[Federal Register: October 4, 2005 (Volume 70, Number 191)] Department of the Treasury Internal Revenue Service 26 CFR Part 1

Application of Section 409A to Nonqualified Deferred Compensation Plans

Part 1 of 2

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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 http://www.irs.gov/regs or via the Federal eRulemaking Portal at http://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

Table of Contents

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 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 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 2^1/2months 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 2^1/2months 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 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 2^1/2month 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 2^1/2month 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 2^1/2month 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 2^1/2month 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 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. T

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 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 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 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 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 States, compensation income generally is subject to U.S. Federal income tax absent an applicable treaty provision. Accordingly, the provisions of section 409A generally are applicable to this type of deferred compensation. In addition, the Treasury Department and the IRS are concerned that providing a broad exception for foreign plans or foreign source income would create opportunities for U.S. citizens and resident aliens to avoid application of section 409A through participation in a foreign plan, or through reallocations of deferrals among U.S. source and foreign source income.

The regulations provide, however, that with respect to non-U.S. citizens who are not lawful permanent residents of the United States, amounts deferred under certain broad-based foreign retirement plans are not subject to section 409A. This exception is intended to allow a worker who is not a green card holder to continue to participate in a broad-based foreign retirement plan that does not comply with section 409A without incurring adverse tax consequences due solely to the worker earning some income in the United States that is in some manner credited under the plan.

Commentators expressed concerns as to U.S. citizens and lawful permanent residents working abroad, and their ability to participate in broad-based plans of foreign employers. Generally, these workers' incomes are subject to Federal income tax, including section 409A. However, when U.S. citizens and lawful permanent residents work abroad for employers who sponsor broad-based foreign retirement plans providing relatively low levels of retirement benefits and such plans are nonelective, the worker's ability to control the timing of the income is limited. In such cases, the concerns with respect to the potential manipulation of the timing of compensation income addressed by section 409A are also limited, and do not outweigh the administrative burdens that would arise if a foreign employer's failure to amend these plans to be consistent with the provisions of section 409A would result in substantial adverse tax consequences to U.S. citizens and lawful permanent residents working abroad who are covered by such plans. Accordingly, an exception for foreign broad-based retirement plans also applies with respect to U.S. citizens and lawful permanent residents, but only with respect to nonelective deferrals of foreign earned income and only to the extent that the amount deferred in a given year does not exceed the amount of contributions or benefits that may be provided by a qualified plan under section 415 (calculated by treating the foreign source income as compensation for purposes of section 415).

Commentators also requested that certain types of payments, referred to as expatriate allowances, be exempted from coverage under section 409A. These payments were defined broadly to include many types of payments to U.S. citizens working abroad, intended to put the service providers in substantially the same economic position as the service providers would have been in had the services been provided in the United States. One very common arrangement involves payments intended to compensate the service provider for any differences in tax rates, often referred to as tax equalization plans. With respect to these plans, the Treasury Department and the IRS recognize that such payments often must be delayed because of the need to calculate foreign tax liabilities after the end of the year. In addition, where the amounts are limited to the amounts necessary to make up for difference in tax rates, the potential for abuse with respect to the timing of compensation income is not great, since the compensation will directly relate to taxes that the service provider has paid to a foreign jurisdiction. Accordingly, these regulations exempt tax equalization plans from coverage under section 409A provided that the payment is made no later than the end of the second calendar year beginning after the calendar year in which the individual's U.S. Federal income tax return is required to be filed (including extensions) for the year to which the tax equalization payment relates.

Other payments are not excluded from section 409A merely because they are denominated as expatriate allowances. The Treasury Department and the IRS believe that the rules provided in these regulations with respect to setting and meeting payment dates under a nonqualified deferred compensation plan will provide sufficient flexibility to permit arrangements involving expatriate allowances to satisfy the requirements of section 409A. For example, as discussed more fully below, these regulations generally provide that to meet the requirement that a payment be made upon a permissible payment event or a fixed date, the service recipient may make the payment by the later of the earliest date administratively practicable following, or December 31 of the calendar year in which occurs, the permissible payment event or fixed date. At the minimum, this should offer almost 12 months of flexibility with respect to a payment scheduled for January 1 of a calendar year. The Treasury Department and the IRS request comments, however, as to circumstances in which this flexibility will not be sufficient.

Commentators also requested a grace period during which arrangements with persons who have become resident aliens during a calendar year may be amended to comply with the requirements of section 409A. These regulations generally provide such relief. With respect to the initial year in which the service provider becomes a resident alien, the plan may be amended with respect to the service provider through the end of that year to comply with (or be excluded from coverage under) section 409A, including allowing the service provider the right to change the time and form of a payment. Provided that the election is made before the amount is paid or payable, initial deferral elections may also be made with respect to compensation related to services in that initial year, if the election is made by the end of the year or, if later, the 15th day of the third month after the service provider meets the requirements to be a resident alien. The relief generally does not extend further because a service recipient and service provider should reasonably anticipate the potential application of section 409A after the initial year in which the service provider attains the status of a resident alien. However, the Treasury Department and the IRS also recognize that there may be significant gaps between the years in which the service provider is treated as a resident alien. Accordingly, the grace period is available in a subsequent year, provided that the service provider has been a nonresident alien for at least five consecutive calendar years immediately preceding the year in which the service provider is again a resident alien.

Commentators also requested that amounts contributed or benefits paid under a foreign social security system that is the subject of a totalization agreement be exempted from coverage under section 409A. Totalization agreements refer to bilateral agreements between the United States and foreign jurisdictions intended to coordinate coverage under the Social Security system in the United States and similar systems of the foreign jurisdictions. These agreements are intended to minimize the potential for application of two different employment taxes, and correspondingly to coordinate the benefits under the two different social security systems. The Treasury Department and the IRS believe that section 409A was not intended to apply to benefits to which the service provider is entitled under the foreign jurisdiction social security system. Accordingly, these types of plans have been excluded from the definition of a nonqualified deferred compensation plan for purposes of section 409A. Similarly, for jurisdictions not covered by a totalization agreement, these regulations provide that amounts deferred under a government mandated social security system are not subject to section 409A.

G. Separation Pay Arrangements

1. In General

Many commentators requested clarification of the application of section 409A to plans or arrangements providing payments upon a termination of services, generally described as severance plans. Some commentators requested that all such arrangements be excluded from coverage under section 409A. However, section 409A(d)(1)(B) contains a list of welfare benefits that are specifically excluded from coverage under section 409A, including bona fide vacation leave, sick leave, compensatory time, disability pay and death benefit plans. Noticeably absent from this list is an exception for severance plans. This is particularly noteworthy because section 457(e)(11) contains the identical list of exclusions, with the one exception that the list of excluded plans under section 457(e)(11) includes severance pay plans, while the list of excluded plans under section 409A(d)(1)(B) does not. Therefore, it appears that Congress intended that severance payments could constitute deferred compensation under section 409A. To avoid confusion with other Code provisions, such as the specific exclusion from coverage under section 457(e)(11) for severance plans or the treatment of such arrangements under section 3121(v)(2), these regulations generally refer to such arrangements as separation pay arrangements.

With respect to payments available upon a voluntary termination of services, there is no substantive distinction between a plan labeled a severance plan or separation pay plan and a nonqualified deferred compensation plan that provides for payments upon a separation from service. If, as is often the case, the service recipient reserves the right to eliminate such arrangement at any time, the service provider may not have a legally binding right to the payment until payment actually occurs, or such other time as the service recipient's discretion to eliminate the right to the payments lapses. However, as provided in these regulations, where such negative discretion lacks substantive significance, or the person granted the discretion is controlled by, or related to, the service provider to whom the payment will be made, the service provider will be considered to have a legally binding right to the compensation.

 Commentators requested that the exclusion from coverage under section 409A contained in Notice 2005-1, Q&A-19(d) for payments during the calendar year 2005 to non-key employees pursuant to severance plans that are classified as welfare plans, rather than pension plans, in accordance with the Department of Labor regulations, be made a permanent exclusion. This approach generally would be consistent with the regulations under section 3121(v)(2) of the Code. However, the Department of Labor regulations reflect different concerns with respect to separation pay arrangements from the concerns addressed in section 409A. The Department of Labor regulations focus on whether an arrangement sufficiently resembles a retirement plan to require funding of the obligations under such a plan, or rather is a welfare plan that would not require funding. In contrast, section 409A focuses on the manipulation of the timing of inclusion of compensation income. Accordingly, these regulations do not categorically exclude these arrangements from coverage under section 409A, although a modified version of this exception has been provided, as discussed below.

Some commentators requested that the Treasury Department and the IRS adopt an exclusion for all amounts payable upon an involuntary separation. This request is based upon the position under certain other Code provisions, and stated in certain court cases, that payments to which an individual becomes entitled upon an involuntary separation from service do not constitute nonqualified deferred compensation. See Kraft Foods North America v. U.S., 58 Fed. Cl. 507 (2003); Sec. 31.3121(v)(2)-1(b)(4)(iv). As discussed above, the statutory language and structure of section 409A strongly suggest that separation pay arrangements, including arrangements providing separation pay upon an involuntary separation, were meant to be covered by section 409A. Furthermore, the Treasury Department and the IRS believe that section 409A was not intended to be applied so narrowly. Section 409A addresses the manipulation of the timing of inclusion of compensation. Payments due to a separation from service, regardless of whether voluntary or involuntary, constitute a payment of compensation. Accordingly, the ability to manipulate the timing of the inclusion of income related to the receipt of those amounts is within the scope of section 409A.

Much of the discussion above relates to predetermined arrangements, where the right to the payment upon an involuntary termination of services arises as part of an arrangement covering multiple service providers, often covering a service provider from the time the service provider begins performing services. Where the separation pay arrangement involves an agreement negotiated with a specific service provider at the time of the involuntary separation from service, commentators asked how deferral elections could be provided that would meet the requirement that the election be made in the year before the year in which the services were performed. Commentators pointed out that even if the service provider does not already participate in any involuntary separation pay arrangement, the rule in section 409A(a)(4)(B) that allows an initial deferral election to be made within 30 days of initial eligibility under a plan applies only with respect to services performed after the election. To address these concerns, these regulations provide that where separation pay due to an involuntary termination has been the subject of bona fide, arm's length negotiations, the election as to the time and form of payment may be made on or before the date the service provider obtains a legally binding right to the payment.

The Treasury Department and the IRS recognize that separation pay arrangements providing for short-term payments upon an involuntary separation from service are common arrangements, and that compliance with the provisions of section 409A may be burdensome. In addition, the Treasury Department and the IRS recognize that where both the amount of the payments and the time over which such payments may be made are limited, these arrangements create fewer concerns with respect to manipulation of the timing of compensation income. Accordingly, these regulations generally exempt such arrangements where the entire amount of payments does not exceed two times the service provider's annual compensation or, if less, two times the limit on annual compensation that may be taken into account for qualified plan purposes under section 401(a)(17) ($210,000 for calendar year 2005), each for the calendar year before the year in which the service provider separates from service, and provided further that the arrangement requires that all payments be made by no later than the end of the second calendar year following the year in which the service provider terminates service. These limitations generally are consistent with the safe harbor under which severance plans may be treated as welfare plans under the applicable Department of Labor regulations, and should allow most of these arrangements to avoid coverage under section 409A.

The Treasury Department and the IRS further recognize that separation pay arrangements often occur in the context of a window program, where certain groups of service providers are identified as being subject to a separation from service, and the service recipient provides the identified service providers an incentive to voluntarily separate from service and obtain a benefit. Although technically these programs involve a voluntary separation from service, these regulations generally treat separations due to participation in a window arrangement the same as arrangements with respect to involuntary separations from service for purposes of the exceptions to coverage from section 409A.

These exclusions for separation pay are not intended to allow for rights to payments that would otherwise be deferred compensation subject to section 409A to avoid application of section 409A by being recharacterized as separation pay. Accordingly, the exclusions for separation pay do not apply to the extent the separation pay acts as a substitute for, or a replacement of, amounts that would otherwise be subject to section 409A. For example, a right to separation pay obtained in exchange for the relinquishment of a right to a payment of deferred compensation subject to section 409A will not be excluded from coverage under section 409A, but rather will be treated as a payment of the original amount of deferred compensation.

2. Treatment as a Separate Plan

Commentators have stated that arrangements involving payments due to an involuntary separation often operate separately from more traditional types of nonqualified deferred compensation plans. In addition, especially in the case of agreements covering an individual, the involuntary separation pay agreement may involve many different types of payments that are of a much smaller magnitude than amounts deferred under other types of nonqualified deferred compensation plans. Commentators expressed concerns that inadvertent violations of section 409A with respect to these unique arrangements could lead to much larger amounts being included in income and subject to the additional tax under section 409A due to the aggregation of such involuntary separation pay arrangements with other arrangements under the definition of a plan. The Treasury Department and the IRS have concluded that a nonqualified deferred compensation plan providing separation pay due to an involuntary separation from service, or participation in a window program, should be treated as a separate type of plan from account balance plans, nonaccount balance plans, and other types of plans (generally equity-based compensation arrangements) in which the service provider may participate that do not provide separation pay due to an involuntary separation from service, or participation in a window program.

3. Application of the Short-Term Deferral Rule to Separation Pay Arrangements

Many commentators asked for a clarification with respect to the application of the short-term deferral rule to separation pay arrangements. The right to a payment that will only be paid upon an involuntary termination of services generally would be viewed as a nonvested right. Accordingly, an involuntary separation pay arrangement may be structured to meet the requirements of the short-term deferral exception.

Some commentators also requested that arrangements involving rights to payments upon termination of services for good reason be treated as a right subject to a substantial risk of forfeiture. These arrangements are common, especially following a transaction resulting in a change in control of the service recipient. The Treasury Department and the IRS are not confident that amounts payable upon a voluntary separation from service, and amounts payable only upon a termination of services for good reason, always may be adequately distinguished. Furthermore, even if the types of good reasons sufficient to constitute a substantial risk of forfeiture could be elucidated, the application of such a rule would involve intensive factual determinations, leaving taxpayers uncertain in their planning and creating a significant potential for abuse. Accordingly, the regulations do not treat the right to a payment upon a separation from service for good reason categorically as a right subject to a substantial risk of forfeiture. However, the Treasury Department and the IRS request comments as to what further guidance may be useful with respect to arrangements containing these types of provisions.

4. Reimbursement Arrangements

Many commentators requested clarification with respect to the application of section 409A to reimbursement agreements, involving the service recipient reimbursing expenses of the terminated service provider. Because the promise to reimburse the former service provider is not contingent on the provision of any substantial services for the service provider, the right to the payment generally would not be treated as subject to a substantial risk of forfeiture. Accordingly, if the period in which expenses incurred will be reimbursed extends beyond the year in which the legally binding right arises, the right to the amount generally would constitute deferred compensation. The Treasury Department and the IRS recognize that reimbursement arrangements following a termination of services are common, and that requiring the service recipient to designate an amount at the time of the termination conflicts with the service recipient's desire to pay only amounts that the former service provider has actually incurred as an expense. However, a categorical exclusion for reimbursement arrangements is not tenable, because such an exclusion would allow for a limitless amount of deferred compensation to be paid without regard to the rules of section 409A, where such compensation took the form of the reimbursement of personal expenses (for example, reimbursements of home mortgage payments). These regulations provide that certain reimbursement arrangements related to a termination of services are not covered by section 409A, to the extent that the reimbursement arrangement covers only expenses incurred and reimbursed before the end of the second calendar year following the calendar year in which the termination occurs. The types of reimbursement arrangements excluded include reimbursements that are otherwise excludible from gross income, reimbursements for expenses that the service provider can deduct under section 162 or section 167, as business expenses incurred in connection with the performance of services (ignoring any applicable limitation based on adjusted gross income), outplacement expenses, moving expenses, medical expenses, as well as any other types of payments that do not exceed $5,000 in the aggregate during any given taxable year.

For purposes of this provision, reimbursement arrangements include the provision of in-kind benefits, or direct payments by the service recipient to the person providing the goods or services to the terminated service provider, if the provision of such in-kind benefits or direct payments would be treated as reimbursement arrangements if the service provider had paid for such in-kind benefits or such goods or services and received reimbursement from the service recipient.

H. Split-Dollar Life Insurance Arrangements

Commentators suggested that split-dollar life insurance arrangements should be excluded from the requirements of section 409A. However, the Treasury Department and the IRS believe that in applying the general definition of deferred compensation to split-dollar life insurance arrangements, the requirements of section 409A may apply to certain types of such arrangements (as described in Sec. 1.61-22). Split-dollar life insurance arrangements that provide only death benefits (as defined in these proposed regulations) to or for the benefit of the service provider may be excluded from coverage under section 409A under the exception from the definition of a nonqualified deferred compensation plan provided in these proposed regulations for death benefit plans. Also, split-dollar life insurance arrangements treated as loan arrangements under Sec. 1.7872-15 generally will not give rise to deferrals of compensation within the meaning of 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. However, policies structured under the endorsement method, where the service recipient is the owner of the policy but where the service provider obtains 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, may provide for a deferral of compensation. Just as a promise to transfer property in a future year may provide for a deferral of compensation (even though the transfer itself is subject to section 83), an endorsement method split- dollar life insurance arrangement that grants the service provider a legally binding right to a future transfer of interests in a policy owned by the service recipient may provide for a deferral of compensation subject to section 409A. For example, where a service recipient enters into an endorsement method split-dollar life insurance arrangement with respect to a service provider, and irrevocably promises to pay premiums in future years, the arrangement may provide for a deferral of compensation within the meaning of section 409A.

Commentators raised concerns about the impact of changes to a split-dollar life insurance arrangement to comply with section 409A, where the split-dollar life insurance arrangement was entered into on or before September 17, 2003, and is not otherwise subject to the regulations set forth in Sec. 1.61-22 (a grandfathered split-dollar life insurance arrangement). Pursuant to Sec. 1.61-22(j)(2), if a grandfathered split-dollar life insurance arrangement is materially modified after September 17, 2003, the arrangement is treated as a new arrangement entered into on the date of the modification. Commentators expressed concern that modifications necessary to comply with section 409A may cause the split-dollar life insurance arrangement to be treated as materially modified for purposes of Sec. 1.61-22(j)(2). Comments are requested 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 for purposes of Sec. 1.61-22(j)(2).

III. Definition of Plan

A. Plan Aggregation Rules

These regulations generally retain the plan aggregation rules set forth in Notice 2005-1, Q&A-9. Under the notice, all amounts deferred under an account balance plan are treated as deferred under a single plan, all amounts deferred under a nonaccount balance are treated as deferred under a single plan, and all amounts deferred under any other type of plan (generally equity-based compensation) are treated as deferred under a single plan. As discussed above, these regulations expand this rule so that all amounts deferred under certain separation pay arrangements are treated as a single plan. The purposes behind these aggregation rules are two-fold. First, because the provisions of section 409A are applied on an individual participant basis, rather than disqualifying the arrangement as to all participants, plan aggregation rules are necessary to implement the compliance incentives intended under the provision. Without such rules, multitudes of separate arrangements could be established for a single participant. Should the participant want access to an amount of cash, the participant would amend one or more of these separate arrangements and receive payments. The participant would argue that only those separate arrangements under which the amounts were paid failed to meet the requirements of section 409A and were subject to the income inclusion and additional tax, although in fact amounts were also available under the additional separate arrangements. Under that analysis, section 409A essentially would act as a 20 percent penalty required to receive a payment, similar to the haircut provisions that were intended to be prohibited by section 409A. The Treasury Department and the IRS do not believe that Congress intended that the consequences of section 409A could be limited in such a manner. However, the Treasury Department and the IRS also believe that complex plan aggregation rules, especially rules reliant on the particular facts and circumstances underlying each arrangement, would lead to unwarranted complexities and burdens with respect to service recipient planning and IRS enforcement. Accordingly, these regulations adopt rules intended to be simple and relatively easy to administer that retain the integrity of the compliance incentives inherent in the statute.

 Commentators asked whether an isolated violation of a term of an arrangement with respect to one participant will be treated as a violation of the same arrangement term with respect to other participants covered by the same arrangement. First, the terms of the arrangement with respect to each participant must be determined, based upon the rights the individual participant has under the plan. Generally, these rights will be determined based upon the written provisions applicable under a particular arrangement, as evidenced by a plan document, agreement, or some combination of documents that specify the terms of the contract under which the compensation is to be paid. However, where the terms of a plan or arrangement comply with section 409A, but the service recipient does not follow such terms, an individual participant's actual rights under the arrangement may be unclear. Where a violation of a provision is not an isolated incident, or involves a number of participants or an identifiable subgroup of participants under the arrangement, the violation may result in a finding that even with respect to a participant who did not directly benefit from the violation, the actual terms of the arrangement differ from the written terms of the arrangement. For example, if a plan document provides for installment payments upon a separation from service, but participants in the arrangement repeatedly are offered the opportunity to receive a lump sum payment, the facts and circumstances may indicate that the arrangement provides for an election of a lump sum payment for all participants.

An analogous analytical framework applies where the service recipient offers different benefits to separate participants in the same plan or arrangement. Under the terms of the overall arrangement, the service provider may grant many different types of rights, including some rights that would not be subject to the requirements of section 409A and some rights that would be subject to those requirements. With respect to the application of section 409A, a plan or arrangement is analyzed as consisting of the rights and benefits that have actually been granted to a particular service provider. For example, with respect to an equity-based omnibus plan that permits the grant of discounted stock options that would be subject to the requirements of section 409A, as well as other types of stock options which would be excluded from coverage under section 409A, only those service providers actually granted the discounted stock options will be treated as having deferred an amount of compensation subject to section 409A, and then only with respect to the stock options subject to section 409A.

B. Written Plan Requirement

Although the statute does not explicitly state that a plan or arrangement must be in writing, the statute requires that a plan contain certain provisions in order to comply with section 409A. For example, section 409A(a)(2)(A) requires that a plan provide that compensation deferred under the plan may not be distributed earlier than certain specific events. Section 409A(a)(4)(B) requires that a plan provide certain restrictions with respect to initial deferral elections. Section 409A(a)(4)(C) requires that, if a plan permits under a subsequent election a delay in a payment or a change in the form of payment, the plan must require certain limits on the scope of such a delay or change. The clear implication of these provisions of section 409A is that the plan or arrangement must be set forth in writing and these regulations incorporate that requirement.

IV. Definition of Substantial Risk of Forfeiture

The scope of the definition of a substantial risk of forfeiture is central to the application of section 409A. In addition to the timing of the potential inclusion of income under section 409A, the existence of a substantial risk of forfeiture may also determine whether an amount is subject to section 409A or whether it qualifies for the exclusion under the short-term deferral rule. These regulations generally adopt the same definition as provided in Notice 2005-1, Q&A- 10. This definition reflects the concerns of the Treasury Department and the IRS that the use of plan terms that purport to prescribe a substantial risk of forfeiture but, in fact, do not put the right to the payment at a substantial risk, may be used to circumvent the application of section 409A in a manner inconsistent with the legislative intent. The definition of a substantial risk of forfeiture in these regulations contains certain restrictions. Certain amendments of an arrangement to extend a substantial risk of forfeiture will not be recognized. The ability to periodically extend, or roll, the risk of forfeiture is sufficiently suspect to question whether the parties ever intended that the right be subject to any true substantial risk, or rather whether the period is being extended through periods in which the service recipient can be reasonably assured that the forfeiture condition will not occur. Similarly, the risk that a right will be forfeited due to the violation of a noncompete agreement can be illusory, such as where the service provider has no intent to compete or to provide such services. In addition, a rational service provider normally would not agree to subject amounts that have already been earned, such as salary payments, to a condition that creates a real possibility of forfeiture, unless the service provider is offered a material inducement to do so, such as an additional amount of compensation. Accordingly, these provisions will not be treated as creating a substantial risk of forfeiture for purposes of section 409A.

V. Initial Deferral Election Rules

A. In General

Section 409A(a)(4)(B)(i) provides that in general, a plan must provide that compensation for services performed during a taxable year may be deferred at the participant's election only if the election to defer such compensation is made not later than the close of the preceding taxable year or at such other time as provided in regulations. The legislative history indicates that the taxable year to which the statute refers is the service provider's taxable year, as it indicates that the Secretary may issue guidance "providing coordination rules, as appropriate, regarding the timing of elections in the case when the fiscal year of the employer and the taxable year of the individual are different.'' H.R. Conf. Rep. No. 108-755, at 732 (2004). Accordingly, these regulations provide as a general rule that a service provider must make a deferral election in his or her taxable year before the year in which the services are performed. As discussed below, certain coordination rules for fiscal year employers have been provided.

An election to defer an amount includes an election both as to the time and form of the payment. An election is treated as made as of the date the election becomes irrevocable. Changes may be made to an initial deferral election, provided that the election becomes irrevocable (except to the extent the plan permits a subsequent deferral election consistent with these regulations) no later than the last date that such an election may be made. Commentators had questioned whether an evergreen deferral election, or a deferral election as to future compensation that remains in place unless the service provider changes the election, would be effective for purposes of section 409A. Such an election satisfies the initial deferral election requirements only if the election becomes irrevocable with respect to future compensation no later than the last permissible date an affirmative initial deferral election could have been made with respect to such compensation. For example, with respect to a salary deferral program under which an employee makes an initial deferral election to defer 10 percent of the salary earned during the subsequent calendar year, a plan may provide that the deferral election remains effective unless and until changed by the employee, provided that with respect to salary earned during any future taxable year, the election to defer 10 percent of such salary becomes irrevocable no later than the December 31 of the preceding calendar year.

B. Nonelective Arrangements

Some commentators asked whether the initial deferral election rules apply to nonelective arrangements. The requirement that the election be made in the year before the services are performed is not applicable where the participant is not provided any election with respect to the amount deferred, or the time and form of the payment. However, as stated in the legislative history, "[t]he time and form of distribution must be specified at the time of initial deferral.'' H.R. Conf. Rep. No. 108-755, at 732 (2004). In addition, the application of the subsequent deferral rules becomes problematic if the original time and form of deferred payment established by the service recipient is not viewed as an initial deferral election. Therefore, in order to avoid application of the initial deferral rules, a plan may not provide a service provider or service recipient with ongoing discretion as to the time and form of payment, but rather must set the time and form of payment no later than the time the service provider obtains a legally binding right to the compensation.

C. Performance-Based Compensation

Section 409A(a)(4)(B)(iii) provides that in the case of any performance-based compensation based on services performed over a period of at least 12 months, a participant's initial deferral election may be made no later than six months before the end of the period. The legislative history indicates that the performance-based compensation should be required to meet certain requirements similar to those under section 162(m), but not all requirements under that section. H.R. Conf. Rep. No. 108-755, at 732 (2004). An example in the legislative history, adopted in these regulations, is that the requirement of a determination by the compensation committee of the board of directors is not required.

Notice 2005-1 did not provide a definition of performance-based compensation. Rather, Notice 2005-1, Q&A-22 provided a definition of bonus compensation that, until further guidance was issued, could be used for purposes of applying the exception to the general rule regarding initial deferral elections.

Under these regulations, performance-based compensation is defined as compensation the payment of which or the amount of which is contingent on the satisfaction of preestablished organizational or individual performance criteria. Performance-based compensation does not include any amount or portion of any amount that will be paid either regardless of performance, or based upon a level of performance that is substantially certain to be met at the time the criteria are established.

Performance-based compensation generally may include payments based upon subjective performance criteria, provided that the subjective performance criteria relate to the performance of the participant service provider, a group of service providers that includes the participant service provider, or a business unit for which the participant service provider provides services (which may include the entire organization), and the determination that the subjective performance criteria have been met is not made by the service provider or a member of the service provider's family, or a person the service provider supervises or over whose compensation the service provider has any control.

Commentators requested that, similar to the provision contained in Sec. 1.162-27(e)(2) governing the requirements for establishing performance criteria for purposes of applying the deduction limitation under section 162(m), service recipients be allowed to establish performance criteria within 90 days of the commencement of a performance period of 12 months or more, rather than having to establish such criteria before the commencement of the period. These regulations adopt a similar provision with respect to the establishment of performance criteria for purposes of the exception under the deferral election rules, permitting the criteria to be established up to 90 days after the commencement of the period of service to which the criteria relates, provided that the outcome is not substantially certain at the time the criteria are established.

The legislative history indicates that to constitute performance- based compensation, the amount must be (1) variable and contingent on the satisfaction of preestablished organizational or individual performance criteria and (2) not readily ascertainable at the time of the election. H.R. Conf. Rep. No. 108-755, at 732 (2004). These regulations clarify that where the right to receive a specified amount is itself not substantially certain, the amount is not readily ascertainable as the amount paid could either be the specified amount or zero. Accordingly, these regulations provide that at the time of the initial deferral election, either the amount must not be readily ascertainable, or the right to the amount must not be substantially certain. So, for example, the right to a $10,000 bonus that otherwise qualifies as performance-based compensation could be deferred by an employee up to six months before the end of the performance period, provided that at the time of the deferral election the employee is not substantially certain to meet the criteria and receive the $10,000 payment.

Under the definition of bonus compensation provided in Notice 2005- 1, Q&A-22, bonus compensation does not include any amount or portion of any amount that is based solely on the value of, or appreciation in value of, the service recipient or the stock of the service recipient. Commentators criticized this limitation as inconsistent with the provisions of Sec. 1.162-27 governing application of the deduction limitation under section 162(m), and the legislative history to section 409A indicating that the definition of performance-based compensation for purposes of section 409A would be similar to that provided under section 162(m) and the regulations thereunder. These proposed regulations eliminate this limitation, so that performance-based compensation may be based solely upon an increase in the value of the service recipient, or the stock of the service recipient, after the date of grant or award. However, if an amount of compensation the service provider will receive pursuant to a grant or award is not based solely on an increase in the value of the stock after the grant or award (for example, in the case of restricted stock units or a stock right granted with an exercise price that is less than the fair market value of the stock as of the date of grant), and that other amount would not otherwise qualify as performance-based compensation, none of the compensation attributable to the grant or award is performance- based compensation. Nonetheless, an award of equity-based compensation may constitute performance-based compensation if entitlement to the compensation is subject to a condition that would cause a non-equity- based award to qualify as performance-based compensation, such as a performance-based vesting condition.

The Treasury Department and the IRS are concerned that the inclusion of such amounts in the definition of performance-based compensation could lead to a conclusion that an election to defer amounts payable under a stock right will necessarily comply with section 409A if the initial deferral election is made at least 6 months before the date of exercise. However, under these proposed regulations, a stock right with a deferral feature is subject to section 409A from the date of grant. To comply with section 409A, the arrangement would be required to specify a permissible payment time and a form of payment. The requirement would not be met if, at some point during the term of the stock right, the stock right becomes immediately exercisable and the holder may decide whether and when to exercise the stock right. In addition, where a deferral feature is added to an existing stock right the stock right generally would violate section 409A because the stock right would have a deferral feature and would not have specified a permissible payment time or event.

D. First Year of Eligibility

Section 409A and these proposed regulations contain an exception to the general rule regarding initial deferral elections, under which a service provider newly eligible for participation in a plan may make a deferral election within the first 30 days of participation in the plan, provided that the election may only apply to compensation with respect to services performed after the election. These regulations further provide that for compensation that is earned based upon a specified performance period (for example, an annual bonus), where a deferral election is made in the first year of eligibility but after the beginning of the service period, the election is deemed to apply to compensation paid for service performed subsequent to the election if the election applies to the portion of the compensation that is no greater than the total amount of compensation for the performance period multiplied by the ratio of the number of days remaining in the performance period after the election over the total number of days in the performance period.

 Commentators had requested that the plan aggregation rules not apply in determining whether a service provider is newly eligible for participation in a plan. The concern is that a mid-year promotion, or management reorganization or other corporate event may make the service provider eligible for an arrangement that is of the same type as an arrangement in which the service provider already participates. For example, an employee participating in a salary deferral account-balance plan may become eligible for a bonus and a bonus deferral arrangement that would also be an account-balance plan.

The Treasury Department and the IRS believe that the plan aggregation rules are necessary in this context. Without such a rule, service providers may attempt to take advantage of the new eligibility exception by establishing serial arrangements. For example, an employer may argue that a 2007 salary deferral program is a new program, and not a continuation of the 2006 salary deferral program. Commentators argue that standards should be provided comparing the terms of the two plans to distinguish new arrangements from those that are merely continuations of existing arrangements. However, such rules would by necessity be complicated and burdensome, generally relying on the facts and circumstances of the individual arrangements and resulting in administrative burden and uncertainties. Accordingly, these regulations retain the plan aggregation rules.

However, as discussed below, certain other initial deferral election rules have been provided that address many of the situations in which service recipients desire to grant service providers the opportunity to make initial deferral elections due to eligibility in new programs. For example, the rule governing initial deferral elections with respect to certain forfeitable rights discussed below allows initial deferral elections upon eligibility for many bonus programs and ad hoc equity-based compensation grants. The Treasury Department and the IRS request comments as to whether these rules adequately address the concerns raised with respect to the definition of plan for purposes of applying the initial eligibility exception.

E. Initial Deferral Election With Respect to Short-Term Deferrals

As discussed above, an amount that is paid by the 15th day of the third month following the end of the first taxable year in which the payment is no longer subject to a substantial risk of forfeiture generally will not constitute a deferral of compensation. Commentators asked how the deferral election rules apply to an election to defer such an amount. Generally, once the service provider has begun performing the services required to vest, no election to defer could be made that would meet the timing requirements for initial deferral elections. Commentators suggested that the rules governing subsequent changes to the time and form of payment could be applied to elections to defer these amounts. The regulations provide that for purposes of an election to defer amounts that would not otherwise be subject to section 409A due to the short-term deferral rule, the date the substantial risk of forfeiture lapses is treated as the original time of payment established by an initial deferral election, and the form in which the payment would be made absent a deferral election is treated as the original form of payment established by an initial deferral election. Accordingly, the service provider may elect to defer the payment beyond the time at which the payment originally was scheduled to be made, in accordance with the rules governing subsequent changes in the time and form of payment. In general, this means that the service provider must make the election at least 12 months before the right to the payment vests, and must defer the payment for a period of not less than 5 years from the date the right to the payment could vest. Thus, no payment could be made within 5 years of the date the right to the payment vests (including upon a separation from service), except for instances of a change in control of the corporation, death, disability or an unforeseeable emergency. This would also mean that if the right to the payment actually vests within 12 months of the election, and the election is given effect so that the payment is not made within the short-term deferral period, the deferral of the payment would violate the requirements of section 409A.

For example, an employee may be entitled to the immediate payment of a bonus upon the occurrence of an initial public offering, where such a condition qualifies as a substantial risk of forfeiture so that the arrangement would constitute a short-term deferral. At some point after obtaining the right to the payment but before the initial public offering, the employee elects to defer any potential bonus payment to a date 5 years from the date of the initial public offering. To comply with the initial deferral election rules, that deferral election must not be given effect for 12 months. Accordingly, if the initial public offering occurred within 12 months of the deferral election, the payment must be made at the time of the initial public offering in accordance with the short-term deferral rules. If the payment is not made at such time, but rather is made, for example, 5 years from the date of the initial public offering, the payment would be deemed deferred pursuant to an invalid initial deferral election effective before the required lapse of 12 months and the arrangement would violate section 409A.

F. Initial Deferral Election With Respect to Certain Forfeitable Rights

Commentators asked how the initial deferral election rules would apply with respect to grants of nonqualified deferred compensation that occur in the middle of a taxable year, especially where such grants were unforeseeable by the service provider. Under these circumstances, an initial deferral election could not be made by the service provider during the taxable year before the year in which the award was granted, unless the service recipient had the foresight to request such an election in the prior year. The Treasury Department and the IRS do not believe that a categorical exclusion from the initial deferral election rules is appropriate, because such a rule would encourage the characterization of all grants of nonqualified deferred compensation as occurring in the middle of the year and in large part render ineffective the initial deferral election rules set forth in section 409A. However, these regulations provide that where a grant of nonqualified deferred compensation is subject to a forfeiture condition requiring the continued performance of services for a period of at least 12 months, the initial deferral election may be made no later than 30 days after the date of grant, provided that the election is made at least 12 months in advance of the end of the service period. Under these circumstances, the election still must be made in all cases at least 12 months before the service provider has fully earned the amount of compensation, analogous to the general requirement that the election be made no later than the end of the year before the services are performed. The Treasury Department and the IRS believe that such a rule will provide a reasonable accommodation to service recipients granting certain ad hoc awards, such as restricted stock units, that often are subject to a requirement that the service provider continue to perform services for at least 12 months.

G. Initial Deferral Election With Respect to Fiscal Year Compensation

The legislative history to section 409A indicates that the Treasury Department and the IRS are to provide guidance coordinating the initial deferral election rules with respect to compensation paid by service recipients with fiscal years other than the calendar year. H.R. Conf. Rep. No. 108-755, at 732 (2004). These regulations provide such a rule, generally permitting an initial election to defer fiscal year compensation on or before the end of the fiscal year immediately preceding the first fiscal year in which any services are performed for which the compensation is paid. For these purposes, fiscal year compensation does not encompass all compensation paid by a fiscal year service recipient. Where the compensation is not specifically based upon the service recipient's fiscal year as the measurement period, the timing requirements applicable to an initial deferral election are unchanged. Accordingly, the rule applies to compensation based on service periods that are coextensive with one or more of the service recipient's consecutive fiscal years, where no amount of such compensation is payable during the service period. For example, a bonus based upon a service period of two consecutive fiscal years payable after the completion of the second fiscal year would be fiscal year compensation. In contrast, periodic salary payments or bonuses based on service periods other than the service recipient's fiscal year would not be fiscal year compensation, and the deferral of such amounts would be subject to the general rule.

H. Deferral Elections With Respect to Commissions

Commentators requested clarification with respect to the application of section 409A to commissions. These regulations address commissions earned by a service provider where a substantial portion of the services provided by the service provider consists of the direct sale of a product or service to a customer, each payment of compensation by the service recipient to the service provider consists of a portion of the purchase price for the product or service (for example, 10 percent of the purchase price), or an amount calculated solely by reference to the volume of sales (for example, $100 per item sold), and each compensation payment is contingent upon the service recipient receiving payment from an unrelated customer for the product or services. In that case, the service provider is treated as having performed the services to which the commission compensation relates during the service provider's taxable year in which the unrelated customer renders payment for such goods or services. Accordingly, under the general initial deferral election rule an individual service provider could make an initial deferral election with respect to such compensation through December 31 of the calendar year preceding the year in which the customer renders the payment from which the commission is derived.

VI. Time and Form of Payment

A. In General

The regulations incorporate the statutory requirement that payments be made at a fixed date or under a fixed schedule, or upon any of five events: a separation from service, death, disability, change in the ownership or effective control of a corporation (to the extent provided by the Secretary), or unforeseeable emergency. As requested by commentators, these regulations provide guidance on what it means for a payment to be made upon one of these events. Where the time of payment is based upon the occurrence of a specified event (such as one of the five events listed above or upon the lapse of a substantial risk of forfeiture as discussed below), the plan must designate an objectively determinable date or year following the event upon which the payment is to be made. For example, the plan may designate the payment date as 30 days following a separation from service, or the first calendar year following a service provider's death. The Treasury Department and the IRS recognize that it may not be administratively feasible to make a payment upon the exact date or year designated. Furthermore, the Tr