MINTZ LEVIN DEFERRED COMPENSATION ADVISORY SERIES
ISSUE NO. 1

NEWS FLASH:
IRS Issues Deferred Compensation Proposed Regulation Under Internal Revenue Code §409A

The American Jobs Creation Act of 2004 substantially overhauled many of the rules governing deferred compensation arrangements by establishing §409A of the Internal Revenue Code (“§409A”). In addition to regulating more traditional deferred compensation plans, the new rules cover many arrangements that were not previously thought of as deferred compensation (e.g., severance arrangements, discounted stock options and stock appreciation rights). Issued in December 2004, Notice 2005-1 clarified some of §409A’s requirements and also furnished generous transition rules. Most recently, on September 29, 2005, the IRS and Treasury issued much anticipated additional guidance under §409A in the form of a proposed regulation (which, for purposes of this advisory, is referred to as the “Proposed Rule”).

On September 30, 2005, Dan Hogans, an Attorney-Advisor at the U.S Department of the Treasury, and one of the key drafters of the Proposed Rule, made a presentation to the New England Employee Benefits Council. It was a matter of coincidence that this was his first public appearance following the issuance of the Proposed Rule, and he was able to provide some useful insights into the details of the Proposed Rule, particularly as they relate to the transition rules described below.

The Proposed Rule is far too voluminous to address in a single client advisory. Therefore, in the coming weeks we will address several features of the Proposed Rule and §409A, topic by topic, in the Mintz Levin Deferred Compensation Advisory Series, of which this is the first issue. The series is designed to provide our clients and friends with analysis and insight into the Proposed Rule and §409A. We also plan to schedule client briefings at several of the Firm’s offices.

This advisory summarizes key transition rules of both Notice 2005-1 and the Proposed Rule. Importantly, while many of the Notice 2005-1 transition rules that were scheduled to sunset on December 31, 2005 have been extended to December 31, 2006, certain transition elections must still be made before January 1, 2006. As a result, plan sponsors and their advisors cannot simply put compliance off until next year, as there are items that must be addressed in the next few months.

Effect of Proposed Rule
The Proposed Rule is a proposed Treasury regulation, which does not yet have the force and effect of law. Nonetheless, Mr. Hogans emphasized that the IRS and Treasury have invested a great deal of time and effort into the formulation of the Proposed Rule. In his view, the Proposed Rule closely approximates what the final rules are likely to look like. Hogans also noted that we are entitled to rely on these rules immediately, despite the fact that they are only proposed, and that compliance with the Proposed Rule will be tantamount to “good faith” compliance with §409A, the importance of which is explained more fully below. While he did not say so explicitly, the strong implication was that employers and practitioners ignore the Proposed Rule at their peril.

Cancellation of Deferrals and Termination of Plan Participation
Notice 2005-1, Q&A 20 permits a plan to be amended to provide a participant the right to terminate plan participation or to cancel outstanding deferral elections during 2005. This transition rule also extends to the exercise of a stock option or stock appreciation right (SAR) that provides for the deferral of compensation (e.g., a stock option that is granted at a discount to fair market value or that has a post-exercise deferral feature.) The Proposed Rule does not extend this transition rule.

ACTION Participants have until December 31, 2005 to terminate their participation in a plan or cancel their outstanding deferral elections under a plan without being required to follow the requirements and restrictions of the new rules.

Termination of Grandfathered Plans
Under Notice 2005-1, Q&A 18(c), the termination of a grandfathered plan and the distribution of benefits is not treated as a material modification. This rule was not extended until the end of 2006.

ACTION Any plan sponsor who wants to terminate a plan and make distributions upon termination must terminate the plan and make distributions by December 31, 2005.

Good Faith Compliance
Under Notice 2005-1, a plan that was adopted on or before December 31, 2005 will not be treated as violating Code §409A if it is operated in good faith compliance with the provisions §409A and Notice 2005-1 during calendar year 2005, and if the plan is amended on or before December 31, 2005 to conform to the requirements of Code §409A. The Proposed Rule extends the good faith compliance period and the date by which conforming amendments must be adopted to December 31, 2006. (Under the Proposed Rule, deferred compensation plans must be in, or be reduced to, writing by the end of 2006 in order to comply with §409A.)

Plan sponsors should also make certain that deferral elections with respect to 2006 compensation (other than performance-based compensation, which is subject to different rules) are made before the end of 2005. Failure to have proper deferral elections in place for compensation earned in 2006 by December 31, 2005 will result in a clear violation of the good faith compliance standard and trigger adverse tax consequences for participants in the form of a 20% excise tax and possible interest penalties.

ACTION Even though plan documents do not need to be amended until December 31, 2006, plan sponsors are required to operate their plans in good faith compliance with the new rules immediately.

While the Proposed Rule is not binding, Code §409A and Notice 2005-1 are now in force and effect. Plan sponsors should take action before the end of this year, particularly with respect to determining whether or not a plan should be terminated, canceling outstanding elections and making 2006 elections. The last quarter of 2005 is upon us, and these are issues that in many instances will require the attention of a plan sponsor’s senior management and even their boards of directors. Lead time is, therefore, essential. Our next advisory will address the transition rules under the Proposed Rule in greater detail and their impact on deferred compensation plan sponsors and participants.

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If you have any questions concerning the topics discussed in this advisory or any other employee benefits topic, please contact
Alden Bianchi (617.348.3057), Thomas Greene (617.348.1886), Charles Grace (617.348.1685), or your primary
contact with the Firm who can direct you to the right person.
We would be delighted to work with you.

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