AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. SUMMARY: This document contains final regulations regarding the application of section 409A to nonqualified deferred compensation plans. The final regulations are necessary to clarify and explain the rules governing 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. FOR FURTHER INFORMATION CONTACT: Stephen Tackney, (202) 927-9639 (not a toll-free number). DATES: Effective Date: These regulations are effective April 17, 2007. Applicability Dates: For dates of applicability, see §1.409A-6(b). SUPPLEMENTARY INFORMATION: 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 a nonqualified deferred compensation plan, 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 (published as modified on January 6, 2005, in 2005-1 CB 274), setting forth initial guidance with respect to the application of section 409A, and supplying transition guidance pursuant to a statutory directive. A notice of proposed rulemaking (REG-15808004, 2005-2 CB 786 [70 FR 57930]) was published in the Federal Register on October 4, 2005. See §601.601(a)(3). A public hearing was conducted on January 25, 2006. In addition, the IRS received written and electronic comments responding to the notice of proposed rulemaking. After consideration of all the comments, the proposed regulations are adopted as amended by this Treasury decision. The amendments are discussed in this preamble. The Treasury Department and the IRS have also issued six additional notices providing transition guidance with respect to section 409A: (1) Notice 2005-94, 2005-2 CB 1208 (transition guidance with respect to 2005 reporting and withholding obligations); (2) Notice 2006-4, 2006-3 IRB 307 (transition guidance with respect to certain outstanding stock rights); (3) Notice 2006-33, 2006-15 IRB 754 (transition guidance with respect to the application of section 409A(b)); (4) Notice 2006-64, 2006-29 IRB 88 (interim guidance regarding payments necessary to meet Federal conflict of interest requirements); (5) Notice 2006-79, 2006-43 IRB 763 (additional transition relief); and (6) Notice 2006-100, 2006-51 IRB 1109 (transition guidance with respect to 2005 and 2006 reporting and withholding obligations). See §601.601(d)(2). For a discussion of the continued applicability of these notices, see the Effect on Other Documents section of this preamble.
Explanation of Provisions and Summary of Comments I. Structure and Format of RegulationsThe final regulations generally adopt the structure and format of the proposed regulations. A table of contents has been included in the final regulations, as well as several additional sets of examples addressing various topics. II. Definition of Nonqualified Deferred Compensation PlanA. Excluded plansThe final regulations exclude the types of plans described in section 409A(d)(1) from the definition of a nonqualified deferred compensation plan, as well as certain other arrangements that were also set forth in the proposed regulations. Accordingly, the final regulations generally provide that a nonqualified deferred compensation plan for purposes of section 409A does not include a qualified plan, a bona fide sick leave or vacation plan, a disability plan, a death benefit plan, or certain medical expense reimbursement arrangements. The final regulations clarify that the exemption from coverage under section 409A for certain welfare plans does not apply to medical expense reimbursements that constitute taxable income to the service provider. The coverage exemption applies only to arrangements that provide benefits that are excludable from gross income under section 105 or section 106. Several commentators requested clarification of when a leave program will be treated as a bona fide sick leave or vacation leave plan for purposes of section 409A. Another commentator requested a clarification of the definition of a compensatory time plan. Because the definitions of these terms may raise issues and require coordination with the provisions of section 451, section 125, and, with respect to certain taxpayers, section 457, the final regulations do not address these issues. Notice 2005-1, Q&A-6 provides that, until further guidance, taxpayers whose participation in a nonqualified deferred compensation plan would be subject to section 457(f) may rely on the definitions of bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan applicable for purposes of section 457(f) as also being applicable for purposes of section 409A. Until further guidance, such taxpayers may continue to rely on such definitions for purposes of section 409A. One commentator requested that a qualified employer plan for purposes of the exclusion from section 409A include certain plans covered by section 402(d) (certain plans with a foreign-situs trust treated as qualified plans with respect to the taxation of the participants and beneficiaries) and retirement plans described in section 1022(i)(2) of the Employee Retirement Income Security Act of 1974, as amended (certain Puerto Rican retirement plans). The final regulations adopt this suggestion. B. Section 457 plansThe final regulations provide that section 409A is not applicable to an eligible deferred compensation plan under section 457(b), but may be applicable to a deferred compensation plan that is subject to section 457(f). Commentators requested clarification of the application of the exception in the proposed regulations from the definition of deferred compensation referred to as the short-term deferral rule (described in section III.C.1 of this preamble) to a section 457(f) plan. As discussed below, a right to deferred compensation generally refers to a legally binding right in one taxable year to compensation that is or may be payable in a subsequent taxable year. For purposes of determining the time of payment, the term “payment” generally refers to an actual or constructive payment of cash or property. However, the final regulations provide that for purposes of the short-term deferral rule, an amount is treated as paid when it is included in income under section 457(f) whether or not an actual or constructive payment occurs. Accordingly, where the income inclusion under section 457(f) stems from the lapse of a substantial risk of forfeiture that is also treated as a substantial risk of forfeiture for purposes of section 409A, the amount included in income will be considered a short-term deferral for purposes of section 409A. However, the right to earnings on amounts that have previously been included under section 457(f) will be deferred compensation for purposes of section 409A unless the right to the earnings independently satisfies the requirements for an exclusion. C. Arrangements with independent contractorsThe final regulations provide that section 409A generally does not apply to an amount deferred under an arrangement between a service provider and an unrelated service recipient if during the service provider’s taxable year in which the service provider obtains a legally binding right to the deferred amount the service provider is actively engaged in the trade or business of providing services (other than as an employee or as a director of a corporation), and provides significant services to two or more service recipients to which the service provider is not related and that are not related to one another. The final regulations retain the safe harbor in the proposed regulations, under which a service provider is deemed to be providing significant services to two or more such service recipients for this purpose if the revenues generated from the services provided to any service recipient or group of related service recipients during such taxable year do not exceed 70 percent of the total revenues generated by the service provider from the trade or business of providing such services. Commentators expressed concern that the safe harbor did not permit independent contractors to know in advance whether the arrangements under which an independent contractor deferred compensation during a taxable year would be subject to section 409A. Commentators requested certain look-back periods, including the ability to use averaging over the previous three to five years, or to satisfy the 70 percent threshold over a certain portion of the previous three to five years. The Treasury Department and the IRS are concerned that the suggested rules would allow service providers to engage in strategic behavior to ensure that activity in certain years would be exempt from section 409A. Accordingly, the final regulations adopt an additional safe harbor that provides that a service provider that has actually met the 70 percent threshold in the three immediately previous years is deemed to meet the 70 percent threshold for the current year, but only if at the time the amount is deferred the service provider does not know or have reason to anticipate that the service provider will fail to meet the threshold in the current year. In response to comments, the final regulations provide that if an independent contractor qualifies for the safe harbor for exclusion from coverage under section 409A with respect to arrangements with unrelated service recipients, an arrangement between the independent contractor and a service recipient related to the independent contractor will not be subject to section 409A if the arrangement, and the practices under the arrangement, are bona fide, arise in the ordinary course of business, and are substantially the same as the arrangements and practices (such as billing and collection practices) applicable to one or more unrelated service recipients to whom the independent contractor provides substantial services and that produce a majority of the total revenue that the independent contractor earns from the trade or business of providing such services during the year. The final regulations further clarify that if at the time the legally binding right to the payment arose, the arrangement was not subject to section 409A because the service provider was an independent contractor that was eligible for this exclusion from coverage under section 409A, the amount deferred under the arrangement during that taxable year (and earnings credited to the deferred amount) will not become subject to section 409A in a later year if the service provider becomes an employee, independent contractor, or other type of service provider subject to the rules of section 409A. Commentators also requested that a service recipient be permitted to rely upon a representation of an independent contractor that the independent contractor meets the exclusion requirements, so that a service recipient will know whether it is subject to the reporting requirements with respect to amounts deferred subject to section 409A. The Treasury Department and the IRS are continuing to study this issue. D. Anti-abuse ruleIf a principal purpose of a plan is to achieve a result with respect to a deferral of compensation that is inconsistent with the purposes of section 409A, the Commissioner may treat the plan as a nonqualified deferred compensation plan for purposes of section 409A. III. Definition of Nonqualified Deferred Compensation PlanA. In generalThe final regulations provide that a nonqualified deferred compensation plan is a plan that provides for the deferral of compensation. The final regulations further provide that a plan generally provides for the deferral of compensation if, under its terms and the relevant facts and circumstances, a service provider has a legally binding right during a taxable year to compensation that, pursuant to its terms, is or may be payable to (or on behalf of) the service provider in a later year. For this purpose, an amount generally is payable at the time the service provider has a right to currently receive a transfer of cash or property, including a transfer of property includible in income under section 83, the economic benefit doctrine or section 402(b). Accordingly, a taxable transfer of an annuity contract is treated as a payment for purposes of section 409A. The definition of deferral of compensation in the final regulations excludes the condition that the amount not be actually or constructively received and included in income during the taxable year, because that language might cause confusion with respect to the applicable rules governing deferral elections and the prohibition on the acceleration of payments For example, if a service provider has made an irrevocable election to defer an amount of his or her salary to a future year, that amount is treated as deferred compensation regardless of whether the service recipient actually pays such amount to the service provider during the year in which the services are performed. Any early payment of the deferred compensation (or any right to receive such an early payment) generally would constitute an impermissible acceleration of the payment of the deferred amount. For this purpose, a plan will be treated as providing for a payment to be made in a subsequent year whether the plan explicitly so provides (including through a service provider election) or the deferral condition is inherent in the terms of the contract. Where the parties have agreed that a payment will be made upon an event that could occur after the year in which the legally binding right to the payment arises, the plan generally will provide for a deferral of compensation (unless otherwise excluded under a specific exception, such as the short-term deferral rule). For example, if a plan provides a service provider a right to a payment upon separation from service, the plan generally will result in a deferral of compensation regardless of whether the service provider separates from service and receives the payment in the same year as the grant, because under the plan the payment is conditioned upon an event that may occur after the year in which the legally binding right to the payment arises. Similarly, if an arrangement such as a stock option or stock appreciation right not otherwise excluded from coverage under section 409A provides a right to a payment for a term of years where the payment could be received during the short-term deferral period or a subsequent period but is not otherwise includible in income until paid, the arrangement will provide for deferred compensation even though the service provider could receive the payment during the short-term deferral period (for example, by exercising the stock option or stock appreciation right). However, where a plan does not specify a payment date, payment event or term of years, (or specifies a date or event certain to occur during the year in which the services are performed), the plan generally will not provide for the deferral of compensation if the service provider actually or constructively receives the payment within the short-term deferral period. The proposed regulations provided that earnings on deferred amounts are generally treated as deferred compensation for purposes of section 409A. Under the final regulations, whether a deferred amount constitutes earnings on an amount deferred, or actual or notional income attributable to an amount deferred, is determined under the principles defining income attributable to the amount taken into account under §31.3121(v)(2)-1(d)(2). A commentator requested clarification of whether a payment for a noncompetition agreement could be subject to section 409A. Because such a payment would occur in connection with the performance or nonperformance of services, and a covenant not to compete does not create a substantial risk of forfeiture for purposes of section 409A, a legally binding right obtained in one year to a payment in a subsequent year in connection with a noncompetition agreement generally would constitute deferred compensation. B. Legally binding rightThe regulations define deferral of compensation in the context of a legally binding right to a payment of compensation in a future taxable year. Commentators requested clarification of the standard that would be used to determine whether a service provider has a legally binding right. A legally binding right includes a contractual right that is enforceable under the applicable law or laws governing the contract. A legally binding right also includes an enforceable right created under other applicable law, such as a statute. One commentator suggested that no legally binding right exists where the payment is made only upon the realization of gain from a particular investment. For example, the commentator argued that a bonus payable based upon the amount that a service provider obtains in selling property should not be treated as granting the service provider a legally binding right to the payment until the property is sold. In such a situation, however, the requirement that the property be sold is a condition to the right to the payment, but the right to the payment is still a legally binding right. The service recipient could not simply revoke the promise, sell the property, and not pay the bonus. However, the condition that the property be sold before the service provider becomes entitled to payment may constitute a substantial risk of forfeiture, depending on the specific facts and circumstances. C. Short-term deferrals1. In generalSubject to the modifications described in this section III.C of the preamble, the final regulations generally adopt the short-term deferral rule that was contained in the proposed regulations. Under the short-term deferral rule, a deferral of compensation does not occur for purposes of section 409A if the arrangement under which a payment is made does not provide for a deferred payment and the payment is made no later than the 15th day of the third month following the later of the end of the service provider’s taxable year or the end of the service recipient’s taxable year in which occurs the later of the time the legally binding right to the payment arises or the time such right first ceases to be subject to a substantial risk of forfeiture (subject to certain extensions for unforeseeable events). For this purpose, an arrangement provides for a deferred payment if it provides for a payment that will be made or completed after a date or an event that will or may occur later than the end of the 2 ½ month period described in the preceding sentence, either because of an affirmative election on the part of the service provider or service recipient or a deferral condition inherent in the terms of the contract (for example, that the amount will be paid upon the service provider’s separation from service, which may occur in a future year). Several commentators requested that additional flexibility be provided to allow payments to be short-term deferrals. By analogy to the rules in the proposed regulations concerning when payments of deferred compensation amounts are considered timely for purposes of the payment date rules, the commentators suggested that payments should qualify as short-term deferrals if made by the end of the year after the year in which a substantial risk of forfeiture lapses, rather than by the 15th day of the third month of that year. The final regulations do not adopt this suggestion. The short-term deferral rule is based on the historical treatment of certain payments paid within a short period following the end of a taxable year as not constituting deferred compensation. See §1.404(b)-1T, Q&A-2(b). That short period has been defined as ending on the 15th day of the third month following the end of the year, subject to certain extensions for unforeseeable events. Extending the payment date by which a short-term deferral could be paid would be inconsistent with this approach and the legislative history of section 409A (H.R. Conf. Rep. No. 108-755, at 735 (2004)), and accordingly is not adopted in the final regulations. However, the final regulations liberalize the standard under which a payment can be a short-term deferral even if it is delayed due to unforeseeable events. The proposed regulations provided generally that payment could be delayed if the payment would jeopardize the service recipient’s solvency and such insolvency was unforeseeable at the time the service provider obtained the right to the payment. By contrast, the final regulations provide generally that payment may be delayed where the payment would jeopardize the ability of the service recipient to continue as a going concern. Commentators asked how the short-term deferral rule applies to a series of payments scheduled to commence following the lapse of a substantial risk of forfeiture. The final regulations provide that the short-term deferral rule applies separately to each payment, applying the technical definition of “payment” set out in the regulations, provided that the entire payment is made during the short-term deferral period. Accordingly, where a payment has been designated as a separate payment, it may qualify as a short-term deferral (and thus not deferred compensation) even where the service provider has a right to subsequent payments under the same arrangement. In contrast, where a payment has not been designated as a separate payment (such as, for example, a life annuity payment or a series of installment payments treated as a single payment), any initial payments in the series will not be treated as a short-term deferral even if paid within the short-term deferral period. For a discussion of the definition of payment, see §1.409A-3. Commentators suggested that a right to a reimbursement be treated as potentially subject to the short-term deferral rule, arguing that the right to the reimbursement payment is subject to a substantial risk of forfeiture that the service provider will not incur the expense. Commentators argued that the short-term deferral rule then could apply if the reimbursement payment were made within a short period following the occurrence of the expense. Generally, the risk that a service provider will fail to incur a reimbursable expense will not qualify as a substantial risk of forfeiture, so the short-term deferral rule will not be applicable. However, the final regulations provide considerable additional flexibility with regard to structuring reimbursement arrangements to meet the requirements of section 409A. For a discussion of these provisions, see section VII.B.2 of this preamble. 2. Application to event-based paymentsSome commentators asked whether any payments based on a legally binding right arising in the year of a separation from service are excluded from coverage under section 409A, if paid by the end of the relevant short-term deferral period. For example, where an employee had accrued benefits under a defined benefit supplemental executive retirement plan (SERP) during his career that was payable immediately upon a separation from service, including an amount accrued in the year of separation from service, commentators asked whether the payment of the portion of the benefits accrued in that final year is excluded from coverage under section 409A if paid by March 15 of the year following the separation from service, because the amount is paid within a short period following the year the service provider obtains a vested legally binding right to the additional benefit accrual. (This generally would be of most concern to specified employees subject to the requirement of a six-month delay in payment following a separation from service.) The analysis that applies in this situation is similar to that applied to the general definition of deferral of compensation, discussed in section III.A of this preamble. The short-term deferral rule does not provide an exclusion from the requirements of section 409A for such current-year benefit accruals because the rule does not apply to amounts of compensation subject to a deferral election. For this purpose, an election to defer includes either an affirmative election on the part of the service provider or a deferral condition inherent in the terms of the contract. Where the parties have agreed that a payment will be made upon an event that does not necessarily coincide with the lapsing of the substantial risk of forfeiture, and could occur at a time beyond the short-term deferral period, the arrangement provides for a deferral election such that the short-term deferral rule does not apply. Accordingly, in this example, because the benefits accrued in the final year of the SERP could have been paid upon an event occurring after the short-term deferral period (if, for example, the individual had not separated from service until a later year), the payment of the benefit accrued in the final year is subject to section 409A and is not a short-term deferral, even if paid by March 15 of the year following the separation from service. Also, for example, if a plan that is not subject to section 457(f) provides that an amount is subject to a substantial risk of forfeiture until the completion of three years of service, and is payable upon a separation of service following the three years of service, the right to the amount is not a short-term deferral even if the service provider separates from service immediately after vesting in the right, because under the plan the payment is based upon an event other than the lapsing of the substantial risk of forfeiture and such event may occur in a year subsequent to the year in which the risk of forfeiture lapses. Conversely, where a plan specifies no payment date or payment event, or specifies only the date at which the substantial risk of forfeiture lapses, the plan may qualify for the short-term deferral rule if the payment is made within the applicable short-term deferral period. However, such a plan generally would violate section 409A if the payment were made after the short-term deferral period. As discussed in this preamble with respect to the general definition of deferred compensation, to implement the statutory scheme, including the applicable reporting and form requirements, taxpayers generally must be able to determine whether an arrangement provides for a deferral of compensation at the time the service provider obtains a legally binding right to the compensation. Although a plan need not specify a payment date to be a short-term deferral that is excluded from coverage under section 409A, the short-term deferral exclusion does not apply if the payment event or date is specified and will or may occur after the end of the short-term deferral period. The preamble to the proposed regulations explained that where a plan requires that a payment be made on a date within the short-term deferral period, but the payment is made after the specified date and after the end of the short-term deferral period, the arrangement will be treated as a nonqualified deferred compensation plan, but the payment date will be treated as a specified date. Thus, under such an arrangement, if the service provider receives the payment after the specified date, but not later than the end of the year in which the specified date occurs, the payment generally will comply with section 409A. However, taxpayers should note that a provision requiring only that a payment be made on or before the end of the short-term deferral period may not qualify as a permissible specified date for this purpose, if under the facts and circumstances the payment could have been made in more than one taxable year. For a discussion of the application of the definition of a specified payment date to this type of plan, see section VII.B of this preamble. For a discussion of when rights to compensation upon a separation from service for good reason may be treated as rights to compensation upon an involuntary termination, and the potential application of the short-term deferral exception to these arrangements, see section III.J.3 of this preamble. D. Stock options and stock appreciation rights1. In generalSubject to the modifications described in this preamble, the final regulations adopt the provisions of the proposed regulations excluding from coverage under section 409A statutory stock options and certain other stock rights. Generally under the regulations, nondiscounted stock options and nondiscounted stock appreciation rights issued on service recipient stock that do not include any additional deferral feature are excluded from section 409A. 2. Statutory stock optionsThe final regulations adopt the exclusion from coverage under section 409A for statutory stock options, including incentive stock options described in section 422 of the Code and options granted under an employee stock purchase plan described in section 423 of the Code. This exclusion applies regardless of whether the statutory stock option would be excluded if the same option were not treated as a statutory stock option. For example, an employee stock purchase plan described in section 423 offering a discounted purchase price is not a deferred compensation plan for purposes of section 409A. Commentators requested clarification, however, of the treatment of a statutory stock option that is modified, or otherwise becomes ineligible to be treated as a statutory stock option. The final regulations adopt the rule set forth in the proposed regulations, and provide that at the time of such modification or event, the modification or other event is treated as the grant of a new option, or causes the option to be treated as having had a deferral feature from the date of grant, as applicable, for purposes of section 409A only if such modification or other event would have been so treated had the option been a nonstatutory stock option immediately before such modification or other event. For example, where an incentive stock option is modified through an extension of the option’s term, the extended option will be treated as having had an additional deferral feature from the date of grant for section 409A purposes only if the same extension of a nonstatutory stock option would have resulted in such treatment. Commentators also requested that the exclusion from coverage under section 409A for certain stock rights issued under plans meeting the requirements of section 423 (employee stock purchase plans) be extended to employee stock purchase plans offered by foreign employers that do not meet such requirements, where the shares are made available for purchase at a discount and substantially all of the participants are nonresident aliens. The legislative history does not provide a basis for extending the exception applicable to options meeting the requirements of section 423 to grants of discounted stock options not meeting the requirements of section 423. Accordingly, this suggestion is not adopted in the final regulations. 3. Definition of service recipient stockThe final regulations adopt the requirement in the proposed regulations that for the exclusion for certain stock rights to apply, the stock right must relate to service recipient stock. Commentators criticized the definition of service recipient stock contained in the proposed regulations as too restrictive. Generally such criticisms centered on two different aspects of the definition of service recipient stock in the proposed regulations – the classes of stock that may qualify as service recipient stock, and the issuer or issuers whose stock may constitute service recipient stock, where the service recipient is comprised of more than one entity. a. Classes of stock that may qualify as service recipient stockCommentators requested clarification and expansion of the classes of stock of a corporation that may constitute service recipient stock. Commentators generally focused on two issues. First, with respect to stock of a particular service recipient corporation, commentators requested that the stock right be permitted to relate to any class of common stock, regardless of whether another class of common stock of that corporation was publicly traded, and regardless of whether that class of common stock had the greatest aggregate value of all classes of common stock issued by that corporate entity. Subject to the restrictions governing certain preferences as to distributions, the final regulations generally provide that any class of common stock may be used, regardless of whether another class of common stock that could qualify as service recipient stock is publicly traded or has a higher aggregate value outstanding, and regardless of whether the class of stock is subject to transferability restrictions or buyback rights (provided such buyback rights reflect the fair market value of the stock at the time of purchase). Second, commentators suggested narrowing the types of preferences on a class of common stock that would prohibit that class from being treated as service recipient stock. One commentator requested that the classes of stock permitted as service recipient stock include any class of stock that is widely held by non-service recipients. While it may be unlikely that a widely–held class of stock was created to facilitate an abusive avoidance of section 409A, it does not follow that service recipient stock rights issued on such stock necessarily would be consistent with the intended application of section 409A if, for example, holders of such class enjoyed preferences that would make such stock rights a suitable substitute for nonqualified deferred compensation. To be treated as service recipient stock under the final regulations, a class of stock must qualify as common stock under section 305 of the Code. Accordingly, the final regulations provide that stock that is not common stock under section 305 is not service recipient stock for purposes of section 409A. However, the mere classification of a class of stock as common stock under section 305 is not sufficient for such stock to be treated as service recipient stock for purposes of section 409A. The Treasury Department and the IRS are concerned that classes of stock that are common stock under section 305 may provide preferences that could permit stock rights with respect to such stock to resemble traditional nonqualified deferred compensation, such that exclusion of such stock rights would permit the avoidance of section 409A. Commentators suggested that a preference with respect to liquidation rights, without any other preferences such as a preferential right to dividends, should be permitted under the definition of service recipient stock. A holder of this class of stock would not be guaranteed any return, but rather would simply be guaranteed preferred distribution rights upon a complete liquidation of the service recipient. The final regulations generally adopt this suggestion. With respect to other preferential rights, commentators were unable to provide a workable standard under which permissible preferences could be distinguished from impermissible preferences. Accordingly, the final regulations do not treat any stock including such preferences as service recipient stock. However, the Treasury Department and the IRS continue to study this area, and the final regulations authorize the publication of other additional guidance, should a workable standard be developed. b. Entities the stock of which may qualify as service recipient stockCommentators also requested an expansion of the class of entities the stock of which can qualify as service recipient stock where the service recipient is comprised of multiple entities. The Treasury Department and the IRS believe that the stock right exception under section 409A was intended to cover stock rights directly reflecting the enterprise value of the entity for which the service provider is providing services. Consistent with this approach, the final regulations provide that service recipient stock may include the stock of the corporation for which the service provider was providing services at the date of grant. In addition, the final regulations provide that service recipient stock may include stock of any corporation in a chain of organizations all of which have a controlling interest in another organization, beginning with the parent organization and ending with the organization for which the service provider was providing services at the date of grant of the stock right. Similarly to the proposed regulations, the final regulations provide that the term “controlling interest” has the same meaning as provided in §1.414(c)-2(b)(2)(i), except that where that regulation requires at least an 80 percent interest, the final regulations generally require only a 50 percent interest. In addition, where the use of such stock with respect to the grant of a stock right to such service provider is based upon legitimate business criteria, the final regulations generally require only a 20 percent interest. For purposes of determining ownership of an interest in an organization, the attribution rules of §1.414(c)-4 apply, and the exclusion rules of §1.414(c)-3 also apply. For example, under the final regulations, with respect to an employee of a subsidiary corporation, the common stock of the ultimate parent corporation, or of a subsidiary corporation anywhere in the chain of corporate ownership between the subsidiary that employed the employee and the ultimate parent corporation (a higher tier subsidiary), could qualify as service recipient stock for purposes of determining whether a stock right issued to such employee with respect to such stock was excluded from coverage under section 409A, provided that the 50 percent or 20 percent ownership standard, as applicable, was satisfied by each corporation in the chain. The proposed regulations contained many requirements for using an ownership level of less than 50 percent. Commentators requested several simplifications of these requirements. In response, the final regulations no longer require a formal election by any corporation. Rather, each individual grant of a stock right is analyzed to determine whether the stock qualifies as service recipient stock with respect to a service provider at the time the stock right is granted. If a corporation owns at least 50 percent of the stock of one corporation and owns less than 50 percent of the stock of another corporation, and it intends to treat its stock as service recipient stock with respect to employees of both corporations, there is no requirement that a legitimate business criteria exist with respect to the issuance of stock rights on the parent corporation stock to service providers of the first such corporation. The legitimate business criteria standard applies only to stock rights issued to service providers of subsidiaries that are not majority-owned, because the test of legitimate business criteria relates to the actual issuance of a stock right to a particular service provider. Accordingly, a subsidiary may have more than one shareholder corporation the stock of which qualifies as service recipient stock with respect to a subsidiary employee such as, for example, where three entities each own a one-third interest in the subsidiary. However, with respect to each grant of a stock right on stock of a particular non-majority shareholder corporation to a service provider of a particular subsidiary, there must exist legitimate business criteria for issuing such a stock right. Even if legitimate business criteria exist with respect to the issuance of a stock right on stock of a particular shareholder corporation to a particular service provider, legitimate business criteria may or may not exist with respect to the issuance of a stock right to the same service provider on stock of another shareholder corporation. The legitimate business criteria requirement is a facts and circumstances test, focusing generally on whether there is sufficient nexus between a particular service provider and the entity, the stock of which underlies the stock right granted to the service provider, for the grant to serve a legitimate non-tax business purpose. As provided in the preamble to the proposed regulations, if a corporation issued a stock right on its stock to a current employee of a joint venture in which the corporation was a venturer, and the employee was a former employee of the corporate venturer, generally the issuance would be based on legitimate business criteria. Similarly, if the corporate venturer issued such a right to an employee of the joint venture who it reasonably expected would become an employee of the corporate venturer in the future, generally the legitimate business criteria requirement would be met. By contrast, where an employee has no real nexus with a corporate venturer, such as generally happens when the corporate venturer is a passive investor in the service recipient, the use of the investor corporation stock as the stock underlying a stock right grant to that employee generally would not be based upon legitimate business criteria. Similarly, where a corporation holds only a minority interest in an entity that in turn holds a minority interest in the entity for which the employee performs services, such that the corporation holds only an insubstantial indirect interest in the entity receiving the services, legitimate business criteria generally would not exist for issuing a stock right on the corporation’s stock to the employee. The Treasury Department and the IRS remain concerned that the manipulation of the structure of a related group of corporations may be used to allow stock options or stock appreciation rights to mimic the characteristics of nonqualified deferred compensation, by compensating holders based on predictable amounts and investment returns unrelated to the enterprise value of an operating entity. Accordingly, the exception contained in the proposed regulations under which the stock of a corporation serving as investment vehicle is not considered service recipient stock has been retained. In addition, an anti-abuse rule has been added to address corporate structures, transactions, or stock right grants, a principal purpose of which is the avoidance of the application of section 409A to an arrangement otherwise providing deferred compensation. These corporate structures, transactions, and stock right grants generally will occur where the structure, transaction, or grant is intended to provide enhanced security for the value of the stock right as a means of providing deferred compensation, rather than as compensation related to an increase in the true enterprise value of the service recipient. The regulations provide that if an entity becomes a member of a group of corporations or other entities treated as a single service recipient, and the primary source of income or value of such entity arises from the provision of management services to other members of the service recipient group, if any stock rights are issued with respect to such entity it is presumed that such structure was established for purposes of avoiding the application of section 409A. c. Equity interests in certain non-corporate entitiesThe final regulations permit certain equity interests in a non-stock mutual company to be treated analogously to equity interests in a corporation. Commentators requested that the definition of service recipient stock be expanded to cover interests in cooperatives and interests in the value of an Indian tribal enterprise. The regulations do not include such interests in the definition of service recipient stock, but provide the IRS authority to provide guidance expanding the definition of service recipient stock. For a discussion of the application of the exclusion for certain stock rights to rights issued on equity interests in entities taxed as partnerships, see section III.G of this preamble. 4. Valuationa. In generalThe final regulations provide that for the exclusion for stock rights to apply, the stock right must specify an exercise price of the stock right that may never be less than the fair market value of the underlying stock on the date the stock right is granted. For purposes of this discussion and the final regulations, the exercise price of a stock appreciation right refers to the base stock value from which the appreciation is measured for purposes of determining the compensation payable under the stock appreciation right (for example, a stock appreciation right providing for a payment of the excess of the fair market value of 100 shares over $100 would have a $1 per share exercise price). Several commentators expressed concerns regarding the determination of the fair market value of the underlying stock. Some commentators requested that the valuation rules applicable to incentive stock options be applied for purposes of the exclusion from section 409A. Under those rules, if the stock option would otherwise fail to be an incentive stock option solely because the exercise price was less than the fair market value of the underlying stock as of the date of grant, generally the option is treated as an incentive stock option if the issuer attempted in good faith to set the exercise price at fair market value. See section 422(c)(1). The Treasury Department and the IRS believe that this is not the appropriate standard for determining whether stock rights are subject to section 409A. Incentive stock options are subject to strict limitations on the amount of such options that may be granted to a particular employee. See section 422(d). In contrast, there are no such limits applicable to nonstatutory stock options, and grants of nonstatutory stock options often far exceed the limitation applicable to incentive stock options. In addition, section 422(c)(1) explicitly provides for the good faith standard with respect to incentive stock options, while no such provisions exist within section 409A or its legislative history. Commentators requested clarification of the consistency standard with respect to the use of a valuation method. Specifically, commentators asked whether one valuation method could be used for purposes of establishing the exercise price while another method could be used for purposes of determining the fair market value of the stock at the time of the payment (for example, to determine the amount of payment in the case of a stock appreciation right or a stock option where the stock is subject to repurchase by the service recipient). The final regulations clarify that consistency is not required, provided that each valuation method used otherwise meets the requirements of the final regulations. Accordingly, a service recipient may use one valuation method for purposes of establishing an exercise price, but another valuation method for purposes of establishing the payment amount (in the case of a stock appreciation right) or the buyback amount (in the case of a stock option where the underlying stock is subject to a buyback arrangement). However, once an exercise price has been established, the exercise price may not be changed through the retroactive use of another valuation method. In addition, where after the date of grant, but before the date of exercise, of the stock right, the service recipient stock to which the stock right relates becomes readily tradable on an established securities market, the service recipient must use a valuation method for stock readily tradable on an established securities market for purposes of determining the payment amount (in the case of a stock appreciation right) or the buyback amount (in the case of a stock option where the underlying stock is subject to a buyback arrangement). b. Valuation - stock readily tradable on an established securities marketThe final regulations adopt the rules under the proposed regulations governing valuation of stock readily tradable on an established securities market, generally requiring that the valuation of such stock be based upon the contemporaneous prices established in the securities market, subject to the modifications discussed in this preamble. Some commentators requested additional guidance with respect to when a stock will be treated as readily tradable. The final regulations adopt the same standard as that set forth in §1.280G-1, Q&A-6(e), that stock is treated as readily tradable if it is regularly quoted by brokers or dealers making a market in such stock. With respect to the rules governing the valuation of stock that is readily tradable on an established securities market, commentators generally focused on the provision of the proposed regulations permitting the use of an average selling price during a specified period that is within 30 days before or 30 days after the date of grant. Specifically, comments concentrated on the requirement that the commitment to grant the stock right with an exercise price set using such an average selling price be irrevocable before the beginning of the specified period. Commentators questioned both the purpose of the requirement of the commitment to the valuation method, as well as the actions required to satisfy the rule if averaging were being used. The rule was intended to prohibit the use of an average price, set on a look-back basis, to ensure a discounted exercise price. For example, if a corporation decided to grant a stock option on July 1, and it could set the exercise price using an average selling price for any period falling within the prior 30 days without having had a prior commitment to a specific averaging period, the corporation could simply look for the lowest price that occurred during the prior June. Furthermore, if the corporation were not committed to grant the stock option on July 1, the corporation could wait until its stock price began to rise and then grant an option using the selling price on a given day during the previous 30 days to provide a particular discount. Accordingly, the final regulations require that the commitment to grant the stock right with an exercise price set using such an average selling price be irrevocable before the beginning of the specified period. To satisfy this requirement, the service recipient must designate the recipient of the stock option, the number of shares the stock option will permit the holder of the stock option to purchase, and the method for determining the exercise price including the period over which the averaging will occur, before the beginning of the specified averaging period. One commentator stated that the requirement of an irrevocable commitment to the averaging period could not be met under French law, because French law requires that the stock option exercise price be set based on the average trading price over the preceding 20 days and the commitment to the grant before the beginning of the period may be viewed as violating that requirement. The final regulations provide that where applicable foreign law requires that the compensatory stock right granted by the issuer must be priced based upon a specific price averaging method and period, a stock right granted in accordance with such applicable foreign law will be treated as meeting the requirement, provided that the averaging period may not exceed 30 days. c. Valuation – stock not readily tradable on an established securities marketi. In generalThe final regulations adopt the provisions in the proposed regulations relating to the valuation of stock not readily tradable on an established securities market, subject to the modifications discussed in this section III.C.4.c. Accordingly, a valuation of stock based upon a reasonable application of a reasonable valuation method is treated as reflecting the fair market value of the stock. To meet this standard, it is not necessary that a taxpayer demonstrate that the value was determined by an independent appraiser. Where the taxpayer can otherwise demonstrate that the valuation was determined by the reasonable application of a reasonable valuation method, the standard will be met. One commentator requested that the factors to be considered in determining the fair market value of the stock should be modified to include consideration of any recent equity sales made by the corporation in arm’s-length transactions. The final regulations adopt this suggestion. The final regulations continue to require that in the case of a stock right issued with respect to stock that was not publicly traded at the time the right was issued, but becomes publicly traded before the right is exercised, the stock value for purposes of calculating the payment amount (in the case of a stock appreciation right) or the buyback amount (in the case of a stock option where the underlying stock is subject to a buyback agreement) must be based upon the rules governing stock that is publicly traded. This does not mean that the initial exercise price determined under the rules governing stock that is not publicly traded must be reset. Rather, this means only that the value at the time of exercise used to determine the payment amount or the buyback amount must be determined under the rules governing stock that is publicly traded. For example, if a service provider holds an excluded stock appreciation right with an exercise price of $1 that was fixed based on a valuation of the closely-held corporate stock at the time of grant, and before exercise the stock becomes readily tradable on an established securities market, the amount payable upon exercise must be the excess of the value of the stock based on its trading price over the $1 exercise price. ii. Safe harbor presumptionsThe final regulations adopt a presumption in specified circumstances that, for purposes of section 409A, a valuation of stock reflects the fair market value of the stock, rebuttable only by a showing that the valuation is grossly unreasonable. The presumption applies where the valuation is based upon an independent appraisal, a generally applicable repurchase formula (applicable for both compensatory and noncompensatory purposes) that would be treated as fair market value under section 83, or, in the case of illiquid stock of a start-up corporation, a valuation by a qualified individual or individuals applied at a time that the corporation did not otherwise anticipate a change in control event or public offering of the stock. Many of the comments with respect to these presumptions related to the presumption applicable to illiquid stock of start-up corporations. As set forth in the proposed regulations, the start-up corporation presumption would not apply if the service recipient or service provider could reasonably anticipate, as of the time the valuation is applied, that the service recipient would undergo a change in control event or make a public offering of securities within the 12 months following the event to which the valuation is applied. Commentators suggested that a 12-month period is too long, because changes occur so rapidly in the business world that it often is difficult or impossible to predict so far in advance whether such an event will occur. Commentators suggested that the service provider should retain the benefit of the presumption unless the issuing corporation entered into a definitive agreement or filed its registration statement with the Securities and Exchange Commission within a period of 15 or 30 days after issuing the stock right. The Treasury Department and the IRS believe that a 15-day or a 30-day period is too short. Although there is always a risk that a public offering will fail or that a corporate transaction will not occur, the Treasury Department and the IRS also believe that a person should reasonably be able to anticipate whether such a transaction will occur during a reasonable period before the transaction. Accordingly, the final regulations provide that the start-up corporation presumption will not apply if at the time the valuation is made, the service recipient or service provider may reasonably anticipate that the service recipient will undergo a change in control event in the next 90 days or an initial public offering within the next 180 days. As under the proposed regulations, the rule in the final regulations is concerned with what the parties may reasonably anticipate at the time the stock right is issued. Other comments requested examples of persons with sufficient knowledge, experience, and skill in valuing illiquid stock of a start-up corporation. Because knowledge, skill and training may be obtained in different ways, the final regulations do not provide specific examples. However, the regulations clarify that the standard to be applied is whether a reasonable individual, upon being apprised of such person’s relevant knowledge, experience, education and training, would reasonably rely on the advice of such person with respect to valuation in deciding whether to accept an offer to purchase or sell the stock being valued. The final regulations also clarify that significant experience generally means at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the service recipient operates. With respect to the presumption based upon a generally applicable buyback formula, some commentators requested that the presumption apply where the formula is applicable to all compensatory stock transactions, but not also applicable to all noncompensatory stock transactions. The final regulations do not adopt this suggestion. However, the final regulations clarify that to meet the requirements of the presumption, the buyback formula is required to be applicable to compensatory and noncompensatory transactions with the issuer or a person owning 10 percent or more of the stock of the issuer, but is not required to be applicable to transactions with other persons or transactions that are part of an arm’s length transaction constituting the sale of all or substantially all of the stock of the issuer to an unrelated purchaser. 5. Modification of a stock rightThe final regulations continue to apply certain rules addressing modifications, extensions and renewals of stock rights. Although these rules in many respects resemble the rules applicable to statutory stock options, the rules are not intended to incorporate the rules applicable to statutory stock options except where explicitly provided. The final regulations generally retain the rules in the proposed regulations that generally treat extensions of the exercise period of a stock right as an additional deferral feature as of the date of grant of the right, with an exception for certain limited extensions following a separation from service. Commentators characterized these rules as unnecessarily restrictive. Specifically, commentators argued that the extension of a stock option upon the occurrence of a separation from service (often in connection with a program of layoffs) or a corporate transaction is a common practice, and that often these extensions cover periods longer than the limited period provided in the proposed regulations. In addition, commentators argued that the same substantive results could be obtained by specifying a longer term for the stock right and providing the service recipient the discretion to shorten the term, rather than providing discretion to extend a shorter term, and that the former approach would be permissible under the proposed regulations. In response, the final regulations provide that the extension of an option exercise period generally is not treated as an additional deferral feature or a modification of the stock option for section 409A purposes if the exercise period is not extended beyond the earlier of the original maximum term of the option or 10 years from the original date of grant of the stock right. Many commentators also requested that the extension of the exercise period of a stock right not be treated as an additional deferral feature for purposes of section 409A, where at the time of the extension the fair market value of the underlying stock does not exceed the exercise price (an “underwater” option). Because the issuance of an otherwise identical option with an exercise period ending after the end of the exercise period of the underwater option would be excluded from coverage under section 409A, the final regulations provide that such an extension does not constitute an additional deferral feature. The final regulations adopt the provisions in the proposed regulations regarding substitution or assumption of stock rights due to a corporate transaction, which are generally in accordance with the corresponding provisions governing incentive stock options. The final regulations clarify that the applicable corporate transactions for this purpose include only those transactions described in §1.424-1(a)(3). One commentator requested that the provision permitting substitutions of stock options be modified to reflect that a holder of a nonstatutory stock option is not required to be employed by the successor entity. The final regulations adopt this suggestion, so that a substituted nonstatutory stock option may be treated as a continuation of the initial option even where the holder of the option is not employed or otherwise providing services to the successor entity, provided the substitution otherwise meets the rules provided in the regulations. 6. Other stock right issuesThe final regulations adopt certain definitions from the regulations governing statutory stock options, modified as appropriate for purposes of applying the rules under section 409A. These include the time and date of grant of an option (§1.421-1(c)), and the definitions of option (§1.421-1(a)), stock (§1.421-1(d)), exercise price (§1.424-1(e)), exercise (§1.421-1(f)), and transfer (§1.421-1(g)). These definitions apply by analogy to stock appreciation rights. The final regulations adopt the rule that a right to a payment of accumulated dividend equivalents at the time of the exercise of a stock right generally will be treated as a reduction in the exercise price of the stock right, causing the stock right to be deferred compensation subject to the requirements of section 409A. The final regulations provide that an arrangement to accumulate and pay dividend equivalents the payment of which is not contingent upon the exercise of a stock right may be treated as a separate arrangement for purposes of section 409A. Such an arrangement generally will be required to comply with section 409A (unless it independently qualifies for an exception from coverage under section 409A), but will not affect whether the related stock right qualifies for the exclusion from coverage under section 409A. The right to the dividend equivalents may be set forth within the stock right plan or the individual stock right grant, or in a separate document, as long as the payment of the dividend equivalents is not contingent upon the exercise of the stock right. Commentators also asked whether the exclusion of stock rights from coverage under section 409A would apply to tandem rights, meaning a stock right that combines a stock option right and a stock appreciation right, exercisable on an alternative basis. Similarly, commentators asked whether the substitution of a stock option for a stock appreciation right, or vice versa, where all the terms except the mode of payment upon exercise are similar, would be treated as a modification of a stock right. The application of section 409A generally is not affected by the medium of a taxable payment (for example, cash or stock). Accordingly, whether a stock right is expressed as a tandem arrangement under which the exercise of one right terminates the other right, or there is a substitution of a stock appreciation right for a stock option identical in all respects except for the medium of payment, generally does not impact whether the arrangement is excluded from coverage under section 409A. Commentators requested further clarification of the application of section 409A to stock option gain deferrals. The ability to defer gain upon the exercise or exchange (including a purported forfeiture) of a stock right is incompatible with the exclusion of certain stock rights from the requirements of section 409A because such exclusion is predicated on the option not having any additional deferral feature. Accordingly, if an arrangement provides for a potential to defer the payment of cash or property upon the exercise or exchange of a stock right beyond the year the right is exercised or beyond the original term of the stock right, the arrangement provides for a deferral feature and must comply with the requirements of section 409A from the time the legally binding right granted by the award arises. Because a stock option with a deferral feature is subject to section 409A regardless of whether the deferral feature is actually utilized, an option that includes a provision permitting deferral of option gain generally will not satisfy the time and form of payment rules under section 409A if the service provider can exercise the option in more than one taxable year. If a deferral feature is added to a preexisting option, the option will be treated as having included a deferral feature as of the original date of grant, generally resulting in a violation of section 409A. However, the final regulations provide that a stock right will not be treated as having a deferral feature where the service recipient delays a payment because the making of the payment would violate applicable Federal, state, local, or foreign law or jeopardize the ability of the service recipient to continue as a going concern. Although these provisions permit the delay for purposes of section 409A, no inference should be drawn as to the Federal tax consequences of such a delay under any other section of the Code or Federal tax doctrine such as section 83, section 451, the constructive receipt doctrine, or the economic benefit doctrine. Commentators requested that the definition of service recipient stock be expanded to include the stock of a corporation for which a service recipient provides substantial services, at least with respect to a service provider of the service recipient that is providing services to the corporation. The legislative history does not support such a broad interpretation of service recipient stock, and the final regulations do not adopt this suggestion. E. Restricted propertyThe final regulations provide, as did the proposed regulations, that a grant of restricted property generally will not constitute a deferral of compensation for purposes of section 409A. Commentators requested that the regulations clarify that a vested right to receive nonvested property in a future year does not constitute deferred compensation. Commentators argued that a right to receive nonvested property is not truly vested. For example, commentators argued that a right to receive restricted stock that will be subject to a substantial risk of forfeiture until the service provider completes three years of future services cannot be a vested right. The final regulations adopt this suggestion, so long as the risk of forfeiture to which the stock is subject constitutes a substantial risk of forfeiture for purposes of section 409A. Commentators specifically requested clarification of the circumstances under which a service provider may elect to be paid a bonus or other payment in the form of restricted stock, rather than cash. Generally an election between compensation alternatives, none of which provides for a deferral of compensation within the meaning of section 409A, will not cause the election to be subject to the section 409A timing restrictions. Thus, a choice between an award of restricted stock or stock options that are not subject to section 409A will not be governed by the section 409A election timing rules. However, where any of the alternatives involves a deferral of compensation subject to section 409A, the election must comply with the provisions of section 409A. In addition, no inference should be drawn as to the Federal tax consequences of such an election provision under any other section of the Code or Federal tax doctrine such as section 83, section 451, the constructive receipt doctrine, or the economic benefit doctrine. F. Section 402(b) trustsThe final regulations continue to except from coverage under section 409A transfers of a beneficial interest in a trust, or a transfer to or from a trust, to the extent such a transfer is subject to section 402(b). The final regulations further clarify that a right to compensation required to be included in income under section 402(b)(4)(A) (alternative taxation of highly compensated employees of a section 402(b) trust that fails to meet the requirements of section 401(a)(26) or section 410(b)) also is not a deferral of compensation. However, a right to receive a benefit formulated as a right to a future contribution to a section 402(b) trust is similar to a right to receive property in a future taxable year, and generally would constitute deferred compensation. G. Arrangements between partnerships and partnersThe proposed regulations did not address the application of section 409A to arrangements between partnerships and partners, and these final regulations also do not address such arrangements. The statute and the legislative history of 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. Commentators raised 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 are continuing to analyze the issues raised in this area. 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 and section II.E. of the preamble to the proposed regulations. Notice 2005-1, Q&A-7 provided that until further guidance is issued for purposes of section 409A, taxpayers may treat the issuance of a partnership interest (including a profits interest) or an option to purchase a partnership interest, granted in connection with the performance of services under the same principles that govern the issuance of stock. For this purpose, taxpayers may apply the principles applicable to stock options or stock appreciation rights under these final regulations, as effective and applicable, to equivalent rights with respect to partnership interests. Taxpayers also may continue to rely upon the explanation in the preamble to the proposed regulations regarding the application of section 409A to guaranteed payments for services described in section 707(c). As stated in that preamble, 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. Commentators raised issues concerning the application of the provision in Notice 2005-1, Q&A-7 stating that until further guidance is issued, taxpayers may treat arrangements providing for payments subject to section 736 (payments to a retiring partner or a deceased partner’s successor in interest) as not being subject to section 409A, except that an arrangement providing for payments that qualify as payments to a partner under section 1402(a)(10) is subject to section 409A. Section 1402(a)(10) provides for an exception from the Self-Employment Contributions Act (SECA) tax for payments to a retired partner, provided that certain conditions are met. Specifically, the payments must be made pursuant to a written plan of the partnership, must be on account of the partner’s retirement and must continue at least until the partner’s death. In addition, to qualify for the exception, the partner must not have rendered services during the partnership’s taxable year ending within or with the partner’s taxable year in which the amounts were received, as of the close of the partnership’s taxable year no obligation must exist from the other partners to such retired partner except with respect to retirement payments under such plan, and before the end of the partnership’s taxable year such retired partner’s share, if any, of the capital of the partnership must have been paid to him in full. Commentators questioned the appropriateness of the inclusion of such arrangements under section 409A, because neither the statute nor the legislative history refers to section 1402(a)(10). However, the Treasury Department and the IRS believe it is appropriate for such arrangements to be subject to section 409A because such arrangements are purposefully created to provide deferred compensation, and do not raise issues regarding the coordination of the provisions of section 409A with the provisions of section 736, specifically the rules governing the classification of payments to a retired partner under section 736(a) (payments considered as distributive share or guaranteed payments) and section 736(b) (payments for interest in partnership). However, further clarification and relief is provided concerning the application of the deferral election timing rules to these payments. Until further guidance is issued, for purposes of section 409A, taxpayers may treat the legally binding right to the payments excludible from SECA tax under section 1402(a)(10) as arising on the last day of the partner’s taxable year before the partner’s first taxable year in which such payments are excludible from SECA tax under section 1402(a)(10), and the services for which the payments are compensation as performed in the partner’s first taxable year in which such payments are excludible from SECA tax under section 1402(a)(10). Accordingly, for purposes of section 409A, the time and form of payment of such amounts generally may be established, including through an election to defer by the partner, on or before the final day of the partner’s taxable year immediately preceding the partner’s first taxable year in which such payments are excludible from SECA tax under section 1402(a)(10). However, this interim relief does not apply a second time where an amount paid under an arrangement in one year has been excluded from SECA tax under section 1402(a)(10), and an amount paid in a subsequent year has not been excluded from SECA tax under section 1402(a)(10) because, for example, the partner performed services in that subsequent year. H. Foreign plans1. Plans covered by an applicable treatyThe proposed regulations provided an exclusion from the definition of a nonqualified deferred compensation plan for any scheme, trust, or arrangement maintained with respect to an individual where contributions made by or on behalf of such individual to such scheme, trust or arrangement are excludable for Federal income tax purposes under an applicable income tax treaty. The final regulations retain that exclusion and clarify that the exclusion applies to the extent contributions made by or on behalf of such individual to such scheme, trust, arrangement or plan, or credited allocations, accrued benefits, or earnings or other amounts constituting income, of such individual under such scheme, trust, arrangement or plan, are excludable by such individual for Federal income tax purposes pursuant to any bilateral income tax convention to which the United States is a party. 2. Exclusion for benefits earned under a broad-based foreign retirement planThe proposed regulations contained an exclusion from coverage under section 409A for amounts deferred under a broad-based foreign retirement plan, subject to certain conditions, including that the service provider not be eligible to participate in a qualified employer plan, and that if the person is a U.S. citizen or lawful permanent resident, the exception only applies to nonelective deferrals of foreign earned income (as defined in section 911(b)(1)) that do not exceed the limits under section 415(b) and (c) that would be applicable if the plan were a qualified plan. Deferrals by participants that are nonresident aliens are not subject to the limitation based on section 415. The final regulations adopt this provision, subject to certain modifications. Many of the commentators requested expansion of the exclusion for broad-based foreign retirement plans. One commentator requested that the exclusion apply to U.S. citizens working in the United States for a foreign employer. The Treasury Department and the IRS do not believe such an exception is justified. However, the exception for U.S. citizens or lawful permanent residents has been expanded to cover nonelective deferrals of foreign earned income as defined in section 911(b)(1) without regard to section 911(b)(1)(B)(iv) and without regard to the requirement that the income be attributable to services performed during the period described in section 911(d)(1)(A) or (B). Accordingly, the exception may now cover certain participation by a U.S. citizen or lawful permanent resident who works overseas during only part of a year, and therefore is not a bona fide resident of a foreign country for an uninterrupted period that includes an entire taxable year, or is not present in the foreign country at least 330 full days during a period of 12 consecutive months. The regulations have also been modified to address nonqualified deferred compensation plans covering bona fide residents of a U.S. possession. Under the regulations a bona fide resident of a possession who participates in a broad-based foreign retirement plan is not subject to section 409A with respect to participation in such plan. In addition, a plan substantially all of the participants in which are bona fide residents of a possession is eligible to be treated as a broad-based foreign retirement plan, so that U.S. citizens and resident aliens (other than bona fide residents of a possession) who participate in such a plan may be eligible for the more limited exclusion for participation in a broad-based foreign retirement plan. Another commentator requested that the exclusion apply to a plan that otherwise meets the requirements for the exclusion, regardless of whether the plan is sponsored by a foreign or U.S. employer. This suggestion has been adopted in the final regulations. Other commentators requested further clarification and revision of certain of the requirements to qualify for the exclusion. One commentator requested a safe harbor treating any plan granted favorable tax treatment under the laws of a foreign jurisdiction as qualifying for the exclusion. The Treasury Department and the IRS believe this standard is both too broad and not administrable, and this suggestion has not been adopted in the final regulations. Another commentator requested that the regulations provide a safe harbor percentage for determining whether substantially all of a foreign plan’s participants are nonresident aliens. The final regulations do not adopt such a provision. However, the final regulations clarify that in determining whether substantially all of a foreign plan’s participants are nonresident aliens or bona fide residents of a possession, only active participants are considered. For this purpose, active participants include individuals who, under the terms of the plan and without further amendment or action by the plan sponsor, are eligible to make or receive contributions or accrue benefits under the plan (even if the individual has elected not to participate in the plan). A similar standard applies to the requirement that the individual not be eligible to participate in a qualified employer plan. The final regulations provide that a service provider will be treated as eligible to participate in a qualified employer plan if, under the plan’s terms and without further amendment or action by the plan sponsor, the service provider is eligible to make or receive contributions or accrue benefits under the plan (even if the service provider has elected not to participate in the plan). The final regulations also clarify that the exclusion for United States citizens and lawful permanent residents applies to nonelective deferrals even if elective deferrals are permitted under the same plan, provided that the amounts deferred through nonelective deferrals and earnings on such amounts are distinguishable from amounts deferred through elective deferrals and earnings on such amounts, such as through the use of separate accounts. 3. Tax equalization paymentsThe proposed regulations excluded from coverage under section 409A certain arrangements, referred to as tax equalization arrangements, that provide for payments intended to compensate the service provider for the excess of taxes actually imposed by a foreign jurisdiction on the compensation paid over the taxes that would be imposed if the compensation were subject solely to United States Federal income tax, subject to certain requirements. The final regulations adopt these provisions, subject to modifications. Based upon the comments received, the final regulations generally expand the exclusion in two respects. First, the final regulations extend the tax equalization payments exception to cover reimbursements of U.S. taxes that exceed foreign taxes. Second, the final regulations provide that the payment must be made by the end of the second taxable year of the service provider following the latest of the deadline for filing a U.S. Federal tax return or the deadline for filing foreign tax returns (or if a foreign return is not required to be filed, the due date for foreign tax payments) reflecting the compensation for which the tax equalization payment is provided. Commentators also asked how such reimbursement agreements could address the potential for an audit or other tax controversy, both in the U.S. and abroad. The same issue arises with respect to tax gross-up payments in general. For a discussion of the treatment of the right to such payments, see section VII.B.4 of this preamble. 4. Certain Limited Deferrals by Nonresident AliensThe proposed regulations provided an exception for amounts deferred by a nonresident alien under a foreign plan maintained by a foreign service recipient, to the extent the amounts deferred during the year did not exceed $10,000. The final regulations adopt this provision, subject to the modifications described in this preamble. In response to comments, the final regulations clarify that the exception applies to amounts deferred in that taxable year up to the specified limit, regardless of whether additional amounts are deferred. In making this modification, the exclusion provision has been moved from the section providing a definition of nonqualified deferred compensation plan (§1.409A-1(a)) to the section providing a definition of an amount deferred (§1.409A-1(b)). In addition, the final regulations clarify that this exception applies to earnings on amounts deferred that were subject to the exception, provided that the taxpayer can identify both the deferred amounts excepted and the applicable earnings. Finally, in response to comments requesting that the limit be increased and indexed, the final regulations increase the limit for the small deferral exception to the limit provided for elective deferrals under section 402(g). The small deferral exception is intended to provide relief to service providers that are not U.S. citizens or lawful permanent residents, are participating in a foreign plan, and perform services in the U.S. for which they are compensated. In such cases, the nonresident alien may inadvertently defer a relatively small amount of compensation that would otherwise be subject to U.S. Federal income tax. This may occur where the service provider defers the compensation that the service provider would otherwise have been paid for a brief period of service in the United States, or where the service provider receives service or compensation credit for a brief period of service in the United States under a benefit formula of a nonqualified deferred compensation plan. Some commentators requested that the exemption be extended to cover all amounts deferred by nonresident aliens under foreign plans to the extent the nonresident alien provides only temporary services in the U.S. Where the compensation earned by such a nonresident alien would be subject to U.S. income tax if paid when earned, the Treasury Department and the IRS do not believe that such a broad exception is warranted. 5. Other Foreign PlansThe final regulations adopt the exclusion in the proposed regulations for deferrals of amounts that would be excluded as foreign earned income under section 911 if the amounts had been paid out when earned. The final regulations clarify that the amount is limited to an amount equal to or less than the difference between the maximum section 911 exclusion for the year and the amount actually excluded for the year. Commentators requested that the exception for the deferral of amounts that would be excluded under section 911 be relaxed, so that U.S. expatriates who return for periods longer than 30 days or who earn compensation for services performed in the U.S. that is not excluded as foreign earned income, may also take advantage of the exception. This exception was not intended to address such plans. Rather, the provision was intended to provide relief from the section 409A requirements for U.S. expatriates who intend to work full-time outside the U.S. for compensation that is less than the exclusion amount under section 911, because it would severely disadvantage such workers to expect them to request that their potential foreign employers modify standard plans to accommodate them, or to expect such workers to otherwise be able to determine how to avoid or comply with section 409A. Commentators pointed out, however, that earnings on deferred amounts, including increases in amounts deferred under a nonaccount balance plan solely due to the passage of time, may not be treated as earned income under section 911 and argued that, nonetheless, such amounts should not lower the amount otherwise available to be deferred under the exception. The final regulations generally provide that rights to earnings credited on amounts that qualify for this exception are also excepted from coverage under section 409A, provided that the earnings satisfy the definition of earnings in §1.409A-1(o). I. Indemnification arrangementsThe final regulations generally provide that the right to the payment of contingent amounts pursuant to a service recipient’s indemnification for expenses incurred as a result of a legal claim for damages related to the service provider’s performance as a service provider, to the extent permissible under applicable law, will not be treated as the right to deferred compensation. Similarly, a right to liability insurance coverage providing for such payments in the event of such a suit also will not be treated as providing for a deferral of compensation. J. Separation pay plans 1. In general The final regulations generally adopt the provisions addressing separation pay plans set forth in the proposed regulations, subject to certain modifications. The final regulations clarify that separation pay refers only to compensation to which the service provider’s right is conditioned upon a separation from service (including a separation from service due to death or disability) and not to compensation the service provider could receive without separating from service (such as an amount also payable upon a change in control, as a result of an unforeseeable emergency, or on a date certain). For example, the right to a gross-up payment for taxes payable due to the application of section 280G will constitute separation pay if a separation from service is required to obtain the payment. The final regulations also clarify that a separation pay plan for purposes of section 409A, including for purposes of the plan aggregation rules, refers only to plans providing for payments of amounts of deferred compensation (disregarding the exceptions from the definition of deferred compensation for certain types of separation pay) where one of the conditions to the right to the payment is a separation from service. A right to a payment upon a separation from service that is not deferred compensation does not become subject to section 409A under the plan aggregation rule. For example, the accelerated vesting due to a separation from service of stock options excluded from coverage under section 409A would not constitute a separation pay plan or otherwise become subject to section 409A under the plan aggregation rules. The final regulations generally retain and supplement the various exceptions from the definition of deferred compensation for certain types of separation pay, providing exceptions for (1) certain bona fide collectively bargained arrangements, (2) certain arrangements providing separation pay due solely to an involuntary separation from service or participation in a window program in limited amounts and for a limited period of time, (3) certain foreign separation pay arrangements, (4) certain reimbursement arrangements providing for expense reimbursements or in-kind benefits for a limited period of time following a separation from service, and (5) certain rights to limited amounts of separation pay. These exceptions from coverage under section 409A for specified separation pay plans may be used in combination. For example, the rights of an employee to the maximum amount available under the exception for separation payments made solely due to involuntary separation from service or participation in a window program, to reimbursements for reasonable moving expenses and outplacement expenses that meet the requirement for exclusion from coverage under section 409A, and to rights to payments that do not exceed the limit on elective deferrals under section 402(g) and accordingly qualify for the limited payment exception, may all be excluded from coverage under section 409A due to application of the various exceptions. The final regulations continue to provide that any amount, or entitlement to any amount, that acts as a substitute for, or replacement of, amounts deferred under a separate nonqualified deferred compensation plan constitutes a payment of deferred compensation or deferral of compensation under the separate nonqualified deferred compensation plan. Commentators asked how this would apply where the service provider would otherwise forfeit a payment upon separation from service but a payment is made anyway, in whole or in part. The regulations provide that if a separation from service is voluntary, it is presumed that the payment results from an acceleration of vesting followed by a payment of the deferred compensation that is subject to section 409A. Accordingly, any change in the payment schedule to accelerate or defer the payments would be subject to the rules of section 409A. The presumption that a right to a payment is not a new right, but is instead a right substituted for an existing nonvested right, may be rebutted by demonstrating that the service provider’s right to the payment after the separation from service would have existed regardless of the forfeiture of the nonvested right. Factors indicating that a right would have existed regardless of the forfeiture include that the amount to which the service provider obtains a right is materially less than the present value of the forfeited amount multiplied by a fraction, the numerator of which is the period of service the service provider actually completed, and the denominator of which is the full period of service the service provider would have been required to complete to receive the full amount of the payment. Another factor is that the payment consists of a type of payment customarily made to service providers who separate from service with that service recipient and do not forfeit nonvested rights to deferred compensation (for example, a payment of accrued but unused leave or a payment for a release of potential claims). 2. Separation pay due solely to involuntary separation from service or participation in a window program The final regulations generally continue the exception from coverage under section 409A in the proposed regulations for rights to payments available only upon an involuntary separation from service or participation in a window program, payable no later than the end of the second taxable year of the service provider following the year of the separation from service, and limited to an amount that is generally the lesser of two times the service provider’s annual compensation or two times the limit on compensation set forth in section 401(a)(17). This exception only applies where the payment is available solely due to an involuntary separation from service of the service provider, or the service provider’s participation in a window program, and not to a plan providing for a payment upon a voluntary separation from service or other event. For a discussion of when a separation from service for good reason may be treated as an involuntary separation from service, see section III.J.3 of this preamble. Commentators requested that the exclusion continue to apply to payments up to the limit, even where the entire amount of the separation payments exceeds the limit. The final regulations adopt this rule. Accordingly, where a service provider is entitled to a payment that qualifies for the exception except that it exceeds the limit, only the excess over the limit will be subject to section 409A. The right to the payment up to the applicable limit will not be subject to section 409A, including the requirement that the payment be delayed for six months in the case of a specified employee, provided that such limited payment is otherwise required to be made, and is made, no later than the end of the second taxable year following the service provider’s taxable year in which the separation from service occurs. The final regulations clarify that for purposes of applying the section 401(a)(17) limit, the statutory limit applicable for the year of the separation from service occurs applies. The final regulations also clarify that for purposes of determining the service provider’s annual rate of pay for the taxable year preceding the taxable year in which the separation from service occurs, an annual rate of pay based upon the service provider’s taxable year immediately preceding the service provider’s taxable year in which the separation from service occurs is used, adjusted for any increase during the year that was expected to continue indefinitely if the service provider had not separated from service. One commentator requested that the limit be set at twice the amount of compensation set forth under section 401(a)(17), regardless of the service provider’s actual income. This suggestion has not been adopted in the final regulations. 3. Definition of involuntary separation from service The proposed regulations provided an exclusion from coverage under section 409A that applied only to certain amounts paid solely because of an actual involuntary separation from service or participation in a window program. Many comments asked how to determine whether a separation from service is involuntary for this purpose. The final regulations contain a definition of involuntary separation from service and also apply this definition for purposes of the definition of a substantial risk of forfeiture, pursuant to which a payment that will not be made unless the service provider experiences an involuntary separation from service is subject to a substantial risk of forfeiture for purposes of section 409A. (See section V of this preamble). The final regulations provide that whether a separation from service is involuntary is determined based on all the facts and circumstances. For this purpose, any characterization of the separation from service as voluntary or involuntary by the service provider and the service recipient in the documentation relating to the separation from service is rebuttably presumed to properly characterize the nature of the separation from service. For example, if a separation from service is characterized as voluntary, the presumption may be rebutted by demonstrating that absent the voluntary separation from service the service recipient would have terminated the service provider’s services, and that the service provider had knowledge that the service provider would be so terminated. Commentators requested that a separation from service for good reason be treated as an involuntary separation from service. The final regulations provide that where the right to a payment is contingent upon a voluntary separation from service following an occurrence that constitutes good reason for the service provider to terminate his or her services, the right may be treated as payable only upon an involuntary separation from service where the good reason condition is such that the service provider’s separation from service effectively is an involuntary separation for purposes of section 409A. To be treated as an involuntary separation for purposes of section 409A, the avoidance of the requirements of section 409A must not be a purpose of the inclusion of any good reason condition in the plan or of the actions by the service recipient in connection with the satisfaction of a condition. In addition, such good reason condition must require actions taken by the service recipient resulting in a material negative change in the employment relationship, such as a material negative change in the duties to be performed, the conditions under which such duties are to be performed, or the compensation to be received. Additional factors that may be relevant to whether a purported separation from service for good reason is the result of a bona fide good reason condition not having as a principal purpose the avoidance of section 409A include the extent to which the payments upon a separation from service for good reason are in the same amount and are made at the same time and in the same form as payments available upon an actual involuntary separation from service, and whether the service provider is required to give the service recipient notice of the existence of the good reason condition and a reasonable opportunity to remedy the condition. Where a good reason condition is sufficient to be treated for purposes of section 409A as a condition requiring an involuntary separation from service, an amount payable on account of a separation from service for good reason will be treated the same as an amount payable on account of an actual involuntary separation from service. The final regulations also provide a safe harbor under which a provision for a payment upon a voluntary separation from service for good reason will be treated for purposes of section 409A as providing for a payment upon an actual involuntary separation from service. Those conditions include that the amount be payable only if the service provider separates from service within a limited period of time not to exceed one year following the initial existence of the good reason condition, and that the amount, time and form of payment upon a voluntary separation from service for good reason be identical to the amount, time and form of payment upon an involuntary separation from service. In addition, the service provider must be required to provide notice of the existence of the good reason condition within a period not to exceed 90 days of its initial existence, and the service recipient must be provided a period of at least 30 days during which it may remedy the good reason condition. For these purposes, a good reason condition may consist of one or more of the following conditions arising without the consent of the service provider: (1) a material diminution in the service provider’s base compensation; (2) a material diminution in the service provider’s authority, duties, or responsibilities; (3) a material diminution in the authority, duties, or responsibilities of the supervisor to whom the service provider is required to report, including a requirement that a service provider report to a corporate officer or employee instead of reporting directly to the board of directors of a corporation (or similar entity with respect to an entity other than a corporation); (4) a material diminution in the budget over which the service provider retains authority; (5) a material change in geographic location at which the service provider must perform the services; or (6) any other action or inaction that constitutes a material breach of the terms of an applicable employment agreement. 4. Collectively bargained plans Commentators requested an exception from coverage under section 409A to address certain plans providing for payments upon a voluntary separation from service, in the context of a collective bargaining agreement covering services performed for multiple employers. The Treasury Department and the IRS believe these issues are better addressed in the definition of separation from service. See section VII.C.2.b of this preamble. 5. Treatment as a separate plan For purposes of the plan aggregation rules, the final regulations provide for separate treatment of plans providing for separation pay solely due to an involuntary separation from service or participation in a window program. This exception is intended to apply only where the amounts are payable solely due to an involuntary separation from service or participation in a window program, and not where the amounts may also become payable for some other reason, even where such payments actually are made due to an involuntary separation from service or participation in a window program. Accordingly, any amount that would be paid as a result of a voluntary separation from service will not be included in this category. An arrangement that does not provide for deferred compensation will not be aggregated with a deferred compensation plan under this rule, merely because the arrangement not providing for deferred compensation accelerates vesting or payment upon an involuntary separation from service (for example, the acceleration of the vesting of a stock option or stock appreciation right that is excluded from coverage under section 409A). 6. Reimbursement and fringe benefit plans a. In general The proposed regulations provided that certain plans under which a service recipient reimburses certain types of expenses (for example, reasonable moving expenses or reasonable outplacement expenses directly related to a termination of the service provider’s services) actually incurred by a service provider (including certain in-kind benefits provided to the service provider) following a separation from service are not nonqualified deferred compensation plans for purposes of section 409A, if such reimbursements are available only for expenses incurred, and the reimbursements are made, during a limited period (generally not after the second taxable year of the service provider following the separation from service). In response to questions from commentators, the final regulations clarify that a right to a benefit that is excludible from income will not be treated as a deferral of compensation for purposes of section 409A. Accordingly, for example, an arrangement to provide health coverage excludible from income under section 105 generally would not be subject to section 409A. Many commentators requested increased flexibility to provide for reimbursement arrangements upon a separation from service, including certain requests to exempt broad categories of such arrangements, such as the continuation of any plan in which the service provider participated while performing services. The Treasury Department and the IRS believe that an exemption from coverage under section 409A is not appropriate in such circumstances, because such plans may provide for rights to significant amounts of deferred compensation over lengthy periods of time. However, the final regulations extend the limited period during which taxable reimbursements of medical expenses may be provided, to cover the period during which the service provider would be entitled (or would, but for such arrangement, be entitled) to continuation coverage under a group health plan of the service recipient under section 4980B (COBRA) if the service provider elected such coverage and paid the applicable premiums. In addition, the final regulations contain several provisions governing reimbursement plans (including plans providing in-kind benefits) that constitute nonqualified deferred compensation plans for purposes of section 409A, so that taxpayers will be able to design such arrangements to comply with the payment timing requirements of section 409A. For a discussion of these provisions, see section VII.B.2 of this preamble. b. Specific exceptions for post-separation reimbursement plans The final regulations continue to exclude from coverage under section 409A the reimbursement of certain expenses such as reasonable outplacement expenses and reasonable moving expenses for a limited period of time due to a separation from service, whether the separation from service is voluntary or involuntary. The final regulations, like the proposed regulations, require that the eligible expense must be incurred by the service provider no later than the end of the second year following the year in which the separation from service occurs. In response to questions from commentators, the final regulations clarify that the exception applies to the qualifying reimbursements available during the limited period of time, even if the plan extends beyond the limited period of time. Several commentators requested that the limited period of time refer solely to the time the expense is incurred, and not the time the expense is reimbursed, to reflect the need for time to process the reimbursement request. Although the final regulations do not adopt this suggestion, the final regulations extend the period during which a service provider can receive a reimbursement payment by providing that such payments must be made not later than the end of the third year following the separation from service. This extension applies only to reimbursements of expenses incurred by the service provider. Where the service recipient provides in-kind benefits (as defined in the regulations), or the service recipient pays a third party to provide in-kind benefits, such benefits must be provided by the end of the second year following the separation from service. Commentators also requested that the final regulations clarify the treatment of rights to a reimbursement of any loss incurred due to a sale of a residence. The regulations clarify that for this purpose, reasonable moving expenses include the reimbursement of an amount related to a loss incurred due to a sale of a primary residence, provided that the reimbursement does not exceed the loss actually incurred. 7. Limited payments of separation pay The final regulations provide that, if not otherwise excluded, a taxpayer may treat a right or rights under a separation pay plan to a payment or payments of an aggregate amount not to exceed the applicable dollar amount under section 402(g)(1)(B) for the year of the separation from service as not providing for a deferral of compensation. Commentators raised questions concerning the calculation of the excluded amount, and requested an increase in the amount. The limited payment exception is intended to avoid the application of section 409A to incidental benefits often provided upon a separation from service, where the parties may not realize that the benefits are nonqualified deferred compensation. The exception is not intended to address extended or significant benefits. Accordingly, the final regulations do not substantially increase the amount of the exclusion. However, to permit the excluded amount to automatically reflect cost-of-living increases, the maximum exclusion now equals the maximum amount of an elective deferral permitted under section 402(g) for the year of the separation from service. The aggregate amount refers to the aggregate amount of payments to which the service provider has a right or rights. The exclusion may be applied to any type of separation pay plan, but may apply only once with respect to amounts paid by a service recipient to a service provider. So, for example, if a service provider treats a right to a payment of separation pay equal to the applicable limit under section 402(g) in the first year following a separation from service as an excluded right, the right to the amount is not treated as a deferral of compensation regardless of when the amount is actually paid (though other provisions of the Code and the constructive receipt doctrine continue to apply). However, once the right is treated as excluded, the service provider may not treat any other right with respect to the service recipient, such as an additional right to a payment equal to the applicable limit under section 402(g) in the second year following the separation from service, as excluded under this exception. K. Non-taxable benefits The final regulations clarify that a legally binding right to receive a nontaxable benefit does not provide for a deferral of compensation for purposes of section 409A, unless the service provider has received the right in exchange for, or has the right to exchange the right for, an amount that will be includible in income (other than due to participation in a cafeteria plan described in section 125). In addition, because such benefits do not provide for a deferral of compensation, the plan aggregation rules will not result in taxation of other benefit plans merely because the terms of such nontaxable benefit arrangements would not comply with section 409A if the arrangement were covered by section 409A. For a discussion of the requirements for a taxable reimbursement plan to satisfy the payment timing requirements of section 409A, see section VII.B.2. of this preamble. L. Legal settlements Commentators requested clarification of the application of section 409A to amounts paid pursuant to litigation between the service provider and service recipient, including both court awards and bona fide settlements, and including amounts characterized as wages or otherwise treated as replacing compensation. The Treasury Department and the IRS believe that section 409A was not intended to govern settlements or awards resolving bona fide legal claims based on wrongful termination, employment discrimination, the Fair Labor Standards Act, or worker’s compensation statutes, regardless of whether such claims arise under Federal, state, local, or foreign laws, even where settlements or awards pursuant to such claims are treated as compensation for Federal tax purposes. The final regulations generally treat such arrangements as not providing for deferred compensation for purposes of section 409A. In addition, the final regulations generally provide that section 409A does not apply to the payment of, or reimbursement for, attorney’s fees incurred in connection with the enforcement of such a claim. However, the exception covers only rights arising from the bona fide claim, and is not intended to allow such settlements or awards to act as substitutes for, or to allow for the restructuring of, preexisting deferred compensation subject to section 409A. For example, a change to the timing of the payment of a pre-existing amount of deferred compensation as part of such a settlement would be subject to the rules governing accelerated payments and subsequent deferral elections. In addition, the payment of an amount upon the execution of a waiver of any or all of such claims does not necessarily indicate that the amounts are paid as an award or settlement of an actual bona fide claim. Rather, to qualify for the exception under this provision, the amounts must be paid with respect to an actual bona fide claim for damages under the applicable law. For a discussion of the treatment of settlements of bona fide disputes regarding the right to preexisting deferred compensation subject to section 409A, see section VIII.G of this preamble. M. Split-dollar life insurance arrangements Some commentators requested that split-dollar life insurance arrangements be excluded from coverage under section 409A. Split-dollar life insurance arrangements are often used as a method of providing deferred compensation and there is no indication in the statute or legislative history of any legislative intent that such arrangements be excluded from coverage under section 409A. In addition, like a promise to transfer property in the future, a promise to transfer an economic benefit in the future may provide for deferred compensation. Accordingly, a split-dollar life insurance arrangement may provide for deferred compensation, and whether a split-dollar life insurance arrangement provides for deferred compensation must be determined through application of the general rules defining deferred compensation and a nonqualified deferred compensation plan. In response to requests for additional guidance, the Treasury Department and the IRS anticipate issuing a notice addressing the application of section 409A to split-dollar life insurance arrangements. Commentators raised issues concerning the interplay between the modifications that may be needed to satisfy the requirements of section 409A and the effective date rules applicable to split-dollar life insurance arrangements under §1.61-22(j). Commentators pointed out that the modifications necessary to meet the requirements of section 409A and these regulations may cause the arrangement to be treated as a new arrangement under §1.61-22(j) and requested relief. The notice will also address this issue. N. Educational benefits Commentators requested an exclusion from coverage under section 409A for promises to provide future taxable educational benefits to service providers. These benefits typically would be provided as an inducement to provide a period of services. Commentators expressed concern that the amount and timing of the payment of such benefits would be difficult to ascertain, because the amount and timing of the payments would depend upon the service provider’s decisions with respect to further education. The final regulations generally provide an exception from coverage under section 409A for rights to educational benefits, where the benefits consist solely of educational assistance (as defined for purposes of section 127(c)) provided solely for the education of the service provider. IV. Definition of PlanA. Plan aggregation rulesThe proposed regulations generally provided that all amounts deferred with respect to a service provider under all plans of a service recipient falling within a particular category would be treated as deferred under a single plan. The enumerated categories included amounts deferred under account balance plans, amounts deferred under nonaccount balance plans, amounts deferred under separation pay plans providing payments due solely due to an involuntary termination or participation in a window program, and amounts deferred under any other plan. The final regulations adopt these provisions, subject to certain modifications described in this preamble. The final regulations provide that the bifurcation rules applicable to plans under §31.3121(v)(2)-1(c)(1)(iii)(B), which are permissive for purposes of the application of section 3121(v)(2), must be applied for purposes of the plan aggregation rules under section 409A. Accordingly, a portion of a nonqualified deferred compensation plan is a separate account balance plan if that portion otherwise qualifies as an account balance plan and the amount payable to service providers under that portion is determined independently of the amount payable under the other portion of the plan. The final regulations also provide additional ca |
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