce compensation payable upon a separation from service for cause or, for example, violation of a covenant not to compete or of a non-disclosure agreement.

• The definition of “eligible issuer of service recipient stock” includes an entity for which a person is expected to, and actually does, begin providing services within 12 months after the grant date of a stock right. Under the 2007 Regulations, only the corporation for which the recipient is providing direct services on the date of grant, or any corporation in a chain of a controlled group of corporations (beginning with the parent and ending with the corporation that is receiving services from the recipient), could issue stock rights. Because this could restrict employers from granting stock rights during employment negotiations, the proposed regulations provide that service recipients may grant stock rights as an inducement to potential service providers; for example, during the employment negotiations process. However, companies considering such grants should first confirm that the grants are permitted by the applicable equity plan. In addition, whenever a company is contemplating the granting of stock rights to a prospective service provider, the company should consider any securities law and/or accounting issues that would result.

• When applying the separation pay plan exception to service providers whose employment begins and ends in the same taxable year, the service provider’s annualized compensation for the taxable year in which the service provider experiences a separation from service may be used for purposes of the separation pay plan exemption.

• A service provider that is terminated and begins performing services as an independent contractor incurs a separation from service if, at such time, the level of services reasonably anticipated to be provided would result in a separation from service under the rules applicable to employees.

• Acceleration of a payment under the plan termination and liquidation rules is permitted only if the service recipient terminates all plans of the same category and does not adopt a new plan of the same category as the terminated plan for the next three years.

• A service provider can be an entity as well as an individual.