Application of Section 409A to Nonqualified Deferred Compensation Plans, 57930-57984 [05-19379]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 70, Number 191 (Tuesday, October 4, 2005)]
[Proposed Rules]
[Pages 57930-57984]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 05-19379]



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Part II





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



Application of Section 409A to Nonqualified Deferred Compensation 
Plans; Proposed Rule

Federal Register / Vol. 70, No. 191 / Tuesday, October 4, 2005 / 
Proposed Rules

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-158080-04]
RIN 1545-BE79


Application of Section 409A to Nonqualified Deferred Compensation 
Plans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations regarding the 
application of section 409A to nonqualified deferred compensation 
plans. The regulations affect service providers receiving amounts of 
deferred compensation, and the service recipients for whom the service 
providers provide services. This document also provides a notice of 
public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by January 3, 
2006. Outlines of topics to be discussed at the public hearing 
scheduled for January 25, 2006, must be received by January 4, 2006.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-158080-04), room 
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
158080-04), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC or sent electronically, via the IRS 
Internet site at www.irs.gov/regs or via the Federal eRulemaking Portal 
at www.regulations.gov (IRS REG-158080-04). The public hearing will be 
held in the Auditorium, Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Stephen Tackney, at (202) 927-9639; concerning submissions of comments, 
the hearing, and/or to be placed on the building access list to attend 
the hearing, Richard A. Hurst at (202) 622-7116 (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION:

Background

    Section 409A was added to the Internal Revenue Code (Code) by 
section 885 of the American Jobs Creation Act of 2004, Public Law 108-
357 (118 Stat. 1418). 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. Section 
409A also includes rules applicable to certain trusts or similar 
arrangements associated with nonqualified deferred compensation, where 
such arrangements are located outside of the United States or are 
restricted to the provision of benefits in connection with a decline in 
the financial health of the sponsor.
    On December 20, 2004, the IRS issued Notice 2005-1 (2005-2 I.R.B. 
274 (published as modified on January 6, 2005)), setting forth initial 
guidance with respect to the application of section 409A, and supplying 
transition guidance in accordance with the terms of the statute. Notice 
2005-1 requested comments on all aspects of the application of Section 
409A, including certain specified topics. Numerous comments were 
submitted and all were considered by the Treasury Department and the 
IRS in formulating these regulations. In general, these regulations 
incorporate the guidance provided in Notice 2005-1 and provide 
substantial additional guidance. For a discussion of the continued 
applicability of Notice 2005-1, see the Effect on Other Documents 
section of this preamble.

Explanation of Provisions

I. Definition of Nonqualified Deferred Compensation Plan

A. In General

    Section 409A applies to amounts deferred under a nonqualified 
deferred compensation plan. For this purpose a nonqualified deferred 
compensation plan means any plan that provides for the deferral of 
compensation, with specified exceptions such as qualified retirement 
plans, tax-deferred annuities, simplified employee pensions, SIMPLEs 
and section 501(c)(18) trusts. In addition, section 409A does not apply 
to certain welfare benefit plans, including bona fide vacation leave, 
sick leave, compensatory time, disability pay, and death benefit plans.
    In certain instances, these regulations cross reference the 
regulations under section 3121(v)(2), which provide a special timing 
rule under the Federal Insurance Contributions Act (FICA) for 
nonqualified deferred compensation, as defined in section 3121(v)(2) 
and the regulations thereunder. However, unless explicitly cross-
referenced in these regulations, the regulations under section 
3121(v)(2) do not apply for purposes of section 409A and under no 
circumstances do these proposed regulations affect the application of 
section 3121(v)(2).

B. Section 457 Plans

    Section 409A does not apply to eligible deferred compensation plans 
under section 457(b). However, section 409A applies to nonqualified 
deferred compensation plans to which section 457(f) applies, separately 
and in addition to the requirements applicable to such plans under 
section 457(f). Section 409A(c) provides that nothing in section 409A 
prevents the inclusion of amounts in gross income under any other 
provision of the Code. Section 409A(c) further provides that any amount 
included in gross income under section 409A will not be required to be 
included in gross income under any other Code provision later than the 
time provided in section 409A. Accordingly, if in a taxable year an 
amount subject to section 409A (but not required to be included in 
income under section 409A) is required to be included in gross income 
under section 457(f), that amount must be included in gross income 
under section 457(f) for that taxable year. Correspondingly, if in a 
taxable year an amount that would otherwise be required to be included 
in gross income under section 457(f) has been included previously in 
gross income under section 409A, that amount will not be required to be 
included in gross income under section 457(f) for that taxable year.
    These proposed regulations are intended solely as guidance with 
respect to the application of section 409A to such arrangements, and 
should not be relied upon with respect to the application of section 
457(f). Thus, State and local government and tax exempt entities may 
not rely upon the definition of a deferral of compensation under Sec.  
1.409A-1(b) of these proposed regulations in applying section 457(f). 
For example, for purposes of section 457(f), a deferral of compensation 
includes a stock option and an arrangement in which an employee or 
independent contractor of a state or local government or tax-exempt 
entity earns the right to future payments for services, even if those 
amounts are paid immediately upon vesting and would qualify for the 
exclusion from the definition of deferred compensation under Sec.  
1.409A-1(b)(5) of these proposed regulations. However, until further 
guidance is issued, State and

[[Page 57931]]

local government and tax exempt entities may rely on the definitions of 
bona fide vacation leave, sick leave, compensatory time, disability 
pay, and death benefit plans for purposes of section 457(f) as 
applicable for purposes of applying section 409A and Sec.  1.409A-
1(a)(4) of these proposed regulations to nonqualified deferred 
compensation plans under section 457(f).

C. Arrangements With Independent Contractors

    Consistent with Notice 2005-1, Q&A-8, these regulations exclude 
from coverage under section 409A certain arrangements between service 
providers and service recipients. Under these regulations, amounts 
deferred in a taxable year with respect to a service provider using an 
accrual method of accounting for that year are not subject to section 
409A. In addition, section 409A generally does not apply to amounts 
deferred pursuant to an arrangement between a service recipient and an 
unrelated independent contractor (other than a director of a 
corporation), if during the independent contractor's taxable year in 
which the amount is deferred, the independent contractor is providing 
significant services to each of two or more service recipients that are 
unrelated, both to each other and to the independent contractor. In 
response to comments, these regulations clarify that the determination 
is made based upon the independent contractor's taxable year in which 
the amount is deferred.
    Commentators also requested clarification of the circumstances in 
which services to each service recipient will be deemed to be 
significant, as required for the exclusion. Determining whether 
services provided to a service recipient are significant generally will 
involve an examination of all relevant facts and circumstances. 
However, two clarifications have been provided. First, the analysis 
applies separately to each trade or business in which the service 
provider is engaged. For example, a taxpayer providing computer 
programming services for one service recipient will not meet the 
exception if, as a separate trade or business, the taxpayer paints 
houses for another unrelated service recipient. To provide certainty to 
many independent contractors engaged in an active trade or business 
with multiple service recipients, a safe harbor has been provided under 
which an independent contractor with multiple unrelated service 
recipients, to whom the independent contractor also is not related, 
will be treated as providing significant services to more than one of 
those service recipients, if not more than 70 percent of the total 
revenue generated by the trade or business in the particular taxable 
year is derived from any particular service recipient (or group of 
related service recipients).
    Commentators also requested clarification with respect to the 
application of section 409A to directors. As provided in these 
regulations, an individual will not be excluded from coverage under 
section 409A merely because the individual provides services as a 
director to two or more unrelated service recipients. However, the 
provisions of section 409A apply separately to arrangements between the 
service provider director and each service recipient. Accordingly, the 
inclusion of income due to a failure to meet the requirements of 
section 409A with respect to an arrangement to serve as a director of 
one service recipient will not cause an inclusion of income with 
respect to arrangements to serve as a director of an unrelated service 
recipient. In addition, the continuation of services as a director with 
one service recipient will not cause the termination of services as a 
director with an unrelated service recipient to fail to constitute a 
separation from service for purposes of section 409A, if the 
termination would otherwise qualify as a separation from service.
    Commentators also requested clarification with respect to the 
application of the rule to directors who are also employees of the 
service recipient. In general, the provisions of section 409A will 
apply separately to the arrangements between the service recipient and 
the service provider for services as a director and the arrangements 
between the service recipient and the service provider for services as 
an employee. However, the distinction is not intended to permit 
employee directors to limit the aggregation of arrangements in which 
the individual participates as an employee by labeling such 
arrangements as arrangements for services as a director. Accordingly, 
an arrangement with an employee director will be treated as an 
arrangement for services as a director only to the extent that another 
non-employee director defers compensation under the same, or a 
substantially similar, arrangement on similar terms. Moreover, the 
separate application of section 409A to arrangements for services as a 
director and arrangements for services as an employee does not extend 
to a service provider's services for the service recipient as an 
independent contractor in addition to the service provider's services 
as a director of the service recipient. Under those circumstances, both 
arrangements are treated as services provided as an independent 
contractor.
    Commentators also requested clarification of the application of the 
exclusion to independent contractors who provide services to only one 
service recipient, when that service recipient itself has multiple 
clients. Specifically a commentator requested that the rule be applied 
on a look through basis, so that the independent contractor will be 
deemed to be providing services for multiple service recipients. The 
Treasury Department and the IRS do not believe that such a rule is 
appropriate. Where multiple persons have come together and formed an 
entity that is itself a service recipient of the independent 
contractor, the independent contractor is performing services for the 
single entity service recipient.
    The Treasury Department and the IRS believe that where the service 
recipient is purchasing an independent contractor's management 
services, amounts deferred with respect to the independent contractor's 
performance of services should not be excluded from coverage under 
section 409A. Among the many objectives underlying the enactment of 
section 409A is to limit the ability of a service provider to retain 
the benefits of the deferral of compensation while having excessive 
control over the timing of the ultimate payment. Where the independent 
contractor is managing the service recipient, there is a significant 
potential for the independent contractor to have such influence or 
control over compensation matters so that categorical exclusion from 
coverage under section 409A is not appropriate. Accordingly, the 
regulations provide that compensation arrangements between an 
independent contractor and a service recipient that involve the 
provision of management services are not excluded from coverage under 
section 409A, and in such cases, the service recipient is not treated 
as unrelated for purposes of determining whether arrangements with 
other service recipients are excluded from coverage under section 409A 
under the general rule addressing independent contractors providing 
services to multiple unrelated service recipients. For this purpose, 
management services include services involving actual or de facto 
direction or control of the financial or operational aspects of the 
client's trade or business, or investment advisory services that are 
integral to the trade or business of a service recipient whose primary 
trade or business involves the management of

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investments in entities other than the entities comprising the service 
recipient, such as a hedge fund or real estate investment trust.

II. Definition of Nonqualified Deferred Compensation

A. In General

    Consistent with Notice 2005-1, Q&A-4, these regulations provide 
that a plan provides for the deferral of compensation only if, under 
the terms of the plan and the relevant facts and circumstances, 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, pursuant to the terms of the plan, 
is payable to (or on behalf of) the service provider in a later year. A 
legally binding right to compensation may exist even where the right is 
subject to conditions, including conditions that constitute a 
substantial risk of forfeiture. For example, an employee that in Year 1 
is promised a bonus equal to a set percentage of employer profits, to 
be paid out in Year 3 if the employee has remained in employment 
through Year 3, has a legally binding right to the payment of the 
compensation, subject to the conditions being met. The right thus may 
be subject to a substantial risk of forfeiture, and accordingly be 
nonvested; however, the promise constitutes a legally binding right 
subject to a condition.
    In contrast, a service provider does not have a legally binding 
right to compensation if that compensation may be unilaterally reduced 
or eliminated by the service recipient or other person after the 
services creating the right to the compensation have been performed. 
Notice 2005-1, Q&A-4 provides that, if the facts and circumstances 
indicate that the discretion to reduce or eliminate the compensation is 
available or exercisable only upon a condition that is unlikely to 
occur, or the discretion to reduce or eliminate the compensation is 
unlikely to be exercised, a service provider will be considered to have 
a legally binding right to the compensation. Commentators criticized 
the provision as being difficult to apply, because the standard is too 
vague, requiring a subjective judgment as to whether the discretion is 
likely to be exercised. The intent of this provision was to eliminate 
the possibility of taxpayers avoiding the application of section 409A 
through the use of plan provisions providing negative discretion, where 
such provisions are not meaningful. In response to the comments, these 
regulations adopt a standard under which the negative discretion will 
be recognized unless it lacks substantive significance, or is available 
or exercisable only upon a condition. Thus, where a promise of 
compensation may be reduced or eliminated at the unfettered discretion 
of the service recipient, that promise generally will not result in a 
legally binding right to compensation. However, where the negative 
discretion lacks substantive significance, or the discretion is 
available or exercisable only upon a condition, the discretion will be 
ignored and the service provider will be treated as having a legally 
binding right. In addition, where the service provider has control 
over, or is related to, the person granted the discretion to reduce or 
eliminate the compensation, or has control over all or any portion of 
such person's compensation or benefits, the discretion also will be 
ignored and the service provider will be treated as having a legally 
binding right to the compensation.

B. Short-Term Deferrals

    Notice 2005-1, Q&A-4(c), set forth an exception from coverage under 
section 409A under which certain arrangements, referred to as short-
term deferrals, would not be treated as resulting in the deferral of 
compensation. Specifically, Notice 2005-1, Q&A-4 provided that until 
further guidance a deferral of compensation would not occur if, absent 
an election to otherwise defer the payment to a later period, at all 
times the terms of the plan require payment by, and an amount is 
actually or constructively received by the service provider by, the 
later of (i) the date that is 2\1/2\ months from the end of the service 
provider's first taxable year in which the amount is no longer subject 
to a substantial risk of forfeiture, or (ii) the date that is 2\1/2\ 
months from the end of the service recipient's year in which the amount 
is no longer subject to a substantial risk of forfeiture. For these 
purposes, an amount that is never subject to a substantial risk of 
forfeiture is considered to be no longer subject to a substantial risk 
of forfeiture on the date the service provider first has a legally 
binding right to the amount. Under this rule, many multi-year bonus 
arrangements that require payments promptly after the amount vests 
would not be subject to section 409A.
    The exception from coverage under section 409A for short-term 
deferrals set forth in Notice 2005-1, Q&A-4, has been incorporated into 
these proposed regulations. Commentators questioned whether a written 
provision in the arrangement requiring the payment to be made by the 
relevant deadline is necessary, or whether the customary practice of 
the service recipient is sufficient. These regulations do not require 
that the arrangement provide in writing that the payment must be made 
by the relevant deadline. Accordingly, where an arrangement does not 
otherwise defer compensation, an amount will qualify as a short-term 
deferral, and not be subject to section 409A, if the amount is actually 
paid out by the appropriate deadline. However, where an arrangement 
does not provide in writing that a payment must be paid by a specified 
date on or before the relevant deadline, and the payment is not made by 
the appropriate deadline (except due to unforeseeable administrative or 
solvency issues, as discussed below), the payment will result in 
automatic violation of section 409A due to the failure to specify the 
payment date or a permissible payment event. In addition, the rules 
permitting the service recipient limited discretion to delay payments 
of amounts subject to section 409A (for example, where the service 
recipient reasonably anticipates that payment of the amount would not 
be deductible due to application of section 162(m), or where the 
service recipient reasonably anticipates that payment of the amount 
would violate a loan covenant or similar contractual provision) would 
not be available, because the arrangement would not have specified a 
payment date subject to the delay. In contrast, where an arrangement 
provides in writing that a payment must be made by a specified date on 
or before the relevant deadline, and the payment is not made by the 
appropriate deadline so that section 409A becomes applicable, the rules 
contained in these regulations generally permitting the payment to be 
made in the same calendar year as the fixed payment date become 
applicable. In addition, the rules permitting a plan to provide for a 
delay in the payment in certain circumstances and the relief applicable 
to disputed payments and refusals to pay would also be available. 
Accordingly, it will often be appropriate to include a date or year for 
payment even when it is intended that the payment will be made within 
the short-term deferral period.
    The short-term deferral rule does not provide a method to avoid 
application of section 409A if the legally binding right creates a 
right to deferred compensation from the outset. For example, if a 
legally binding right to payment in Year 10 arises in Year 1, but the 
right is subject to a substantial risk

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of forfeiture through Year 3, paying the amount at the end of Year 3 
would not result in the payment failing to be subject to section 409A, 
but rather generally would be an impermissible acceleration of the 
payment from the originally established right to payment in year 10.
    Commentators also questioned whether the 2\1/2\ month deadline for 
payment could be extended where the payment was not administratively 
practicable, or where the payment was made late due to error. These 
regulations provide that a payment made after the 2\1/2\ month deadline 
may continue to be treated as meeting the requirements of the exception 
from the definition of a deferral of compensation if the taxpayer 
establishes that it was impracticable, either administratively or 
economically, to avoid the deferral of the receipt by a service 
provider of the payment beyond the applicable 2\1/2\ month period and 
that, as of the time the legally binding right to the amount arose, 
such impracticability was unforeseeable, and the payment is made as 
soon as practicable. Some commentators had asked for a rule permitting 
delays due to unintentional error to satisfy the standard for the 
exclusion. However, the exception is based upon the longstanding 
position set forth in Sec.  1.404(b)-1T, Q&A-2(b) regarding the timing 
of the deduction with respect to a payment under a nonqualified 
deferred compensation plan. Similar to the deduction rule, the 
exclusion from coverage under section 409A treats a payment made within 
the appropriate 2\1/2\ month period as made within such a short period 
following the date the substantial risk of forfeiture lapses that it 
may be treated as paid when earned (and not deferred to a subsequent 
period). Also similar to the rule governing the timing of deductions, 
the exclusion from coverage under section 409A permits only limited 
exceptions to the requirement that the amount actually be paid by the 
relevant deadline. Pending further study, the Treasury Department and 
the IRS believe that providing further flexibility with respect to 
meeting the deadline would create the potential for abuse and 
enforcement difficulty.

C. Stock Options and Stock Appreciation Rights

In General
    The legislative history states that section 409A does not cover 
grants of stock options where the exercise price can never be less than 
the fair market value of the underlying stock at the date of grant (a 
non-discounted option). See H.R. Conf. Rept. No. 108-755, at 735 
(2004). Thus an option with an exercise price that is or may be below 
the fair market value of the underlying stock at the date of grant (a 
discounted option) is subject to the requirements of section 409A. 
Consistent with the legislative history and with Notice 2005-1, Q&A-4, 
these regulations provide that a non-discounted stock option, that has 
no other feature for the deferral of compensation, generally is not 
covered by section 409A. However, a stock option granted with an 
exercise price below the fair market value of the underlying shares of 
stock on the date of grant generally would be subject to section 409A 
except to the extent the terms of the option only permit exercise of 
the option during the short-term deferral period.
    Commentators stressed that in many respects, a stock appreciation 
right can be the economic equivalent of a stock option, especially a 
stock option that allows the holder to exercise in a manner other than 
by the payment of cash (a cashless exercise feature). Accordingly, 
Notice 2005-1, Q&A-4 exempted from coverage certain non-discounted 
stock appreciation rights that most closely resembled stock options--
stock appreciation rights settled in stock. The Treasury Department and 
the IRS were concerned that the manipulation of the purported stock 
valuation for purposes of determining whether the stock appreciation 
right was issued at a discount or settled at a premium could lead to a 
stock appreciation right being used to circumvent section 409A. 
Accordingly, the exception was limited to stock appreciation rights 
issued with respect to stock traded on an established securities 
market.
    Commentators criticized the distinction between public corporations 
and non-public corporations, asserting that this distinction is not 
meaningful and unfairly discriminated against the latter corporations 
and placed such corporations at a severe competitive disadvantage. In 
addition, commentators questioned whether the distinction between 
stock-settled and cash-settled stock appreciation rights was relevant, 
where the amount of income generated would be identical.
    In response to the comments, these regulations treat stock 
appreciation rights similarly to stock options, regardless of whether 
the stock appreciation right is settled in cash and regardless of 
whether the stock appreciation right is based upon service recipient 
stock that is not readily tradable on an established securities market. 
The Treasury Department and the IRS remain concerned that manipulation 
of stock valuations, and manipulation of the characteristics of the 
underlying stock, may lead to abuses with respect to stock options and 
stock appreciation rights (collectively referred to as stock rights). 
To that end, these regulations contain more detailed provisions with 
respect to the identification of service recipient stock that may be 
subject to, or used to determine the amount payable under, stock rights 
excluded from the application of section 409A, and the valuation of 
such service recipient stock, discussed below.
2. Definition of Service Recipient Stock
    The legislative history of section 409A states that the exception 
from coverage under section 409A for certain nonstatutory stock options 
was intended to cover options granted on service recipient stock. H.R. 
Conf. Rept. No. 108-755, at 735 (2004). Section 409A(d)(6) provides 
that, for purposes of determining the identity of the service recipient 
under section 409A, aggregation rules similar to the rules in section 
414(b) and (c) apply. Taxpayers requested that the definition of 
service recipient be expanded for purposes of the exception for stock 
rights to cover entities that would not otherwise be treated as part of 
the service recipient applying the rules under section 414(b) and (c). 
The Treasury Department and the IRS agree that the exclusion for 
nonstatutory stock rights was not meant to apply so narrowly. 
Accordingly, for purposes of the provisions excluding certain stock 
rights on service recipient stock, the stock right, or the plan or 
arrangement under which the stock right is granted, may provide that 
section 414(b) and (c) be applied by modifying the language and using 
``50 percent'' instead of ``80 percent'' where appropriate, such that 
stock rights granted to employees of entities in which the issuing 
corporation owns a 50 percent interest generally will not be subject to 
section 409A.
    Commentators also requested that the threshold be dropped below 50 
percent to cover joint ventures and other similar arrangements, where 
the participating corporation does not have a majority interest. These 
regulations provide for such a lower threshold, allowing for the stock 
right, or the plan or arrangement under which the stock right is 
granted, to provide for the modification of the language and use of 
``20 percent'' instead of ``80 percent'' in applying section 414(b) and 
(c), where the use of such stock with respect to stock rights is due to 
legitimate business criteria. For example, the use of such stock with

[[Page 57934]]

respect to stock rights issued to employees of a joint venture that 
were former employees of a corporation with at least a 20 percent 
interest in the joint venture generally would be due to legitimate 
business criteria, and accordingly would be treated as service 
recipient stock for purposes of determining whether the stock right was 
subject to section 409A. A designation by a service recipient to use 
either the 50 percent or the 20 percent threshold must be applied 
consistently to all compensatory stock rights, and any designation of a 
different permissible ownership threshold percentage may not be made 
effective until 12 months after the adoption of such change.
    The increased ability to issue stock rights with respect to a 
related corporation for whom the service provider does not directly 
perform services could increase the potential for service recipients to 
exploit the exclusion for certain stock rights by establishing a 
corporation within the group of related corporations, the purpose of 
which is to serve as an investment vehicle for nonqualified deferred 
compensation. Accordingly, these regulations provide that other than 
with respect to service providers who are primarily engaged in 
providing services directly to such corporation, the term service 
recipient for purposes of the definition of service recipient stock 
does not include a corporation whose primary purpose is to serve as an 
investment vehicle with respect to the corporation's interest in 
entities other than the service recipient (including entities 
aggregated with the corporation under the definition of service 
recipient incorporating section 414(b) and (c)).
    Commentators also questioned whether the exception for certain 
stock rights could apply where a service recipient provides a stock 
right with respect to preferred stock or a separate class of common 
stock. The Treasury Department and the IRS believe this exception was 
intended to cover stock rights with respect to service recipient stock 
the fair market value of which meaningfully relates to the potential 
future appreciation in the enterprise value of the corporation. The use 
of a separate class of common stock created for the purpose of 
compensating service providers, or the use of preferred stock with 
substantial characteristics of debt, could create an arrangement that 
more closely resembles traditional nonqualified deferred compensation 
arrangements rather than an interest in appreciation of the value of 
the service recipient. An exception that excluded these arrangements 
from coverage under section 409A would undermine the effectiveness of 
the statute to govern nonqualified deferred compensation arrangements, 
contrary to the legislative intent. Accordingly, these regulations 
clarify that service recipient stock includes only common stock, and 
only the class of common stock that as of the date of grant has the 
highest aggregate value of any class of common stock of the corporation 
outstanding, or a class of common stock substantially similar to such 
class of stock (ignoring differences in voting rights). In addition, 
service recipient stock does not include any stock that provides a 
preference as to dividends or liquidation rights.
    With respect to the foreign aspects of such arrangements, 
commentators requested clarification that service provider stock may 
include American Depositary Receipts (ADRs). These regulations clarify 
that stock of the service recipient may include ADRs, provided that the 
stock to which the ADRs relate would otherwise qualify as service 
recipient stock.
    Commentators also requested that certain equity appreciation rights 
issued by mutual companies, intended to mimic stock appreciation 
rights, be excluded from coverage under section 409A. These regulations 
expand the exclusion for stock appreciation rights to include equity 
appreciation rights with respect to mutual company units. A mutual 
company unit is defined as a specified percentage of the fair market 
value of the mutual company. For this purpose, a mutual company may 
value itself under the same provisions applicable to the valuation of 
stock of a corporation that is not readily tradable on an established 
securities market. The Treasury Department and the IRS request comments 
as to the practicability of this provision, and whether such a 
provision should be expanded to cover equity appreciation rights issued 
by other entities that do not have outstanding shares of stock.
3. Valuation
    Notice 2005-1, Q&A-4(d)(ii) provides that for purposes of 
determining whether the requirements for exclusion of a nonstatutory 
stock option have been met, any reasonable valuation method may be 
used. Commentators expressed concern that the standard was too vague, 
given the potential consequences of a failure to comply with the 
requirements of section 409A.
    These regulations provide that with respect to service recipient 
stock that is readily tradable on an established securities market, a 
valuation of such stock may be based on the last sale before or the 
first sale after the grant, or the closing price on the trading day 
before or the trading day of the grant, or any other reasonable basis 
using actual transactions in such stock as reported by such market and 
consistently applied. Commentators pointed out that certain service 
recipients, generally corporations in certain foreign jurisdictions, 
would not be able to meet this requirement because the service 
recipient is subject to foreign laws requiring pricing based on an 
average over a period of time. To allow compliance with these 
requirements, these regulations further provide that service recipients 
(including U.S. service recipients) may set the exercise price based on 
an average of the price of the stock over a specified period provided 
such period occurs within the 30 days before and 30 days after the 
grant date, and provided further that the terms of the grant are 
irrevocably established before the beginning of the measurement period 
used to determine the exercise price.
    Commentators asked for clarification of the definition of stock 
that is readily tradable on an established securities market. 
Specifically, commentators requested clarification of the scope of an 
established securities market, and whether that term includes over-the-
counter markets and foreign markets. The regulations adopt the 
definition of an established securities market set forth in Sec.  
1.897-1(m). Under that definition, over-the-counter markets generally 
are treated as established securities markets, as well as many foreign 
markets. However, the stock must also be readily tradable within such 
markets to qualify as stock readily tradable on an established 
securities market.
    With respect to corporations whose stock is not readily tradable on 
an established securities market, these regulations provide that fair 
market value may be determined through the reasonable application of a 
reasonable valuation method. The regulations contain a description of 
the factors that will be taken into account in determining whether a 
given valuation method is reasonable. In addition, in an effort to 
provide more certainty, certain presumptions with respect to the 
reasonableness of a valuation method have been set forth. Provided one 
such method is applied reasonably and used consistently, the valuation 
determined by applying such method will be presumed to equal the fair 
market value of the stock, and such presumption will be rebuttable only 
by a showing that the valuation is grossly unreasonable. A method will 
be treated as used consistently where the same method is used for all 
equity-based compensation

[[Page 57935]]

granted to service providers by the service recipient, including for 
purposes of determining the amount due upon exercise or repurchase 
where the stock acquired is subject to an obligation of the service 
recipient to repurchase, or a put or call right providing for the 
potential repurchase by the service recipient, as applicable.
    Commentators specifically requested clarification as to whether a 
valuation method based upon an appraisal will be treated as reasonable, 
and if so with respect to what period. These regulations provide that 
the use of an appraisal will be presumed reasonable if the appraisal 
satisfies the requirements of the Code with respect to the valuation of 
stock held in an employee stock ownership plan. If those requirements 
are satisfied, the valuation will be presumed reasonable for a one-year 
period commencing on the date as of which the appraisal values the 
stock.
    Commentators also specifically requested clarification of whether a 
valuation method based on a nonlapse restriction addressed in Sec.  
1.83-5(a) will be treated as reasonable. Under Sec.  1.83-5(a), in the 
case of property subject to a nonlapse restriction (as defined in Sec.  
1.83-3(h)), the price determined under the formula price is considered 
to be the fair market value of the property unless established to the 
contrary by the Commissioner, and the burden of proof is on the 
Commissioner with respect to such value. If stock in a corporation is 
subject to a nonlapse restriction that requires the transferee to sell 
such stock only at a formula price based on book value, a reasonable 
multiple of earnings or a reasonable combination thereof, the price so 
determined ordinarily is regarded as determinative of the fair market 
value of such property for purposes of section 83.
    The Treasury Department and the IRS do not believe that this 
standard, in and of itself, is appropriate with respect to the 
application of section 409A. The Treasury Department and the IRS are 
not confident that a formula price determined pursuant to a nonlapse 
restriction will, in every case, adequately approximate the value of 
the underlying stock. The Treasury Department and the IRS are also 
concerned that such formula valuations, in the absence of other 
criteria, may be subject to manipulation or to the provision of 
predictable results that are inconsistent with a true equity 
appreciation right. Further, the Treasury Department and the IRS do not 
believe that the burden of proof with respect to valuation should be 
shifted to the Commissioner in all cases where such formulas have been 
utilized. Accordingly, the use of a valuation method based on a 
nonlapse restriction that meets the requirements of Sec.  1.83-5(a) 
does not by itself result in a presumption of reasonableness. However, 
where the method is used consistently for both compensatory and 
noncompensatory purposes in all transactions in which the service 
recipient is either the purchaser or seller of such stock, such that 
the nonlapse restriction formula acts as a substitute for the value of 
the underlying stock, the formula will qualify for the presumption that 
the valuation method is reasonable for purposes of section 409A. In 
addition, depending on the facts and circumstances of the individual 
case, the use of a nonlapse restriction to determine value may be 
reasonable, taking into account other relevant valuation criteria.
    Commentators also expressed concern about the valuation of illiquid 
stock of certain start-up corporations. These commentators argued that 
the value of such stock is often highly speculative, rendering 
appraisals of limited value. Commentators also noted that such stock 
often is not subject to put rights or call rights that could be viewed 
as a nonlapse restriction. Given the illiquidity and speculative value, 
commentators argued that the risk that taxpayers would use rights on 
such shares as a device to pay deferred compensation is low. In 
response, these regulations propose additional conditions under which 
the valuation of illiquid stock in a start-up corporation will be 
presumed to be reasonable. A valuation of an illiquid stock of a start-
up corporation will be presumed reasonable if the valuation is made 
reasonably and in good faith and evidenced by a written report that 
takes into account the relevant factors prescribed for valuations 
generally under these regulations. For this purpose, illiquid stock of 
a start-up corporation refers to service recipient stock of a service 
recipient that is in the first 10 years of the active conduct of a 
trade or business and has no class of equity securities that are traded 
on an established securities market, where such stock is not subject to 
any put or call right or obligation of the service recipient or other 
person to purchase such stock (other than a right of first refusal upon 
an offer to purchase by a third party that is unrelated to the service 
recipient or service provider), provided that this rule does not apply 
to the valuation of any stock if the service recipient or service 
provider reasonably may anticipate, as of the time the valuation is 
applied, that the service recipient will undergo a change in control 
event or participate in a public offering of securities within the 12 
months following the event to which the valuation is applied (for 
example, the grant date of an award). A valuation will not be treated 
as made reasonably and in good faith unless the valuation is performed 
by a person or persons with significant knowledge and experience or 
training in performing similar valuations.
    As stated in the preamble to Notice 2005-1, the Treasury Department 
and the IRS are concerned about the treatment of stock rights where the 
service recipient is obligated to repurchase the stock acquired 
pursuant to the stock right, or the service provider retains a put or 
call right with respect to the stock. Where the service provider 
retains such a right, the ability to receive a purchase price that 
differs from the fair market value of the stock could be used to 
circumvent the application of section 409A. Accordingly, these 
regulations generally require that where someone is obligated to 
purchase the stock received upon the exercise of a stock right, or the 
stock is subject to a put or call right, the purchase price must also 
be set at fair market value, the determination of which is also subject 
to the consistency requirements for the methods used in determining 
fair market value.
4. Modification
    Commentators asked under what conditions a modification, extension, 
or renewal of a stock right will be treated as a new grant. The 
treatment as a new grant is relevant because although the original 
grant may have been excluded from coverage under section 409A, if the 
new grant has an exercise price that is less than the fair market value 
of the underlying stock on the date of the new grant, the new grant 
would not qualify for the exclusion from coverage under section 409A. 
Accordingly, the regulations set forth rules governing the types of 
modifications, extensions or renewals that will result in treatment as 
a new grant. The regulations provide that the term modification means 
any change in the terms of the stock right that may provide the holder 
of the right with a direct or indirect reduction in the exercise price 
of the stock right, or an additional deferral feature, or an extension 
or renewal of the stock right, regardless of whether the holder in fact 
benefits from the change in terms. Under this definition, neither the 
addition of a provision permitting the transfer of the stock right nor 
a provision permitting the service provider to exchange the stock right 
for

[[Page 57936]]

a cash amount equal to the amount that would be available if the stock 
right were exercised would be modifications of the stock right. In 
addition, these regulations explicitly provide that both a change in 
the terms of a stock right to allow for payment of the exercise price 
through the use of pre-owned stock, and a change in the terms of a 
stock right to facilitate the payment of employment taxes or required 
withholding taxes resulting from the exercise of the right, are not 
treated as modifications of the stock right for purposes of section 
409A.
    Generally, a change to the exercise price of the stock right (other 
than in connection with certain assumptions or substitutions of a stock 
right in connection with a corporate transaction or certain adjustments 
resulting from a stock split, stock dividend or similar change in 
capitalization) is treated as a modification, resulting in a new grant 
that may be excluded from section 409A if it satisfies the requirements 
in these regulations as of the new grant date. However, depending upon 
the facts and circumstances, a series of repricings of the exercise 
price may indicate that the original right had a floating or adjustable 
exercise price and did not meet the requirements of the exclusion at 
the time of the original grant.
    Generally, an extension granting the holder an additional period 
within which to exercise the stock right beyond the time originally 
prescribed will be treated as evidencing an additional deferral feature 
meaning that the stock right was subject to section 409A from the date 
of grant. Commentators stated that it is not uncommon upon a 
termination of employment to extend the exercise period for some brief 
period of time to allow the terminated employee a chance to exercise 
the stock right. In response, these regulations provide that it is not 
an extension of a stock right if the exercise period is extended to a 
date no later than the later of the fifteenth day of the third month 
following the date, or December 31 of the calendar year in which, the 
right would otherwise have expired if the stock right had not been 
extended, based on the terms of the stock right at the original grant 
date. The regulations further provide that it is not an extension of a 
stock right if at the time the stock right would otherwise expire, the 
stock right is subject to a restriction prohibiting the exercise of the 
stock right because such exercise would violate applicable securities 
laws and the expiration date of the stock right is extended to a date 
no later than 30 days after the restrictions on exercise are no longer 
required to avoid a violation of applicable securities laws.
    These regulations also provide that if the requirements of Sec.  
1.424-1 (providing rules under which an eligible corporation may, by 
reason of a corporate transaction, substitute a new statutory option 
for an outstanding statutory option or assume an old option without 
such substitution or assumption being considered a modification of the 
old option) would be met if the right were a statutory option, the 
substitution of a new right pursuant to a corporate transaction for an 
outstanding right or the assumption of an outstanding right will not be 
treated as the grant of a new right or a change in the form of payment 
for purposes of section 409A. Section 1.424-1 applies several 
requirements. Among them is the requirement under Sec.  1.424-
1(a)(5)(ii) that the excess of the aggregate fair market value of the 
shares subject to the new option over the exercise price immediately 
after the substitution must not exceed the excess of the fair market 
value of the shares subject to the old option over the exercise price 
immediately before the substitution. In addition, Sec.  1.424-
1(a)(5)(iii) requires that on a share by share comparison, the ratio of 
the exercise price to the fair market value of the shares subject to 
the option immediately after the substitution not be more favorable 
than the ratio of the exercise price to the fair market value of the 
shares subject to the old option immediately before the substitution.
    Commentators expressed concern that the use of the regulations 
contained in Sec.  1.424-1, and specifically the ratio test prescribed 
in Sec.  1.424-1(a)(5)(iii), would prove difficult to apply in 
circumstances where, to reduce dilution, the acquiring corporation 
wished to issue a smaller number of shares than the shares underlying 
the old option, but also wished to retain the entire aggregate 
difference between the fair market value of the shares and the exercise 
price that had been available to the service provider before the 
substitution. In response, Notice 2005-1, Q&A-4 and these regulations 
provide that the requirement of Sec.  1.424-1(a)(5)(iii) will be deemed 
to be satisfied if the ratio of the exercise price to the fair market 
value of the shares subject to the right immediately after the 
substitution or assumption is not greater than the ratio of the 
exercise price to the fair market value of the shares subject to the 
right immediately before the substitution or assumption. For example, 
if an employee had an option to purchase 25 shares for $2 per share, 
and immediately prior to a substitution by reason of a corporate 
transaction the fair market value of a share was $5, then the aggregate 
spread amount would be $75 (25 shares multiplied by ($5-$2) = $75). The 
ratio of the exercise price to the fair market value would be $2/$5 = 
.40. As a part of the transaction, new employer wishes to substitute 
for the option an option to purchase 5 shares of new employer, when the 
shares have a fair market value of $20 per share. To maintain the 
aggregate spread of $75, the new grant has an exercise price of $5 (5 
shares multiplied by ($20 - $5) = $75). The ratio of the exercise price 
to the fair market value immediately after the substitution is $5/$20 = 
.25, which is not greater than the ratio immediately before the 
substitution. Provided that the other requirements of Sec.  1.424-1 
were met, this substitution would not be considered a modification of 
the original stock option for purposes of section 409A.
    One commentator asked for more flexible rules concerning 
adjustments to and substitutions of options following a spinoff or 
similar transaction because short-term trading activity in the period 
immediately following such a transaction frequently does not accurately 
reflect the relative long-term fair market values of the stock of the 
distributing and distributed corporations. To address this problem, the 
regulations provide that such adjustments or substitutions may be made 
based on market quotations as of a predetermined date not more than 60 
days after the transaction, or based on an average of such market 
prices over a period of not more than 30 days ending not later than 60 
days after the transaction.
    These provisions addressing substitutions and assumptions of rights 
apply to stock appreciation rights, as well as stock options. However, 
the guidance provided in these regulations with respect to the 
assumption of stock appreciation right liabilities should not be 
interpreted as guidance with respect to issues raised under any other 
provision of the Code or common law tax doctrine.

D. Restricted Property

    Consistent with Notice 2005-1, Q&A-4(e), these regulations provide 
that if a service provider receives property from, or pursuant to, a 
plan maintained by a service recipient, there is no deferral of 
compensation merely because the value of the property is not includible 
in income in the year of receipt by reason of the property being 
nontransferable and subject to a substantial risk of forfeiture, or is 
includible in income solely due to a valid election under section 
83(b). However, a plan under which a service provider obtains a

[[Page 57937]]

legally binding right to receive property (whether or not the property 
is restricted property) in a future year may provide for the deferral 
of compensation and, accordingly, may constitute a nonqualified 
deferred compensation plan.
    Commentators asked for clarification with respect to how this 
provision applies to a promise to transfer restricted property in a 
subsequent tax year. Specifically, commentators questioned how section 
409A would apply to a bonus program offering a choice between a payment 
in cash and a payment in substantially nonvested property. Because the 
promise grants the service recipient a legally binding right to receive 
property in a future year, this promise generally could not constitute 
property for section 83 purposes under Sec.  1.83-3(e), and could 
constitute deferred compensation for purposes of section 409A. However, 
the regulations provide that the vesting of substantially nonvested 
property subject to section 83 may be treated as a payment for purposes 
section 409A, including for purposes of applying the short-term 
deferral rule. Accordingly, where the promise to transfer the 
substantially nonvested property and the right to retain the 
substantially nonvested property after the transfer are both subject to 
a substantial risk of forfeiture (as defined for purposes of section 
409A), the arrangement generally would constitute a short-term deferral 
because the payment would occur simultaneously with the vesting of the 
right to the property. For example, where an employee participates in a 
two-year bonus program such that, if the employee continues in 
employment for two years, the employee is entitled to either the 
immediate payment of a $10,000 cash bonus or the grant of restricted 
stock with a $15,000 fair market value subject to a vesting requirement 
of three additional years of service, the arrangement generally would 
constitute a short-term deferral because under either alternative the 
payment would be received within the short-term deferral period.

E. Arrangements Between Partnerships and Partners

    The statute and legislative history to section 409A do not 
specifically address arrangements between partnerships and partners 
providing services to a partnership, and do not explicitly exclude such 
arrangements from the application of section 409A. The application of 
section 409A to such arrangements raises a number of issues, relating 
both to the scope of the arrangements subject to section 409A, and the 
coordination of the provisions of subchapter K and section 409A with 
respect to those arrangements that are subject to section 409A. The 
Treasury Department and the IRS continue to analyze the issues raised 
in this area, and accordingly these regulations do not address 
arrangements between partnerships and partners. Notice 2005-1, Q&A-7 
provides interim guidance regarding the application of section 409A to 
arrangements between partnerships and partners. Until further guidance 
is issued, taxpayers may continue to rely on Notice 2005-1, Q&A-7.
    Commentators have asked whether section 409A applies to guaranteed 
payments for services described in section 707(c). Until further 
guidance is issued, section 409A will apply to guaranteed payments 
described in section 707(c) (and rights to receive such guaranteed 
payments in the future), only in cases where the guaranteed payment is 
for services and the partner providing services does not include the 
payment in income by the 15th day of the third month following the end 
of the taxable year of the partner in which the partner obtained a 
legally binding right to the guaranteed payment or, if later, the 
taxable year in which the right to the guaranteed payment is first no 
longer subject to a substantial risk of forfeiture.
    The Treasury Department and the IRS continue to request comments 
with respect to the application of section 409A to arrangements between 
partnerships and partners.

F. Foreign Arrangements

    The regulations provide guidance with respect to the application of 
section 409A to various foreign arrangements. As an initial matter, the 
regulations provide that an arrangement does not provide for a deferral 
of compensation subject to section 409A where the compensation subject 
to the arrangement would not have been includible in gross income for 
Federal tax purposes if it had been paid to the service provider at the 
time that the legally binding right to the compensation first arose or, 
if later, the first time that the legally binding right was no longer 
subject to a substantial risk of forfeiture, if the service provider 
was a nonresident alien at such time. Accordingly, if, for example, a 
foreign citizen works outside the United States and then retires to the 
United States, the compensation deferred and vested while working in 
the foreign country generally will not be subject to section 409A.
    With respect to U.S. citizens or resident aliens working abroad, 
the regulations provide that an arrangement does not provide for a 
deferral of compensation subject to section 409A where the compensation 
subject to the arrangement would have constituted foreign earned income 
(within the meaning of section 911) paid to a qualified individual (as 
defined in section 911(d)(1)) and the amount of the compensation is 
less than or equal to the difference between the maximum section 911 
exclusion amount and the amount actually excludible from gross income 
under section 911 for the taxable year for the individual. This 
hypothetical exclusion is applied at the time that the legally binding 
right to the compensation first exists or, if later, the time that the 
legally binding right is no longer subject to a substantial risk of 
forfeiture. Under section 911, a U.S. citizen or resident alien who 
resides in a foreign jurisdiction generally may exclude up to $80,000 
of foreign earned income (to be adjusted for inflation after 2007). For 
example, an individual with $70,000 of foreign earned income excluded 
under section 911 in 2006 could also defer up to $10,000 of additional 
compensation that would not be subject to section 409A, if the 
additional compensation would qualify as foreign earned income if paid 
to the individual in 2006. This exception to coverage under section 
409A is intended to be applied on an annual basis, so that individuals 
will not be entitled to carry over any unused portion of the exclusion 
under section 911 to a future year. This exception also is not intended 
to modify the rules under section 911 or the regulations thereunder.
    Similarly, these regulations also address deferrals of compensation 
income that would be excluded from gross income for Federal income tax 
purposes under section 893 (generally covering compensation paid to 
foreign workers of a foreign government or international organization 
working in the United States), section 872 (generally covering certain 
compensation earned by nonresident alien individuals), section 931 
(generally covering certain compensation earned by bona fide residents 
of Guam, American Samoa, or the Northern Mariana Islands) and section 
933 (generally covering certain compensation earned by bona fide 
residents of Puerto Rico). The regulations provide that an arrangement 
does not provide for a deferral of compensation subject to section 409A 
where the compensation subject to the

[[Page 57938]]

arrangement would have been excluded from gross income for Federal tax 
purposes under any of these sections, if the compensation had been paid 
to the service provider at the time that the legally binding right to 
the compensation first arose or, if later, the time that the legally 
binding right was no longer subject to a substantial risk of 
forfeiture.
    The Treasury Department and the IRS understand that nonresident 
aliens may work for very limited periods in the United States. Many 
deferrals of the compensation earned by nonresident aliens for services 
rendered in the United States will not be covered by section 409A, 
because under an applicable treaty the amount of compensation deferred 
would not be includible in gross income for Federal tax purposes if 
paid at the time the legally binding right to the compensation deferred 
was no longer subject to a substantial risk of forfeiture. However, 
certain compensation earned in the United States by a nonresident alien 
might be includible in gross income under such circumstances, where 
there is no applicable treaty or where the treaty does not provide an 
exclusion. Where a nonresident alien defers such compensation earned in 
the United States under a foreign nonqualified deferred compensation 
plan--for example because the service in the United States is credited 
under the plan--the application of section 409A to the deferrals of the 
compensation subject to Federal income tax could be exceedingly 
burdensome in light of the relatively small amounts attributable to the 
service in the United States. Accordingly, these regulations adopt a de 
minimis exception, under which section 409A will not apply to an amount 
of compensation deferred under a foreign nonqualified deferred 
compensation plan for a given calendar year where the individual 
service provider is a nonresident alien for that calendar year and the 
amount deferred does not exceed $10,000.
    Commentators requested clarification of the application of section 
409A to participation by U.S. citizens and resident aliens in foreign 
plans. In this context, it should be noted that under these 
regulations, transfers that are taxable under section 402(b) of the 
Code generally are not subject to section 409A. See Sec.  1.409A-
1(b)(6) of these regulations and Notice 2005-1, Q&A-4. Such transfers 
may consist of contributions to an employees' trust, where the trust 
does not qualify under section 501(a). Many foreign plans that hold 
contributions in a trust will constitute funded plans. To the extent 
that a contribution to the trust is subject to inclusion in income for 
Federal tax purposes under section 402(b), such a contribution will not 
be subject to section 409A.
    These regulations also provide that section 409A does not override 
treaty provisions that govern the U.S. Federal taxation of 
participation in particular foreign plans. Where a treaty provides that 
amounts contributed to a foreign plan by or on behalf of a service 
provider are not subject to U.S. Federal income tax, section 409A will 
not cause such amounts to be subject to inclusion in gross income.
    Some commentators requested that any participation in a foreign 
plan be exempted from section 409A, or that only deferrals of U.S. 
source compensation income be subject to section 409A. However, with 
respect to U.S. citizens working abroad, and with respect to resident 
aliens in the United St