AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on
Proposed Regulations on Nonqualified Deferred Compensation Plans
Under Section 409A (REG-158080-04)
Section 409A Proposed Regulations Working Group
G. Edgar Adkins, Jr.
Gary Q. Cvach
Mark Knipp
Susan K. Kobrin
David K. Morgan
Douglas F. Newman
Thomas Von Riesen
Stephen R. Sutten
Anne Waidmann
Deborah Walker
Ruth Wimer
Lisa Winton, AICPA Technical Manager
February 16, 2006
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
Comments on
Proposed Regulations on Nonqualified Deferred Compensation Plans
Under Section 409A (REG-158080-04)
The AICPA commends Treasury and the Internal Revenue Service (“IRS”) for providing
generally clear and comprehensible guidance in the proposed regulations under section 409A.
Given this particularly complex statute, we recognize what a challenge it is to draft plainlanguage regulations. We encourage Treasury and the IRS to continue your efforts to make these
regulations as understandable as possible. We also encourage you to add a table of contents to
assist users of these regulations in finding specific provisions.
Our comments below appear in the same general order as the related provisions in the proposed
regulations.
DEFINITION OF COMPENSATORY TIME
Proposed reg. section 1.409A-1(a)(5) excludes from the term “nonqualified deferred
compensation plan” any bona fide vacation leave, sick leave, compensatory time, disability pay,
or death benefit plan. Taxpayers may interpret the term “compensatory time” very broadly,
perhaps in a manner inconsistent with the legislative intent of section 409A. Thus, we request
that the final regulations contain further guidance as to the meaning of compensatory time.
Examples would be particularly helpful.
DEFINITION OF LEGALLY BINDING RIGHT
Proposed reg. section 1.409A-1(b)(1) states that a plan provides for the deferral of compensation
if the service provider has a legally binding right during a taxable year to compensation that has
not been actually or constructively received and included in gross income, and that is payable to
the service provider in a later year. The proposed regulations do not directly define the term
“legally binding right.” Instead, the proposed regulations describe circumstances under which a
legally binding right does not exist (i.e., compensation that may be reduced unilaterally or
eliminated by the service recipient).
Given the fact that the term “legally binding right” is of paramount importance to the
determination of whether deferred compensation exists, we recommend that the final regulations
include a specific definition of the term.
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STOCK OPTIONS, STOCK APPRECIATION RIGHTS AND OTHER EQUITY-BASED
COMPENSATION
Incentive stock options are exempt from section 409A. The proposed regulations provide that
nonstatutory stock options and stock appreciation rights (referred to in the regulations as “stock
rights”) are generally subject to section 409A, unless certain conditions are met. Specifically,
stock rights are not subject to section 409A if all of the following requirements are met:

The exercise price can never be less than the fair market value of the stock as of the grant
date,

The number of shares subject to the stock right is fixed on the grant date,

The stock right has no other feature that defers compensation, and

The underlying stock is “service recipient stock” (discussed below).
If a stock right does not meet these requirements, it is subject to section 409A. One of the major
practical impacts of section 409A on stock rights is that the service recipient or service provider
must choose an exercise date or event at the grant date, and this choice must be restricted to
separation from service, disability, death, a fixed payment date, a change in control, or an
unforeseeable emergency.
The proposed regulations do not directly address the practical impact of section 409A on stock
rights that are subject to the requirements of section 409A. We request that the final regulations
provide guidance on this matter. For example, it would be helpful for the regulations to provide
guidance related to the application of a fixed payment date under section 409A(a)(2)(A)(iv) to
stock rights. We believe that the service provider should be able to exercise the option upon
reaching the fixed payment date, or let the option lapse at that time without exercise. This
flexibility to let the option lapse without exercise is particularly important for private companies,
given the illiquid nature of private company stock. In our view, the exercise of an option on
private company stock typically is attractive only when there is an impending “liquidity event,”
such as an initial public offering or a sale of the company.
DEFINITION OF SERVICE RECIPIENT STOCK
As noted above, stock rights must be on “service recipient stock” in order to be exempt from
section 409A. Proposed reg. section 1.409A-1(b)(5)(iii) sets forth provisions for determining
whether a stock right is for service recipient stock. Service recipient stock is “stock that, as of
the date of grant, is common stock of a corporation that is a service recipient (including any
member of a group of corporations or other entities treated as a single service recipient) that is
readily tradable on an established securities market, or if none, that class of common stock of
such corporation having the greatest aggregate value of common stock issued and outstanding of
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such corporation, or common stock with substantially similar rights to stock of such class
(disregarding any difference in voting rights).”
Identification of service recipient stock in a group of corporations or other entities treated as a
single service recipient
Although we feel that the provision referred to above lacks sufficient clarity, it is our
interpretation that Treasury and the IRS may have intended for service recipient stock to be
identified on an overall related group basis. As a result, a particular entity within a related group
might have no stock of that entity that qualifies as service recipient stock, such as a private
company that is in a related group with a public company (i.e., only the public company’s stock
qualifies as service recipient stock). In this case, the entity would not be able to issue stock
rights on its own stock without those rights being subject to section 409A. We believe that the
entity should be able to issue stock rights on its own stock to its service providers without that
act alone causing the stock rights to be subject to section 409A. We do not believe that it is the
intent of section 409A to discourage entities from issuing stock rights on their own stock.
We believe that in identifying the service recipient stock of a particular entity within a related
group of entities, taxpayers should be able to apply the criteria set forth in the regulations not
only on an overall related group basis, as currently provided by the regulations, but also
separately with respect to each entity in the related group. Specifically, we request that the
definition of service recipient stock for a particular entity be expanded to include the following
stock:

Stock of that particular entity that is readily tradable on an established securities market,
or if none:

The class of common stock of that particular entity having the greatest aggregate
value; or

Common stock of that particular entity with substantially similar rights to the stock
having the greatest aggregate value.
We also believe that once an entity has identified its service recipient stock as defined directly
above, any other entity in a related group should be able to issue stock rights on that stock
without causing the stock rights to be subject to section 409A. For example, suppose a group
consists of two private companies, where one company is the parent and the other company is a
subsidiary. Using the criteria above, the parent company would identify its service recipient
stock on a stand-alone basis. We believe the subsidiary should then be able to issue stock rights
on the parent company’s service recipient stock, as well as on the subsidiary’s own service
recipient stock. In addition, the parent company should be able to issue stock rights on the
subsidiary company’s service recipient stock, as well as on its own service recipient stock.
We appreciate Treasury and the IRS’s efforts to define service recipient stock in a manner that
curbs the potential abuse associated with using stock rights to circumvent the intent of section
409A. However, we believe that restricting the definition of service recipient stock to common
stock that is readily tradable on an established securities market or common stock that has the
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greatest aggregate value of all common stock (including stock with similar rights) is sufficient to
curb the potential abuse. We do not believe it is necessary to curtail the ability of entities to
issue stock rights on their own stock or on that of other entities in a related group, as currently
may be the intent of the proposed regulations.
DETERMINATION OF THE FAIR MARKET VALUE OF SERVICE RECIPIENT
STOCK
Request for valuation corridor
Proposed reg. section 1.409A-1(b)(5)(iv) sets forth provisions for the determination of the fair
market value of service recipient stock. These provisions are of paramount importance in the
determination of whether a stock right is subject to section 409A, given the requirement in prop.
reg. section 1.409A-1(b)(5)(i)(A)(1) that a stock option’s exercise price may never be less than
the fair market value of the underlying stock on the date the option is granted, and the
requirement in prop. reg. section 1.409A-1(b)(5)(i)(B)(1) that compensation payable under a
stock appreciation right cannot be greater than the difference between the fair market value of
the stock on the date of grant and the fair market value of the stock on the date the stock
appreciation right is exercised.
With respect to the valuation of private company stock, prop. reg. section 1.409A-1(b)(iv)(B)(1)
provides that fair market value means a value determined by the reasonable application of a
reasonable valuation method. The regulations set forth factors to be considered under a
reasonable valuation method. Proposed reg. section 1.409A-1(b)(iv)(B)(2) further sets forth
three valuation methods that are presumed to result in a reasonable valuation; the Commissioner
may rebut this presumption only upon a showing that the valuation method was grossly
unreasonable.
For various reasons, some private companies may not use any of the three valuation methods
referenced above that are presumed to yield a reasonable valuation. In this case, the companies
will need to use a “value determined by the reasonable application of a reasonable valuation
method,” as mentioned above. It is our interpretation that when this method is used, the burden
of proof is on the taxpayer to show that the fair market value so determined is accurate. Given
the difficulties of valuing private company stock, we request that the final regulations provide
that whenever a reasonable valuation methodology is applied, the valuation under such
methodology will be acceptable as the fair market value for section 409A purposes as long as it
falls within a stated corridor (e.g., ten percent) below any value that may later be determined by
the Commissioner as the fair market value.
Formula valuation
Proposed reg. section 1.409A-1(b)(iv)(B)(2)(ii) provides for the valuation of service recipient
stock based upon a formula. Such a valuation is presumed to be reasonable, provided that the
Commissioner may rebut such a presumption upon a showing that either the valuation method or
the application of such method was grossly unreasonable. One of the criteria for the use of the
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formula valuation is that the formula is used to value the stock for all noncompensatory
purposes, “including regulatory filings, loan covenants, issuances to and repurchase of stock
from persons other than service providers, and other third-party arrangements.” We seek
clarification that the formula valuation may be used, even though the company can be sold to an
independent third party, in whole or in part, at a price other than the formula value. If the use of
this valuation method requires that the formula be used even upon the sale of the company, then
we believe that the formula valuation approach would rarely be a desirable alternative for the
valuation of stock for purposes of section 409A.
MODIFICATIONS,
EXTENSIONS,
ASSUMPTIONS OF STOCK RIGHTS
RENEWALS,
SUBSTITUTIONS
AND
Extensions of stock rights
Proposed reg. section 1.409A-1(b)(5)(v)(A) states that “When a stock right is extended or
renewed, the stock right is treated as having had an additional deferral feature from the date of
grant.” We request clarification as to whether this means that any nonstatutory option that is
extended or renewed is subject to section 409A on a retroactive basis. In other words, would a
nonstatutory option that was not subject to section 409A upon grant be retroactively subject to
section 409A if extended or renewed? We also seek guidance as to situations in which the
cancellation of an outstanding stock right, followed by the grant of a new stock right, would be
treated as an extension or renewal.
Rescission of modifications to stock rights
Proposed reg. section 1.409A-1(b)(5)(v)(I) provides that a change to the terms of a stock right
that results in a modification can be rescinded in order to avoid treatment as a modification. The
deadline for doing so is the earlier of the date the stock right is exercised, or the last day of the
calendar year during which the change occurred. We recommend that additional time be
provided for the rescission of modifications that are made close to the end of the calendar year.
For example, under the proposed regulations, if a modification is made on December 31, there is
no time to rescind the modification. In contrast, if a modification is made on January 1, there is
an entire year to rescind the modification.
We recommend that a period of up to 2½ months following the modification be allowed for
rescission. Thus, the deadline to rescind a modification would be the earlier of:

The date the stock right is exercised, or

The later of

The last day of the calendar year during which the modification occurred, or

2½ months after the date of the modification.
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EXPATRIATE ARRANGEMENTS
The preamble to the proposed regulations, at Section II.F., indicates that Treasury and the IRS
intend that certain payments made to employees under a tax equalization plan be exempt from
section 409A.
Companies that send employees on expatriate assignments oftentimes cover such employees
under what is referred to as a tax equalization plan or policy. Expatriate employees covered
under these plans may be either a U.S. citizen sent on assignment to a foreign country or a nonU.S. citizen sent to work in the United States. In general, the objective of a tax equalization
policy is to put the employee in approximately the same economic position, with respect to taxes,
that the employee would have been in had the employee not been on an expatriate assignment.
As such, the employer bears the cost of any additional taxes that result from the employee’s
being on the expatriate assignment, including the tax costs associated with any additional
expatriate allowances that are paid to the employee over and above the compensation the
employee would have earned if he or she had not been on the expatriate assignment.
Payments due to employees under such plans, often referred to as tax equalization settlements,
are generally paid to the employee in a year subsequent to the year in which the services were
rendered. This is due to the necessity to have complete information to calculate the employee’s
U.S. and foreign income tax liabilities, which is generally not available until after the end of the
year. We applaud Treasury and the IRS for providing at prop. reg. section 1.409A-1(b)(8)(iii)
that these payments will not be treated as deferred compensation as long as the payments are
made by the end of the second calendar year beginning after the calendar year in which the
service provider’s U.S. Federal income tax return is required to be filed for the year to which the
tax equalization payment relates.
Although Treasury and the IRS intended to exempt tax equalization payments from section
409A, the provisions of prop. reg. section 1.409A-1(b)(8)(iii) are too narrow to encompass all of
the types of payments that a service provider commonly pays under a tax equalization program.
As currently provided in the proposed regulations, the term “tax equalization arrangement”
would cover only payments that are the result of excess taxes imposed by a foreign jurisdiction.
Under a typical tax equalization arrangement, the settlement payment in a subsequent year may
result from not only excess taxes imposed by a foreign jurisdiction, but also from excess U.S.
and/or state taxes imposed on additional compensation earned due to the expatriate assignment.
Accordingly, we suggest that the second sentence in prop. reg. section 1.409A-1(b)(8)(iii) be
modified to more closely match our understanding of Treasury and the IRS’s intent, as stated in
the preamble. For example, the second sentence could be restated as follows:
For purposes of this paragraph (b)(8)(iii), the term tax equalization arrangement refers
to an arrangement that provides payments intended to compensate the service provider
for any additional taxes actually imposed on compensation paid by the service recipient
to the service provider over the taxes that the service provider would have paid had the
service provider not been on expatriate assignment, and provided that the payments
made under such arrangement may not exceed such excess and the amount necessary to
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compensate for the additional taxes on the amounts paid under the arrangement.
SPLIT-DOLLAR LIFE INSURANCE ARRANGEMENTS
Section II.H. of the preamble to the proposed regulations states that split-dollar life insurance
arrangements treated as loans and those that provide only death benefits generally will not give
rise to deferrals of compensation under section 409A, as long as certain conditions are met.
More specifically, the preamble states that split-dollar life insurance arrangements treated as loan
arrangements under reg. section 1.7872-15 generally will not give rise to the deferral of
compensation under section 409A, provided that there is no agreement under which the service
recipient will forgive the related indebtedness, and no obligation on the part of the service
recipient to continue to make premium payments without charging the service provider a market
interest rate on the funds advanced. We seek guidance as to how section 409A is applied to an
arrangement that initially contains no provisions regarding forgiveness of indebtedness or belowmarket interest rates, but is later amended to add a provision under which the service recipient
will forgive the indebtedness, or the addition of a provision which obligates the service recipient
to continue to make premium payments without charging the service provider a market interest
rate on the funds.
Under current law, split-dollar life insurance arrangements entered into after September 17,
2003, are taxed under one of two regimes, depending on the owner of the contract. If the
employer owns the contract, any economic benefits provided to the employee are includible in
the employee’s gross income under the economic benefit regime set forth in reg. section 1.61-22.
If the employee owns the contract, the employer’s premium payments are treated as a series of
loans under the loan regime set forth in reg. section 1.7872-15. Arrangements entered into on or
before September 17, 2003 that are not materially modified after that date are subject to different
rules. In general, employees must include either the value of current life insurance protection in
gross income (but may use Table 2001 premium rates to determine this amount), or treat
premium payments as loans.
We request that future guidance clearly state whether section 409A applies to arrangements
entered into on or before September 17, 2003 which have taken advantage of and comply with
the transition rules in Notice 2002-8, Section IV, Paragraphs 2 or 3. We also request that future
guidance clearly state whether section 409A applies to split-dollar life insurance arrangements
entered into after September 17, 2003. In addition, for arrangements entered into after
September 17, 2003, that are taxed under the economic benefit regime, it would be helpful for
future guidance to note that benefits will be taxed when available or no longer subject to a
substantial risk of forfeiture; thus, these arrangements could utilize the short-term deferral
exception under prop. reg. section 1.409A-1(b)(4) or the transfer of restricted property exception
under prop. reg. section 1.409A-1(b)(6).
The preamble notes that if the employer is the owner of the policy, a deferral of compensation
under section 409A may arise, because the employee may obtain a legally binding right to
compensation includible in income in a taxable year after the year in which a substantial risk of
forfeiture (if any) lapses. Section 409A appears to apply only to arrangements entered into on or
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before September 17, 2003, that did not take advantage of the grandfather rule. This is the case
if:

Arrangements entered into after September 17, 2003, are consistently treated as loans and,
therefore, not subject to the nonqualified deferred compensation rules under section 409A, or
are taxed under the economic benefit regime and, thus, exempted under the short-term
deferral or restricted property exceptions under prop. reg. sections 1.409A-1(b)(4) or 1.409A1(b)(6); and

Those arrangements using the grandfather provisions provided in Notice 2002-8, Section IV,
Paragraphs 2 or 3 are exempted as either loan or death benefit arrangements.
Under Revenue Rulings 64-328 and 66-110, which generally apply to such arrangements, the
owner of the arrangement is immaterial to the tax result. We believe that the taxation of these
amounts should be made clear by providing an example.
The following example illustrates these points.
In Year 1, an employee entered into an equity split-dollar arrangement under which the
employer pays premiums and the employee is required to pay the employer the lesser of
the premiums or the cash surrender value upon termination of employment. All other
amounts are payable to the employee. As the value of the arrangement increases beyond
the amount payable to the employer, the employee has compensation income. If the
employee includes the value of the arrangement in income when it is no longer subject to
a substantial risk of forfeiture, the employee meets the short-term deferral and restricted
property exceptions under prop. reg. sections 1.409A-1(b)(4) and 1.409A-1(b)(6). If the
employee does not recognize income within the short-term deferral period, this gives rise
to nonqualified deferred compensation subject to section 409A. This is true whether the
employee owns the arrangement directly or transfers it to a life insurance trust. In
contrast, if the employer were to make premium payments that were included in the
employee’s gross income in Year 1, these amounts would not be nonqualified deferred
compensation under section 409A.
The preamble requests comments as to the scope of changes that may be necessary to comply
with, or avoid application of, section 409A, and under what conditions those changes should not
be treated as material modifications under reg. section 1.61-22(j)(2). In general, we believe that
Treasury and the IRS should provide specific guidance concerning split-dollar life insurance
arrangements entered into on or before September 17, 2003, irrespective of whether the
grandfather rules of Notice 2002-8 apply, and those entered into after September 17, 2003. In
particular, we believe the final regulations under section 409A should provide that any material
modification of a split-dollar life insurance arrangement that is made with a good faith intention
of bringing the plan into compliance with, or avoiding application of, section 409A will not be
treated as a material modification under reg. section 1.61-22(j)(2).
While the preamble to the proposed regulations discusses split-dollar life insurance
arrangements, there are no specific provisions in the proposed regulations. We request that
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future guidance incorporate specific provisions regarding whether such arrangements are subject
to section 409A.
WRITTEN PLAN REQUIREMENT
The statutory language of section 409A does not provide that a nonqualified deferred
compensation plan must be in writing. However, certain provisions are required to be included
in a plan in order for the plan to comply with Section 409A. Thus, we agree with the position
stated at prop. reg. section 1.409A-1(c)(3) that a plan must be in writing.
Request for list of required written terms
The proposed regulations address the specific statutory provisions that require written
documentation. These various provisions are not all addressed in one place within the proposed
regulations, resulting in some confusion on the part of taxpayers regarding the plan terms that are
required to be written. We recommend that the regulations provide a list of the required written
terms in order to alleviate the existing confusion, and to make it easier for taxpayers to comply
with the written plan requirement.
Deferral elections
Deferrals of compensation are typically made through a service provider’s written election to
defer a set amount of compensation, pursuant to the terms contained within an underlying written
plan document. Taken together, the written plan document and the written election form contain
the required plan provisions (e.g., permitted distribution dates for the deferral). Given the
interplay between the written plan and the service provider’s written deferral election, we
recommend that Treasury and the IRS provide guidance to the effect that the required written
terms of a nonqualified deferred compensation plan may be contained within either the written
plan document or the service provider’s election form, and that these two documents will be read
together in interpreting the plan’s written terms.
Request for model plan amendments
The preamble to the proposed regulations provides, at Section XI.B., that the deadline by which
plan documents must be amended to comply with the provisions of section 409A and the
regulations is December 31, 2006. We request that Treasury and the IRS publish model plan
amendments that may be used as a guide for the amendments to bring nonqualified deferred
compensation plans into compliance with section 409A. These model amendments could also be
used on an ongoing basis as a guide to preparing written plan terms. We believe that the
publication of model amendments would be a worthwhile effort because the model amendments
would help to facilitate taxpayers’ compliance with section 409A.
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Request for extension of plan amendment deadline
We also request that the deadline by which plan documents must be amended to comply with the
provisions of section 409A and the regulations be extended to December 31 of the calendar year
following the year in which the regulations are finalized. We believe that this extension will be
necessary in order to understand and interpret the final regulations, given the complex issues
surrounding section 409A.
SEPARATION FROM SERVICE FROM PERSONAL SERVICE CORPORATIONS
Most personal service firms that are organized as corporations are unique in that they are wholly
owned by professionals providing services to those firms. Many of these firms consider
retirement to occur when a shareholder surrenders all of his or her stock in the corporation.
Although some firms structure the retirement of their shareholders as a redemption of the stock
of the shareholder, resulting in a capital transaction to the shareholder, other firms provide a
stream of payments in the form of ordinary income payments to the individual, upon surrender of
his or her stock, for some period of time (hereinafter referred to as “surrender payments”). This
is somewhat analogous to the treatment of retiring partners pursuant to either section 736(b) or
section 736(a), respectively. These firms may also have more traditional arrangements that
represent a deferral of current compensation; our comments are not directed toward such
arrangements.
It is a common practice for many of these professionals to continue to provide services to the
firm in which they formerly held an equity interest, during the period that they are receiving
surrender payments. Section 409A(a)(2)(A) provides that payments under a nonqualified
deferred compensation plan may be made upon separation from service, or upon certain other
specified events or times. Pursuant to section 409A(a)(3), the payment of deferred compensation
may not be accelerated, except as provided in regulations by the Secretary. The continuing
services of the former shareholders described above may be so significant that, based on the
thresholds set forth in prop. reg. section 1.409A-1(h), a separation from service would not be
deemed to have occurred. The proposed regulations do not contain any exception from the antiacceleration rule for surrender payments. As a result, these surrender payments may not be
permitted under the proposed regulations, unless one of the other permissible distribution events
under section 409A(a)(2)(A) has occurred.
The legislative history suggests that Congress believed that nonqualified deferred compensation
arrangements were subject to abuse by permitting participants to receive distributions upon
request, suffering only minimal forfeitures (i.e., haircut provisions). In citing abuses reported by
the staff of the Joint Committee on Taxation in the report on their investigation of Enron
Corporation, it appears that the concern of abuse was heightened in large corporations where
shareholders had little practical control over manipulations of the deferred compensation plans.
Small, closely-held personal service corporations, however, are significantly different from
these, and other, corporations. The surrender payment agreements are fully disclosed between
the corporation and each of the shareholders. Further, we feel that these arrangements do not
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represent an abuse of constructive receipt, since the deferred compensation payments can be
received only upon the surrender of the equity of the shareholder/professional, and the payment
terms are objectively stated so that there is no ability to control the stream of payments upon
surrender of the shares. The surrender of equity in a personal service firm is a significant event
in the life of a professional that results in major, bona fide differences in the relationship between
the firm and the individual. It is not a step taken lightly.
Section 409A(a)(2)(A)(i) explicitly gives the Secretary the authority to define separation from
service. It appears that Congress clearly understood that there would be certain circumstances
where a general definition of separation from service would not adequately serve the purpose of
section 409A. We request that the Secretary exercise his authority by providing in regulations
that the redemption of all of the equity of a shareholder/professional employee in a closely-held
personal service corporation with less than a specified number of shareholders (e.g., 100 or fewer
shareholders) be considered to be a “separation from service” for compensation received as a
result of the redemption, where the compensation is based solely upon the shareholder’s equity
percentage of the value of the goodwill of the entity, as determined by prior agreement of the
entity and the redeeming shareholder/professional employee. We believe that the payment of
what may be considered goodwill to the equity holders whose personal efforts created that
goodwill upon the surrender of their equity interests is a significant and unique event that should
be considered to be a separation of service with regard to surrender payments for purposes of
section 409A.
We believe that another alternative to permit the surrender payments described above is for the
Secretary to use his regulatory authority under section 409A(a)(3) to provide in regulations that
commencement of payments of compensation pursuant to the terms of a shareholder agreement
upon the redemption of all of the equity of a shareholder/professional employee in a closely-held
personal service corporation is not a prohibited acceleration of payments under section 409A,
and may be made without violating the requirements of section 409A.
CLARIFICATION OF WHEN A CONTRACTUAL REQUIREMENT IS SIMILAR TO A
LOAN COVENANT
Proposed reg. section 1.409A-2(b)(5) contains provisions that permit the delay of payments of
nonqualified deferred compensation under certain circumstances. One of these circumstances is
a payment that the service recipient reasonably anticipates will violate a loan covenant or similar
contractual requirement to which the service recipient is a party, and the violation will cause
material harm to the service recipient. The compensation arrangement must provide that the
payment will be made at the earliest date at which the service recipient reasonably anticipates
that the making of the payment will not cause a violation or material harm to the service
recipient. Further, the facts and circumstances must indicate that the service recipient entered
into the loan agreement or other similar contract for legitimate business reasons, and not to avoid
the requirements of section 409A.
We appreciate the position taken by Treasury and the IRS that under certain circumstances, a
delay of payments is justifiable. We seek clarification regarding certain aspects of these
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provisions.
First, we request that the regulations clarify whether the loan agreement must be with an
unrelated third party, or whether the provisions to delay payment may be applied to agreements
between the service recipient and related parties, including the service provider. We believe that
the provisions should apply to loan agreements between the service recipient and related parties,
as long as the agreement was entered into for legitimate business reasons, and not to avoid the
requirements of section 409A.
We also seek clarification as to when a contractual requirement is similar to a loan covenant. It
is unclear as to whether a similar contractual requirement must relate to an agreement that is in
the nature of a loan, or whether any contractual requirement that places restrictions on cash
payments by the service recipient may serve to delay the payment of nonqualified deferred
compensation. We believe that there are several instances in which contracts between the
service recipient and another party (including the service provider) contain provisions that permit
a delay in payment for sound economic reasons.
For example, a provision for a delay in payment for economic reasons is often incorporated into
a deferred compensation arrangement maintained by a professional service firm. The currently
employed professionals in such a firm want assurances that they are not merely working for the
benefit of the retired professionals, yet the retired professionals want restrictions on any delays
so that their deferred compensation is not unreasonably withheld by the currently employed
professionals. Given the divergence in interests between the service recipients (the owners and
currently employed professionals) and the service providers (the retired professionals), we
believe that the objectives of section 409A are not avoided where bona fide, objective economic
triggers providing for delays in deferred compensation payments that would cause material harm
to the service recipient are contained in such deferred compensation arrangements, as long as the
delays cease at the earliest date at which the triggers suggest that material harm will no longer
impact the service recipient.
We request that the provisions that allow for the delay in payments that would violate a loan
covenant be expanded to include other contractual requirements that limit cash payments made
by the service recipient, including contracts between the service recipient and related parties.
LIMITATIONS AND DEFERRAL OF PAYMENTS TO PROTECT A SERVICE
RECIPIENT’S FINANCIAL STABILITY
Many accounting firms, law firms and other professional services firms impose a limitation on
the amount of total deferred compensation that is paid in any given year. These annual
limitations are imposed in order to ensure that deferred compensation payments to retired or
other separated professionals do not become a financial burden to the firm. Some firms provide
that when an individual’s payment is reduced in any given year due to the limitation, the amount
of the reduction is carried over and paid in a subsequent year. The payment limitation may be
defined in various ways, such as a percentage of net income.
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In addition to the overall payment limitation described above, some professional service firms
impose an offset to a retired or separated individual’s payment of deferred compensation related
to cash flow considerations that are directly related to the individual. For example, the
individual’s deferred compensation may be reduced for accounts receivable of the individual’s
former clients that remain outstanding. If the receivables are collected in a subsequent year, the
individual’s payment of deferred compensation is increased accordingly in the year of collection.
Section 409A and the proposed regulations primarily address the timing of payments rather than
the amount of payments. However, the proposed regulations do address payment amounts in the
context of payments that are made at a specified time or fixed schedule. According to prop. reg.
section 1.409A-3(g)(1), “amounts are payable at a specified time or pursuant to a fixed schedule
if objectively determinable amounts are payable at a date or dates that are objectively
determinable at the time the amount is deferred. An amount is objectively determinable for this
purpose if the amount is specifically identified or if the amount may be determined pursuant to a
nondiscretionary formula.”
We request that the provisions of prop. reg. section 1.409A-3(g)(1) described above apply not
only to payments made at a specified time or pursuant to a fixed schedule of payments, but also
to the other permissible distribution events under section 409A(a)(2)(A), such as separation from
service. We also request that the regulations provide that payment limitations, offsets and any
other factors used to determine a payment amount are permissible, as long as the timing and
amounts of the limitations, offsets and other factors are determined using an objective,
nondiscretionary formula that is set worth in the written terms of the plan.
We request guidance as to the ability to increase a payment in a subsequent year when a prior
year’s payment has been reduced due to a limitation, offset or other factor. Section
409A(a)(4)(C) places restrictions on the ability to delay the timing of payments. Specifically, an
election to delay payment may not take effect until at least twelve months after the date on which
the election is made, the payment must generally be delayed for at least five years, and the
election may not be made less than twelve months prior to the date of the first scheduled
payment. Proposed reg. section 1.409A-2(b)(5) provides that payments may be delayed under
certain circumstances, and that such delays will not constitute a subsequent deferral election
subject to the restrictions of section 409A(a)(4)(C). We request that the provisions in prop. reg.
section 1.409A-2(b)(5) be expanded to include subsequent payments of the amounts affected by
the limitations, offsets and other factors described above.
FIXED PAYMENT DATE
Proposed reg. section 1.409A-3 addresses permissible payments under section 409A. We
applaud the considerable flexibility that is provided in the regulations for designating the timing
of payments. For example, prop. reg. section 1.409A-3(b) provides that an arrangement may
provide that a payment is to be made during an objectively determinable calendar year following
the year in which the event occurs. We also applaud the flexibility afforded to the exact timing
of the payment. Specifically, prop. reg. section 1.409A-3(d) provides that a payment is treated as
made upon the date specified under the arrangement if the payment is made on the date or a later
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date within the same calendar year, or if later, by the 15th day of the third calendar month
following the date specified under the arrangement.
We seek clarification with respect to the designation of a time (or fixed schedule) specified under
the plan (prop. reg. section 1.409A-3(a)(4)). Specifically, we request clarification as to whether
it is necessary to specify an exact date (i.e., month, day, and year), or whether it is acceptable to
simply specify only the exact calendar year.
PERMITTED DISTRIBUTIONS TO SATISFY SECTION 280H
A personal service corporation (PSC), as defined in section 441(i)(2), may make an election
under section 444 to have a taxable year other than a calendar year. A PSC that makes such an
election is subject to minimum distribution requirements under section 280H(a). If the PSC fails
to comply with this requirement, its deduction for amounts paid or incurred to employee-owners
is limited.
In periods of increasing revenues, a PSC typically distributes enough money to its owners to
exceed the minimum distribution threshold, due to the fact that its owners are earning increasing
amounts of pay. In contrast, if revenues are decreasing, then amounts paid to the owners usually
decrease. This creates a situation in which the PSC may fail to satisfy the minimum distribution
requirements. As a result, income taxes must be paid on any compensation that exceeds a
maximum deductible amount, as defined in section 280H(d). This compensation is taxed at a
corporate rate of 35 percent.
Proposed reg. section 1.409A-3(h)(2) sets forth various exceptions to the prohibition in section
409A(a)(3) against accelerated payments. We request that these provisions in the regulations be
expanded to permit PSCs to accelerate the payment to owners of amounts from nonqualified
deferred compensation plans, to the extent necessary to satisfy the minimum distribution
requirements of section 280H.
ACCELERATION
REQUIREMENTS
OF
PAYMENTS
TO
SATISFY
SEC
INDEPENDENCE
We request an exemption from the anti-acceleration rules for payments made in compliance
with SEC independence requirements. Firms subject to the SEC independence rules must be
permitted to accelerate the payment of deferred compensation of a former partner or employee
who goes to work for an SEC-registrant audit client of the firm, in order to comply with the SEC
rules. These requirements are a responsibility of the service recipient, and must be taken very
seriously by auditing firms. In the event that a partner, former partner, employee, or former
employee accepts a position with an SEC-registered audit client of the firm, that individual must
be divested of any financial interest in the firm. This situation may also arise when a former
partner or employee sits on the board of a company that becomes an SEC registrant for the first
time; the former partner or employee must be divested of all interests in the audit firm.
Typically, firms either pay the former partner or employee the lump sum value of their future
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payments, or establish a rabbi trust to fund their deferred compensation, in compliance with SEC
rules. A third alternative is to withdraw from the client engagement in order to eliminate the
independence violation. The treatment may differ with respect to any particular situation. We
request that Treasury and the IRS provide guidance as soon as possible to indicate that all of
these alternatives are permissible under section 409A.
FUNDING
Section 409A(b)(1) provides that in the case of assets set aside in a trust (or other arrangement
determined by the Secretary) for purposes of paying deferred compensation under a nonqualified
deferred compensation plan, the assets will be treated as property that has been transferred to the
service provider, if the assets are located outside the United States. Proposed reg. section
1.409A-5 has been reserved for future guidance on this issue.
Definition of the term “trust”
We believe that it is important for Treasury and the IRS to address the definition of the term
“trust.” We propose that the term “trust” refer only to trusts and similar arrangements as they are
defined under established U.S. principles. This approach to defining the term would rely upon a
well-established framework for the identification of arrangements that would qualify as a trust
with respect to section 409A.
Other funding arrangements
We believe that if Treasury and the IRS decide to expand the definition of an offshore funding
arrangement to other types of non-trust funding arrangements, the arrangements so identified
should be those whose primary purpose is for a U.S. employer providing U.S. compensation to
its U.S. employees to circumvent creditors’ claims by moving assets offshore.
ANNUAL REPORTING OF DEFERRALS
Section 6041(g)(1) and section 6051(a)(13) require that deferrals for the year under a
nonqualified deferred compensation plan be separately reported on a Form 1099, Miscellaneous
Income, or a Form W-2, Wage and Tax Statement, respectively. Annual reporting of all
compensation deferred under a plan is required, regardless of whether the compensation is
includible in gross income.
The IRS addressed these reporting requirements in Notice 2005-1. The Service subsequently
issued Notice 2005-94, which suspends these reporting requirements for 2005. We are
appreciative of this suspension, given the considerable uncertainty that exists regarding both the
identification and calculation of amounts to be reported.
The reporting obligations described above will require that service recipients report deferral
amounts even before the service provider has a right to actually or constructively receive the
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amounts. We believe that tracking deferral amounts prior to the time they are vested would
result in a significant burden on service recipients’ customary tracking and reporting practices.
These amounts are not currently tracked at the time of accrual within payroll and other reporting
systems. Consequently, significant changes to systems would be required in order to ensure that
all deferrals of compensation subject to section 409A are correctly identified and quantified at
the time of their accrual.
For example, consider the practical issues that would arise for employers should they be required
to report amounts under a severance plan as they accrue. To ease the burden on service
recipients, we suggest that the reporting requirements for section 409A purposes follow the rules
already in place for FICA reporting under section 3121 and the underlying regulations. These
rules require reporting at the time that there is no longer a substantial risk of forfeiture (i.e.,
vesting), and at the time of distribution. Employers already must comply with the FICA
reporting requirements and therefore currently have the capability of calculating and
subsequently reporting amounts as they vest and as they are distributed. By following this
framework for section 409A purposes, only minimal additional resources would be required on
the part of the service recipient, as they would be able to leverage the reporting systems already
in place.
We recognize that under reg. section 31.3121(v)(2)-1(b)(4)(ii), stock options and stock
appreciation rights are not treated as nonqualified deferred compensation for FICA tax purposes.
Thus, the strict implementation of the approach we have recommended above would result in no
reporting of deferral amounts with respect to stock options and stock appreciation rights that are
subject to section 409A. Therefore, we believe it would be appropriate to provide a special rule
to require the reporting of vested amounts related to stock options and stock appreciation rights
that are subject to section 409A.
We urge Treasury and the IRS to issue guidance related to reporting as soon as possible, so that
service recipients will have enough time to incorporate the reporting requirements into their
information processing systems.
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